Trends in Corporate Governance, Proxy Fights & Poison Pills

In this study I examine activism trends, proxy fights issues and success rates, as well as arrive at defense and poison pill analytics. Poison pills in force are declining and companies are increasingly letting pills expire naturally – and with that there are fewer plans in force, resulting in a decline in the number of shareholder proposals in favor of redeeming or removing plans.

It appears that companies have seen little impact on stock price as a result of adopting or renewing a poison pill. I also shed light on triggers and historical precedent rights plans. My study reveals that historically, only a handful of companies increased the exercise price of their poison pills and in most cases this resulted in excess abnormal returns. Counterintuitively and interestingly, a targets’ ability to fend off a hostile acquirer is not dependent on having a poison pill. I then describe with examples structural defense and takeover defense.

Poison Pills – Overview & Mechanics

U.S. companies are dismantling their takeover defenses. The decrease can be attributed to companies switching to annually elected directors from staggered board terms, companies removing poison pills, and less companies providing that directors can only be removed for cause. The pace at which companies are erecting barriers against proxy contests and enacting rules to maintain tight rein over shareholder meetings has slowed significantly too. Also companies are increasingly allowing poison pills to expire.

I tackle these and other issues in our M&A series. Here I explain the general idea behind poison pills; in the event of a hostile takeover attempt, poison pills give shareholders (except for the would-be acquirer) the right to buy stock in their own company or in the acquiring company at a deep discount, if the bidder acquires a certain percentage of the outstanding shares. With other shareholders then able to buy shares at discounted price, the target company would become financially unattractive and the voting power of the potential acquirer would be diluted -i.e., acquiring the company under those terms would be like swallowing a poison pill.

Securities Lending

SUMMARY

Most institutional investors now participate in a securities lending program, whether directly or indirectly. Although securities lending income typically constitutes no more than a few basis points, given volume, the absolute dollar amount can be significant. In some cases, it can even pay for a large portion of the expenses associated with running an investment program. Securities lending income, however, is not a free lunch. The risks cannot be ignored, however small they may be. Minimizing risk should take precedence over maximizing returns.

Securities lending is a temporary collateralized loan of assets from a portfolio (lender) to a borrower. A contract between borrower and lender governs all elements of the loan. It enables beneficial owners the ability to finance their securities inventory, thereby generating incremental income. There are many reasons for borrowing securities. Some include to avoid trade settlement failure (securities sold but not available for delivery). Or to cover short trading positions. Or to support hedging, derivative, and arbitrage strategies. In other cases, it is to support Broker/Dealer efforts to match book funding. The borrower posts collateral equal to at least 100% of market value of lent securities. Collateral can take the form of cash, other securities, or letters or credit. The transfer of loaned securities and collateral constitutes a pledge. The lender retains economic benefits of the security; however, proxy voting is transferred from lender to borrower. Lender can sell securities at any time, which subject to timely advice, will be returned within normal settlement periods.

Firms engaged in this business often work with others who select approved borrowers that meet internal credit standards. They also broadcast the portfolio on an aggregate basis to identify lending opportunities. They negotiate loans, process lending transactions, and manage collateral. Routine functions include the daily mark-to-market of loaned securities and collateral as well as billing, reconciliation, recordkeeping, and reporting.

WHAT IS SECURITIES LENDING?

Market participants such as broker-dealers and hedge funds borrow securities to execute trading strategies that may include short sales or arbitrage trades. Owners of securities lend them to those who need to borrow them, in exchange for reasonable compensation. Intermediaries such as custodial banks and third-party securities lending agents help facilitate the securities lending process. Lending Agents are appointed by the lender to manage the lending decision and most are large custodians.

Many institutional investors engage in securities lending programs with the objective of generating additional revenue by taking on exceptionally low levels of risk. There is a securities lending market for both equity and fixed income securities. The industry continues to develop as new participants are attracted and new technology serves to facilitate this growth.

Investors participate in securities lending programs either directly for their separate account portfolios (portfolios that hold individual securities in the name of the investor), or indirectly through commingled or mutual funds (where the investor owns units of the fund, not the individual securities, which are owned by the fund). In the latter case, the investor has no control over the securities lending program, as the lending guidelines are determined by the fund companies.

HOW DOES IT WORK?

There are two basic ways to structure a securities lending program:

  • Principal-basis
  • Agency-basis

In a principal-based securities lending program, the investor agrees to lend the entire portfolio (or specific portions) to a single borrower on an exclusive basis. Major borrowers are securities dealers and banks, ranging from US Broker & US Gov’t security dealers to universal banks.  So, essentially, anyone in the business of dealing in securities is a potential borrower. Many borrowers may not be borrowing just to meet their own proprietary trading needs, so they act as intermediaries by relending to the ultimate borrower, or end-user.  The end-users typically are hedge funds, abitrageurs or other institutional investors. In exchange for exclusive rights, the borrower will typically guarantee either a minimum portfolio percentage on loan, or some minimum revenue target.

U.S.-based institutional investors predominantly participate in agency-based securities lending programs. In this case, a lending agent attempts to lend the portfolio on a best-efforts basis. The lending agent could be the custodial bank, or a third-party agent. The exhibit provides a schematic of the basic steps in a program.

  • The lending agent finds a borrower for the securities. The borrower deposits collateral – either cash or non-cash – with the lending agent. The loan is typically collateralized at around, depending on markets, 102% for domestic securities and a bit higher for riskier for non-U.S. securities. The collateral is marked-to-market daily. In the case of cash collateral, the lending agent negotiates the interest rate to be paid on the collateral to the borrower of securities, referred to as the rebate rate. In the case of non-cash collateral, the lending agent negotiates a fee to be paid by the borrower.
  • The lending agent invests the cash collateral in capital markets with the goal of earning something over and above the rebate rate.
  • When the loan is no longer required, the borrower returns the securities to the lending agent. The close-out of the loan may occur because the borrower no longer needs the security, or because the owner needs the security returned due to a sale by the portfolio manager. At this stage, the lending agent returns the cash collateral plus the agreed-upon rebate rate to the borrower.
  • The difference between the return earned on the cash collateral investment and the rebate rate is the gross spread. The lending agent retains a portion of the gross spread as its fee and credits the remainder to the owner of the securities.

REVENUES DEPEND ON:

  • Lendable portfolio value.  The value of the securities available for lending. Non-lendable investments include private equity, real estate, and investor shares in commingled/mutual funds.
  • Type of securities.  Small-cap domestic stocks, international stocks and treasuries are in greater demand in the securities lending market than large-cap domestic stocks and corporate bonds.
  • Percentage of portfolio on loan.  The greater the proportion of the portfolio on loan, the greater the potential for securities lending revenue. The average percentage of the portfolio on loan depends on the type of securities in the portfolio, as well as the ability of the securities lending agent to loan them out.
  • Rebate rate.  The rate of interest paid to the borrower of a security on the collateral. In general, the rebate rate negotiated will be low if the security being lent is in short supply.
  • Return on collateral investment.  The higher the return on the collateral investment, the greater the revenue generation.
  • Spread.  Difference between the return on collateral investment earned and the rebate rate paid.

The gross return from a securities lending program can be expressed as follows:

Gross Securities Lending  Revenue = Lendable Portfolio Value  x  Percentage on Loan  x  Spread

The securities lending agent typically retains 15% to 35% of the gross revenues from securities lending programs as its fee. The balance is the net revenue to the investor from securities lending. The split typically depends on the securities lending revenue-generating potential of the portfolio.

RISKS IN A SECURITIES LENDING PROGRAM

Key risks include:

  • Collateral Investment Risk.  The greatest risk in a securities lending program comes from collateral investments. Even aggressive collateral investment guidelines are unlikely to add more than a few basis points annually to the return of the overall fund, while the downside, can be meaningful.

Collateral investments typically take on duration risk and credit risk to enhance the securities lending revenues. Security loans can be considered as overnight transactions that are rolled over daily. Collateral is typically invested in instruments with longer maturities to try to capitalize on higher yields (assuming an upward-sloping yield curve), creating an asset/liability mismatch. Collateral losses can result if interest rates rise (interest rates and the value of fixed-income securities are inversely related – a rise in rates causes the market value of a bond to decline, and vice versa). Returns are also enhanced by taking on some credit risk. Losses can occur if spreads widen, the issuer of the fixed-income paper is downgraded, or the issuer defaults. Securities lending can be viewed in a sense as fixed-income leverage.

  • Borrower Risk or Counterparty Risk.  Borrower risk is the risk that the borrower does not return the borrowed securities. Borrower risk can be controlled by approving only high quality borrowers, setting individual borrower limits, and regularly monitoring the borrowers. Further protection is available to the lenders in the form of the collateral deposited by the borrowers (102% to 105%) which is marked-to-market on a daily basis. Indemnification against borrower default is typically offered by the lending agent or can be negotiated in a securities lending program. In a principal securities lending program, the entire counterparty risk is with a single borrower, unless the portfolio has been split into various pools and distributed among various principal borrowers to achieve diversification.
  • Operational Risk.  Securities lending involves a number of moving parts. Collateral has to be collected in exchange for lending securities; collateral has to be marked-to-market daily; compliance of borrower limits have to be monitored; corporate actions on securities need to be tracked; securities lent have to be recalled when sold, and so on. Securities lending agents should have processes in place to manage each aspect of a securities lending program to minimize the operational risk.

It is common industry practice for the lending agent to earn a portion of the securities lending revenues but not share in the losses on collateral investments. This asymmetric reward structure could motivate the lending agent to take undue risks. In the past securities lending programs have incurred losses as a result of an increase in interest rates. In most cases, the lending agent covered the losses even though it was contractually not obligated to do so. Also, some securities lending programs have incurred losses due to issuer defaults in the collateral investments.

Investors can certainly lose money by participating in securities lending programs, but losses have been few and far inbetween. Although the reward structure for the agent is not necessarily aligned with the interest of the investor/lender, in general the business risk from losses in a securities lending program have served as a check on lending agents. Collateral investment risk can be virtually eliminated by investing in duration-matched government securities/repurchase agreements, but this can significantly reduce (if not eliminate altogether) the revenue-generating potential, which might make a securities lending program unviable for many institutional investors. Most lending agents offer a choice of collateral investment pools with different risk/return characteristics. The collateral investment pools attempt to control risk by approaches such as evaluating each credit, investing in high-quality instruments, limiting the maximum duration and maturity, and limiting the maximum investment in the paper of a single issuer.

Large institutional investors can also specify that their collateral be managed separately according to guidelines tailored to their needs. If the collateral to be managed is not substantial, though, diversification may not be achieved to the same extent as in the collateral investment pools.

CONCLUSION

A carefully structured securities lending program can help offset some plan expenses. Investors need to determine the amount of risk they are willing to take and it is best to be conservative. The objective in a securities lending program should be to minimize the risk of loss, not to maximize income.

USPS Should Exit the Real Estate Business

United States Postal Service (USPS) is in dire financial straits and in desperate need of reform. Privatization is not an option.  Monetization of its real estate portfolio offers significant potential strategic, financial and operating advantages. I examine its portfolio of asset holdings and show how asset monetization can still support its strategic, financial, operational and execution objectives. I also show how this can be done – given political will.

Alternative Investments in SWF and Central Bank Portfolios

The proceedings of the global Public Investors Conference jointly hosted by World Bank, Bank for International Settlements, and the World Bank were published by Palgrave Macmillan in a book “Portfolio and Risk Management for Central Banks and Sovereign Wealth Funds“. This book contains original readings on Reserves Management for central banks and sovereign wealth funds.

I had the privilege to participate as speaker, and also contributed a chapter “Alternative Investments in SWF and Central Bank Portfolios“. I found the extract chapter online and here it is.

Are Sovereign Wealth Funds Suave Tactical Opportunistic Investors?

It appears not. As a cohort they are largely benchmark huggers with varying degrees of core-satellite active-passive combinations. To further answer this, I examined SWF activity during multiple periods of extended market dislocation as well as economic and financial crisis. In examining history, one period stands out however, where 12 SWFs were very active in distressed deals deploying huge amounts of capital. This was during the global financial crisis of 2007-08 where these deep pools of permanent capital participated extensively in bank recapitalizations, for which they were well rewarded. I have reconstructed these transactions as well a provided the market reaction by way of augmenting flavor.

At ActiveAllocator.com we continue to monitor deal activity as well as research notable historic transactions for lessons.

Spin-Offs and Carve-Outs

As the Covid-19 induced crisis progresses, we expect companies to separate portions of business. Such actions will be driven by strategic decisions to divest businesses and/or valuation creation opportunities. These may take form of spin-offs, carve-outs or sales.

Primary reasons for spin-off include (i) Value creation – both for parent company and new separate public company; (ii) Certainty of execution; (iii) Tax free to parent and its shareholders; (iv) Can be run parallel with other divestiture alternative. These are typically a 6-12-month process that involves carving out a business from the parent (e.g. financials, management). It involves various documentation and filing requirements (e.g. SEC filings, IRS private letter ruling) and may or may not be preceded by an IPO. We provide an overview here.

When Should a Country Establish a Sovereign Wealth Fund?

ActiveAllocator has researched the economic conditions of countries with SWFs prior to their establishment. Our objective has been to uncover economic conditions in place to help determine the timing for the creation of future SWFs. We chose key relevant  budget and balance of payment economic ratios from 18 countries, and focus our analysis on the five years prior to the inception of each country’s respective SWF. These ratios, many normalized for GDP, are the GDP growth rate, inflation, fiscal balance, trade balance, financial account, current account, foreign exchange reserves and levels of external debt. To bring specificity to context I also compared a particular nation’s (name anonymized) ratios that is now considering establishing a SWF, with summary ratios from other countries that have already established SWFs. The exercise provides both summary and individual indicators at the time prior to establishing a SWF. It may also serve as a framework for policy makers considering setting up new SWFs.

Our findings reveal, there is no ideal timing or any one measure that must be at a certain level to create a SWF.  In fact, many countries have created SWFs in the face of deficits, inflationary periods and low growth.  However, in most cases, the overall economic picture was pointing in a positive direction prior to inception.

Decluttering HealthCare – a System Dynamics Approach

I took a long hard look at the confusing HealthCare sector, replete with acrimonious public debate in the U.S. To arrive at inter-sector allocation we leaned heavily on the System Dynamics discipline conceived at MIT – one that ” can help us better understand complex challenges, shape policy, influence decision-making, and yield lasting benefits for businesses and society.” I present a preview of how we transcend traditional thinking to arriving at an understanding of what HealthCare investing is really all about. Schematic representation of elements, processes and pathways can be further developed in a comprehensive system dynamics model.

Measuring Political Risk Premium

Sovereign spreads sometimes overstate and sometimes understate the actual extent of an investment’s “political risk”, for example. We suggest an alternative to spreads between Sovereign Bonds of the country and US Treasury as proxy for country risk premium. The Political Risk Premium (PRP) can be arrived at from Residual Income Value (RIV) implied cost of equity for the companies in EM and then compared to the weighted average cost of equity of global peers.

Anatomy of Ecuador Sovereign Debt Exchange Transaction

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Ecuador – 2000 Sovereign Debt Exchange Transaction Anatomy

In order to include Distressed Sovereign Restructured Debt as an asset sub-class within ActiveAllocator we examined the past 30 sovereign default crisis with 270 bonds in multiple emerging markets including Argentine, Bulgaria, Colombia, Ecuador, Iraq, Mexico, Nigeria, Panama, Peru, Philippines, South Africa, Turkey, Ukraine,  Venezuela etc. Given the large variation of returns between crisis episodes, aggregating statistics from these events is a spurious exercise; the sample size is much too small, restructurings idiosyncratic, haircuts and losses vary widely as well as heterogeneous debt security-level characteristics.

Our approach is to parse the anatomy of each restructured deal – restructuring defined as a distressed debt exchange in which creditors receive instruments with less-favorable terms than the original issues -beginning with an examination of the original debt offer documents as well as the specifics of each deal.

Wall Street Journal, July 18, 2020 “ Funds Clash Over Deal on Ecuador “

To swap $18 billion bonds into new that pay lower interest with delayed maturity. Restructuring debt proposals create creditor – including Ashmore Group, BlackRock, T. Rowe Price, Contrarian Capital – differences in how different bonds are to be treated. New transactions being asked to linked to ESG goals.

  • Ecuador seeking to restructure debt during coronacrisis, and lower oil prices given new liquidity and debt sustainability challenges
  • Oil dependent economy heavily reliant on external credit where external interest payments are 10% of current external receipts
  • For history of Ecuador Debt Restructuring we recommend: Feibelman, A. (2017). Ecuador’s 2008–2009 Debt Restructuring. In J. Bohoslavsky & K. Raffer (Eds.), Sovereign Debt Crises: What Have We Learned? (pp. 48-64). Cambridge: Cambridge University Press. doi:10.1017/9781108227001.004
  • We examine here the  anatomy of  Ecuador Debt Exchange Transactions — 2000 , the first instance of default in Brady Bonds

Argentina Sovereign Debt Case Study – 2001

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Argentina -Sovereign Debt Exchange Transactions 2001 Anatomy

In order to include Distressed Sovereign Restructured Debt as an asset sub-class within ActiveAllocator we examined the past 30 sovereign default crisis with 270 bonds in multiple emerging markets including Argentine, Bulgaria, Colombia, Ecuador, Iraq, Mexico, Nigeria, Panama, Peru, Philippines, South Africa, Turkey, Ukraine,  Venezuela etc. Given the large variation of returns between crisis episodes, aggregating statistics from these events is a spurious exercise; the sample size is much too small, restructurings idiosyncratic, haircuts and losses vary widely as well as heterogeneous debt security-level characteristics.

Our approach is to parse the anatomy of each restructured deal – restructuring defined as a distressed debt exchange in which creditors receive instruments with less-favorable terms than the original issues -beginning with an examination of the original debt offer documents as well as the specifics of each deal.

The Wall Street Journal, July 8, 2020  reports” Argentina Bonds Rise On New Debt Deal ” : Average recoveries around $53.50, swaps existing bonds to newer lower interest paying, delayed maturity..

Earlier on May 23,  2020 The Wall Street Journal reported  ” Argentina Defaults on Sovereign Debt Amid Coronavirus Crisis – The country is struggling with economic contraction, runaway inflation and a hard-currency squeeze”

Argentina defaulted on sovereign debt for the ninth time in its history, as Latin America’s third-biggest economy grapples with a new cycle of economic contraction, runaway inflation and a hard-currency squeeze exacerbated by the coronavirus pandemic. The cash-strapped country officially entered into default on Friday after failing to make a $500 million interest payment on foreign debt. The…

We examine here the  anatomy of historical instances of Argentina Debt Exchange Transactions — February and June 2001

–Argentina Reverse Dutch Auction exchange – February 2001 when the Republic successfully exchanged over $8.0 billion of international and domestic securities

–Argentina “Mega Debt Exchange”—June 2001 when the Republic successfully executed a $29.5 billion debt exchange of 46 eligible international and domestic debt securities

Capital Distribution Decision – Share Buybacks

The Fed now allows the nation’s big banks to resume share buybacks in the first quarter of 2021 though dividends will continue to be capped. Banks have healthy key capital ratios and augmented loss absorption capacity. Meanwhile to preserve cash during the pandemic many S&P 500 companies suspended buybacks.

I examined 6045 Company announcements over the years and was positively pleased to see a direct relation between share repurchase size and excess returns at announcement. Both self-tender offers and open market repurchase programs have historically generated lasting excess returns. Also I found that multiple repurchasers benefit from large repurchase announcements. And share repurchase can enhance EPS growth, inter alia. When tax rates on dividends and capital gains are equivalent, share buybacks give investors the option to benefit from continued appreciation and defer taxes by selling shares at later date.

Contents : Distribution Decision, Dividends vs. Share Repurchases, Positive Effects of Distributions, Positive Reaction to Share Buybacks, Special Dividends for S&P 1500 Companies, Open Market vs. Tender Offers , Share Repurchase Can Enhance EPS Growth, Formulating a Repurchase Strategy, Tender Offer Program Overview

Merger Arbitrage – Hedging the Time Period Deal Risk in M&A

In public market M&A transactions, where at least part of the consideration is stock of the acquiror public company, the value offered is subject to market risk as the acquiror’s stock price changes. Collars – long underlying, long put options, financed with short call options-  provide some degree of price protection to acquiror and target between signing (announcement) and closing.  Valuing the hedge correctly is key to making profitable M&A arbitrage trades.

Anatomy of Master Limited Partnerships——

This year I have substantially augmented our algorithms and allocation methodology to better reflect the inclusion of  Master Limited Partnerships within asset allocation and portfolio construction.

The MLP is a publicly traded partnership formed to own and operate natural resources assets. Suitable assets are stable cash generating assets that qualify under the tax code for certain advantages. Its tax efficient structure eliminates double taxation at the corporate level, and it allows for tax efficient contribution of assets from a sponsor into the MLP. Moreover, it allows a sponsor to contribute assets without relinquishing control through ownership of the partnership’s General Partner. Investors expect an MLP’s asset base to provide a pre-established minimum quarterly cash distribution with some expectations for internal and external growth while recognizing that incentive distributions to the sponsor reduce upside potential.

Contents: Overview of the MLP Structure, History, What is an MLP?, Concept, Creation: Key Criteria, Asset Areas, Typical Investor Questions, General Pros & Cons, Issuer/Sponsor Perspective, Illustrative Term Sheet, Illustrative IPO Valuation, The GP / LP Relationship, Distribution Policy, Tax Example: Cost Basis Illustration, Fees & Incentive Plans: Case Studies, Governance: Case Studies, Typical IPO Timetable

Rising Protectionism in Cross-border Inbound U.S. M&A

Protectionism includes foreign investment restrictions, antitrust regimes and takeover rules that regulators use to block or influence deal outcomes. Protectionism and trade barriers and inward-looking sentiment is seeping into policy and regulation. There have been many changes in discussions between Congress and Committee on Foreign Investment in the United States (CFIUS). Opposition is no longer just vocal; a lot of activity is taking place behind the scenes in Washington. Constituency interests, too are crowding out traditional policy interests. I describe what’s happening:

Contents:

M&A Activity Especially Inbound Drastically Reduces

Protectionism Norms: Evolving

Protectionism in Foreign M&A Deals: U.S. Actors

Protectionism in Foreign M&A Deals: Rising 

Foreign M&A Deals: Typical Post-Announcement Timeline Delay

Reaction to Japanese Investment: Exon-Florio Amendment

Exon-Florio Overview

CFIUS Reform: FINSA and FIRRMA

Reform: Overdue

Due Diligence Check List Questions: Acquirer

Post-Announcement Timeline

Post CFIUS >SEC Review Process

Share Purchase Considerations

Allocating to Alternative Investments

A pre-requisite for constructing any great portfolio is identifying skilled managers that an investor believes can consistently generate alpha. Although investors intuitively recognize the value of alpha, they have historically lacked the tools required to build portfolios that include active managers. ActiveAllocator addresses newer challenges by designing a rigorous, integrated and, perhaps most importantly, practical framework for active investing. Extensive testing provides evidence that our framework can significantly improve upon more traditional portfolio construction methods. Our approach is unique in that it:

  1. More accurately measures manager alpha and beta on historical basis.
  2. Explicitly forecasts manager performance by combining historical data with other information.
  3. Quantifies unique risks of active managers.
  4. Accounts for these unique risks when constructing portfolios.

While the details of this approach are outside the scope of this note we summarize the general characteristics of alternative investments here.

The Capital Allocator’s Perspective

Due Diligence Framework for Direct Investing.

The capital allocator is in the business of entering into partnerships with fund sponsors to potentially generate significant returns, mainly through long-term capital appreciation, by making, holding and disposing of privately negotiated equity and related investments. Such investments are usually made as a passive investor in vehicles directed by a third party fund sponsor; as a result, the investor has only indirect influence over-achieving ultimate investment objectives. I believe that a methodical approach to selecting sponsors—which combines scientific rigor with seasoned subjective judgment— may contribute to creating strong results in a variety of economic environments.

I present here a ‘best practices’ framework for selecting financial sponsors. I draw attention to important issues, metrics and considerations deemed worthy of exploration. What follows does not represent an exhaustive list, of course. Each investment and operational diligence mission inevitably take one down paths that are not common to other missions. One must be prepared for this—and even seek it and relish it. For, it is forays beyond the common and readily available, that enable real insight into the people with whom one entrusts with one’s capital.

I had written a piece way back when I allocated capital to inform my own understanding. Here is an updated version.

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Reflections on the Global Financial Crisis 2007- European Banks

As this decade closes, I reflect that as defining the Covid pandemic crisis has been to this decade, the Global Financial Crisis was to the previous. Narratives analyzing the 2007 GFC have been largely US centered, long on prose and short on detail. Not much is written on how the European banking sector was affected and the manner in which European banks navigated the 2007 GFC.

In this presentation I show that the combined misjudgments of central banks, regulators, rating agencies, investors and bankers  led to a buildup of an unsustainable amount of leverage in the global financial system. This was further exacerbated by the normal peak and downturn of the credit cycle in 2007-2008. Extreme volatility in dislocated markets tested negative correlation assumptions. Financial turmoil limited banks’ ability to transfer loans off balance sheet to ABS and secondary markets and resulted in the consolidation of conduits and SIVs.  Consequently, unplanned asset growth put bank capital ratios under pressure. Write-downs on sub-prime exposures, leveraged loans and impacted asset classes led banks to raise capital through equity and equity-linked markets or directly from sovereign wealth funds. Central Banks, much as they did during the Covid crisis, took bold actions to stimulate market liquidity as well as the economy.  This focus provided sufficient liquidity to keep interbank markets functioning;  banks recapitalized, loans were guaranteed, special liquidity schemes instituted as well as multiple other actions taken. Coordinated policy and response measures included political guarantees, deposit guarantee, rescue debt, collateralization and other actions. European banks subsequently raised capital, increased liquidity, reduced their U.S. structured credit exposure and relied on the economy to recover to reduce non-performing loans.

I conclude that during such crisis banks themselves have much recapitalization, balance sheet and business model restructuring to undertake. These are best done in close cooperation with governments and regulators. 

Convertible Debt and Hybrid Securities

Convertible Debt and Hybrid Securities are notoriously hard to value and near impossible to include purposively within asset allocation and portfolio construction methodologies. As equity-linked financing alternatives now abound, their variants too preclude a one size fits all approach. For example the Bond Hedge & Warrant (“BH&W”),  a structural enhancement to a convertible bond to effectively raise the conversion premium, adds complexity. Hybrid capital securities have evolved to now refer to a range of non-dilutive fixed income instruments that incorporate equity-like features. The accounting treatment for such securities too differs from those applicable to traditional in the United States.  

I highlight these and other considerations in our latest research piece. In this presentation I address five key areas of interest ; (i) What are Convertibles and Why are They Issued?; (ii) Overview of Convertible Debt; (iii) Overview of High-Equity Content Convertibles; (iv) Accounting Review; (iv) Investors and Market Dynamics

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Investment Banking – How to Buy a Company?

I have spent the bulk of my career in wealth management, asset management, investment banking and more recently in entrepreneurial FinTech. To develop domain expertise and bridge the gap between theory and practice I’ve published extensively over the years – though never around investment banking. The investment banking practitioner space doesn’t have much literature and one learns on the job. It is an incestuous world, with high entry barriers, much like the guilds in the medieval age to preserve high rents and transaction fees. I bring sunlight to this space here by explaining the typical process of buying a company.

Contents: Buy-Side Process, Assessment, Bidding Strategy, Negotiation and Execution, Transaction Considerations, Structure, Regulatory Issues, Financing, Accounting Treatment, Takeover Defenses, Valuation Methodologies, Tender and Closing, Timeline, Role of Advisor

Special Purpose Acquisition Corporation – SPAC

October 2020 has 290 SPACs with $86.5 billion in cash that have either filed for IPOs, are searching for targets, or have announced proposed mergers. I put on my investment banker hat and describe how a Special Purpose Acquisition Corporation can be set up. I then put on my investor hat and describe by modelling a hypothetical deal how sponsors and IPO pre-merger investors stand to make money and post-merger investors loose.

Takeaways: (i) SPAC is not a  poor man’s private equity, much as Alternative Mutual Fund is not a poor man’s hedge fund; (ii)SPAC structure results in severe dilution of the value of SPAC shares : post-merger share prices fall and price drops are highly correlated with dilution or cash shortfall ; (iii) SPAC investors bear structural cost of the dilution band pay for companies they bring public; (iv) SPAC creates substantial costs, misaligned incentives, and losses for investors who own shares at the time of SPAC mergers: SPAC shares tend to drop by one third of their value or more within a year following a merger (iv) Only those who buy shares in SPAC IPOs and either sell or redeem their shares prior to the merger do very well ( typically 10-13% historical annual return): IPO investors who are pre-merger shareholders should exit at the time of the merger, either by redeeming their shares or selling them on the market; (v) Investors that buy later and hold shares through SPAC mergers bear the costs of the generous deal given to IPO-stage investors (vi) Sponsor’s promote, underwriting fees, and dilution of post-merger shares caused by SPAC warrants and rights transfer value from SPAC investors to pre-merger investors; (vii)Sponsor has an incentive to enter into a losing deal for SPAC investors if its alternative is to liquidate.

Bankruptcy Primer

Bankruptcy- What exactly is it ?

I’ve been studying bankruptcy as part of a wider project around distressed and event driven investing. I came across a lot of jargon and had to Google extensively. To clarify concepts for myself I took it upon me to write a simple primer that I am sharing here. (Nothing very original here as it’s stuff I found in different places on the internet).

Management Compensation in LBO

How do management teams get compensated during private equity deals?— —
This is an opaque area and has been largely kept hush. So using my own proprietary and coinvestment deal data as well as copious notes I’ve taken over the years, I examined 29 private equity buyouts (all in the U.S.) to arrive at real world insights into team compensation. I provide color here on components such as retention bonus, transaction bonus, new equity incentive, equity rollover and other general comp characteristics.

As these deals are private I am not identifying them by name nor sharing anything more than aggregated insights.