Courtly Love

Contrary to the cynicism that can pervade discussions of [mergers and acquisitions], many top level M & A advisors have a genuine concern about the integrity of large scale transactions and a desire for the fiduciaries involved to serve the interests they represent in a good faith and effective way. This is not to say that they do not seek to advance the interests of their clients in obtaining legitimate economic advantage, but they do want the game to be a fair one.

— Leo E. Strine, Jr., Chief Justice, Delaware Supreme Court ^1,2,3

¹ While I appreciate Chief Justice Strine’s sentiment and respect for the basic integrity and desire for fair play which does indeed hold sway among the large majority of professional advisor participants in M&A processes, I find his proposal that we make our lives—and those of our clients—before his and other benches easier by documenting in much greater detail the twists and turns of our recommendations and analyses in medias res of transactions to be both impractical and naive. Surely Chief Justice Strine, among all jurists, must appreciate the role accident, error, and chance play in almost every complex process such as a merger or acquisition and how, even when said twists and turns are faithfully and comprehensively memorialized the twin imps of imperfect memory and hostile interpretation can confuse and bedevil the faithful interpretation of the facts of the matter. I suspect Mr. Strine, being both professionally empowered and constitutionally predilected for the role of fact finder and detective, simply prefers a clearer trail of evidence to allow him to judge the facts of the case properly and render more equitable judgments. However, I also suspect virtually no internal or external investment bank counsel or deal lawyer of any kind will be remotely interested in providing more potential fuel for the fires of devious and aggressive plaintiffs’ counsel for the sole purpose of making Justice Strine’s and his colleagues on the bench’s jobs easier. After all, that is why they pay him the big bucks and solicit him to speak at ABA conferences: because his job is difficult. Plus, we never know when some bozo will relocate litigation jurisdiction away from the Halls of Justice and Light in Delaware to some one-horse hick town in Texas where the judges don’t even know how to read PowerPoint. I’ll go out on a limb and reckon his suggestion is not gonna happen anytime soon. It was a nice try, though.
² This quote also reminds me of an excellent article by philosopher David Papineau, who wrote about the distinction which can be drawn between the rules of the game and the notion of fair play in both sport and politics. I think a similar analysis could be performed for the highly ritualized, rule bound competition which is mergers and acquisitions. Maybe if you’re nice to me and send me a fruit basket I’ll undertake such an explanation one day.
³ Does it count as a blog post if the chief substance of your remarks lies sequestered in footnotes? Does it count as a speech? Did Chief Justice Strine read each and every footnote as well when he delivered his speech? These are some of the mysteries which consume my restless nights.

© 2014 The Epicurean Dealmaker. All rights reserved.

Amakudari Revisited

Thomas Nast, Mr. Moneybags

“If you were sensible of your own good, you would not wish to quit the sphere in which you have been brought up.”
“In marrying your nephew, I should not consider myself as quitting that sphere. He is a gentleman; I am a gentleman’s daughter; so far we are equal.”
“True. You are a gentleman’s daughter. But who was your mother? Who are your uncles and aunts? Do not imagine me ignorant of their condition.”
“Whatever my connections may be,” said Elizabeth, “if your nephew does not object to them, they can be nothing to you.”

— Jane Austen, Pride and Prejudice

Newly listed advisory boutique Moelis & Company set the cat among the pigeons yesterday by announcing it has hired former House Majority Leader Eric Cantor to be a director of the company and a Vice Chairman in their advisory group. This news seems to have pleased approximately everybody, from Moelis & Co., which is delighted with their prominent and newsworthy new hire; Mr. Cantor himself, who can anticipate being approximately $3.4 million richer over the next 18 months or so; and up to and including critics of the Washington-to-Wall Street revolving door, who are now in possession of rich fodder for tut-tutting opinion pieces bemoaning the sorry state into which our crony capitalist democracy has sunk. In Washington, D.C. and on Wall Street as well, it is an ill wind that blows nobody any good.

While the generous cash and restricted stock which Mr. Cantor is receiving from his new employer seems to have been viewed by most as sufficient and self-evident explanation of why he chose to accept Moelis’s offer, there does seem to be some confusion among certain commentators as to why Moelis wanted him. Dennis Kelleher, former Senate staffer and head of non-profit public interest lobbying group Better Markets—about which nobody was talking last week and about which everybody (or at least a larger number of somebodies) is talking this week, thanks to said announcement—claims loudly that Moelis hired Cantor because 1) they wanted the publicity, 2) they want his political insight and connections to lobby for legislation and regulation favorable to their business, and 3) they want to matter more in Washington. While Matt Levine effectively deflates the more grandiose and overreaching of Mr. Kelleher’s claims—and particularly punctures the notion that a focused advisory boutique like Moelis & Co., which faces few of the proprietary trading or balance sheet capital issues its larger integrated universal bank competitors do, has common cause with said competitors in shaping the larger regulatory agenda—I cannot disagree with the broad outline of Mr. Kelleher’s remarks.

The important nuance which I would add, however, is that Moelis’s hire of Mr. Cantor must be examined in light of their mission as a client-focused advisory firm. Mr. Kelleher’s claims gain more weight if one properly understands that, notwithstanding the official job titles which Moelis & Co. have granted the deposed ex-Congressman, his real role at the company should be understood as Pet Famous Politician.¹

As such, Mr. Cantor has several interrelated roles and duties:

• Publicity magnet – To raise, by his very presence, the profile and awareness of Moelis & Company in Washington, D.C., the news media, and the general population at large. Ken Moelis, while broadly known on Wall Street and among the business community, does not carry the star wattage to pull this off by himself. This is known as general brand advertising.
• Fame whore magnet – Notwithstanding all their wealth, power, and influence in the economy—and their often low opinion of and fraught relationship with government—even the most illustrious businessperson tends to get a flutter of excitement when they meet a well-known politician. This can probably be laid to the fact that even the meanest politician tends to have fame and celebrity status well in excess of the average business leader, and almost everybody is curious to meet a celebrity. It also probably has to do with the fact that politicians tend to have power, and business people tend to be the kind of people who are attracted to power.
• Door opener – As Messrs. Kelleher and Levine both agree, Mr. Cantor is neither trained in nor necessarily exhibits any of the transaction processing skills of an advisory investment banker. Nevertheless, Mr. Cantor is likely to have some contacts in his Rolodex whom his new colleagues would love to get in front of to pitch their wares, and I am sure they will hand him a prioritized call list as soon as he walks in the door. Even if Mr. Cantor does not personally know all of his employer’s prospective clients, senior calling officers will be eager to use him as bait (see Fame whore magnet, supra and Subject matter expert, infra) to get that key meeting with a high priority target CEO or Board of Directors which they’ve been trying to break into for ages. The kind of large, high profile clients which a Moelis & Co. wants to work with tend to have overwhelming numbers of investment bankers constantly importuning them for business and usually limit their work to a small handful of trusted relationships. Hence they tend to keep unknown bankers at a firm arms length. The flimsiest excuse to get a client to open the door and take a meeting—“Hey, come meet the former House Majority Leader of Congress!”—is welcome. Besides, correctly or not, most senior bankers believe once they get in front of a client they have the skill to win the assignment themselves; all it takes is access. Mr. Cantor will only have to smile, relate a few political war stories, and then shut up.
• Subject matter expert – Our ex-Congressman does have one obvious skill set which is highly valuable in corporate advisory work and which is cultivated assiduously by senior bankers eager to build a name and a business for themselves: he is very well connected and extremely knowledgable in an important segment of the economy and the dealmaking environment. The fact that his subject matter is relevant in multiple dimensions to almost every business which Moelis & Co. would like to serve is just icing on the cake. Chief Executives and Board directors will be exceedingly interested in the insights Mr. Cantor can share about who knows what, who hates whom, and how things get done inside the Beltway, because in almost every instance that will have a direct effect on their daily business and/or the particular capital raising, M&A, or corporate finance transaction at hand. This is an area where Mr. Cantor will be able to add real content to the discussion and share valuable information and intelligence all on his own, and it won’t involve him smiling and shaking hands like a bobble doll.
• Deal originator – Of course, under the right circumstances, there is nothing to prevent Mr. Cantor from using the assets and attractants listed above to source his very own transactions, instead of just contributing to those of his colleagues. This would certainly entitle him, in my book, to a shot at much larger incentive compensation than Moelis & Co. have guaranteed him for joining the firm. There is also circumstantial evidence that Mr. Cantor may indeed have key senior investment banker skills of a high order. After all, a very large component of his job as Congressman and House Majority Leader involved selling, creative dealmaking, and high stakes, high pressure negotiation. These are the critical skills a senior investment banker must bring to bear to win assignments and close transactions, not filling in spreadsheets or wordsmithing press releases. That’s what the little people do. If Mr. Cantor is looking for inspiration along these lines, he could do worse than consult the case of Rahm Emanuel, who turned a senior political aide position in the Clinton administration into a two-and-a-half year stint at Wasserstein Perella that earned him over $18 million.

Perhaps Mr. Cantor is not quite so unworthy after all.

* * *

Of course, in your wonted role as Clever and Discriminating Readers, you delightful people will already have noted that nowhere in my speculative litany of tasks for which Moelis & Company may have hired our peripatetic politician is the duty of lobbyist. It is possible, of course, that his employer does anticipate fielding Mr. Cantor back inside the Beltway when his current restrictions expire. But, if so, I suspect any such lobbying will be indirect and done on behalf of clients rather than for Moelis & Co. itself. In fact, I venture to guess Mr. Cantor will most likely offer access and intelligence on whom to contact within government to his employers and clients, rather than leading any direct or indirect lobbying charge himself. After all, if he pulls off his other roles appropriately, he will be both too busy and making too much money for the firm to spend much time hanging out with politicians and regulators.

I suppose this is the best explanation of both Mr. Cantor’s appeal to an investment bank like Moelis and the amount of money a former Congressman like him can make via amakudari. Like it or not, government is important to business, and the people who know how it works, how to make it work, and whom to work to make it work carry extremely valuable intelligence, even if they do not meddle directly in the process. In fact, I suspect Moelis & Co. spends less on senior lobbyists than they hope and intend to pay Mr. Cantor.

After all, investment banks are in the business of making money. Not changing regulations.

Related reading:
Moelis & Company, Form 8-K dated September 2, 2014
Annie Lowrey, What Eric Cantor Is Really Going to Do on Wall Street (New York, September 2, 2014)
Matt Levine, What Can a House Majority Leader Do for a Bank? (BloombergView, September 2, 2014)
Timothy P. Carney, Cantor’s not lobbying, but his big payday should upset conservatives (Washington Examiner, September 2, 2014)
Amakudari (January 20, 2007)

¹ It is important to note I claim no special insight into Moelis & Company’s actual rationale for hiring Mr. Cantor or its future plans for him. These remarks constitute rank speculation, based solely on public information and my over 20 years of experience in the Wall Street septic tank, not privileged insider information. That being said, I have seen similar scenarios before, and they almost all fit the pattern which I lay out for you charming people above. My rank speculation, in this instance, is probably a pretty good guess.

© 2014 The Epicurean Dealmaker. All rights reserved.

A Cure Worse Than the Disease

Messenger: “I see, lady, the gentleman is not in your books.”
Beatrice: “No; an he were, I would burn my study. But, I pray you, who is his companion? Is there no young squarer now that will make a voyage with him to the devil?”
Messenger: “He is most in the company of the right noble Claudio.”
Beatrice: “O Lord, he will hang upon him like a disease: he is sooner caught than the pestilence, and the taker runs presently mad. God help the noble Claudio! if he have caught the Benedick, it will cost him a thousand pound ere a’ be cured.”

— William Shakespeare, Much Ado About Nothing

I suppose it does little harm to admit, O Dearly Beloved and Long-Suffering Readers, that this site is shot through and through with what my colleagues across the gaping divide in Sales & Trading would call “talking your book.” Notwithstanding the slings and arrows sent this way by those who can see no redeeming social or economic benefit to my profession, I am proud of what I do, and I firmly believe I offer real value to my clients in return for the shiny simoleons which they so graciously bestow on me, however so (and too) infrequently. This should not really be that surprising. I think there must be few human beings who do not find some sustaining or redeeming value in their daily occupation, even if only as a sop to their self esteem or a dodge against despair, and despite all your protestations I continue to aver that investment bankers are human, too.If you prick us, do we not bleed?

That being said, I think I have been pretty honest in these pages (and in the conduct of my daily duties, too) that M&A advisory services are not for everyone. There are many reasons a client might consider in deciding whether to employ someone like me, and not all of them make sense or can be justified by any honest calculus. While there are plenty of dissembling shysters roaming my industry intent on imposing their services and extravagant fees on anyone they can convince to write a check, I have always been of the opinion that you make a client happy in the long run by only recommending what is truly beneficial for them, rather than yourself. And often, hiring an M&A advisor is not the best course of action. At least not yet.

* * *

So I am pleased to take this opportunity to respond to an article on private equity and venture capital shill site peHUB, written by a corporate attorney, about things to consider when you are selling a private company. As advertised, it is geared towards the owners of private companies, who generally face a simpler and less complicated set of constraints and obligations than the Boards of publicly held ones. Of its type, it is a reasonably comprehensive and useful guide.¹

In it, Mr. Stewart offers the following considerations concerning whether you should hire a flesh-eating investment banker like me when you are selling your private company:

*Do You Need an Investment Banker? Investment bankers can add significant value in an M&A process, but they are expensive. Investment banker fees typically range from 1 percent to 2 percent of the deal value, although the fees vary by deal size and profile. Typical benefits of having a banker in an M&A process include having an agent to (1) advise on market trends and valuation, (2) approach potential acquirers with which the target’s executive management would not otherwise have contact, (3) take the difficult, “bad cop” negotiating positions, and (4) co-manage the sale process with the target’s legal counsel.

Now this is fine advice, as far as it goes, but it omits some pretty important content and nuance that I, your reliable guide to all things overpriced and intermediary, will be happy to impart herewith.

Deferring our discussion on whether M&A advisory fees are in fact “expensive” and if so how for later (I promise), I can first address Mr. Stewart’s itemized reasons for hiring a banker by contrasting them with what corporate lawyers typically do in deal contexts. On the first two points the author is correct by implication: rare (and professionally worrisome) is the lawyer who is concerned with markets and valuation, and even rarer (and in likely violation of her professional ethics) is the lawyer who spends time and energy soliciting buyers for her client. These are tasks for which lawyers are unsuited by training, focus, and predilection, and if the client wants someone other than himself to weigh in on such matters and perform such heavy lifting he needs to hire someone for whom they are suited. The third task is more nuanced, as lawyers are perfectly capable of acting (and often quite happy to act) as “bad cop” (read flaming asshole) in matters properly considered legal, but it is true that bankers adopt this role more naturally and properly in matters business.

The fourth task is generally a bone of contention for lawyers and bankers on a deal, as each usually considers the other an interfering nuisance who focuses on the wrong things at the wrong times. Nevertheless, it is true that a properly run deal process usually starts with the banker running things until definitive negotiations begin between the seller and the potential buyer, at which point the seller’s attorney takes over to control the legal minutiae of drafting purchase agreements and other such trivia. While I am convinced many if not most deal attorneys would be delighted if they never had to deal with another investment banker again, bankers are more than pleased to have lawyers around to handle the boring scut work of transaction documentation and risk mitigation. After all, somebody has to stay behind to argue over semicolons while the banker takes her client off for a nice, celebratory bottle of Échezeaux.

* * *

But Mr. Stewart misses three very important reasons why it usually makes sense for a private company, in particular, to hire an investment banker to sell itself. The first is the fact—evident if an attentive reader were to consider the range and complexity of the tasks Mr. Stewart himself recommends the seller perform—that selling a company is long, complex, and difficult work. A typical sale process, depending on its structure and the number of potential buyers it involves approaching, can last anywhere from four to six months or longer, and that is if all goes well. During that time, company management and owners (usually the same people) must continue to run the firm with the same level of intensity and focus they do normally, otherwise things being things and people being people results will start to wobble or decline, and the intrinsic value and earning power of the business will erode. Yet pre-deal preparation, internal due diligence, and identification and potential communication with selected potential buyers all take a substantial amount of time, and once the deal is launched keeping it humming along and tending to its myriad details and interruptions requires constant daily attention. Virtually no private company of normal size has the extra personnel or dedicated, trained professionals to handle this properly, and, frankly, few private company CEOs or CFOs have the skill or training either, even if they did have the time. (And they don’t. Or shouldn’t.) A skilled sell-side advisor will manage this entire process, and she will arrange things so company management spends as little time as necessary providing the input, attention, and personal presence they must so they can continue to focus on their day jobs. Lawyers just don’t do this sort of thing.

Second, a good² M&A advisor will bring market intelligence to bear on a sell-side assignment which nobody else—not even a dedicated internal M&A functionary at a large private company—can come close to providing. This is detailed, intimate knowledge of a firm’s potential buyers, based on comprehensive discussions and extensive deal experience and interaction with all of them. As I’ve written before,

You might think that a participant in a particular industry should know the strategic intentions and capabilities of its direct competitors well, but normally you would be wrong. Competitors do not talk to each other directly about strategy because—wait for it—they are competitors. On the other hand, it is the job and practice of any good investment banker not only to develop an informed opinion about how each significant competitor in a space thinks about strategy but also to have done so by talking directly with them, frequently if possible. This is simply not practical for most corporations. Investment bankers are normally far better informed about the strategic landscape of an industry than any one of its participants.

And this knowledge is not limited to other companies, either. A good advisor will also know the likely, potential, and just-barely-possible buyers of her client among the financial sponsor (private equity) community, too. Not only will such a banker know these parties and their own acquisition appetites and capabilities well, she will know which ones of them are complete and utter assholes, which ones tend to fire the management teams they acquire with companies within the first year of purchase, which ones like to bait and switch sale processes by bidding high then whittling down their offer during exclusive negotiations, and which ones are irredeemable bottom feeders.³ This is invaluable information which even the best informed private company in the most incestuous industry has very little of, if any.

Knowing the likely buyers in the private equity world and being able to bring them to the table is critical in virtually every industry sale process nowadays. Not only are sponsors often the best capitalized and most aggressive buyers, they are almost always faster and more professional than the strategic buyers in an industry, because unlike the latter the former do deals for a living. Incorporating this type of determined, fast-moving buyer into a sale process is very helpful even if the seller and his banker think the most likely buyer is a competitor in the same business, because it helps the banker keep time pressure and process discipline on the strategic buyer which might otherwise dissipate. They also usually offer a very different purchase alternative to a private company seller: sell us your business, then come work with us as a (junior) partner to build it bigger so we can sell it to the next guy, and you will get a second bite at the apple. This, in contrast, to the typical offer from a strategic competitor: sell us your business, then either join us as a salaried employee or go away. Many private company owners prefer selling to private equity firms for this very reason nowadays, but they are babes in the woods when it comes to knowing those buyers. A skilled investment banker can offer crucial guidance in this area.

Third and last, surprisingly enough—given the regular beatings good sell-side advisors give potential buyers in M&A deals—most serious buyers prefer private companies to have professional sell-side help engaged. This is for all the reasons cited above: they know most private companies do not have the time, M&A experience and discipline, or negotiating skill to run a tight, efficient transaction process. Buyers want to know the person sitting across the table from them is not procrastinating, flip-flopping on deal provisions or objectives midstream, or negotiating in a disingenuous or irrational manner. Being a buyer of companies is expensive and time-consuming, too, and buyers who are serious don’t like to suspect their time is being wasted. Having a professional investment banker across the table gives them some confidence, because everybody knows no investment banker would allow herself to be hired by a client who wasn’t serious themselves.

And this, at the last, is probably the most compelling reason a private company should hire a financial advisor to sell itself: because that banker will make sure to keep her client disciplined and focused on accomplishing the sale. Privately held companies—for all sorts of good, bad, and indifferent reasons—can often be pretty squirrelly, and nothing will kill a deal faster than a squirrelly seller. After keeping buyers in line, a good sell-side advisor’s principal role is to keep her own client’s eyes on the prize.

* * *

Which brings us to the matter of expense. It is true that, for most deals, the check a seller writes to his investment banker is usually the biggest one crossing the closing table other than the purchase price itself. Even so, one or two percent of the transaction value is arguably a pretty small price⁴ to pay for someone who has broadened the potential universe of buyers, guided and directed the sale to achieve the highest price and best non-price terms available given the seller’s other objectives, and performed all the tiresome, dirty work of managing a complex sales process for upwards of six months or more. Even more compelling, except for the occasional nominal retainer, the success fee a banker earns upon her client’s sale is just that: a success fee. If the sale fails, or her client withdraws his company from the process for whatever reason, she does not earn anything. Her risks and incentives are completely aligned with those of her client, assuming of course her client really wants to sell.

And that is the real answer: if you’re not really sure you want to sell your company, don’t hire an investment banker. It is our job and embedded in the way you pay us to do everything in our power to close your transaction, including beating you up if you’re backsliding, procrastinating, or otherwise doing anything unreasonable and likely to derail a potential sale. Other bad reasons—like you’d like to play investment banker yourself, no matter how much it costs you in distraction from your core business, diminished transaction value, and fruitless legal and accounting expense—are also good arguments for not hiring a banker, but presumably you are too intelligent to need me to tell you that.

Of course, any good corporate law firm would be more than happy to accommodate you in such circumstances. After all, they charge by the hour.

Related reading:
Matt Stewart, Things to consider when selling a private company (peHUB, July 28, 2014)
Eight Reasons Not to Hire an M&A Advisor. And One Reason to Do So (May 14, 2011)
A Good Start (January 19, 2011)

¹ If I’m being honest, as I claim, I think the author is a little lackadaisical about describing the necessary structure and elements of the sale process for a private company. While he gets the major elements right, he is a little slapdash in describing how they all fit together. It has been my experience that a robust and disciplined process is absolutely necessary to keep deals moving at an appropriate pace, to encourage potential buyers to play nicely, and to keep the seller focused on what needs to be done. Without a firm hand on the tiller (and an eagle eye on the clock), there is a tendency for all deals to fritter away into time- and money-wasting nonsense. Given the fact that, of all the players involved in these little dramas, lawyers are usually the only ones paid by the hour, I will leave it to the cynics in the audience to conclude whether this omission was intentional.
² The perceptive among you will note that my use of “good” here is definitely normative, if not prescriptive. The type of knowledge which informs nuanced, deep understanding of the strategic landscape of an industry is normally only collected by investment bankers focused on and active in that industry. This means if you value and want such knowledge you should search for an advisor from among those who actually have it, rather than the generalist sell-side firms who market themselves as one size fits all. They are prolific sausage factories, it is true, but all the sausages tend to come out the other end looking the same. Just sayin’.
³ Yes, we know who you are. All of you. You, too.
⁴ Unless you are paying 2% for a billion dollar deal or greater, in which case your banker is a shyster and you are a fool. Or neither one of you cares how much of your public shareholders’ money you waste.

© 2014 The Epicurean Dealmaker. All rights reserved.

Where Did He Learn to Negotiate Like That?

Korbin Dallas: “We need to find the leader. Mangalores won’t fight without the leader.”
Mangalore Leader: “One more shot, we start killing hostages.”
Korbin Dallas: “That’s the leader.”
Mangalore Leader: “Send someone to negotiate.”
Security Chief: [to Dallas] “I I I I I’ve never negotiated I…”
Korbin Dallas: “Mind if I… try?”
Security Chief: “No, no, sure, sure. Sure. [to Mangalores] We’re sending somebody in to negotiate!”
Korbin Dallas: [walks into room, shoots Mangalore leader between the eyes] “Anybody else want to negotiate?”
Security Chief: “Wh-wh-wh-where’d he learn to negotiate like that?”

— The Fifth Element

Unlike many of you, O Dearly Beloved, I am old enough to remember a time when air travel did not offer wireless internet in flight. As a result, when junior bankers like me did not have work papers to review or spreadsheet modeling or presentation editing to do on our laptops,¹ we were thrown back on our own devices when it came to entertaining ourselves with something other than the crappy movies playing on low res CRT screens hanging from the ceiling. Normally I would bring some combination of newspapers, magazines, equity research reports, and a book or two to occupy my time, but occasionally said distractions would fail to engage me or I would simply run out of material to read before the flight ended. On those occasions, in desperation for something to distract me from the grim environs of a 30-year-old narrow body aluminum tube stuffed with sweaty tourists and bedraggled business travelers, I would sometimes stoop to leafing through the airline magazine jammed conveniently in the seat back pocket in front of me.

This rarely offered much relief, but I do recall frequently encountering the same stiff, glossy multipage ad for a well-dressed chap named Chester Karras, who generously offered to teach the ambitious road warrior the secrets to becoming a master negotiator, for a hefty price. “You don’t get what you deserve,” his tagline warned, “You get what you negotiate.” Putting aside the wisdom of advertising such services to the rumpled middle manager wedged into the middle seat of aisle 32 on the 9:18 pm flight from Dallas to Abilene, these ads always reminded me that true negotiating skill is surprisingly rare among most businesspeople.

* * *

For spectacular anecdotal proof of this observation, we need only turn to last week’s article in DealBook about the nasty bollocking mustachioed technology advisor extraordinaire Frank Quattrone’s firm Qatalyst Partners delivered to its erstwhile client, Trulia, in the latter’s recently announced sale to competitor Zillow. To an aficionado of the dark arts of M&A, there are many odd and interesting nuggets to be gleaned from this brief article about the behavior of Trulia and Qatalyst, which I thought you kindly people would find amusing to review with me on a languid Saturday afternoon.

First, there is the apparent fact that, after hiring Qatalyst three years ago to sell itself to (presumably) Zillow and perhaps one or more other potential buyers, Trulia apparently never terminated the engagement when it failed to lead to a sale. This, as we technically describe it in the trade, was Just Fucking Stupid. Engagement letters between clients and financial advisors are normally open-ended contracts which describe reciprocal duties and obligations which do not expire until the transaction contracted for occurs or one or both of the parties explicitly terminate them. The notion that Trulia could hire Qatalyst to sell itself, have that process fail, and subsequently move on to an initial public offering and other activities for three years without bothering to terminate an open-ended sale contract is just ludicrous. For this mistake alone, somebody in the executive suite of Trulia—the General Counsel or Chief Financial Officer are the most likely candidates—should have their head handed to them.

Second, there is the matter of Qatalyst’s original fee, which the DealBook article describes as “about 2 percent.” Now, I don’t know (or care) what Trulia’s purported enterprise value was three years ago when it first engaged Quattrone’s merry band, but I would be surprised if it was much below a billion dollars. (Remember, they just got sold for $3.5 billion this past week.) Now I understand that the technology world operates in its own reality distortion field, but I have to confess I was stunned by that fee percentage. In the normal business world, where industrial logic and economic pressures operate in place of the moonbeams and unicorn piss of tech land, a billion dollar sale mandate should earn the sell-side advisor flogging it significantly less than one percent of transaction value. Advisor success fees are heavily negotiated on a deal-by-deal basis, but they normally have some relation to normal fees normally earned by normal advisors normally. This one looks like Trulia’s CEO just hiked up his skirts and asked his Qatalyst banker how far he wanted him to bend over the barrel.

Third, there is the matter of the fee Trulia negotiated with JPMorgan for the current mandate which resulted in its sale to Zillow. This DealBook reported as about 1.5 percent. You might think JPMorgan was mighty gentlemanly to accept a lower percentage fee for the higher sale amount, until I inform you it is somewhere between four to five times the normal fee for a three billion plus dollar transaction outside tech land. The rack rates which investment banks try to achieve in M&A transactions are based on advisory fee schedules which in turn are based on competitive fees earned by them and their competitors in hundreds of transactions annually. In other words, a market. These fees decline as a percentage of transaction value as the size of the transaction increases, and most financial advisory firms’ fee schedules show transaction fees of fractions of a percent at these levels.

* * *

Now perhaps Qatalyst Partners’ and JPMorgan’s technology bankers really are the sort of special snowflakes who can deliver $50 to $70 million of advisory value to Trulia. Perhaps Frank Quattrone and his colleagues use secret photos of every Silicon Valley founder, CEO, and venture capitalist engaged in unnatural acts with scrofulous barnyard animals to boost their negotiating leverage when it comes to striking terms on engagement letters and actual transactions. Barring that, however, I am skeptical, as a technology outsider, that any of these clowns can offer anything special enough to merit fees which are many multiples of the fees which highly talented M&A advisors outside the technology bubble would be delighted to work for. Especially if both transactions were targeted primarily or solely at one buyer, Zillow, which makes many of the deal dynamics and negotiating complexities much less burdensome. After all, it’s not like the companies involved are particularly technical or require particularly specialized skills from their advisors.

I take this as yet more proof that the denizens of Silicon Valley think they are special, and the normal rules of gravity and economic interactions do not apply to them. Perhaps the executives and owners of technology firms are delighted to spread higher than normal fees around to their pals and enablers in the banking world in exchange for extracting ridiculous sums from the pockets of widows, orphans, and idiot venture capitalists to fund their fantasy business models in the first place. I’m not sure I would be so happy to pay an extra $40 million in success fees to bankers who sold my company because my CEO and his staff were too inept to negotiate their way out of a paper bag with a map and a blowtorch, but then again I am not Silicon Valley’s demographic.

And this, in the end, has clearly been my mistake. Effective immediately, I am rebranding myself as an M&A advisor for technology companies, offering skilled buy- and sell-side services at a mere 300% of retail.

Shit, I use Twitter and Blogger.com. I’m a friggin’ natural.

Related reading:
David Gelles, Old Attempt to Sell Real Estate Website Trulia Rewards Ex-Adviser Qatalyst Now (DealBook, July 29, 2014)
Killing People Is a Bad Habit (August 28, 2009)

¹ You might think plane flights would be an excellent time to get tasks like this done: no interruptions by clients or superiors, relative quiet, and few distractions of interest. In actual fact, bankers often forgo catching up on pressing work due to the risk competitors or strangers on the plane might look over their shoulder and get a glimpse of confidential information. Quarters are close in economy class, and unless your immediate neighbor is a co-worker who can shield you from prying glances, most serious work should be deferred until you get back into the office. So, once again, junior bankers are screwed.

© 2014 The Epicurean Dealmaker. All rights reserved.

In Loco Parentis

“You know, Mrs. Buckman, you need a license to buy a dog, or… drive a car. Hell, you need a license to catch a fish. But they’ll let any butt-reaming asshole be a father.”

— Parenthood

One of the advantages of being a sole pseudonymous proprietor of an obscure online opinion emporium—insulated from the interference of officious editors, hypersensitive advertisers, and unhinged commenters still seething over the unflattering piece I posted about their dipsomaniac uncle six years ago—is the freedom to write whatever I will. Periodically then, this freedom licenses me to post explanatory articles which illuminate often obscure features or issues about my chosen profession which, to be perfectly honest, will be of little interest to most of you Charming Visitors.¹ So unless you would like to learn a little bit more about the current regulatory environment surrounding mergers & acquisitions, I suggest you skip over this entry and revisit the latest internet outrage du jour on Gawker or Slate, instead. Or better yet, read a book.²

The impetus for this post is the release, this January, of what is known in the trade as a “No-Action” letter by the SEC in response to a formal inquiry by a gaggle of M&A lawyers. Now in layman’s terms, a no-action letter is simply a formal statement by the SEC that, under a certain limited set of circumstances as laid out in exhaustive detail by the petitioners, it will choose not to enforce existing securities laws. In the particular instance under consideration, the no-action letter effectively eliminates the existing requirement for advisors who participate in mergers and acquisitions involving private companies to be registered as broker dealers with the SEC.

Now Charming Visitors like you, I am sure, can just imagine how this news was received among certain shouty quarters of the internet and associated environs:“Wall Street Banksters Celebrate
SEC Trashcanning of Investor Protections
Over Lavish Meal of Roast Baby Seal,
Fricasséed Retirees’ Dreams”

Fortunately—or unfortunately, perhaps, if you are one who prefers to keep her mental map of the financial system conveniently colored in morally unambiguous shades of black and white—I am here to reassure you that baby seals and investor dreams face no greater threat than they did before, and this particular instance of deregulation running, as it were, against the tide of increasing regulation in the brave new world of Dodd Frank makes eminent and prudent regulatory sense.

* * *

It will help me make my case if you understand the historical background of the existing regulation which the SEC has decided to waive enforcement of. Historically, as you might expect from an organization entitled the “Securities and Exchange Commission,” the SEC has been particularly concerned with the regulation of anything and everything to do with securities. Simplifying greatly for the non-lawyers in my audience, the SEC has traditionally said that any financial intermediary who participates in the origination, solicitation, negotiation, marketing, or general fricaséeing of a security and gets paid a fee for doing so (i.e., all of us) is required by law to register as a broker-dealer. In other words, if you make money assisting the transfer of securities from one party to another–whether by making a market in secondary shares, underwriting a new bond issue, or selling companies—you need a license. What may not have occurred to you is that the securities of private, non-publicly-traded companies count as securities under the SEC’s purview, too. And M&A transactions, which usually involve the purchase, transfer, or exchange of securities for cash and/or other securities, definitely count.

Given the SEC’s mandate to protect investors, this makes eminent sense when M&A involves companies with publicly-traded securities. After all, if there are public securities involved, somewhere or other a widow or an orphan is likely to get caught up in the deal, and nobody—least of all the SEC—wants nefarious unregulated doings clouding the pale and fevered brows of said Ws and Os. At least not publicly. Of course pure M&A advisors almost never handle customer funds or securities—a big hot button for the widow and orphan protection unit—and they rarely provide financing for the transaction, unless they are one of the monster integrated investment banks intent on sucking more fees out of their clients’ wallets by lending their own balance sheet to the equation. But the overarching presence of public securities is as probably as good a reason as one can muster for the licensing of M&A advisors who participate in transactions involving public companies, even if it might be considered, for various reasons, a bit of overkill.

But the inclusion of M&A deals involving purely private companies under this licensing requirement has never made much sense. I will allow the helpful lawyers at Morrison & Foerster to explain:

The application of the broker-dealer regulatory framework to private company M&A advisers has always been somewhat awkward. Much of that framework is designed to protect customers against abusive sales or trading practices and to ensure that customer funds and securities are safeguarded. However, in the typical private company M&A transaction, the terms of the deal are negotiated directly by the principals with assistance from their financial and legal advisers. Unlike the customer who buys or sells stock based on a brief conversation with his broker, the owners of a private business are generally very involved in the negotiation process, which may take place over a period of weeks or months. Moreover, the financial intermediary never touches the customer’s funds or securities. The “broker” in private company M&A transactions functions essentially as an adviser to its client and its role bears little resemblance to more traditional broker-dealers.

This, I can tell you from long and painful experience, is absolutely true. The principals in a private company transaction are either other companies or financial sponsors, all of whom tend to be very experienced in doing M&A themselves and/or are protected by the advice and counsel of armies of very experienced lawyers, accountants, and professional M&A advisors like me. We take oceans of time for due diligence and negotiate the everloving crap out of every possible term of these deals six ways from Sunday. The notion that an average billion dollar corporation or financial sponsor with a three billion dollar fund needs the indirect, implicit investor protection that a broker-dealer license from the SEC purportedly conveys to its M&A advisor when it purchases a $25 million dollar business is patently ludicrous.

But historically the SEC has been a big fan of one-size-fits-all legislation: what’s good for Aunt Millie is good for Steve Schwarzman. I have complained in the past that the conflation of retail and wholesale finance under one legislative rubric structurally designed to protect the widows and orphans of 1933 and 1934 from boiler room operations is just silly. Financial transactions among professionally advised, intimately involved, professional principals like corporations and financial sponsors just should not be treated in the same way as Aunt Millie’s purchase of a mutual fund from her stockbroker Chuck. And M&A deals, both public and private, definitely count as the former.

* * *

The prior restrictions were not without negative effects, by the way. In order to satisfy the rules, M&A brokers who wanted to actively advise their clients often had to twist the transaction structure into an asset sale, thereby avoiding the requirements triggered by the involvement of securities, whether that was the most financially efficient structure or not. Or they simply ignored the law, in the hopes that the SEC would look the other way. In the latter case, their clients usually shrugged indifferently, since they knew they were fully protected by intensively negotiated legal engagement contracts and fully applicable anti-fraud provisions under the law anyway. Most aficionados of jurisprudence will tell you a law which only encourages scofflaws or evasion is bad legislation.

Lastly, the prior regime enforced a very inefficient structure in the market for private company M&A. In order to comply with the law, many individual advisors or small boutiques which could do M&A either had to associate with an existing licensed broker-dealer or apply for a license and maintain ongoing registration themselves. This, for smaller outfits, was not trivial, costing potentially hundreds of thousands of dollars up front and entailing substantial ongoing reporting obligations, dedicated compliance and administrative personnel, and non-trivial financial expense. It likely substantially curtailed the establishment of small independent advisors who otherwise wanted to and could provide professional advisory services to privately held companies. The outcome of this regulatory barrier to entry, of course, has probably been higher prices for customers who want to do M&A.

So I congratulate the SEC for finally seeing the light of intelligent market regulation in the M&A world. No true investor protections have been lost, and barriers to entry in a high cost service industry have been lowered at a stroke. Who knows, maybe this is the start of a new era of intelligent regulation of financial markets, not more regulation.

Naahh…³

Related reading:
United States Securities and Exchange Commission, No-Action Letter Dated January 31, 2014
Morrison & Foerster LLP, Private Company M&A Brokers Don’t Need to Register With the SEC as Broker-Dealers (February 6, 2014)
You’re Doing It Wrong (October 22, 2011)


¹ This, of course, incorporates the perhaps heroic assumption on my part that anything I write here is of interest to more than zero of you. But, since this is my website, I can damn well assume as much such nonsense as I choose. So take it as given.
² I hear some mid-range Princeton author has an inflammatory new book out about Wall Street traders who like to expose themselves in public that’s getting a lot of press. Flasher Boys, or something like that.
³ In the isn’t-it-interesting-what-a-coincidence department, the SEC no-action letter comes at a time when legislation is currently wending its way through Congress that would enshrine the exemption of M&A advisors from broker-dealer registration requirements in actual law. The original bill, H.R. 2274/S. 1923, and the omnibus bill which incorporates it, H.R. 4304, incorporate virtually the same exemptions from registration as are included in the no-action letter, with the slight addition of size limits for transactions. Note that neither the no-action letter nor the proposed legislation lets M&A brokers off the hook from registration if they do public company M&A or normal securities financing work, like private placements. Any investment bank which aspires to the full range of agency services, even if they do not have capital markets trading activities, will still have to register. Relax, Aunt Millie: the dogs of war are not completely off the chain.

© 2014 The Epicurean Dealmaker. All rights reserved.

Apocalypse, Ciao!

Francie Stevens: “I’ve never caught a jewel thief before! It’s stimulating! It’s like... It’s like...”
John Robie: “Like sitting in a hot tub?”

— To Catch A Thief

Part of the real pleasure of the interwebs for me, O Dearly Beloved, is the occasional opportunity Your Muddle-Headed Correspondent has to engage in a stimulating conversation with one or more individuals who are clearly more intelligent, better read, and cleverer arguers than Yours Truly. I tend to gain a lot from such interactions, if only a better understanding of my own opinions and the limitations of my knowledge and intelligence. They tend to generate a crush of sensations, including excitement, the sheer terror of discovery that I am out of my depth, and an urgent desire to land a couple of cheap shots on the champion before I scramble out of the ring to safety.

Today’s reflections are inspired by the response Carolyn Sissoko made to my recent post on unlimited liability in finance. While I am not equipped to address some of her points—especially on the topic of what she sees as the increasingly pernicious use of collateral by modern financial intermediaries—I would like to venture a few remarks and intuitions, in the spirit of a novice fighter taking a couple tentative jabs at Mike Tyson. Hopefully she will be gracious enough to let me run away thereafter.

First, Ms Sissoko uses historical evidence (what’s that?) to demonstrate that a regime of unlimited liability is not necessarily inconsistent with low required rates of return on capital:

The system of unlimited liability banking grew up in an environment with usury laws, so interest rates (on short-term debt) did not exceed 5% per annum. Market rates often fell as low as 2%. It’s far from clear that low interest rates for borrowers are inconsistent with unlimited liability on the part of lenders who choose to use their ability to borrow to leverage their returns (i.e. to act as partial reserve banks).

But I think this point misses the thrust of my previous argument. My intuition about unlimited liability is that capital providers subject to it have a natural limit to the amount of credit they are willing to extend regardless of price. Each lender sets her individual limit based on her estimation of the likelihood of loss beyond initial capital invested. Beyond that there is no price at which she would be willing to lend. This certainly would be my preference: if I faced the loss of my home and possessions, penury, and utter ruination, you can damn well be sure I would not extend just one more loan to capture an extra fifty, hundred, or even thousand basis points of yield. I do not think I am alone among heartless, flinty-eyed rentiers in this regard. The historical evidence Andrew Haldane cites from early 19th century Britain is entirely consistent with this: compared to the situation today, banks were massively overequitized and highly liquid, and bank assets and hence lending were a very low proportion of the economy. If my intuition is correct, it may well be that prevailing market rates of interest during that period evidence less that capital was plentiful and demand fully satisfied and more that supply and demand were balanced in a regime of artificially limited supply. Certainly Mr. Haldane contends—based upon what, I do not know—that the system of unlimited liability was not capable of supplying the growing need for capital during the rapid industrialization of the mid 19th century.

I strongly suspect that if we attempted to reimpose a regime of unlimited liability on capital providers nowadays, the pool of capital available to the economy would shrink, and likely dramatically. People with capital would simply become unwilling to lend to or invest in risky projects beyond a certain point, and the evidence from 19th century Western industrial societies seems to indicate that point would be at a dramatically lower level than we have become used to over the past 70 years. Unlimited liability could well be massively contractionary. This, I assume we all can agree, would not be a good thing.

* * *

Second, Ms Sissoko rather loses me when she asserts that

from a theoretic point of view, a banking system doesn’t need capital, it needs trust (aka credit). If the institutional framework is carefully structured (that is, debts are enforceable, outright fraud is disincentivized/rare, etc.) there is no shortage of capital — capital is created out of thin air by a plethora of unsecured, but trustworthy, promises. Effectively, capital is cheap, because the institutional structure of finance reduces the risk of losses to a minimum.

It may be that the intestinal parasite (me) within the dinosaur simply cannot conceive of a world without dinosaurs or dinosaur intestines, but I don’t get this. Capital is, in my understanding, at base a buffer against loss. Perhaps capital and bank lending vanishes when you sum all of its offsetting accounts across the entire economy, but capital serves a very important protective function at the “local” level of real creditors and borrowers. Capital absorbs loss, and either stops or slows the propagation of that loss through the daisy chain of economic interrelationships economic actors maintain. It is like the collapsible drums filled with water at the top of a freeway exit, whose function is to slow or impede the destructive progress of a runaway car. Sure, a runaway car will eventually stop of its own accord due to friction and gravity—if not another car or building—but do we really want to conclude from this that crash drums aren’t desireable or necessary?

I presume Ms Sissoko would counter that, with appropriate care and attention, we could design freeways and perhaps even cars so that we need not worry about collisions or runaways, but I fear that implies a level of omniscience—and systemic rigidity—which I find hard to credit. Financial loss is triggered both endogenously and exogenously. Being unable to anticipate all the ways financial loss can occur and directions from which it can come, I would much prefer to have various pools of capital sitting around the system, hopefully helpfully positioned between me and disaster. Besides, without capital, how can we enforce incentives? Capital belongs to someone. I thought the point was to reduce unnecessary systemic risk by presenting those positioned to create the risk of loss in the first place with incentives not to do so recklessly. How else can we do this except by making them the first to bear that loss; i.e., lose their capital?

* * *

One of the most pernicious effects, in my opinion, of the evolution of limited liability in the financial system, and the consequent transfer of more and more tail risk to society at large, has been the weakening of our understanding of the price of risk. Now don’t kid yourself: society always stands as the loss-absorber of last resort, under any capital, economic, or financial regime, because there are some losses which are too large for any system to absorb. (Think about a kilometer-wide asteroid hitting New York City or Los Angeles, for example.) After all, financial losses happen to a society. But the drawback of risk assumed by government and taxpayers is that it is not explicitly priced. Leading up to the recent financial crisis, as financial actors’ capital at risk shrank and society assumed ever more tail risk, more and more of the spectrum of possible financial loss fell outside the capital markets’ risk pricing mechanisms. Risk, whether from risky investment projects, financial leverage, or whatnot, looked cheap because an increasing portion of it was not being priced. We all levered up and engaged in riskier activities because we thought those activities had somehow got less risky. Remember the “Great Moderation?” It turns out instead we were just hiding a lot of potential loss out of sight, in the Grandma’s attic of a taxpayer backstop.

I continue to maintain two important things about financial risk. First, that it is incompressible; that is, a certain level of risk is ineluctably tied to the pursuit of a particular level of returns. No matter how you slice it, you cannot reduce the risk associated with a certain return. If it looks like risk is lower than you anticipated based on past history, rest assured it has not declined. You have either transferred it to someone else (e.g., through derivatives, in which case you have transferred some of your return, as well), or you have just lost track of some of it (perhaps by shifting it onto taxpayers). Second, that the risk-return relationship obtains at a society-wide level, as well. It may very well be the case that we unknowingly assumed more risk than we are comfortable with as a society, because we lost track of some of it by shifting it outside the financial markets, unpriced, onto our own backs. We pursued a growth and consumption agenda that was a lot riskier, in retrospect, than we believed at the time. But lowering the risk of loss we are willing to accept as a society will have ironclad implications on the types of returns we enjoy.

Surely there is a happy medium between a low-growth, capital-constrained economy hobbled by unlimited liability to capital providers and the reckless bacchanal we financed with “other” people’s money up to the financial crisis.¹ But make no mistake, the decisions we make about how we allocate, limit, and distribute financial risk throughout society—including how much to put financial intermediaries on the hook—will reverberate broadly through the system and ultimately affect our very living standards and prospects:

So part of the conversation we continue not to have in the public domain is what kind of returns—in the broadest sense—we desire for our economy and society, and therefore what level of risk we are willing to tolerate. Sure, we could turn the entire banking industry into a regulated utility, with mandated minimum equity levels, maximum allowed returns on equity, and limits on institutional size and interconnectedness (assuming we can understand, monitor, and control such parameters, which may be a slightly heroic assumption). But what knock-on effects would that have on investors, on businesses in search of risk capital for their growth projects, on consumers, and on the economy at large? Dampen the incentives and ability of financial intermediaries to originate, take on, and distribute investment risk, and it is not clear to me that overall risk-taking (i.e., investment) in the economy will not go down. But if that happens, are we not explicitly or implicitly settling for less growth and fewer wealth creation opportunities in the economy overall? Is that really the outcome we are seeking?

By this, I do not mean to say our current system works well, or that the level of risk inherent in the financial system is appropriate or even efficiently distributed given our overall economic return objectives. But it does mean that we need to be a little more thorough, and a little more honest with ourselves and our opponents in debate, in thinking about the consequences of individual actions or “solutions” we advocate imposing on financial intermediaries. For consequences will flow inexorably in directions we do not—and perhaps even cannot—anticipate, and we will be remiss—and even no less irresponsible than the people who allowed the recent financial crisis to happen in the first place—if we do not make provision to address them.

But cheer up. Things could be a lot worse.

Related reading:
Carolyn Sissoko, A little fear is a good thing (Synthetic Assets, February 4, 2012)
The Blind Men and the Elephant (June 21, 2011)


¹ Oops. I guess it was our money all along, after all.

© 2012 The Epicurean Dealmaker. All rights reserved.

Methinks Thou Dost Protest Too Much

Any sufficiently advanced technology is indistinguishable from magic.

— Arthur C. Clarke

Attentive Readers will realize that I have used my durable and insightful epigraph before, specifically in a post which defended my industry against accusations of malfeasance arising from the common tendency of merchants in any economy reliant upon buying and selling to conceal the true costs and profits embedded in their activities. It was my contention then and is now that no law, human or otherwise, compels a vendor to offer buyers of its wares the “best price”—whatever that may be—or, indeed, prevents it from doing what profit-maximizing enterprises are commonly presumed to do: maximize profits. As long as said vendor is not selling faulty merchandise to inappropriate customers in a fraudulent manner, we should not expect to know nor require it to reveal all of its secrets.

This, however, is not that post.

For those of you with half a brain will (or should) realize that my idyllic little précis of laissez-faire capitalism skips lightly over two critical assumptions: that 1) all this happy buying and selling take place in reasonably competitive markets, where other vendors compete to offer the same good or reasonable substitutes therefor, and 2) the manufacture and sale of these goods does not impose intolerably noxious externalities on the society in which they are sold. The first of these can be seen as simply a special case of the latter, in which the externality which society should naturally seek to limit is economic rent-seeking in all its forms: monopoly, oligopoly, producer or factor cartels, preferential government regulation, etc. Of course, this tends to assume that the economy should be servant to society, rather than vice versa, which belief seems unhappily out of fashion nowadays.¹ Go ahead, call me a dreamer.²

A cynic might say that politics is nothing more than a neverending argument over the size and distribution of economic rents in society. But let us set that question aside for now. Instead, I would like to focus on other kinds of externalities: those corrosive and destructive injuries to society which are generated as ineluctable byproducts of the activity of certain unsavory economic actors, like arms dealers, child pornographers, and television reality show producers.

And investment banks.

* * *First, some history.

One of the principal functions of investment banks is the distribution of economic risk in society, from those who wish to sell it (and its associated productive return) to those who wish to buy. In the past, investment banks generally worked pretty well as conduits for risk, passing it from natural seller to natural buyer pretty effectively while skimming a small percentage off the top as recompense for their services. On the wholesale securities side of the house, they acted as large, temporary warehouses, buying and selling securities and derivatives on behalf of clients and maintaining minimal stocks in inventory to satisfy unforseen demand. It was a model which required little equity capital to support it, so investment banks levered up with short-term financing of their short-term assets and earned a nice return on the shareholder or partner equity they employed. Operating with so little equity entailed substantial risk, as a simple mistake or unexpected market shock could send the entire house of cards tumbling down. But because they tended to deal in liquid, easily marketed instruments, failed investment banks could be liquidated with relatively little disruption to their counterparties or the financial markets. Of course, the shareholders or equity partners got wiped out, but that was understood as part of the game. Live by the sword, die by the sword.

But then came the Great Moderation, and the industry changed. Investment banks merged and converted into universal banks, with commercial lending, mortgage businesses, and retail depositors, and they began swelling like mutant ticks on a hemophiliac dog. They began to warehouse more and more securities and derivatives to accommodate increased trading volumes on the market-making side. They began to warehouse more and more financial instruments for their own proprietary trading efforts. And they began to manufacture securities and derivatives, like mortgage-backed securities, credit default swaps, and other “structured products,” to meet investors’ insatiable demand for adequate returns in a seemingly riskless world. But as their balance sheets ballooned, these banks stuck with the tried and true risk management philosophy they had developed over decades as pure investment banks: mark your assets to market in real time, get out of losing positions early, and never hold risky assets in inventory without hedging them. Unfortunately, this is a strategy which depends at its core on operating in liquid, transparent markets, where prices are well known, trading volumes are robust, and hedging instruments are effective and liquid themselves. It also depends on a key principle which every trader knows: it doesn’t matter whether the markets are liquid or not if your position has become so large that you effectively are the market.

In addition, investment banks began to take on more and more counterparty risk as they waded deeper and deeper into such activities as leveraged lending, prime brokerage (lending and clearing for hedge fund clients), and derivatives and other structured products. And this was not the simple counterparty trading risk of old, where your primary worry was whether the party you traded with would deliver a security. It was counterparty credit risk, incurred as part of a trade in which your ultimate profit depended on your counterparty’s ability to satisfy its financial obligations, like repaying a loan, delivering an unencumbered security, or paying off a derivative. And let’s face it: investment banks have historically been lousy at credit analysis. Oh, sure, they’re fine when it’s short-term, secured lending, like a margin loan collateralized by liquid, easily-marketable securities with transparent market values. But lending money (or, what is the same thing, contracting for delivery of future economic value under certain circumstances) to counterparties subject to multiple financial risks and multiple financial obligations over a longer period of time? Not so much. And this is a big problem, because it seems that investment banks as a group have become their own biggest credit counterparties in many markets, particularly derivatives.

* * *

The problem is neatly illustrated by a recent Bloomberg article on the European sovereign credit default swap market:

Five banks—JPMorgan, Morgan Stanley, Goldman Sachs, Bank of America Corp. (BAC) and Citigroup Inc. (C)—write 97 percent of all credit-default swaps in the U.S., according to the Office of the Comptroller of the Currency. The five firms had total net exposure of $45 billion to the debt of Greece, Portugal, Ireland, Spain and Italy, according to disclosures the companies made at the end of the third quarter. Spokesmen for the five banks declined to comment for this story.

While the lenders say in their public disclosures they have so-called master netting agreements with counterparties on the CDS they buy and sell, they don’t identify those counterparties. About 74 percent of CDS trading takes place among 20 dealer- banks worldwide, including the five U.S. lenders, according to data from Depository Trust & Clearing Corp., which runs a central registry for over-the-counter derivatives.

Gross exposures are many multiples higher, of course, but the banks like to advertise their net exposures instead. The problem is that net exposures are not the clean, unassuming things a layperson might think they are. Take the following scenario: Bank A sells a $100 million credit default swap on Underlying Company or Country X to Hedge Fund 1. Then, in order to hedge itself, it buys an identical $100 million CDS on X from Bank B. Bank A has completely eliminated its exposure to X and can sail off into the sunset, happily counting the money it made in spread between the two transactions, right? Wrong. Bank A has not eliminated its risk exposure at all, it has merely introduced a credit risk exposure to Bank B, which is now on the hook to pay off the CDS if X craters. But what if B craters? Bank A is still on the hook, and now it is completely naked short a $100 million CDS. Now Bank A could try to protect itself against Bank B’s default by buying a CDS on Bank B from Bank C or Hedge Fund 2, but I think you must begin to see that that merely introduces a credit exposure to Bank C or Fund 2. Of course in real life all these counterparties try to ameliorate this exposure by requiring frequently refreshed margin collateral on these trades, with the objective that any party’s true risk exposure at any point in time is simply the difference between the value of the collateral held (usually cash) and the net cost to replace the instrument in question.

The challenge to global financial stability posed by investment banks conducting these activities is threefold, in my humble opinion. First, the daisy chain of trades illustrated above clearly demonstrates that investment banks never completely eliminate the residual risk involved in buying and selling investment contracts like CDSs and other derivatives. There will always be some risk attendant on any transaction which has not been completely immunized (like, e.g., Bank A buying an offsetting CDS from Hedge Fund 1, which would have the effect of cancelling the original trade), whether this is direct credit exposure to your counterparty or basis risk introduced by trying to hedge counterparty credit risk indirectly, like via short-selling its stock. Each such trade adds residual risk to the bank’s balance sheet and, given the tremendous aggregate volume of gross derivative trades investment banks do, these residual risks can accumulate to a very large and scary extent.

Second, because most big banks have overall margin agreements (Credit Support Annexes) in place with each other that aggregate offsetting daily margin requirements across all trades outstanding between the firms, the collateral protection mechanism itself can trigger contagion both within and across tightly linked firms. A bank or large hedge fund faced with a substantial margin call in one market or security might liquidate positions in other, more liquid securities in order to meet its obligations. If substantial enough, this can cascade through the markets and the trading books of interlinked investment banks, causing broader market sell-offs and further associated margin calls. This sensitivity is exacerbated by the highly leveraged financial profiles of most major financial market participants, especially the large trading banks and derivatives dealers.

Third, the ineluctably bilateral nature of many of these structured products and derivatives means that, no matter how careful and conservative any one investment bank is in structuring and managing its risk profile, nobody can be assured they are not transacting with another AIG Financial Products or, less dramatically, that systemically dangerous net exposures are not accumulating in disturbing quarters. The chief reasons that AIGFP’s collapse exacerbated the financial crisis were because it did not post collateral (due to its AAA credit rating), it transacted in difficult-to-value, illiquid markets, and it accumulated huge net exposure to mortgage-backed securities. And yet investment banks and others gleefully piled into counterparty credit exposure with AIGFP (the “dumb money”) until it cried uncle. Wall Street piled into copycat trades and lending relationships with Long-Term Capital Management, too, in a 1998 dress rehearsal for 2008’s systemic collapse. The very nature of secretive, cutthroat competition in my industry means that none of us want to share information that might reveal the existence of unsafe concentrations of credit risk in the system.³ How else can one explain why French-Belgian bank Dexia was able to write so many interest rate swaps that it required a government margin call bailout to the tune of $22 billion? Last month.

* * *

The practice of counterparty risk management on Wall Street has improved mightily since the Panic of 2008. Given that disaster, it damn well better have. But given the nature of massively connected, highly leveraged investment banks acting as conduits and collectors of the risk of the financial system, and their historical blindness to risks like counterparty exposure and risk concentration which were the very risks which nearly killed them (and us), I am loathe to take them entirely at their word that everything is hunky-dory now. Short of requiring all derivatives and structured products to be cleared through global exchanges (with associated net position limits and centralized margin posting) and sharply limiting overall financial leverage at trading banks, I do not see a failsafe solution to this conundrum. Investment banks are bred in the bone to be highly competitive and take substantial risks. Their competitive risk taking added materially to the accumulation of dangerous stresses and vulnerabilities preceding the crisis, and there is no reason to believe it will not do so again.

I would be delighted to be proved wrong about this by those who know much more about the plumbing of the financial system than I do.⁴ What is to prevent the occurrence of another AIG Financial Products? How can existing system controls prevent or dampen the cascade of credit failures through the system? Are potential leverage-induced death spirals limited to markets with illiquid, opaquely valued securities? If so, what prevents them from spilling over via contagion into other markets? What is to prevent a major securities or derivatives market meltdown from forcing another massive government bailout?

And if you are brave, knowledgeable, and/or foolish enough to try to answer these questions, please keep in mind the admonition of another very clever man whom few now trust:

There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don't know we don't know.

A wise man learns to plan for all three.

Related reading:
Committee on the Global Financial System, The role of margin requirements and haircuts in procyclicality (BIS CGFS Papers No. 36, March 2010)
Selling More CDS on Europe Debt Raises Risk for U.S. Banks (Bloomberg, November 1, 2011)

An early response:
Brandon Adams, Response for @Epicurean Deal (November 5, 2011)


¹ An economy is simply the set of organizing principles and rules which a society establishes to allocate and employ resources for the benefit of its members. How these rules are established and maintained is politics. To assert otherwise, or claim as some do that society and politics have no proper claim on the organization or maintenance of economic activity (e.g., via regulation or taxation), is the height of folly or disingenuousness.
² Those among you who cannot comprehend this concept and who would prefer to call me much less flattering names than “dreamer” are welcome to stock up on canned peaches and armor-piercing ammunition and join your fellow nutcases in Galt’s Gulch. The rest of us will come annihilate you when we can spare a moment. (Or just let you starve to death.)
³ For example, my best and most comprehensive source to-date for understanding the intricacies of the issues under discussion would not allow me to share them directly, in part because (s)he believed some of the generic information (s)he provided could provide a competitive advantage. And you people think I’m secretive.
⁴ All reasonable, informed, and specific responses are heartily welcome. I may publish or link to the most informative and interesting of these here. Please direct your responses to the email address found on this site, or notify me on Twitter (@EpicureanDeal) or by email if you have published it on another site. Please indicate if you would prefer no attribution.


© 2011 The Epicurean Dealmaker. All rights reserved.

Tort Reform

Overheard this morning at breakfast:

Lawyer #1: “Being a litigator is like cleaning the Augean Stables: it’s not particularly pleasant work, but you know you’ll always have a job.”

Lawyer #2: “That’s nothing. You should try representing investment bankers. It’s like being a streetsweeper in the Rose Parade: you have to deal with a neverending parade of horses’ asses, and you’re always cleaning up their shit.”

I love lawyer jokes. Especially when they’re told by lawyers.

Happy Friday.


© 2011 The Epicurean Dealmaker. All rights reserved.

You’re Doing It Wrong

And he sampled the time-winds, sensing the turmoil, the storm nexus that now focused on this moment place. Even the faint gaps were closed now. Here was the unborn jihad, he knew. Here was the race consciousness that he had known once as his own terrible purpose. Here was reason enough for a Kwisatz Haderach or a Lisan al-Gaib or even the halting schemes of the Bene Gesserit. The race of humans had felt its own dormancy, sensed itself grown stale and knew now only the need to experience turmoil in which the genes would mingle and the strong new mixtures survive. All humans were alive as an unconscious single organism in this moment, experiencing a kind of sexual heat that could override any barrier.

— Frank Herbert, Dune

There is something deeply wrong with this country, O Dearly Beloved.

We seem to have painted ourselves into a corner from which we cannot escape. Grass roots movements as diverse as the Tea Party and Occupy Wall Street implicitly recognize this fact and have sprung up in response to it. People from a broad spectrum of Americans less committed, strident, and/or crazy than these activists have shown themselves to be largely sympathetic to their discontent. Depending on where you stand, and which hobby horse you happen to be riding at the moment, our predicament can appear in any number of guises: corrupt crony capitalism, grossly overbearing and inefficient government, a broken financial system deeply riddled with self-interest, or a society-wide breakdown of personal responsibility and uprightness.¹ Our so-called leaders—the very men and women we elected to get us out of this mess—cannot seem to tie their own shoes, much less offer a solution or even a direction in which to begin marching. Politicians are the only group of individuals more despised and less respected than investment bankers nowadays. Believe you me, as one of the latter, I can attest that that is a pretty damning indictment.

A common feature of many of our ills is the unmanageable size and complexity of our institutions and practices. This is certainly true of the government itself, our regulatory and tax systems, and our financial system. Part of this problem—size—may be an ineluctable outgrowth of the sheer mass of our nation and economy. One can certainly argue that size itself can lead to myriad ills. One can credibly entertain the notion that perhaps governing over 300 million people and managing a $14 trillion economy may be beyond the collective ability of any group of people, however intelligent or dedicated. Size certainly seems to have flummoxed the captains of my industry and their regulators in the most recent crisis.

But the bigger culprit, in my opinion, is complexity. Complexity makes things more difficult to manage. Complexity imposes substantial extrinsic costs, which must be expended simply to deal with complexity itself, apart from any underlying issues at hand. Complexity increases uncertainty, introduces distortions, and encourages mistakes. Want examples? Just think of the tax code, or the current state of the global financial system.

And yet we cannot seem to hit the rewind button on complexity. The latest example of this is the appalling complexification that the Volcker Rule—which was included in the Dodd-Frank financial reform act in order to prevent risky proprietary trading by government-backed depositary institutions—has undergone at the hands of those drafting the final regulations. The Beltway rulemaking sausage factory has turned what was a three-page initial proposal and a ten-page section in Dodd-Frank into a 300-page monster. A monster which, by all accounts, nobody loves.

Now, without a doubt a substantial portion of blame for this complexification can be laid squarely at the feet of industry lobbyists and banks themselves. They were the ones who lobbied so expensively and extensively for exemptions and extensions. They were the ones who no doubt insisted that the simple premise of the Volcker Rule was too simplistic to impose on a complex, interconnected industry without causing unacceptably expensive and potentially dangerous disruptions to established business practices.² I’m sure they offered all sorts of eminently reasonable objections to straightforward implementation of a separation between proprietary trading and depositary lending, while simultaneously missing or pretending not to understand that THAT IS THE VOLCKER RULE’S ENTIRE FUCKING POINT. That these dickwads and their hired guns were able to impose their will to neuter this piece of legislation you may credit to another virulent contagion in our polity: the pervasive and poisonous influence of corporate and individual money on politics and regulation.^{3, 4}

* * *

But the more general contributor to this legislative abortion is a structural one. Too many (all?) of the people writing these rules—both on the regulatory side and the industry itself—are lawyers. And lawyers have strong professional and cognitive biases against simplicity when drafting rules, laws, contracts, or indeed any sort of document designed to govern behavior. In all such situations, it is lawyers’ job, objective, and desire to minimize interpretation. They do this because they want to forestall future disputes and potentially expensive litigation by exhaustively codifying behavioral rules and spelling them out under every conceivable circumstance. Since when have you not seen a lawyer sorely tempted to insert a “provided, however” phrase into the simplest contract? Yeah, me neither.

A charitable reader like yourself might understand this impulse as a natural outgrowth of the pervasively litigious culture in the United States. For whatever reason, this tendency to sue first and ask questions later has led to a preponderance of rule-based, as opposed to principle-based regulation in this country. Nevertheless, codifying a principle as clear and straightforward as the Volcker Rule into a 300-page cookbook of recipes for what is and is not allowed in the financial sector is a wrongheaded exercise in futility. For one thing, exactly no-one can possibly anticipate how the financial markets and their constituent banks will change over the forseeable future. The global financial system is just too dynamic, and the likelihood that a piece of regulation penned in 2011 will be able to effectively anticipate and regulate financial market developments over the next several years is simply ludicrous. Investment banks themselves don’t know what kind of opportunities and threats they will face—and hence what they’re actually going to be doing—next quarter, much less in 2012 or 2015. How can we expect a static document drafted by a bunch of underpaid, cover-your-ass government lawyers who couldn’t recognize a proprietary trading desk if they were sitting at it to do so?

Because of this, regulators must have the ability to flexibly interpret and respond to changing conditions in the financial markets and the businesses of their regulatees.⁵ The relentless, rapid evolution of finance requires that financial regulation be principle-based, not rule-based. Reformed quant Emanuel Derman makes the case persuasively that we cannot understand financial markets using rigidly codified models. If that is true, how, then, can we ever hope to regulate them with a framework based on rigid, over-codified rules?

No points for guessing: we can’t.

* * *

So what does that mean for the Volcker Rule and financial reform in general? Well, one might argue that the best solution is to scrap that overlawyered piece of toilet paper and go back to the author of the eponymous rule’s own suggestion:

“I’d write a much simpler bill. I’d love to see a four-page bill that bans proprietary trading and makes the board and chief executive responsible for compliance. And I’d have strong regulators. If the banks didn’t comply with the spirit of the bill, they’d go after them.”

Of course, this would be principle-based regulation. As Mr. Volcker points out, such a regulatory regime would require strong and well-informed regulators. I have made the same point, too many times to link to here, over and over in the past. Professor Derman is with me too. You would want ex-bankers, experienced in sales, trading, structured finance, and derivatives, who would work closely with regulated banks to monitor, understand, and control the changing nature of risks, activities, and opportunities in the markets. You would create performance incentives which completely insulate them from the results of their regulatees, and you would impose strict prohibitions on them returning to the industry before their active market and industry knowledge has gone stale.

Such regulation would demand close, realtime cooperation and consultation between regulators and industry participants. But if it is done properly, it should work out to everyone’s benefit. Regulators would get realtime information on risk exposures and market practices from their regulatees, and regulatees would receive realtime feedback and guidance from regulators on overall market developments and trends in risk management. Done properly, this model would not stifle innovation or profit-making. It would enhance it, while simultaneously reducing systemic risk and giving regulators early warning of developing threats to global financial security.

* * *

The Dodd-Frank legislation at over 2,000 pages is an abortion. The Volcker Rule at 300 pages is an abortion. They cannot succeed. If we cannot empower intelligent, experienced regulators to monitor and control the wholesale financial system using heuristic principles, we are fucked. Under the current financial regulatory system, and its proposed rules, we are all fucked. I will leave it to my Loyal and Long-Suffering Readers to decide whether that is a state of affairs which can be corrected. I suspect these pearls will be trampled like all the others into the muck of the pig wallow. Only time will tell.

In the meantime, we need to reinvent our rulemaking processes. Currently we make laws and regulations like oysters make pearls, except instead of starting with a tiny grain of sand and covering it with precious nacre, we start with a tiny pearl of sensible principles and cover it with layer upon layer of sand, grit, and detritus. This makes for ugly pearls, and lousy legislation.

When are we going to wake up?

Related reading:
Paul Kingsnorth, This economic collapse is a ‘crisis of bigness’ (The Guardian, September 25, 2011)
Grains of Sand (August 10, 2007)
James Stewart, Volcker Rule, Once Simple, Now Boggles (The New York Times, October 21, 2011)
Emanuel Derman, Maybe markets need more principles and less regulation (Reuters, October 21, 2011)


¹ For the avoidance of doubt, just in case you do care, I believe all of these things to be true. In my opinion, we are in deep doo-doo, and I see no-one on the horizon with a shovel.
² The premise behind these shenanigans is faulty. It is not the obligation of regulators to adapt, weaken, and modify regulations to minimize disruption to regulatees’ current business practices. It is the obligation of regulatees to modify their fucking business practices to comply with regulation. Jesus.
³ There is a part of me that hopes the Volcker Rule is implemented in its currently bastardized form so mega-banks will be forced to expend ridiculous amounts of shareholder money and management attention complying with the Frankenstein’s monster they have helped create. Karma can be a bitch.
⁴ As an aside, SCOTUS’s decision in Citizens United was an abortion of American jurisprudence. Just sayin’.
⁵ My focus throughout this piece is on regulation of the wholesale financial sector; that is, investment banks, commercial banks, and other entities which provide services to corporations, institutional investors, hedge funds, and other such non-retail customers. I have nothing to say about retail financial regulation, since that is neither my area of expertise nor my day-to-day concern. Perhaps more rule-based regulation makes sense for consumer finance, since I suspect that field is less changeable and dynamic than the wholesale sector. But I defer to others with better knowledge on that topic.

© 2011 The Epicurean Dealmaker. All rights reserved.