Volcker Rules
The end of proprietary trading may hit banks’ profits but help their stock prices
Forget Inflation
How the financial stability mandate may change the art of central banking
DECEMBER 2010/JANUARY 2011
Raining Money
Meet the top deal makers of 2010 in our 2nd annual Rainmakers of the Year
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THE 2011 ALL-AMERICA EXECUTIVE TEAM
The Best of Corporate America These innovative corporate chiefs are finding ways to keep their companies growing — and their shareholders smiling. Page 40
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SDOM THE FUTURIST THE CHARTIST
FEATURES
CONTENTS INSIDE II TICKER FIVE QUESTIONS PEOPLE
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DECEMBER 2010 / JANUARY 2011
70
40
62
58
58 Building a
DERIVATIVES
54 Good-Bye to BANKING
40
THE 2011 ALL-AMERICA EXECUTIVE TEAM
The Best of Corporate America BY LESLIE KRAMER & KATIE GILBERT
These innovative corporate chiefs are finding ways to keep their companies growing — and their shareholders smiling.
78
Better House
BY SUZANNE MILLER
All That
BY IMOGEN ROSE-SMITH
Reform will spell the end of prop trading as banks knew it — and that could be good news for investors.
Will the creation of clearinghouses to bring OTC derivatives under one roof really reduce systemic risk?
62 The New Art of
MONETARY POLICY
Central Banking BY TOM BUERKLE
Can central bankers stop worrying about inflation and learn to love the new culture of financial stability?
institutionalinvestor.com BLOGS Stephen Taub delivers timely dispatches from the ever-changing world of hedge funds.
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70 Renminbi Bridge CHINA
BY ALLEN T. CHENG
China’s currency expands creatively to attract investors.
78 Cuba Libre CUBA
BY JONATHAN KANDELL
Foreign developers want a piece of the action as Raúl Castro commits to private enterprise.
VOLUME XLIV, NO. 10 • AMERICAS EDITION
RESEARCH The Mandarin Oriental in Tokyo tops our exclusive annual ranking of the World’s Best Hotels.
WEB EXCLUSIVE CFO Stacy Smith discusses tech giant Intel Corp.’s current acquisition strategy.
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WISDOM THE FUTURIST THE CHARTIST
CONTENTS INSIDE II TICKER FIVE QUESTIONS PEOP
ETC
7
OPENING
Ticker Wall Street salaries take a tumble • Regulators are setting their sights on expert networks • Paamco’s paternity called into question• Five Questions For Terrence Deneen • People Faces in Finance • This Month in Finance
38
18 DONE DEALS
24 MARKETS
BY CHARLES WALLACE
BY LAURIE KAPLAN SINGH
Abbott joins the rush into emerging markets.
Investors are flocking to emerging-markets bonds.
Drugs Tour
20 ALTERNATIVES
Never Be Closing BY STEPHEN TAUB
Private equity is on the mend, but raising a fund takes longer than it used to.
CAPITAL
34
22 THE BUY SIDE
Strength in Numbers BY LOCH ADAMSON
RAINMAKERS
Rainmakers of the Year
BY XIANG JI AND DAVID ROTHNIE
Institutional Investor pays tribute to the bankers who sealed 2010’s top deals.
Winton Capital finds its long-only game.
23 THE BUY SIDE
Daily Mirror BY CHRISTOPHER ALESSI
SRL Global’s portfolio tracker lets clients follow multiple managers.
83
High Standards for Globe Trotters Leading hotels stand out by offering refined service in distinctive settings.
Good Debt
26
GLOBAL SECURITIES SERVICES
Knowledge Thirst BY FRANCES DENMARK
Clients are demanding better third-party oversight.
5 111
Inside II Inefficient Markets 113 Unconventional Wisdom 114 The Futurist 116 The Chartist
28 GREEN SHOOTS Solar Eclipse
BY CHRISTOPHER ALESSI
Renewables outfit Ecofin turns to gas and utility plays.
30 CEO INTERVIEW New Rx
BY NEIL SEN
Andrew Witty focuses GSK on emerging markets.
To see the latest on these stories or provide feedback, visit institutionalinvestor.com
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DENNIS BRACK/BLOOMBERG NEWS
7
RESEARCH & RANKINGS
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EDITOR William H. Inman AMERICAS EDITOR Michael Peltz INTERNATIONAL EDITOR Tom Buerkle ART DIRECTOR Nathan Sinclair
Drucker’s Legacy
MANAGING EDITOR Thomas W. Johnson LONDON BUREAU Loch Adamson (Chief) ASIA BUREAU Allen T. Cheng (Chief) WEB MANAGER Barry Whyte WEB EDITOR James Johnson WEB PRODUCTION/DESIGN Michelle Tom WEB INTERN Franziska Scheven SENIOR WRITER Frances Denmark STAFF WRITERS Imogen
Rose-Smith, Julie Segal,
Neil Sen REPORTER Xiang Ji SENIOR CONTRIBUTING EDITORS Firth Calhoun,
Nick Rockel SENIOR CONTRIBUTING WRITERS Pam Baker, Hugo
Cox, Katie Gilbert, Fran Hawthorne, Jonathan Kandell, Leslie Kramer, Scott Martin, Ben Mattlin, Craig Mellow, Virginia Munger Kahn, Cherry Reynard, David Rothnie, Harvey D. Shapiro, Henry Scott Stokes, Paul Sweeney, Stephen Taub SENIOR EDITORS Tucker Ewing, Jane B. Kenney (Editorial Research) ASSOCIATE EDITORS Denise Hoguet, Fritz Owens (Editorial Research) COPY EDITORS Monica Boyer, Ruth Hamel,
Catheryn Keegan, Patrick Sheehan DEPUTY ART DIRECTOR Diana Panfil ART DEPARTMENT Alex Agius, Israt Jahan,
Bethany Mezick, John Miliczenko EUROMONEY INSTITUTIONAL INVESTOR PLC CHAIRMAN Padraic Fallon DIRECTORS Sir Patrick Sergeant, The Viscount
Rothermere, Richard Ensor(managing director), Neil Osborn, Dan Cohen, John Botts, Colin Jones, Diane Alfano, Christopher Fordham, Jaime Gonzalez, Jane Wilkinson, Martin Morgan, David Pritchard, Bashar Al-Rehany INSTITUTIONAL INVESTOR, 225 Park Avenue South, New York, NY 10003; (212) 224-3300; Fax: (212) 224-3171. www.institutionalinvestor.com London Bureau: Nestor House, Playhouse Yard, London EC4V 5EX, U.K.; (44-207) 303-1703; Fax: (44-207) 303-1710 Hong Kong Bureau: 27/F, 248 Queen’s Road East, Wan Chai, Hong Kong; 852-2912-8030; Fax: 852-2842-7011 © 2010 Institutional Investor, Inc. (ISSN 0020-3580) No statement in this magazine is to be construed as a recommendation to buy or sell securities. Neither this publication nor any part of it may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system, without the prior written permission of Institutional Investor magazine. For reprints and Web links, contact: Dewey Palmieri (212) 224-3675; Fax: (212) 224-3563; e-mail:
[email protected]. Printed by Cadmus Specialty Publications, Richmond, VA U.S.A. For customer service inquiries please call (800) 945-2034; Overseas: (212) 224-3745; Fax: (615) 377-0525. CHAIRMAN, INSTITUTIONAL INVESTOR Diane E. Alfano FOUNDER Gilbert E. Kaplan
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THE MAN WHO INVENTED
modern management hated number- crunchers and bosses who operated by rote and abstraction. After all, Peter Drucker cut his teeth as a Jewish journalist in Nazi Germany, risking his life bashing authority and phony political and economic ideas. Nobody was immune. He savaged John Maynard Keynes, guru of his time, for caring more about commodities than “behavior of people”; and Alfred P. Sloan, builder of General Motors, for his inability to take criticism. Drucker’s books had the distinction of being banned on both sides of the Atlantic, burned by Nazis in Europe, and deemed forbidden reads at GM and the fixed cultures of other Fortune 500 companies. His writing expressed common themes: respect for the worker, respect for the customer, simplification, decentralization; avoidance of last year’s methods, macroeconomics and taking any action without thinking. No finer testament to Drucker’s values can be found than in the comments from
some of the most-admired corporate leaders, members of Institutional Investor’s 2011 All-America Executive Team (page 40). “Talent is a key asset in our business,” declares Francisco D’Souza, the CEO of Cognizant Technology Solutions Corp. and the No. 1 chief executive in Computer Services & IT Consulting. “It’s the way we deliver our services.” MetLife chief C. Robert Henrikson, voted Best CEO in the Insurance sector: “A s i g n i f i c a n t amount of time is spent with shareh o l d e r s .” A n d Kroger CEO David Dillon, the sell side’s choice for top executive in Retailing/Food & Drug Chains: “I enjoy spending time with our shareholders,” he says,“and probably learn as much from them as they do from me.” Drucker would buy from all these guys.
Avoiding last year’s methods and dubious economics
— WILLIAM H. INMAN EDITOR, INSTITUTIONAL INVESTOR
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CALL FOR NOMINATIONS! Institutional Investor’s
2011 U.S. INVESTMENT MANAGEMENT AWARDS In March 2011, Institutional Investor will announce the winners of its 2nd annual U.S. Investment Management Awards, which recognize U.S. money managers across more than a dozen asset classes and strategies that stood out for their exceptional performance, risk management and service, as well as U.S. institutional investors whose innovative strategies and fiduciary savvy resulted in impressive returns over the past year. Winners will be honored and awarded at a dinner and ceremony on Monday, May 16th, at the Mandarin Oriental in New York City that will bring industry leaders together for a night of networking and recognition. NOMINATION DEADLINE: FRIDAY, JANUARY 21, 2011
For more information and to submit a nomination, please visit www.usinvestmentawards.com/nominate
Morningstar Overall Rating™ for Class A shares as of 10/31/2010. Morningstar measures risk-adjusted returns. The overall rating is a weighted average based on a fund’s 3-, 5- and 10-year star rating.
Prudential Jennison Equity Income Fund (SPQAX) Among 1,117 Large Value funds. The 3-, 5- and 10-year ratings are 5 stars out of 1,117 funds, 5 stars out of 948 funds, and 3 stars out of 489 funds, respectively.
Prudential Jennison 20/20 Focus Fund (PTWAX) Among 1,514 Large Growth funds. The 3-, 5- and 10-year ratings are 3 stars out of 1,514 funds, 3 stars out of 1,287 funds, and 5 stars out of 768 funds, respectively.
Prudential Jennison Natural Resources Fund (PGNAX) Among 104 Natural Resources funds. The 3-, 5- and 10-year ratings are 3 stars out of 104 funds, 3 stars out of 66 funds, and 4 stars out of 38 funds, respectively.
Prudential Jennison Mid-Cap Growth Fund, Inc. (PEEAX) Among 683 Mid-Cap Growth funds. The 3-, 5- and 10-year ratings are 4 stars out of 683 funds, 4 stars out of 600 funds, and 3 stars out of 367 funds, respectively.
Prudential Global Real Estate Fund (PURAX) Among 117 Global Real Estate funds. The 3-, 5- and 10-year ratings are 3 stars out of 117 funds, 3 stars out of 40 funds, and 5 stars out of 16 funds, respectively.
Prudential Muni High Income Fund (PRHAX) Among 133 High Yield Muni funds. The 3-, 5- and 10-year ratings are 4 stars out of 133 funds, 4 stars out of 104 funds, and 4 stars out of 89 funds, respectively.
Prudential Short-Term Corporate Bond Fund, Inc. (PBSMX) Among 378 Short-Term Bond funds. The 3-, 5- and 10-year ratings are 4 stars out of 378 funds, 4 stars out of 326 funds, and 4 stars out of 189 funds, respectively.
Bright
Consider a fund’s investment objectives, risks, charges, and expenses carefully before investing. The prospectus contains this and other information about the fund. Contact your financial professional for a prospectus and read it carefully before investing. The risks associated with investing in these funds include but are not limited to: derivative securities, which may carry market, credit, and liquidity risks; short sales, which involve costs and the risk of potentially unlimited losses; leveraging, which may magnify losses; high yield (“junk”) bonds, which are subject to greater market risks; small/mid cap stocks which may be subject to more erratic market movements than large cap stocks; foreign securities, which are subject to currency fluctuation and political uncertainty; real estate, which poses certain risks related to overall and specific economic conditions as well as risks related to individual property, credit and interestrate fluctuations; and mortgage-backed securities, which are subject to prepayment and extension risks. Sector funds and Specialty funds may not be suitable for all investors. Such funds are nondiversified, so a loss resulting from a particular security will have greater impact on the Fund’s return. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. The risks associated with each fund are explained more fully in each fund’s respective prospectus. There is no assurance a Fund’s objectives will be achieved. Some Morningstar Ratings may not be customarily based on adjusted historical returns. If so, an investment’s independent Morningstar Rating metric is compared against the retail mutual fund universe breakpoints to determine its hypothetical rating for certain time periods. For each fund with a 3-year history, Morningstar calculates a Morningstar rating based on a Morningstar risk-adjusted return measure that accounts for variation in a fund’s monthly performance, including the effects of sales charges, placing more emphasis on downward variationsandrewarding consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Funds were rated against U.S.-domiciled funds. Other share classes may have different performance characteristics. ©2010 Morningstar, Inc. All rights reserved. The information contained herein(1)isproprietarytoMorningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Mutual funds are distributed by Prudential Investment Management Services LLC, a Prudential Financial company. Prudential Investments, Prudential, Jennison Associates, Jennison, the Prudential logo, and the Rock symbol are service marks of Prudential Financial, Inc., and its related entities, registered in many jurisdictions worldwide.
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December 2010/January 2011 News and views from the world of finance
Gorman (left) and Sanders: Odd bedfellows on pay
WALL STREET
GORMAN: JIN LEE/BLOOMBERG; SANDERS: TIM SHAFFER/BLOOMBERG NEWS
PAYDAY OF RECKONING THE PUSH FOR COMMON SENSE A recent Wall Street Journal survey predicted that compensation for the Street would rise 4 percent in 2010. By past standards, that might seem modest. Nonetheless, socialist-leaning U.S. Senator Bernie Sanders from Vermont INSTITUTIONALINVESTOR.COM
called the payouts “unconscionable.” Some on Wall Street might agree, but from a different perspective: They may well regard their bonuses as too meager. Goldman Sachs, whose third-quarter profits declined from $3.2 billion in 2009 to just $1.9 billion in 2010, said it was slashing 2010 compensation by 26 percent. Morgan Stanley, which lost $91 million
in the third quarter, is cutting investment bankers’ bonuses by 8 percent. The (strictly relative) hardship is not spread across finance. Alan Johnson, a Wall Street compensation expert, estimates that fixed-income and equities traders are looking at a reduction of 25 to 30 percent in their bonuses. By contrast, asset management, hedge fund, private equity and wealth management executives are likely to get 10 to 15 percent hikes in their incentive comp.
Although it might seem obvious that it should, pay does not automatically decline on Wall Street when profits do. Yale political scientist Jacob Hacker, co-author of Winner-Take-All Politics, a recent book purporting to show how Washington helped create a new class of rich, says recompense in finance was seemingly designed “so that it is good when times are bad and even better when times are good.”
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DE II OPENING TICKER FIVE QUESTIONS PEOPLE THIS MONTH IN FINANCE DONE DEALS ALTERNAT Wall Street Research
“
[Reregulation means] people will be leaving the financial sector, and wages are going to go down. —Ariell Reshef University of Virginia
”
Stanley, complained that a lot of people on Wall Street are “frankly pretty average” yet undeservedly earn 10 times what their counterparts in other industries do. Gorman, who himself took home $15.1 million last year, asserted it was about time that Wall Street created “a compensation system that better aligns or balances shareholders’ interests and the broader society’s interests with the individual’s interests.” Washington appears to be groping in that direction (or was until the midterm elections). Federal financial regulators’ “Guidance on Sound Incentive Compensation Policies” for banks stipulates that their incentive pay should balance risk and results so that
EXPERT TEASE DO EXPERT NETWORKS GO TOO FAR?
employees aren’t tempted to take imprudent risks. How the government proposes to enforce this dictum was not made clear. The Dodd-Frank Wall Street Reform and Consumer Protection Act gives shareholders a voice in determining the pay of financial executives. In October the SEC followed up with proposed “say on pay” regulations. Such measures are partly a response to the public outcry over taxpayer-rescued Bank of America’s having paid $3.6 billion in bonuses
in 2008 to executives of Merrill Lynch, which BofA had just acquired, even though the brokerage firm had lost $15 billion that year. Congress demanded that executives at banks bailed out by the Troubled Assets Relief Program receive comparatively modest cash salaries and take most of their pay in deferred compensation reflecting their firm’s performance. (To escape this constraint, bailed-out banks rushed to pay back TARP loans well ahead of schedule.)
Wall Street seems to be quietly heeding the blowback over unmerited compensation. Five years ago half of Wall Street bonuses were cash and half equity in the recipient’s firm; today closer to 75 to 80 percent is doled out in deferred stock, according to compensation expert Johnson. The Street is also beginning to employ clawbacks to recover part or all of a bonus if, say, a trader’s investments go sour in subsequent years. Yet these pose legal issues and have been used only in isolated cases. INSTITUTIONALINVESTOR.COM
RAMIN TALAIE/BLOOMBERG
Hacker and his coauthor, Berkeley political science professor Paul Pierson, argue that financial industry compensation must be restructured so that incentives that can “cause huge problems for the rest of the economy” are minimized and Wall Streeters engage in more-productive activities. This can no longer be regarded as a fringe opinion. In an October speech, James Gorman, CEO of Morgan
dle research and compliance, warned its hedge fund clients that they needed to strictly control their relationships with expert networks to avoid compliance issues. Integrity Research’s 143-page report, based on an extensive survey of the hedge fund industry and expert network firms, found that most analysts and portfolio managers were neither well informed nor overly concerned about compliance considerations when employing expert networks. Moreover, the report said, 18 of 38 expert networks refused to discuss their own compliRESEARCH ance capabilities, in many cases because they were minimal. U.S. Attorney Integrity Research chairman Bharara makes his Michael Mayhew tells Institutional complicated case Investor that expert networks in general are not fraught with compliance On Wall Street the most sought-after commod- problems. “Our real issue,” he says, “is that we saw ity is not gold but information. So in November, some firms with great compliance and some with not-great compliance.” when U.S. Attorney Preet Bharara and the SEC Mayhew emphasizes that the transfer of material charged a French doctor with insider trading for nonpublic information to investors poses inherent allegedly slipping a hedge fund early results from risks for all parties involved. (Paradoxically, the very the clinical trial of a potential blockbuster drug, vagueness of insider trading rules as they relate to the reaction was shock — and puzzlement. expert networks may make adoption of elaborate Are so-called expert networks — collections of compliance systems all the more important.) doctors and other professionals as well as ex– Mayhew’s firm cautioned in 2009 that to be seen corporate officials, typically brought together by as credible players in the market, expert networks boutique firms — suddenly in Bharara and the may need to invest in compliance systems. One SEC’s crosshairs as they carry out a sweeping crackdown on insider trading? Hedge funds, leading expert network, Gerson Lehrman Group, which often rely on outsourced expertise, worry now employs no fewer than 18 compliance peothat the agency aims to make it a crime to tap ple, according to its general counsel, Laurence industry insiders for insights into developing trends Herman. (He says an expert at his firm was questioned but not charged.) in a bid to gain an edge on competitors. Integrity Research’s advice about beefing up However, the thrust of the probe should not compliance may have come a little late, however, have caught so many hedge funds by surprise. A for expert networks now under investigation. year ago, Integrity Research Associates, a New — STEPHEN TAUB York–based firm that helps asset managers han-
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Are these steps enough to rein in the Wall Street bonus culture? Kevin Murphy, a compensation expert at the University of Southern California, observes that 38 percent of the senior executives covered by TARP rules quit and found other jobs rather than accept pay limits. He adds that if a firm tries to reduce bonuses across the board because of poor performance in one division, top performers in other parts of the firm might well exit. The new rules may be too mild-mannered to reduce risky behavior. Thomas Cooley, an economics professor at NYU’s Stern School of Business and co-author of a new book, Regulating Wall Street, asserts that “shareholders and managers can be perfectly aligned [on pay], but if incentives provided by the financial system, such as the moral hazard created by too-bigto-fail guarantees and mis-priced FDIC insurance, encourage riskier behavior, then that’s not in the interest of the public.” In the end, stricter regulations, such as Dodd-Frank’s ban on proprietary trading, may make Wall Street a less alluring place to work. Ariell Reshef, an economics professor at the University of Virginia, studied a century of Wall Street compensation. He found that after the federal government imposed heavy regulation in the 1930s, finance industry wages fell relative to pay in other industries and didn’t start rising in relative terms until deregulation began in the Reagan era. Now that regulation seems to be coming back, Reshef says, “people will be leaving the financial sector, and wages are going to go down.” If that means firms take fewer risks and have more-reliable profits, it could be as good for Main Street as it is for Wall Street. — Charles Wallace
could retain control. However, Sussman insisted upon the right to convert the loan into equity at some point. Paamco’s four founders prospered, and today the firm oversees Paloma’s almost $10 billion. Sussman: A big To date, Sussman’s headache — return on what and gain was ostensibly a $2 million investHEDGE FUNDS BAD SEED ment may turn out THE PAAMCO LESSON to be worth more than $60 million. Yet this seeming As the founder of a success story has left a sour successful hedge fund taste and underscored the firm — Paloma Partners risks of seeding arrangements. Management Co. — S. Donald To establish his claim to a Sussman is aware of how 40 percent stake, Sussman had remunerative owning a hedge to take Paamco to court. In fund can be. So over the years August a U.S. District Court he has seeded hedge fund start- judge found in his favor, and ups, backing such firms as D.E. recently Paamco’s founders Shaw & Co. said that although there were Ten years ago, Sussman saw “strong grounds” for an appeal, another such opportunity in it would not be in clients’ or a fund of hedge funds, Pacific employees’ best interests. Alternative Asset Management The whole episode is a bit of Co. Based in Irvine, California, a legal head-scratcher. At the Paamco was launched by James crudest level, it consisted of a Berens, Jane Buchan, Judith Posnikoff and William Knight, all of whom had been portfolio managers at fund of hedge funds Collins Associates. In 2000, Sussman loaned Paamco $1.3 million to help get the firm going, and not long afterward he agreed to up the cap on the loan to $2 million. The credit was for ten years and in exchange for 10 percent annual interest or, alternatively, 40 percent of the profits, whichever was greater. The deal was nominally structured as a loan — Jane Buchan Paamco Founders so that Paamco’s founders
“
The original charge only affects the four founders. Paamco was never party to any lawsuit. We are pleased to have put this behind us.
classic “he said, she said” dispute over the terms of the seed contract. Sussman contended that he had the right to convert his loan to equity at any time before 2010. Paamco’s founders contended that he could convert his loan into equity only if Paamco were to be sold or pay off the loan early. An attorney representing Paamco says the case turned on revisions made to the original credit agreement and approved by both parties in 2003 when Buchan and company formed Paamco Founders to separate their partnership interests from those of the firm. Apparently, those reviewing the contract for Paamco missed critical language, although that too is a matter of dispute. Once Sussman filed suit, Paamco Founders countercharged that 10 percent on a loan of between $1.5 million and $2 million constituted usury in New York State. Judge Richard Sullivan ordered Paamco Founders to pay the back interest and issue Sussman’s holding company a “membership interest certificate” entitling him to 40 percent of Paamco Founders. Paamco, meanwhile, has entered damage-control mode. Buchan has been calling clients to reassure them.“The original charge only collectively affects the four founders,” she points out.“Paamco was never party to any lawsuit. We are pleased to have put this behind us.” Nonetheless, some clients are plainly worried that the fallout will hamper Paamco’s performance. Already, the Los Angeles Water and Power Employees’ Retirement Plan has withdrawn its $35 million investment, and the Kansas City Public School INSTITUTIONALINVESTOR.COM
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Retirement System is taking out its $18 million. Paamco’s troubles don’t end with the resolution of the lawsuit, though. Judge Sullivan speculated that Paamco’s peculiar ownership structure “may have been designed to mislead” investors into thinking the firm was majority-owned by women and thus eligible for investments intended exclusively for such firms. The SEC has begun a probe. Paamco wrote its investors that a full review of the record will show that there is “no basis to conclude that we acted improperly in any way.”Although Paamco says it never officially went after so-called minority-content mandates, some observers say the firm did not dis-
“
[Paamco’s ownership structure] mayhave been designed to mislead. — Judge Richard Sullivan U.S. District Court
”
courage the view that it was owned by women. The SEC will have to decide if Sussman’s equity-conversion rights were such that he should have been included on Paamco’s annual ADV ownership disclosure form. (Sussman appears for the first time on the 2010 form.) As it was, Buchan and Posnikoff appeared to hold 51 percent of Paamco. One longtime hedge fund seeder, Hugh Lamle of M.D. Sass, says that even when seed agreements run to more than 1,000 pages, he reviews every page himself. That may not be such a bad idea. — Frances Denmark
FIVE QUESTIONS FOR
TERRENCE DENEEN ERISA EVOLVING In October the Pension Benefit Guaranty Corp. took over the underfunded pension plan of bankrupt Sea Island Co., largely safeguarding the retirement benefits of the Savannah, Georgia–based resort operator’s nearly 2,000 workers and retirees. Terrence Deneen, the PBGC’s chief insurance program officer, has been involved in countless such bailouts since he joined the PBGC in 1978. In fiscal 2010 alone, the PBGC paid out $5.6 billion in benefits (up to $54,000 a person) to 800,000 participants in defunct plans and assumed responsibility for a further 700,000 who have yet to retire. Deneen, 59, who himself retires in January, has been overseeing a wide range of vital risk management and loss-mitigation functions for the PBGC. An attorney (University of Illinois College of Law), Deneen had a hand in drafting the Multiemployer Pension Plan Amendments Act of 1980, a major reform
of PBGC insurance for pension plans spanning many employers (typically, those negotiated by unions). As the administrator of the PBGC’s multiemployer insurance division, he set in motion efforts to remedy the complex problems of multiemployer plans — demographic shifts, investment losses, and so on. Outside the PBGC, Deneen may be best known as an expert on the omnibus U.S. pension law: the Employee Retirement Income Security Act of 1974. In a recent interview with Institutional Investor Senior Writer Frances Denmark, Deneen provided a perspective on the aging ERISA and the PBGC’s ongoing role at a time when the law may need more of an overhaul than a face-lift.
1
Was the pension world very different in 1974 when ERISA was enacted?
There was a big difference in the economy and the workforce. More than 40 percent of workers in the private sector were union-represented [today it is 12 percent]. The big focus in ERISA was on defined benefit plans, where there had been failures and scandals.
2
Was ERISA successful in dealing with the pressing issues?
In large measure the problems addressed by ERISA have been taken care of. Consider vesting
and accrual rules. Pre-ERISA, people worked every day until they retired. If you lost your job, no pension. With vesting, say you lost your job after ten years — you still got a retirement benefit.
3
ERISA also created the PBGC.
Yes, and the PBGC has played a big role in backstopping pensions when companies go under. But the PBGC’s initial role evolved. Early in its history, it was relatively cheap and easy for plan sponsors to dump plans on the agency. The Single Employer Pension Plan Act of 1986 changed that. Now companies can’t dump plans on the PBGC unless there’s a bankruptcy and they meet certain criteria.
4
What about the decline of defined benefit plans generally?
The head count of DB plan participants actually hasn’t gone down over the years — it’s still 30 million people. But dig deeper and you’ll see that this statistic masks profound changes. Today well over 55 percent of the total [DB] universe are retirees or inactive.
5
If you could rewrite ERISA from scratch, how would you do it?
I’d create a national system — a central program like a defined contribution plan but with mandatory employer/ employee contributions. It should be a true retirement fund with no withdrawals — centralized, minimal administrative costs, leakage prevention [to stem plan defections]. There are models in other countries where you can buy an annuity when you retire. INSTITUTIONALINVESTOR.COM
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PEOPLE PRADA’S CHINA CHIC; HUAND BYE AT SEC; ESTEVES TO GOLDMAN-IZE BTG PRADA SAYS NADA TO WEST No luxury brand connotes status quite like Prada. So the decision of Miuccia Prada and her husband, Prada CEO Patrizio Bertelli, to list the Amsterdambased, Italian-inspired haute fashion house in Hong Kong rather than, say, Milan makes perfect sense. At a time when most Western markets are looking a little shabby, Hong Kong — inundated in IPOs — appears to epitomize capitalist chic. And as Prada told one reporter, “My idea is always to avoid nostalgia.” — Franziska Scheven
When Mary Schapiro hired Henry Hu in September 2009, the SEC chief said the crisis-rattled agency “needed someone who is committed to thinking about risk in a different way” to build up its new Division of Risk, Strategy and Financial Innovation. Hu, 56, a University of Texas law professor, fit the job description as if chosen by a clever algorithm. He says he lives at the intersection of law, financial economic theory, capital markets and corporate governance. As early as 1993, Hu warned in a scholarly article that even sophisticated financial institutions can misunderstand derivatives. When he was just two months into his job at the SEC, Congress, then mulling deriva-
tives legislation, asked him to share his expertise by testifying. Hu would go on to create a division known for its interdisciplinary thinking. He recruited key people from diverse backgrounds, tapping major hedge funds for specialists in derivatives, risk management and trading, and hiring Ph.D.s in economics, finance and mathematics. His staff would in time number 60. Lately, they’ve been focusing on such disparate matters as clearinghouses, securities-based swap dealers and the Volcker rule limitations on proprietary trading. SEC watchers praise Hu for helping to break down silos at the agency by getting different departments to confer on critical matters. “It’s a very rich group of academic disciplines
and real-world skill sets, leading to an incredible amount of cross-fertilization,” he says. When the SEC undertook a thorough review of the proxy infrastructure, Hu’s people provided pivotal input. Showing its scope, the risk division has also participated in the SEC’s consideration of such matters as municipal securities markets, flash trading and various hedge fund issues. “We are involved across the entire spectrum of the SEC’s activities,” Hu says. But Hu’s heart — or maybe his head — has always been in academia. In late October, he confides, he arrived at a tipping point. He was participating in a roundtable on financial innovation and risk at the Peace Palace in the Hague, not as an SEC official but as a scholar.
He recounts being on a panel with Lord Woolf of Barnes, a former lord chief justice of England and Wales, and Nout Wellink, chairman of the Basel Committee on Banking Supervision. He remembers thinking, “Boy, I enjoyed being an academic.” Hu knew it was time to return to Austin. So in midJanuary he will be leaving his SEC post after 16 months, just in time for the University of Texas’ spring semester. “I always intended it to be short-term,” he says. “I like to think that we’ve made a difference. I feel I was let in the candy store at a critical time. When I am in the old folks’ home, I will be boring others to death about helping to establish interdisciplinary analysis at the SEC and INSTITUTIONALINVESTOR.COM
PRADA: GIUSEPPE ARESU/BLOOMBERG NEWS; HU: ANDREW HARRER/BLOOMBERG; ESTEVES: CLAUDIO EDINGER/BLOOMBERG MARKETS VIA BLOOMBERG NEWS
HENRY HU HEADS HOME
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RKETS GLOBAL SECURITIES SERVICES GREEN SHOOTS CEO INTERVIEW RAINMAKERS THE 2011 AL Counterclockwise from top left: fashionable Prada, academically inclined Hu, expansive Esteves, political rebel Sipprelle, NEC director-in-waiting Altman and China skeptic Magnus
replace Larry Summers as head of President Obama’s National Economic Council, the Evercore founder mixed and mingled with the likes of Mayor Mike Bloomberg and Lazard CEO Ken Jacobs at a book-signing party for a fellow investment banker and old chum, Felix Rohatyn, held at the New York Public Library. The Wall Street elder statesman, who chronicles the often humiliating process of being considered for public office in his new memoir, can commiserate with Altman. But then, Altman, 64, is an old hand at political games, having worked as a Treasury official for presidents Jimmy Carter and Bill Clinton. And as Rohatyn, 82, knows, you’re never too old to network. — Imogen Rose-Smith
BEAR IN THE CHINA SHOP
about landmark derivatives reform — as well as about the joys of academic research.” — Stephen Taub
ALTMAN: JONATHAN FICKIES/BLOOMBERG; MAGNUS: GRAHAM BARCLAY/BLOOMBERG NEWS
TROPICAL FEAT Twenty-two years ago, André Esteves started out as a backoffice intern at Brazilian investment bank Pactual. Today, at 41, he not only runs the bank, now BTG Pactual, but is one of the richest and most influential people in the country (Institutional Investor, October 2010). In the latest twist to this striking success story, BTG Pactual has attracted $1.8 billion in capital from a consortium led by three of the world’s biggest sovereign wealth funds. The group’s 18.65 percent stake puts a value on the bank of almost $10 billion. With all that INSTITUTIONALINVESTOR.COM
fresh capital — and with Brazil and other emerging markets ascendant — BTG Pactual may yet become what Esteves predicted it would someday be: a “tropical Goldman Sachs.” — Jason Mitchell
REBEL WITH A PAUSE? For a pillar of the establishment — rich, Republican, suburban — Scott Sipprelle has a rebellious streak. In the mid-2000s he was one of the ex–Morgan Stanley bankers who led a coup that ousted former Dean Witter boss Phil Purcell as CEO after Morgan Stanley merged with the brokerage house. So it was not such a surprise when Sipprelle, now 47 and heading a Princeton, New Jersey, venture capital firm,
Westland Ventures, decided to run for Congress from New Jersey’s overwhelmingly Democratic 12th district. His “Blueprint for Renewal” of America created a buzz in Republican circles. But his call for a coalition to promote “fiscal responsibility and common sense” didn’t resonate with enough voters, and he lost. Now that he’s had time to reflect, Sipprelle confides that as tough as working on Wall Street could be, “it was harder to run for office — just the constant, grueling emotional toll of having to be at your peak at all times.” — F.S.
ORDEAL BY SERVICE While Washington and Wall Street speculated over whether Roger Altman would
Analyses of China seem to disagree not on whether the country will surpass the West, but only on how soon. So it’s refreshing and a bit surprising that UBS’s veteran senior economic adviser, George Magnus, offers a contrary view in his new book, Uprising: Will Emerging Markets Shape or Shake the World Economy? The longtime market observer, 61, disputes “the linear projections” of Chinese growth by some investment banks. Magnus points out that China must cope with a rapidly aging society, like the West, but without the West’s high per capita income or social services network.“China is definitely not the oldest country, but it is among the fastest-aging,” he says. For that and other reasons, Magnus concludes that China’s fastest growth is behind it. — Xiang Ji
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OPLE OPENING THIS MONTH IN FINANCE DONE DEALS ALTERNATIVES THE BUY SIDE MARKETS GLO
MONEY MANAGEMENT The California Public Employees’ Retirement System is set to shift its allocation framework into five new categories to more closely focus on risk. (The California State Teachers’ Retirement System is also weighing such risk-centric investing.) Pension Consulting Alliance is recommending that both funds shift the emphasis of their asset allocation from asset classes to risk classes — a strategy that targets correlated risk across traditional asset classes. CalPERS’s five categories are liquidity, growth, income, real assets and inflation-linked assets. A spokesman for the giant Golden State fund says the new framework will allow the fund to be more “nimble” in respondng to violent market shifts, with a clearer eye to what may threaten or bolster its investments. — Money Management Letter
TRADING Proprietary trading is the next target area for the Financial Industry Regulatory Authority, which is preparing enforcement cases against certain of
investors rely too heavily on external ratings. Commission officials said that this overreliance creates a herd mentality that can trigger mass sell-offs of bonds in ratings-agency downgrades. But securitization officials in London warn that such measures would place extra compliance costs on investing firms. — Derivatives Week
PRIVATE EQUITY In the Fall 2010 issue of the Journal of Private Equity, Joan McPhee, Kirsten Mayer and Amanda Raad write that the increasing global appetite for anticorruption enforcement, combined with everlower thresholds for liability, signifies new frontiers of potential exposure. With private equity firms invested in high-risk industries around the world, often in countries with different business customs and practices, the upstream risk of inadvertently incurring civil as well as criminal liability from the actions of portfolio companies abroad can be substantial. Firm personnel who serve as officers or directors of portfolio companies may increasingly face personal liability. A clear understanding of emerging risks is essential.
FIXED INCOME INVESTING The European Commission is proposing regulations to reduce buy-side reliance on ratings-agency ratings and require investors to instead internally rate their own cash and synthetic securitization positions. The far-reachng proposals stem from regulators’ concerns that institutional
Gerald Buetow Jr., Frank Fabozzi and Brian Henderson assert in the Fall 2010 Journal of Fixed Income that the pattern of higher returns and lower standard deviations for bonds during expansive monetary policy periods was not present in recent years. This pattern suggests that either the linkage between monetary policy and bond returns has
changed or that the previously documented results arose spuriously because of the historically high yield curve in the 1970s and early 1980s. By analyzing changes in the shape of term structure across policy periods, they purport to demonstrate that changes in level are particular to the early sample period while changes in slope and curvature are consistent across periods.
CORPORATE FINANCE A unit of NASA has teamed up with the Electric Power Research Institute on an initiative to protect the U.S. power grid from solar storm activity. The project, Solar Shield, monitors solar eruptions that emit ionized gas, which can wreak havoc on the magnetic field and highvoltage transmission systems. It gives utilities two days’ notice to prepare. The sun has an 11-year cycle with peaks and valleys, and “right now we are starting to climb away from the solar minimum,” says Antti Pulkkinen, project leader. The next solar storm maximum is slated for 2014. A 1989 solar storm knocked out the Hydro-Québec grid for nine hours. — Power Financing and Risk Finance industry news briefs compiled by Institutional Investor’s Newsletters division. INSTITUTIONALINVESTOR.COM
ANDERS WENNGREN
THIS MONTH IN FINANCE RISK CLASSES VS. ASSET CLASSES
these types of firms. The self-regulatory organization is slated to file charges in which it will allege that prop desk traders have exploited gaps in their firms’ trading systems to trade through their limits, according to James Shorris, acting chief of FINRA enforcement. The excessive trading created risks for their firms, Shorris told delegates at a seminar hosted by the Securities Industry and Financial Markets Association’s compliance and legal division. Shorris said that in at least one instance the gaps existed because the firm used more than one system to execute trades and the limits weren’t properly aligned between the different systems. The cases should be filed in the coming months, he added. — Compliance Reporter
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CONSISTENT DIVIDENDS For more than a century, Kellogg Company has been
®
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Kellogg Company 50-Year Dividend History
dedicated to producing great-tasting, high-quality,
($ per share, adjusted for stock splits)
nutritious foods that consumers around the world know
5-year CAGR 7%
and love. With 2009 sales of nearly $13 billion, Kellogg
increase f
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foods. Kellogg Company has consistently paid dividends to shareowners since 1925. Over the past 5 years (2004 through 2009), the annual dividend has increased 42%, a compounded annual growth rate (CAGR) of 7%.
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2010
September 2010 quarterly dividend $0.405 per share.
INVESTOR RELATIONS CONTACT: Kathryn
Koessel–
[email protected]
®, ™, © 2010 Kellogg NA Co. | ®, ™, © 2010 Kashi Co. | ®, ™, © 2010 Kellogg Company
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E QUESTIONS PEOPLE THIS MONTH IN FINANCE DONE DEALS ALTERNATIVES THE BUY SIDE MARK
CAPITAL
T MAXWELL HOLYOKE-HIRSCH
THANKS TO THE GROWING PRESSURE TO HELP CONTAIN
health care costs by using generic drugs instead of costlier branded ones, the U.S. market is a slow-growth zone for most major drugmakers. So it’s no surprise that U.S. and non-U.S. pharmaceuticals companies are on the prowl to expand their portfolios in the developing world, where growth is 3 times higher than in the industrialized West. Abbott Laboratories is the latest to splurge on an emerging-markets acquisition, buying the branded generics business of India’s Piramal Healthcare for $3.7 billion in September. The developing world will account for about 70 percent of the pharmaceuticals industry’s revenue growth within five years, from 35 percent today, according to Los Angeles–based Wedbush Securities. “If you go to countries like India and China, where people may have never had health care, let alone pharmaceuticals, the growth in those areas will be explosive,” says Dimitri Drone, New York–based leader of U.S. transaction services for pharmaceuticals and life sciences at business consulting firm PricewaterhouseCoopers. By acquiring Piramal’s branded generics business, North Chicago–based Abbott vaulted into first place in the $8 billion Indian pharmaceuticals market, with a 7 percent share. William Chase, vice president for licensing and acquisitions at Abbott, says Piramal’s 2011 sales should be about $500 million. Abbott projects its Indian pharma business will hit $2.5 billion a year in the next decade. “We looked at all the major targets in India to try to figure out which would pair best with Abbott,” Chase says. “Piramal kept coming out on top for a number of different reasons, including INSTITUTIONALINVESTOR.COM
management strength, business practices similar to our company’s, position in the market and the fact that it was a very well-run business that had significant growth.” Phillip Nalbone, senior medical technology analyst at Wedbush, says Abbott paid a “big fat premium”: about 8.7 times the Piramal division’s $426 million in sales for fiscal 2010. Abbott agreed to give Piramal $2.12 billion up front, followed by four annual payments of $400 million, all from cash on the balance sheet. “There was a very competitive bidding process because people really do want access to these markets, and they want it now,” Nalbone says. Abbott is on a spending spree. In September 2009 it bought the pharma business of Brussels-based Solvay for $6.6 billion in cash. The unit has $3 billion in annual sales, about 75 percent outside the U.S., including 25 percent in Latin America and Eastern Europe. Diversification appears to be working: In the third quarter of 2010, Abbott’s earnings and sales grew 14.1 percent and 21.7 percent, respectively, over the same period in 2009. Branded generics makers like Piramal and Solvay are a new venture for Abbott. In Abbott joins the rush the developing world, which to buy emerging-markets offers little patent protection, pharmaceuticals makers. some generics bear corporate BY CHARLES WALLACE brands and sit high on the pharma food chain.“They’ve got very attractive margins, and those brands, when sold by a multinational, become very compelling in the Indian market because of perceptions of quality as well as the brand heritage,” Abbott’s Chase says. Branded generics make up 25 percent of the global pharmaceuticals market and a majority share in the developing world. Competition for top companies is intense. London-based GlaxoSmithKline bought Argentina’s Laboratorios Phoenix for $253 million in June, and a month later GSK snapped up New York–based Bristol-Myers Squibb Co.’s Middle East branded generics business for $390 million. “One of the biggest challenges people will have in India and China is that they don’t have the same level of legal protections they do in the U.S. and Western European countries,” says PwC’s Drone. “I think that one of the reasons they buy established companies in these markets is to gain knowledge and connections and relationships that you just can’t get if you set up shop on your own.” ••
Drugs Tour
Comment? Click on Banking & Capital Markets at institutionalinvestor.com.
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EALS CAPITAL ALTERNATIVES THE BUY SIDE MARKETS GLOBAL SECURITIES SERVICES GREEN SH Until lately, Guggenheim Partners’ Charles Stucke wisely held off on private equity
Never Be Closing
Private equity may be on the mend, but raising a fund can take a lot longer than it once did. BY STEPHEN TAUB
A
FTER SETTING OUT TO RAISE
$1 billion for their fourth fund several years ago, Greg Feldman and his team at New York private equity firm Wellspring Capital Management closed the fund in six weeks. But when Wellspring passed the hat for a fifth fund in 2009, it got a very different reception. Co-founder and managing partner Feldman had a good story to tell, including a gross internal rate of return of more than 40 percent, but potential investors were strapped for cash thanks to large previous private equity commitments and huge drops in their asset values. In the end, it took Wellspring a year and a half to close on its $1.2 billion fund.“About 99 percent of the reason was liquidity issues and not performance issues,” Feldman says.
Wellspring is not alone. The average time to close a private equity fund in 2010 was 19.8 months — double the wait in 2004, according to London-based alternative-investment research firm Preqin. These trials underscore several challenges facing the private equity business, even as it recovers from recent setbacks. At the height of the financial crisis, as the capital markets froze, private equity funds found it all but impossible to exit earlier deals. For the year ended March 31, 2009, they lost an average of 30 percent, although they were up 21.8 percent for the 12 months through March 2010, according to Preqin. The market appears to be turning. A total of 515 private equity buyout deals, worth $66.7 billion, were announced in the third quarter of 2010, the best quarterly period since early 2008. “Financing has come back and is quite strong,” says Chip Baird, a partner with Boston-based private equity firm Weston Presidio. There’s plenty of cash to do deals. Worldwide in the third quarter of 2010, 83 private equity funds raised about $59 billion. That boosted so-called dry powder to $447 billion, slightly off 2009’s record $500 billion. Because funds typically have a five-year investment period to charge full management fees, a big chunk of this money needs to be spent soon. Preqin figures 2006-vintage funds still have $40 billion of dry powder, while 2007 funds have $100 billion. Bank financing, however, is still not readily available. The standard deal today uses nearly half equity, way up from about 35 percent in 2006 and early 2007, according to PitchBook Data, a Seattle-based private equity research firm. “The access to credit and capital in the middle market is not as great as it is for the market for large companies,” says Weston Presidio partner David Ferguson. Meanwhile, older funds feel a growing pressure to exit previous deals.“There is a lot of overhang from aging portfolios,” says Adley Bowden, manager of research operations at PitchBook. Still, many institutional investors plan to boost allocations to private equity. In North America, private equity’s share of institutional portfolios will rise from 4.3 percent to 6.8 percent by 2012, according to a recent Russell Investments global survey of 119 large institutions. “Investors are smarter now,” notes Stephan Breban, director of private equity with Seattle-based Russell, which provides investment products and services. For example, Breban says, many pension funds realize they can allocate as much as half of their assets to less liquid investments like private equity. Kenneth Muller, a partner and co-chairman of the private equity fund group at San Francisco–based law firm Morrison & Foerster, says he’s seeing larger institutions commit to private equity, but with fewer individual managers. The crisis gave investors a chance to rebalance their portfolios and mix of managers, he adds. One person who wisely held off private equity until recently is Charles Stucke, senior managing director at Chicago- and New York–based investment firm Guggenheim Partners and CIO of Guggenheim Investment Advisors. Between 2006 and 2008, Guggenheim largely avoided new private equity commitments. It began allocating again in the fall of 2008, Stucke says, making a contrarian bet: “Lack of bank financing and the closed IPO windows for many firms are two reasons private equity is a compelling opportunity now.” •• Comment? Click on Hedge Funds/Alternatives at institutionalinvestor.com. INSTITUTIONALINVESTOR.COM
CHINA CONSTRUCTION BANK
Strategic Changes Deliver Strong Results On October 27, 2005, China Construction Bank (CCB) became the first of China’s four major state-owned commercial banks to list in Hong Kong. Five years later, CCB’s strong financial results are evidence of its achievements. As of September 30, 2010, CCB’s assets reached RMB10.68 trillion ($1.6 trillion), which is 2.6 times the amount before its listing. Its non-performing loan ratio was 1.14 percent, a drop of 2.7 percentage points from the end of 2005. Both its annualized return on average assets, at 1.46 percent, and its annualized return on average equity, at 24.87 percent, were near the best among major international banks. Both net profit and market capitalization ranked second among all listed banks globally. CCB’s ranking in the Fortune Global 500 jumped from number 315 five years ago to number 116. More important, CCB has been able to achieve substantial enhancement of its own management capability, service standards and overall competitiveness. It has attained worldclass levels in the areas of internal checks and balances, strategic planning, compliance management, team spirit and information disclosure. Five Strategic Transformations Since Shareholding Reform • By expanding vigorously into consumer finance and residential mortgage loans, CCB has shifted to an equal emphasis on wholesale and retail banking. As of June 30, 2010, personal loans accounted for more than 23 percent of the total. The balance for residential mortgage loans broke through the RMB1 trillion ($150 billion) mark. A cumulative total of 26.38 million credit cards have been issued and CCB now ranks first in the Chinese banking industry in the number of card-holding customers, consumer transaction amount and asset quality. • In order to give equal emphasis to traditional and emerging businesses, CCB has embarked on an all-out expansion of financial services for small enterprises, agriculture-related domains (agriculture, farmers and rural areas), livelihood projects and cultural industries. In the last three years, the average annual growth rate of loans to small enterprises was 28 percent, representing the cumulative issuance of more than RMB960 billion ($144 billion) in loans to some 100,000 small enterprise clients. Average annual growth of agriculture-related loans in this period was 30 percent, with the focus on supporting the construction of new villages, the planting of economic crops and the intensive processing of agricultural by-products. Loans to education, healthcare and cultural sectors also saw rapid growth with more than RMB300 billion ($45 billion) in balances. • In the last five years CCB’s fee-based business grew at an annual average rate of 50 percent, the highest among the four major state-owned commercial banks in China. Income from its fee-based business accounted for 22 percent of incomes from all main businesses—a 16 percent rise from pre-listing days. • CCB has become a multi-functional bank through full-scale expansion in the areas of investment banking, funds, trusts, leasing and insurance. This shift has greatly enhanced CCB’s ability to offer comprehensive financial solutions to customers. • CCB is developing as an international bank by increasing the scale of cooperation with international strategic partners,
Net Profit Growth (RMB hundred million)
Asset Growth (RMB trillion)
1,068
10.6 9.6 7.6
691
6.6 5.4 4.6
05
06
05
07
09
10*
471
463
05
06
07
08
09
1.46 1.15
1.11
24.87 21.75
1.24
19.50
0.92
05
06
10*
Increase in Return on Average Equity (%)
Increase in Return on Average Assets (%) 1.31
1,106
926
20.68
20.87
08
09
15.00
07
08
09
10*
05
06
07
10*
*First three quarters of 2010
stepping up the application and establishment of overseas branches and offices, and optimizing its global network. Currently, CCB has nine overseas branches and a number of overseas subsidiaries, along with a service network that covers all major financial centers around the world. At the Top in Productivity, Risk Control and Loan Quality CCB has one of the fastest rates of increase in labor productivity among China’s enterprises. Productivity has surged from less than 30 percent of the level for major European and American banks five years ago to around 65 percent. Between the end of 2005 and the end of 2009, CCB’s average assets per employee and average profit generated per employee doubled, to RMB31.91 million ($4.7 million) and RMB354,000 ($53,000), respectively. CCB’s average assets per employee have already attained half of the average level of the 32 European and American banks listed in the Financial Times Global 500, while its average profit per employee is 1.6 times the corresponding average. Internal risk control ranks at the top of the industry, while CCB’s loan quality remains the best among all major stateowned banks. As of the end of June 2010, its non-performing loans amounted to RMB65.168 billion ($9.7 billion) or a decrease of RMB29.301 billion ($4.4 billion) from the end of 2005. Its non-performing loan ratio was 1.22 percent, a decrease of 2.62 percentage points from year-end 2005. CCB will continue to adjust its business structure and enhance innovation and overall competitiveness to achieve its vision as a pioneer always at the forefront of China’s economic modernization, striving to be a world-class bank.
Sponsored Statement • December 2010/January 2011
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IVES CAPITAL THE BUY SIDE MARKETS GLOBAL SECURITIES SERVICES GREEN SHOOTS CEO INTER
T
TRUST A BRAINY QUANTITATIVE
macro manager like David Harding and his team of Ph.D.s to try to improve upon long-only passive index investing with an equity fund that aims to reduce volatility and mitigate risk. Harding’s London firm, Winton Capital Management, recently won regulatory approval in Europe for the Winton Global Equity Fund, a systematic, highly scalable long-only fund designed to outperform the MSCI world index by 2 to 3 percentage points, with markedly less volatility. Before launching Winton in 1997, Harding co-founded London-based quant fund manager Adam Harding & Lueck, now part of Man Group under the name AHL. His current firm, which oversees $16 billion in assets, isn’t the first hedge fund shop to Its flagship Winton Futures try building a long-oriented quant-driven equity fund with lots of room for investors; Fund, which uses exchangeJames Simons, founder of East Setauket, Quant shop Winton Capital finds its longtraded futures and options New York–based Renaissance Technolo- only game with a new fund built to scale. to invest in up to 120 marBY LOCH ADAMSON gies, launched the Renaissance Institutional kets, has an annualized 17 Equities Fund in 2005. Simons asserted at percent net return since the time that this long-biased fund — fashinception 13 years ago. ioned to outstrip the Standard & Poor’s 500 For the Global Equity index — could handle up to $100 billion. Fund, Harding and his team At its peak in December 2006, RIEF managed some $14 billion have adapted their methods to invest in a single asset class. Although in assets. But liquidity-starved investors pulled back during the the new fund uses the MSCI world index as a benchmark, the resemeconomic crisis, even though the fund was beating its benchmark. blance is superficial. Unlike the index, it doesn’t weight stocks by Assets now sit at about $5.2 billion. market capitalization. Most market-cap-weighted equity indexes are Whether the Global Equity Fund can avoid a similar fate remains dominated by a relatively small number of very large-cap stocks — so to be seen. Still, Harding — Winton’s founder, chairman and head of much so that the top 10 percent of those holdings usually account for research — says he’s convinced an unleveraged long-only fund with some 50 percent of total weightings, Precious says. In his view, market low fees and an integrated approach to risk can stand out in “a large cap is not a good indicator of return or risk, so the team has designed an and rather undistinguished market” of long-biased quant offerings. array of quantitative and qualitative metrics to determine weightings. Winton is just one high-profile London hedge fund firm seeking to “Most of the weightings will come from risk, and the most take advantage of Undertakings for Collective Investment in Trans- straightforward measure of risk is volatility,” says Precious, who ferable Securities (UCITS), a European regulatory designation that joined Winton in 2006 from UBS, where he was co-head of global allows asset managers to market a collective investment fund across equity strategy.“We will give low weightings to high-volatility stocks, the European Union based on authorization from a single member with the aim of having less concentration of risk than you would have state. Others with UCITS-approved funds include Brevan Howard in any market-cap-weighted fund.” Asset Management and Marshall Wace. Also informing the weightings are technical and fundamental Winton’s new fund, managed by head of equity research Mark inputs, including an expected-return component for individual stocks, Precious, capitalizes on the firm’s strength in quantitative analysis. momentum analysis and Winton’s own fundamental analysis. HardINSTITUTIONALINVESTOR.COM
GEORGE BATES
Strength in Numbers
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RVIEW RAINMAKERS THE 2011 ALL-AMERICA EXECUTIVE TEAM BANKING DERIVATIVES MONETARY
ing and Precious began road testing the long-only equity strategy in June 2008 with $10 million of their firm’s capital. Since inception through October 31, 2010, the fund returned a modest 3.2 percent but outperformed the MSCI world index by 20.4 percentage points. In 2010 the Global Equity Fund is up 9.81 percent, beating its benchmark by 281 basis points. Given institutions’ need for better long-only management in the wake of the crisis, Precious is confident the fund will attract interest. It has a management fee of only 20 basis points (zero until March 25) and a 20 percent incentive fee on relative outperformance. Harding is preparing for the challenge of introducing an unusual fund to Winton’s institutional clients — not least because it’s a shift in focus for the firm. “Our current clients are hedge fund investors; the long-only guys are down the corridor to the left and behind the potted plants, so it will take us some time to reach them,” he says with a laugh.“But we are cautiously optimistic that we will.” ••
Daily Mirror SRL Global’s portfolio tracker lets clients follow multiple managers trade by trade.
BY CHRISTOPHER ALESSI
N
EIL PURI BELIEVES HE HAS STARTED
a revolution. Admitting that it happened “more by luck than by judgment,” the CEO of London-based SRL Global asserts that the investment world has been transformed by a software platform he designed to help asset owners track their hefty portfolios. SRL’s Nexus Enterprise Solution is a specialized portfolio management tool for clients that don’t invest directly in securities, such as funds of funds, endowments and family offices. According to Puri, these investors “want to see how their manager allocations — both traditional and hedge fund — fit all together as a whole portfolio.” Puri developed Nexus when he worked at Man Group as a hedge fund manager specializing in systematic trading and statistical arbitrage. The concept grew out of talks with colleague Alexander Lowe, who was CEO of Man Global Strategies, London-based Man’s $19 billion managed account platform, and now works alongside Puri at SRL as commercial director. Nexus led to the 2007 launch of SRL, which began as a trading and technology joint venture with Man until Puri spun it off from the investment firm in mid-2009. SRL targets allocators with portfolios of at least £5 billion ($7.8 billion), who pay an annual fee of several hundred thousand pounds. The firm’s platform allows a client to view and manipulate its entire portfolio in real time, through a front-office application INSTITUTIONALINVESTOR.COM
called Nexus Analytics. The software mines raw data from the portfolio’s various sources, such as managers, prime brokerages and counterparties, then enriches it by showing the investments side by side and explaining in layman’s terms how they relate to one another. To illustrate Nexus’ usefulness, Lowe gives the example of a pension fund with 50 to 70 different outside managers and a small in-house investment team. “As the portfolio starts to grow, who’s monitoring it?” he asks, noting the challenges of dealing with numerous managers. “It’s about taking the fixed-income and equity parts of the portfolio and bringing them together,” Lowe adds. Through Nexus, clients store their data securely on SRL’s private cloud. After compiling all of the third-party investment information for a portfolio, a manager of managers can play with it, trying out possible outcomes to better manage risks and exposures, Puri says. Although there are other successful portfolio management platforms — chief among them the offerings of New York–based PerTrac Financial Solutions — they are mainly research tools whose primary role is to analyze monthly net asset values. Nexus calculates daily NAVs of underlying funds, and Puri says it also yields up-to-theminute analysis of the trades that make up those funds.“It can handle managed accounts and pooled investments across all hedge fund strategies and complex instruments,” he adds. In other words, Nexus lets clients see what each part of an investment strategy is delivering, while revealing how a given manager is trading a particular stock at any moment. Revere Capital Advisors — a New York–, London- and Singapore-based hedge fund seeding and management firm founded by former Man executives in 2008 — uses the platform to monitor and select managers for its internal research team. Director of manager research Andrew Godfrey says Nexus has changed the way Revere does its due diligence. One of a handful of people at the firm with access to Nexus, Godfrey can examine Revere’s holdings based on risk, returns, a scenario analysis, a stress test or a sensitivity analysis — methods that allow him to make projections about the health of the portfolio based on different hypothetical variables, such as a change in interest rates. There is also a series of exposure views, including country, asset class, currency, equity and fixed income. Before it started using Nexus, Revere had to sort through a wide range of files once a month to understand its portfolio. “Making sense of these different files was a full-time job,” says Godfrey, who now gets a comprehensive update each day. Security concerns have prompted many asset owners to build their own portfolio management software rather than buy it. At Revere, Nexus — which transmits confidential information through a private server — has relieved such worries. Godfrey and his colleagues each carry an access key that provides a new password every 15 to 20 seconds. “The whole model runs on security,” explains Puri, who knew he had to cover that angle to win over some of the world’s richest portfolios. For Puri, though, the SRL platform’s most revolutionary feature is that it does what other portfolio trackers can’t.“It’s not a crystal ball, and it’s not going to replace an asset manager,”he says.“But it answers the question, why is my portfolio looking a certain way?” •• Comment? Click on Asset Management at institutionalinvestor.com.
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SIDE CAPITAL MARKETS GLOBAL SECURITIES SERVICES GREEN SHOOTS CEO INTERVIEW RAINM
Good Debt Investors are flocking to emerging-
Baltimore-based Legg Mason’s $649 million Western Asset Emerging Markets Debt Fund. Dollar-denominated sovereign bonds are trading at spreads with little room for more tightening, Gardner admits, BY LAURIE KAPLAN SINGH but he still sees opportunity in local currency and corporate bonds. Claire Husson-Citanna, co-manager of the $287 million Emerging Market Debt Opportunities Fund for San Mateo, California–based Franklin Templeton Investments, thinks too much short-term money may have again poured into emerging debt markets, with no regard for risks such as inflation or a stronger-than-expected rebound in the U.S. But Gardner maintains that the bulk of asset flows are there to stay.“It isn’t just hot money,” he says, noting that much of the cash is from sovereign wealth funds and low-turnover mutual funds. This is hardly surprising given robust economic growth and the fact that most developing countries spent much of the past decade restructuring debt and enforcing prudent monetary and fiscal policies. As a result, they’ve become much stronger credits. ISSATISFACTION WITH Another draw is the potential for local currency appreciation, low interest rates and sluggish growth in the developed world is lur- driven by a weak U.S. dollar. Despite recent interventions, investors ing bond investors to emerging markets. In the first ten months of this expect emerging-markets foreign exchange pressures to persist. And year, the 929 emerging-markets bond funds tracked by Cambridge, like local currency sovereign bonds, corporate bonds are still attracMassachusetts–based EPFR Global pulled in $49.5 billion in new tively valued. Sixty percent of the TCW Emerging Markets Income assets. That’s more than five times the $9.5 billion they received in Fund’s assets are in corporate bonds, while the average emerging2009 and 52 percent of total emerging-markets bond fund assets. markets debt fund has a 25 percent allocation. That difference largely Investors have been well rewarded. Since the rally began in March explains the fund’s 21 percent year-to-date gain through October 31. James Carlen, who co-manages Boston-based Columbia Manage2009, local currency bonds in Indonesia and Brazil jumped 128 percent and 72 percent, respectively, through October 31, according to ment Investment Advisers’ $234 million Emerging Markets Bond JPMorgan Chase & Co. Meanwhile,Argentina’s dollar-denominated Fund, is keen on Brazil’s real-denominated sovereign bonds, which sovereign bonds soared 224 percent. In the first ten months of 2010, he says have appealing carry characteristics. Carlen also likes Russian the more-diversified 110 mutual funds in Morningstar’s emerging- corporate bonds and Indonesian local currency sovereign bonds. Like markets bond universe climbed 15 percent, on average. Brazil, Indonesia, which is growing at more than 7 percent a year, benThe rally isn’t overheated, says Keith Gardner, manager of efits from a strong economy and global demand for its commodities. Franklin Templeton’s Husson-Citanna favors THE TEN LARGEST EMERGING-MARKETS BOND FUNDS emerging-markets bonds TOTAL ANNUAL THREE-YEAR over the long haul, although NET ASSETS RETURN RETURN ANNUALIZED NAME MANAGER(S) ($ MILLIONS) YTD (2009) RETURN she’s mindful of the shortterm risks. A reversal of U.S. PIMCO Emerging Local Bond Instl Michael Gomez $5,844 17.27% 29.23% 9.41% monetary policy would stun Fidelity New Markets Income John Carlson 4,592 14.51 44.56 10.32 countries that borrowed PIMCO Emerging Markets Bond A Curtis Mewbourne 3,612 16.13 30.02 8.83 heavily and cheaply on the PIMCO Developing Local Markets A Michael Gomez 3,468 8.44 21.13 3.54 global capital markets, she MFS Emerging Markets Debt A Ward Brown and 3,197 14.48 30.85 9.71 says. But precluding such an Matthew Ryan event, capital will keep flowT. Rowe Price Emerging Michael Conelius 2,713 15.58 34.95 8.41 ing to emerging bond marMarkets Bond kets. “This is still a largely GMO Emerging Country Debt III Thomas Cooper and 1,996 28.46 50.17 8.75 William Nemerever underinvested asset class,” Goldman Sachs Local Emerging Samuel Finkelstein and 1,811 17.01 26.48 NA says James Craige, manager Markets Debt A Ricardo Penfold of the $324 million Stone Dreyfus Emerging Markets Debt Alexander Kozhemiakin 1,130 13.46 21.12 NA Harbor Emerging Markets Local Currency A and Javier Murcio Debt Fund. •• 1,114 21.04 44.78 15.13 TCW Emerging Markets Income I Penelope Foley, David
markets bonds. But do the risks outweigh the rewards?
D
Robbins and Javier Segovia JPMorgan emerging market bond index global MSCI world index
16.11
28.18
9.95
4.60
26.98
–10.10
Source: Morningstar.
Comment? Click on Banking & Capital Markets at institutionalinvestor.com. INSTITUTIONALINVESTOR.COM
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KETS CAPITAL GLOBAL SECURITIES SERVICES GREEN SHOOTS CEO INTERVIEW RAINMAKERS TH
Hedge fund administrators are cashing in on investors’ calls for more — and better — third-party oversight. BY FRANCES DENMARK
C
ORY THACKERAY HAS BEEN
taking advantage of hedge fund investors’ growing demands for greater transparency and oversight. “Investors and consultants are really driving much of the change,” says the New York–based global head of fund services administration at Goldman Sachs Bank USA. Thackeray should know. He’s held his post since 1996, when administration was a back-office function and there was less than $260 billion in the entire hedge fund industry, according to Chicago-based Hedge Fund Research. Today global hedge fund assets stand at $1.8 trillion, close to the peak of almost $2 trillion they hit in mid-2008 before plummeting to $1.3 trillion early the next year. That dramatic upheaval has left investors badly bruised. Shaken by average losses of 18 percent during the first few months of 2009, lack of access to gated funds and the shock of the Bernard Madoff scandal, they expect more from their managers — and from their fund administrators. Investor requests for sharper net asset valuations, independent account reconciliation and more clarity on multiple risks — including counterparty and liquidity — are commonplace. Meanwhile, with expected regulatory change comes increased reporting complexity. No one gets this new reality better than the folks at the center of the data hub. Once an invisible aide, the administrator is now a front-and-center participant in the investment process. “There’s a lot more collaboration on product enhancements that’s driving the industry along,” Thackeray explains. “This includes communication among investors, consultants and investment managers, and even a healthy dialogue between fund administration competitors.” Like his peers, Thackeray has seen business come roaring back — his unit has $202 billion in assets under administration — as hedge fund investors insist on third-party oversight.
At Chicago-based Northern Trust Corp.’s alternative asset servicing unit in Ireland, senior product manager Ian Headon notes the uptick in U.S. hedge funds’ hiring outside administrators. While the bulk of European hedge funds have always used independent administration services, the practice is only now becoming the norm in the U.S. Headon estimates that the number of U.S. hedge funds that outsource their back offices has risen from 50 percent in 2007 to 75 percent today. More business and a wider variety of reports for vehicles such as separately managed accounts have put administrators on the hedge fund schedule, not the old pension or custody timetable.“This is a daily world; it’s not a monthly world anymore,” Headon says. The need for better reports, combined with stronger technology, has led administrators to improve their number-crunching. Re- sponding to investors’ fears that they got different levels of information for varying liquidity needs, Morgan Stanley Fund Services developed what New York–based CEO Seth Weinstein calls the first branded fund reporting product. Dubbed Stratum, it allows hedge fund managers to reveal as much data as each investor requires. “We’ve become the recipient of many more investor due-diligence requests, in addition to those directed toward the managers themselves,” notes Weinstein. Investors also use administrators to reach out and touch hedge funds. “We see investors frequently on our premises,” says Citigroup hedge fund services boss Michael Sleightholme, who finds himself pulling out NAVs or reconciliation packages for them at his New York office. “The depth to which people are delving is much deeper.” Administrators are digging deeper too, into new asset classes, services and manager — Cory Thackeray structures. Goldman Sachs has global head of fund moved fund services from the services administration, securities and prime brokerage Goldman Sachs Bank USA unit to the bank, where they are under the regular scrutiny of regulators. Robert Donahoe, former head of sales at Citi’s fund services group, was hired to bring in hedge funds that don’t use Goldman’s prime brokerage services. Thackeray is gearing up to expand into private equity and fund-of-hedge-funds administration, following rivals like Citi. ••
“
Investors and consultants are really driving much of the change.
”
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EVAN KAFKA
Thirst for Knowledge
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ICES CAPITAL GREEN SHOOTS CEO INTERVIEW RAINMAKERS THE 2011 ALL-AMERICA EXECUTIVE
F
OSSIL FUEL PRICES HAVE
tumbled since the global financial crisis began, making the green-energy sector far less attractive to investors, who can now turn a handsome profit quickly by investing in traditional power sources. Ecofin, a London-based alternative-energy investment management firm, is no exception. Founded in 1992, Ecofin has stepped outside its core business by investing some $40 million in U.S. shale gas. More significantly, the firm — whose CIO, Bernard Lambilliotte, recently waxed poetic about “creating a carbon-free world” — plans to launch a fixed-income, high-yield investment trust in January that will target U.S. gas, utility and power companies. Oil offers quicker profits than solar or wind The postcrisis climate has proved frustrating for investors in renewable energy, particularly wind. Even for a $2.2 billion veteran like Ecofin, it’s tough to find worthwhile plays. Vincent Barnouin, EcoBefore the crisis renewable assets were highly fin’s COO, asserts that his prized, explains David Kotler, managing director Veteran renewables investor Ecofin firm knows how to tackle on the oil and gas team at the London office of turns to gas and utility plays. what he describes as a comBY CHRISTOPHER ALESSI New York–based asset management and financial plex sector well suited to a advisory firm Lazard. But today, Kotler notes, there specialist approach. But he are many stranded wind projects. “Where is the offers few details, saying money going to come from?” he asks. “The returns only that Ecofin is uniquely that investors went for are not going to be realized.” qualified to “see where the Patrick Hummel, an Opfikon, Switzerland–based renewable energy arbitrages are in the energy value chain” because it views renewmarkets analyst at UBS, agrees. “The wind sector as a substitute for ables through its utilities business knowledge. utility companies is not a very compelling business case right now,” he When Ecofin launched two decades ago, the renewables landscape says, adding that there are cheaper alternatives, such as gas and coal. was a desert and institutional investors had even fewer options than Still, Ecofin hasn’t given up on renewable energy. The firm is hedg- today. “Investing in waste-to-energy was the closest one came to ing its bets that fossil fuel prices will eventually rise again — a view investing in renewable energy at that time,” Lambilliotte says, referstrengthened by oil’s climb above $87 per barrel in early November ring to the practice of burning garbage to generate power. — by launching a new equity fund dedicated to wind and solar By 2006, with its long-short Ecofin Special Situations Utilities technology, slated to open in the first quarter of 2011. Fund, Ecofin was making serious investments — and returns — in This long-short offering will focus on the U.S. rather than Europe, wind and solar. That year the fund acquired 20 percent of Airtricity, which Lambilliotte calls a difficult place for alternative and renew- a wind asset development company based in Ireland. The fund’s able investments because “the regulatory environment is not clear.” managers provided €132 million ($162 million) in equity, then sat on He cites Germany’s windfall taxes on nuclear power plants and a Airtricity’s board for two years before cashing out with €265 million. reduction in government subsidies to the sector in Spain. Nonetheless, Ecofin seems to recognize that investment in wind But things are not necessarily sunnier in the U.S. John Cusack, is now a longer-term project. By investing in traditional energy, the founder and president of Gifford Park Associates, an Eastchester, firm offers its clients an opportunity for speedier returns as they wait New York–based sustainability management and consulting firm, out the slowdown in renewables. says the lack of a national renewable-energy policy has bred great “If you have a time horizon of two to five years, then good olduncertainty there. However, Cusack sees this ambiguity as a potential fashioned gas-fired power generation is the best way to go,” Lazard’s opening for institutional investors because it’s driving down the price Kotler says. “This is probably where the returns will be.” •• of wind-energy production. He argues that there’s plenty of money Comment? Click on Green Investing at institutionalinvestor.com. to be made in wind, if investors take a long-term view. INSTITUTIONALINVESTOR.COM
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L SECURITIES SERVICES GREEN SHOOTS
CEO INTERVIEW
RAINMAKERS THE 2011 ALL-AM
GlaxoSmithKline’s Witty: On a mission
S
SOME CEOS OF MULTINATION-
als hold themselves aloof. Not Andrew Witty.The 46-year-old chief of GlaxoSmithKline visits African villages to see for himself the state of health care. Indeed, he speaks of addressing the medical needs of the least-developed countries with a missionary zeal, and it is not bluster. Since becoming CEO of the world’s second-biggest pharmaceuticals company by sales in May 2008, the native Briton has slashed GSK’s drug prices in the poorest regions. No less boldly, he has pledged to spend 20 percent of group profits on medicines for underdeveloped areas and on improving their health care infrastructure. He sees this as good not only for the locals, but also for GSK shareholders. Witty’s active, hands-on approach well suits the volatile pharmaceuticals industry.A side effect of making medi- Andrew Witty wants cines seems to be the occasional crisis, GlaxoSmithKline to shift and GSK has lately had its share of from “white pills, Western them, after undergoing years of cost- markets” to vaccines in emerging markets — cutting and head-count reductions. GSK’s diabetes drug, Avandia, introduced in 1999, is a In October the London-based and to improve lives case in point. After fresh evidence of side effects emerged company reached a $750 million in the process. recently, U.S. and European regulators issued safety alerts. settlement with the U.S. Food and BY NEIL SEN Once GSK’s second-biggest product, Avandia saw its sales Drug Administration after pleading plunge 65 percent in the third quarter, to just £70 million guilty to long-standing FDA charges ($111 million). that it knowingly manufactured cerThe research-to-reward ratio for a drugmaker can tain “adulterated” drugs at its Cidra, become even more imbalanced for the more ephemeral Puerto Rico, plant, now closed. At the time, Witty was in Singapore as varieties of drugs. Although fears of a pandemic such as swine flu senior vice president of GSK’s Asia-Pacific operations. However, he has can boost sales of a vaccine in the short run, they tend to drop off been busy practicing damage control with shareholders and the public. quickly. Meanwhile, the research effort can be enormous. Witty, A more common problem in producing drugs is that they can speaking of GSK’s swine flu vaccine, Pandemrix, says: “We spent take decades to develop but may have short commercial life spans. £2 billion on developing technology and increasing capacity. We INSTITUTIONALINVESTOR.COM
CHRIS RATCLIFFE/BLOOMBERG
New Rx
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OOTS CEO INTERVIEW RAINMAKERS THE 2011 ALL-AMERICA EXECUTIVE TEAM BANKING DERIVA
“It is emotionally different running a company you’ve been with for so long. You treat it with more respect; you’re more long-termist and less cavalier.”
How does GSK incorporate improving lives into its mission?
We have tried to improve access to drugs with a tiered pricing approach. The richest countries pay the most, and in the poorest countries we have cut prices by two thirds or even 75 percent. Our HIV drugs in Africa, for instance, are sold at cost. In middle-income countries too, we have cut prices on some medicines. In India they sell for one rupee, the lowest price you can charge. We’re investing in research centers for neglected tropical diseases, and we’ve opened them up to non-GSK scientists. This is not a bolt-on part of the company; it is a core part of our mission.
I became CEO, I wanted to move this agenda forward aggressively. I wanted to prioritize it, and I believe it is consistent with serving shareholders because this approach can boost sales. For instance, since we’ve reduced the price of Cervarix in the Philippines by 60 perent, our sales have increased sixfold. We’ve also maintained around a 35 percent margin in emerging markets. After ten years, are Glaxo Wellcome and SmithKline Beecham a successful union?
Yes, it definitely feels like one company. It’s been a very successful merger, but not in the way that was envisaged in 2000. At that time, the potential to invest in research and development was given as the rationale. But in fact it’s turned out that it is perfectly possible to improve R&D without just spending more money. Instead, the real benefit of the merger has been that we’ve been able to reallocate our increased resources efficiently in our most important units. How so?
In particular, the former SmithKline consumer and vaccine businesses, along with Glaxo’s respiratory business, have been properly invested in. And we have bigger capacity all-round, including distribution, so that, for instance, we’re well placed in growing markets such as India and China. This is the second big merger I’ve been through at the company — I was around when Glaxo and Wellcome merged in 1995 — and I think both deals have worked well in driving sales growth. So big mergers can work. And you’ve just hired a veteran deal maker from Goldman Sachs Group, Simon Dingemans, as CFO. Is a deal in the offing?
I’m not opposed to big mergers in principle. But all the possible targets for us are challenged in their sales lines because they’re on a patent [expiration] cliff — which means their sales growth will slow. A deal might generate more profits in the short term, but I’m not convinced it would generate shareholder value. And it would slow sales growth. For the next four or five years at least, we need to focus on organic sales growth, bolt-on acquisitions and other innovative deals. And Simon is not just a deal maker. He is a strategic thinker with wide experience and has a broad knowledge of different sectors. If I am the consummate insider, Simon is the consummate outsider. What is your strategic priority for GSK?
We are moving away from “white pills, Western markets” and increasingly investing in vaccines and emerging markets. So far we’ve taken almost £2 billion of costs out of traditional markets and reinvested it in those growth areas. We’re already seeing the benefits. Our emerging-markets sales were up 14 percent in the third quarter compared to the same period in 2009, and they now account for 24 percent of the group’s total. Our vaccines business is now the biggest in the world. ••
It’s admirable, but is it in shareholders’ interest?
I’ve run GSK’s operations in Africa, India, Pakistan and Bangladesh; I’ve seen for myself what a difference we can make. When
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produced 400 million doses of the vaccine in the period from April to August 2009. That was virtually D-day in its scale.” In 2011 the patent on GSK’s top-selling drug in the U.S., the asthma reliever Advair, expires. At stake: £2.7 billion in annual sales. Nevertheless, this may not be quite the crisis it appears. GSK forecasts continued strong Advair sales because rivals will have trouble replicating the proprietary inhaler technology needed to create a generic version. (None has done so yet.) Still, dwindling sales of Avandia and antiviral drugs, along with the impact of austerity measures in Europe and health care reforms in the U.S., contributed to a 2 percent slide in GSK’s third-quarter sales, to £6.8 billion. Operating profits fell 5 percent after restructuring charges, to about £2 billion. Witty, a 1985 economics graduate of the University of Nottingham, has spent virtually his entire career, apart from a few months at a biotechnology firm, at Glaxo and its successors. (Glaxo and Burroughs Wellcome merged in 1995, and Glaxo Wellcome combined with SmithKline Beecham in 2000.) “Every time I felt the grass was greener somewhere else, the company came up with another opportunity,” he says. During his 25 years at GSK, he has run businesses in Africa and Asia, giving him a firsthand feel for emerging markets, which offer the most promising growth prospects. He sees his long tenure as a distinct advantage. “It is emotionally different running a company you’ve been with for so long,” Witty says. “You treat it with more respect; you’re more long-termist and less cavalier.” He believes GSK is well placed to increase sales as important drugs make their way through its pipeline. For example, Benlysta, which treats lupus, has potential sales of $3 billion, estimate analysts at J.P. Morgan. Approval could be imminent, as an FDA advisory panel has signed off on the drug. Witty recently met with Institutional Investor Staff Writer Neil Sen to discuss how his early desire to “do something connected to improving peoples’ lives” — which is partly what impelled him to join Glaxo — is reflected today in the company’s core philosophy.
e thes ports e r t e. s m y a l s a e an h t l . l . . a s e ar les
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Rain makers Year of the
With takeovers on the rebound, Institutional Investor celebrates the bankers who sealed the ten biggest deals of 2010.
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By Xiang Ji and David Rothnie
AINMAKERS ARE REGAINING THEIR SWAGGER. AFTER TWO PUNISH-
ing years, when the financial crisis and global recession caused mergers and acquisitions activity to drop by half, deal making is on the rise again. Announced global M&A volume for 2010 totaled $2.49 trillion at the start of December, up 21 percent from a year earlier. Revenues also rose a healthy 21 percent over the same period, according to Dealogic. Perhaps just as important, life has gotten more difficult for the securities trader, the rainmaker’s perennial rival for power and influence on Wall Street. The Dodd-Frank Wall Street Reform and Consumer Protection Act appears destined to curb the decadelong dominance of traders and push old-fashioned relationship banking to the forefront (see “Say Goodbye to All That,” page 58). In a world where short-term trading faces restraints through higher capital charges and the so-called Volcker rule on proprietary trading, veteran deal makers — who often spend years getting to know their corporate clients — should deliver a bigger share of investment banking profits. Centerview Partners’ Blair Effron was one of two key advisers to PepsiCo on its $15.5 billion buyback of bottlers PAS and PBG, a deal whose estimated $113 million in fees were 2010’s richest INSTITUTIONALINVESTOR.COM
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MONEY IN THE BANK For advisers, the biggest deals don’t always command the fattest paychecks. Here are the top ten M&A transactions of 2010 by estimated fees.
Institutional Investor’s Rainmakers DEAL VALUE FEE RANK ACQUIRER SELLER DATE COMPLETED ($ MILLIONS) ($ MILLIONS) of the Year certainly delivered in 2010. The top ten deals by fees, as estimated by 1 PepsiCo Pepsi Bottling Group/ February 26 $15,500 $113 investment consulting firm Freeman & PepsiAmericas Co., brought in a cool $839 million, with 2 Kraft Foods Cadbury February 2 22,400 112 PepsiCo’s acquisition of two bottling units 3 UAL Corp. Continental Airlines October 1 6,500 91 and Kraft Foods’ purchase of Cadbury 4 Xerox Corp. Affiliated Computer February 8 8,400 89 accounting for a quarter of that total. Four Services of the ten deals were in technology, a sector 5 Exxon Mobil Corp. XTO Energy June 25 35,500 81 that generated revenues of $1.3 billion — 6 TPG Capital/Canada IMS Health February 26 5,200 76 more than any other sector — in the first Pension Plan Investment Board eleven months of 2010. Private equity 7 Frontier Verizon July 1 8,600 75 players, which generated huge fees during Communications Corp. Communications the boom years only to swoon during the 8 Hewlett-Packard Co. April 12 3,200 74 3Com Corp. bust, made a comeback. TPG Capital’s 9 Biovail Corp. Valeant September 28 5,500 70 $5.2 billion buyout of IMS Health with the Pharmaceuticals Canada Pension Plan Investment Board International ranks No. 6 on our list. Only three of the 10 SAP Sybase July 29 7,100 58 top ten transactions involved a company Sources: Deal values courtesy of Dealogic; fee estimates provided by Freeman & Co. outside the U.S., but cross-border deals are growing in overall importance. With economic recovery continuing, albeit at a modest pace in places, did just that with PepsiCo before winning his payoff last year. The and with companies having amassed great financial firepower, most Purchase, New York–based soft-drink giant tapped Effron and his bankers are anticipating a strong rise in M&A activity in the coming team at investment banking boutique Centerview Partners, along 12 months.“Twenty-eleven is going to be an action-packed year,”says with Bank of America Merrill Lynch, as its main advisers on the Paul Parker, global head of M&A at Barclays Capital.“Our anticipation $15.5 billion buyback of two bottling units. Unlike Steven Baronoff, the BofA Merrill chairman of global is for deal volume to grow up to 15 percent, to reach a total of $3 trillion or more.”Stefan Selig, executive vice chairman of global corporate and M&A who also worked on the deal, Effron wasn’t involved when investment banking at Bank of America Merrill Lynch, concurs:“With PepsiCo spun off the bottling units, PepsiAmericas (PAS) and Pepsi record levels of cash on corporations’ balance sheets and historically Bottling Group (PBG), in 1999. Nor was he in on Pepsi’s last major attractive debt markets with record-low interest rates, all of the cata- deal, the acquisition of Quaker Oats Co. for $13.4 billion in 2000. lysts to do deals are in place for a strengthening M&A market.” But Effron had toiled diligently behind the scenes for Pepsi on Cross-border deals and transactions involving emerging markets various strategic issues over the years, and he brought a wealth will remain engines of growth. By the start of December, announced of knowledge to the complex transaction after two decades spent cross-border deal volume was $902 billion, up 66 percent from the advising on high-profile consumer deals. Effron, 48, worked on same period a year earlier, and emerging-markets volume had grown Gillette’s $57 billion sale to Procter & Gamble Co. in 2005 and on 63 percent, to $808 billion. With the U.S. dollar expected by many InBev’s $52 billion acquisition of Anheuser-Busch Cos. in 2008, and to stay weak and developing economies hungry for resources and his strategic thinking is top-notch. other assets, bankers say they will boost their presence in Asia, Latin Pepsi debated whether to try to restructure the relationship with America, the Middle East and Africa. its bottlers, combine PAS and PBG, or buy back part or all of them. Private equity deals are also expected to continue to grow, “We concluded the last option would bring the most significant although at a more sober pace. Although there are likely to be trans- financial impact in terms of cost and revenue synergies,” Effron actions as big as $10 billion, medium-size deals should predominate. says. “It’s also the best path in which Pepsi can maximize its exper“Seventy percent of private equity deals are in the middle-market tise in marketing, innovation, branding and bringing products to space that we define as companies with ebitda of $50 million or less,” market.” The deal is expected to create annual pretax synergies of says Everett Schenk, CEO of BNP Paribas North America, referring $300 million by 2012. to earnings before interest, taxes, depreciation and amortization. Brisk and quick-witted, Effron says acquiring two companies at “We have never had a stronger deal flow at the bank, and we expect once presented unique and daunting challenges.“It affects how you — X.J. make each move,” he notes. “You have to think, ‘If I do something it to get stronger in 2011.” here, it will have a knock-on effect over there, and how should I think through that?’” For example, Pepsi’s early proposals to PBG and PAS emphasized that each transaction would depend on the other one closing. After rejections from the bottlers, Pepsi removed that BLAIR EFFRON AND TEAM / CENTERVIEW PARTNERS clause with the larger company, PBG, prompting PAS to push for the It can take years of patient work to build a relationship and win the same treatment. But negotiations had reached the last stage, and four confidence of a corporate client. Veteran deal maker Blair Effron weeks later Pepsi closed the two mergers simultaneously.
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The big buyback was a boon to the banks involved, which collected an estimated $113 million in fees. PBG’s sole adviser, Morgan Stanley, with a team led by vice chairman and global head of M&A Robert Kindler, earned a whopping $43 million. Goldman, Sachs & Co., led by Adam Taetle (who joined Barclays Capital in December 2009 to become co-head of its global consumer group), advised PAS and received $20 million. Fees for Pepsi’s advisers — Effron’s team, Baronoff and his colleagues at BofA Merrill, and Citigroup — were not disclosed, but Freeman & Co. estimates their total at close — X.J. to $50 million.
WEISS: STEPHANE GIZARD
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ANTONIOWEISS AND TEAM / LAZARD Improvisation in the midst of a fast-changing takeover battle can be critical to the art of deal making. But rarely has a bank had to respond quickly in a crisis the way Lazard did while advising Kraft Foods on its hostile bid for British confectioner Cadbury. Lazard’s legendary leader, Bruce In a cross-border transaction that yielded the year’s second-biggest fee payout, Lazard’s William Rucker Wasserstein, had overshadowed (left), Peter Kiernan and Antonio Weiss served as lead advisers to Kraft Foods when it acquired Cadbury dozens of other bankers involved in the heated contest. He played a pivotal role in devising takeover strategy and pricing with Kraft weeks before Wasserstein’s death on October 14, 2009, Britain’s CEO Irene Rosenfeld, notably insisting that the company hold off Panel on Takeovers and Mergers set a November 9 deadline for on increasing its offer for as long as possible. Tragically, however, Kraft’s formal bid. In contrast to the U.S., U.K. takeover rules don’t Wasserstein died suddenly at the height of the negotiations after being typically allow any financing contingency. In addition, a buyer hospitalized with an irregular heartbeat. cannot retract a formal offer, and British boards are forbidden Lazard’s deep bench of seasoned bankers on both sides of the to deploy so-called poison pills (whereby the target company Atlantic stepped in to fill the void. The team included New York– issues more shares) or sue to stop a takeover. Racing against time, based head of investment banking Antonio Weiss; Lazard’s London Weiss and his team also had to deal with an unhappy public and CEO, William Rucker; and London-based managing director Peter sensitive politics. Kiernan. The trio smoothly navigated the deal’s late stages and The results showed the brilliance of their strategy and its flawless ensured that Lazard remained the sole lead financial adviser to execution. On January 19, after almost five months of resistance, Cadbury’s board recommended that shareholders accept Kraft’s Northfield, Illinois–based Kraft. For the 44-year-old Weiss, whose specialty is cross-border deals, final offer. The deal valued Cadbury shares at 840 pence ($13.20), the takeover was unrivaled in its complexity.“It was unprecedented up from the initial offer of 755 pence. That price was 12.9 times 2009 to use that much stock in a cross-border transaction of this sort,” he ebitda, less than the 13.6 multiple Kraft paid for Groupe Danone’s says.“Stock was 60 percent in the initial approach.” (It subsequently biscuit business in 2007 and far below Mars’s 19.3 multiple for its fell to 40 percent.) 2008 acquisition of Wm. Wrigley Jr. Co. “The tactics were speDiffering regulatory frameworks also made things tricky. Two cifically designed to acquire the company at the lowest possible INSTITUTIONALINVESTOR.COM
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price,” says Weiss, referring to the deal’s unsolicited nature. “Kraft succeeded by sticking to its initial path.” — X.J.
3.
JAMES LEE JR. AND TEAM / JPMORGAN CHASE The $6.5 billion merger of UAL Corp.’s United Air Lines and Continental Airlines involved some of the biggest names in corporate deal making, but one stood out: James (Jimmy) Lee Jr. Lee, a vice chairman and veteran financier and merger adviser at JPMorgan Chase & Co., knew the deal inside out — and rightly so, given that he had negotiated an almost identical transaction for UAL chief executive Glenn Tilton in 2008. Tilton, a fan of consolidation, had started conversations with a handful of fellow airline CEOs back in 2006. Continental looked like the ideal merger partner, and Lee and Tilton negotiated a deal only to have Continental CEO Lawrence Kellner and his board pull out on the eve of the announcement. In 2009, when Kellner’s sucEvercore Partners’ Daniel Mendelow (left), Eduardo Mestre and Michael Price earned their firm cessor, Jeffery Smisek, got wind $18 million for steering telco Frontier Communications through an $8.6 billion acquisition from Verizon that Tilton — again advised by Lee — was talking to US Airways Group, he called the UAL boss and suggested that the two of them sit down together. Lee says the deal they hammered out is virtually the same as the proposed transaction of 2008. Lee, 57, ran a heavyweight JPMorgan team that included Thomas BEN DRUSKIN AND TEAM / CITIGROUP Miles, a managing director who left to join Morgan Stanley in July; For Ben Druskin, Citigroup’s co-head of global technology, media and Christopher Ventresca, co-head of North American M&A; and telecommunications banking, having Dad on the board of a key client David Fox, head of Midwestern investment banking. He struck a company might suggest the possibility of favoritism. But when Druskin good deal for Tilton: The owners of United parent UAL would hold and his team brought home $32.5 million in fees from the sale of 55 percent of the combined company, with Continental shareholders Affiliated Computer Services (ACS) in February, the gigantic paycheck taking the rest. The latter got 1.05 UAL shares in exchange for each was solely the result of their tenacity through a tortuous six-year journey one of theirs. The combined entity formed the world’s largest carrier to the deal. The effort that led to ACS’s $8.4 billion takeover by Norwalk, by revenues, leapfrogging Delta Air Lines. Tilton also took counsel from Goldman Sachs’s Michael Carr, a Connecticut–based printer-and-copier giant Xerox Corp. began senior member of the firm’s merger leadership group. Both banks in 2004 — four years before Druskin’s father, former Citi COO were on par in terms of advice, but JPMorgan enjoyed a deeper rela- Robert Druskin, joined the ACS board. The relationship between tionship because it has long been a lender to UAL. Morgan Stanley Ben Druskin and business-process outsourcing provider ACS dated M&A chief Robert Kindler worked with Continental alongside to 1997, when the New Jersey native started giving strategic advice Lazard managing director Harry Pinson. — D.R. to then-CEO Jeffrey Rich. Over the years, Druskin, 42, worked on INSTITUTIONALINVESTOR.COM
EVAN KAFKA
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many deals with Rich and two subsequent ACS chief executives, Mark King and Lynn Blodgett. Dallas-based ACS’s quest for a buyer started on the wrong foot.The company’s founder,Texas billionaire Darwin Deason, first aimed for a leveraged buyout of the company he launched in 1988, but a potential deal with Blackstone Group and TPG Capital collapsed in 2005 over price differences. Then negotiations with Cerberus Capital Management broke off in late 2007 as markets grew rocky. Later, talks with Kohlberg Kravis Roberts & Co. folded in the catastrophic fall of 2008. Druskin, along with Citi managing directors Eric Levengood and Edward Wehle, served as sole adviser to ACS during these negotiations. Meanwhile, Xerox had its eye on ACS. Last spring, Xerox asked its long-standing adviser Blackstone to consider possible approaches. In a reflection of today’s complex deal-making landscape, John Studzinski and Christopher Pasko of the private equity firm’s advisory division teamed up with Paul (Chip) Schorr of its buyout unit (who had led the 2005 bid to acquire ACS). They contacted ACS’s Deason about a sale to Xerox; they first proposed that Blackstone co-invest, but an outright acquisition quickly followed. Druskin represented ACS on price and deal structure, working closely with Blackstone and Douglas Braunstein, then head of investment banking and now CFO at JPMorgan. Those two firms claimed $20 million apiece, according to securities filings. For advising ACS’s special committee, Evercore Partners received $16 million. — X.J.
cubic feet of gas resource base to ExxonMobil’s portfolio, more than half of it in the high-growth shale-gas category. Elliott and his team helped ExxonMobil smoothly execute the $35.5 billion deal in less than four months.“Jimmy is highly regarded in the energy sector for his superb industry expertise,” attests Stephen Arcano, a partner at law firm Skadden, Arps, Slate, Meagher & Flom who advised XTO. The deal was finalized ten days before Christmas 2009 and completed in June 2010, bringing JPMorgan an estimated $33 million in fees. Securities filings show that XTO’s advisers, Jefferies & Co. and Barclays Capital, each earned $24 million. — X.J.
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RAVI SACHDEV AND TEAM / DEUTSCHE BANK When Deutsche Bank signed on as adviser to IMS Health four years ago, the buyout market was red-hot. Through the lean times that followed, Deutsche stuck with IMS, deploying some 20 bankers to the account without a payday. Its reward was a $24 million fee for the first big leveraged buyout after the financial crisis: IMS’s $5.2 billion sale to TPG Capital and the Canada Pension Plan Investment Board. IMS was one of the accounts brought to Deutsche by Ravi Sachdev when he joined the bank in 2006 from Peter J. Solomon Co., a New York investment banking boutique specializing in mergers and acquisitions in the health care sector. David Carlucci, chairman and recently retired CEO of IMS, had built the company into a market leader and was looking for the next growth opportunity. So in 2007 he hired Deutsche, which for the next two years advised the board JAMES ELLIOTT AND TEAM / JPMORGAN CHASE on strategic alternatives, including a possible sale or recapitalization. When Irving, Texas–based oil supermajor Exxon Mobil Corp. “In 2007 the credit markets were good and IMS was a natural began mulling the purchase of independent gas producer XTO LBO candidate,” says Sachdev, the lead banker to IMS.“It had strong Energy, it turned to one of the energy industry’s most legendary market share, stability and free cash flow generation, but the credit advisers: JPMorgan. The bank’s team, led by global head of M&A markets had started to deteriorate, making an LBO challenging.” James (Jimmy) Elliott, has advised on many energy deals, including Sachdev and his team, which came to include Bruce Evans, head of Phillips Petroleum Co.’s $25 billion merger with Conoco in 2002 Americas M&A for Deutsche, met regularly with IMS’s board and and Burlington Resources’ $37 billion sale to ConocoPhillips Co. management. “IMS deserves a lot of credit because it had a continuin 2006. It also presided over the $86 billion merger ous process in place to look at ways of maximizing of Exxon Corp. and Mobil Corp. that created Exxshareholder value,” says Sachdev, 34. “The secret of onMobil in 1999. the success of the deal was that we, in conjunction with Elliott, 58, and team members Douglas Petno, IMS, had already looked at so many alternatives, we were able to quickly take advantage of a change in Laurence Whittemore and Jeremy Wilson, were the credit markets. This company did not suddenly called in to help after XTO approached ExxonMobil have to determine if a sale transaction was the right in the summer of 2009. The Fort Worth, Texas–based company had been battered by declining natural-gas alternative.” prices and surging supplies. Recognizing that XTO Long an admirer of IMS, TPG had garnered sector needed to merge with a big player so it could compete experience through several deals, including the 2003 in an increasingly capital-intensive industry, chairacquisition with Bain Capital of Quintiles Transnaman Bob Simpson and board member Jack Randall tional Corp., a biotechnology and health care services proposed an acquisition to ExxonMobil. company. “TPG differentiated themselves from the For Elliott, who cut his teeth doing energy deals in start with their knowledge of the sector, the speed in the 1970s at First Boston Corp., the XTO takeover which they moved and their comfort in terms of offermade strong strategic sense. Demand for natural gas ing the board strong deal protection,” Evans says. is expected to grow 1.8 percent annually through — Jack MacDonald TPG showed its commitment with a $2 billion 2030, compared with 0.8 percent for oil. Also, Bank of America Merrill Lynch equity check, and it also brought in GS Mezzanine natural-gas prices are at a cyclical low since hitting Partners, which was prepared to underwrite $1 billion continued on page 96 their peak in 2008. Buying XTO added 45 trillion
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The euro was falling offa cliff, so we had towork pretty much round the clock for two weeks to finalize the transaction.
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THE 2011 ALL-AMERICA EXECUTIVE TEAM
THE 2011 ALL-AMERICA EXECUTIVE TEAM
The Best of Corporate America
These innovative corporate chiefs are finding ways to keep their companies growing — and their shareholders smiling.
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By Katie Gilbert & Leslie Kramer ILLUSTRATIONS BY MICHAEL GILLETTE
THE U.S. ECONOMY OFFICIALLY EMERGED from recession about 18 months ago, but
many companies are still struggling with sluggish sales and sagging profits. Firms continue to hoard cash, fearful of undertaking major expenditures until the economy shows signs that it is poised for stable, sustainable growth. There are exceptions to every rule, however, and some U.S. companies that were well positioned before the financial crisis have found opportunities for expansion despite the protracted downturn. No doubt many corporate leaders would be willing to change places with Francisco D’Souza, chief executive officer of Cognizant Technology Solutions Corp., who says his biggest challenge at the moment is managing expansion at the Teaneck, New Jersey–based consulting and outsourcing-services provider.“We were surprised by how fast growth came back in 2010,” says D’Souza.
Cognizant Technology Solutions Corp. CEO Francisco D’Souza INSTITUTIONALINVESTOR.COM
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THE 2011 ALL-AMERICA EXECUTIVE TEAM MetLife CEO C. Robert Henrikson
Not that Cognizant’s team of executives was unprepared for a rebound. At the time of the market meltdown, in the fall of 2008, financial services firms accounted for about 42 percent of Cognizant’s revenue. (A further 23 percent of Cognizant’s revenue came from health care companies; manufacturing, retail and logistics made up about 19 percent; and media, entertainment and technology, about 13 percent.) D’Souza and his colleagues knew that Cognizant would be especially hard hit if those financial-services clients stopped spending, so they took to the road and met with executives of companies most affected by the crunch. “We wanted to really understand what was going on in our clients’ minds at that point,” explains the Kenya-born 42-year-old, who was named CEO in 2007.“We realized that there was a cyclical downturn going on in the economy, as well as some very significant secular changes that our customers were going through. These were deep structural changes in nearly every industry, brought about by new technologies, globalization, demographic shifts with the rise of the millennials, and more virtualized ways of working — all of which had little to do with the cyclical downturn in the economy.” Cognizant decided to focus on providing solutions to those deeper secular problems. “We redirected our investments in prudent ways around new geographic expansions and made acquisitions to gain new capabilities,” he says.“And we pushed the envelope on new and innovative services to take to our clients,” he says. In May and June, respectively, the company acquired London-based consulting firm PIPC Group and Galileo Performance, a provider of information technology testing services that is headquartered in Paris; the terms
of the deals were not disclosed.“These acquisitions were undertaken to add certain capabilities or geographic reach to the company,” D’Souza adds. “We decided to focus our attention on managing our business through the short term, but without taking our eyes off the long term, so that we’d be in a stronger position after the crisis than when we went into it.” And so they are. In August, Cognizant announced that its revenue had jumped 42 percent year-over-year in the second quarter, to $1.1 billion; that was the first time the company’s quarterly sales had crossed the billion-dollar mark. Net income as determined by generally accepted accounting principles shot up nearly 22 percent, to $172.2 million, over the same period. The third quarter was even better: Year-over-year revenue leapt 43 percent, to $1.2 billion, and GAAP net income vaulted a whopping 49 percent, to $203.7 million. Analysts and portfolio managers applaud the company’s strategic response to the slowdown. Cognizant is the only company to capture first-place honors in every category in its sector in the 2011 All-America Executive Team, Institutional Investor’s second annual ranking of the nation’s best chief executive officers, chief financial officers, investor relations professionals and IR companies. Buy- and sell-side analysts agree that, in the Computer Services & IT Consulting sector, D’Souza is the Best CEO; Gordon Coburn, its Best CFO; and David Nelson, its Best IR Professional. They also say Cognizant provides better IR services than any of its peers. (The top-ranked executives and companies in each sector appear in the tables on the surrounding pages; more-detailed results can be found on our web site, institutionalinvestor.com.) “We have a comprehensive The 2011All-America Executive Team: Most Honored Companies program of investor outreach Listed below are companies ranked by first-place positions won. Two top spots are available per category, for a total of eight overall. intended to keep investors upTotal First to-date with what is happenRank Company Sector Place CEOs CFOs IR Pros. IR Cos. ing with the business,” Nelson 1 Cognizant Technology Computer Services & IT 8 2 2 2 2 explains. “At the core of this Solutions Corp. Consulting program are the quarterly earn2 Cisco Systems Telecommunications 6 2 1 1 2 ings calls. Frank is extensively 2 Coca-Cola Co. Beverages 6 0 2 2 2 involved in all aspects: messag2 Express Scripts Health Care Technology 6 1 1 2 2 ing, preparation and delivery. & Distribution Throughout the quarter we con2 Freeport-McMoRan Metals & Mining 6 2 2 1 1 Copper & Gold duct numerous calls with insti2 Kroger Co. Retailing/Food & Drug Chains 6 1 1 2 2 tutional investors, although the bulk of these calls are within the 2 MetLife Insurance 6 2 2 1 1 three or four days post–earnings 2 Philip Morris International Tobacco 6 2 1 1 2 release or immediately after any 2 Target Corp. Retailing/Broadlines 6 1 1 2 2 & Department Stores key event,” he adds. “We also 2 United Technologies Corp. Aerospace & Defense 6 0 2 2 2 attend 20 to 25 investor conferElectronics ences per year, and these confer11 Cummins Machinery 5 2 2 0 1 ences usually feature a company 11 Goldman Sachs Group Brokers, Asset Managers 5 1 2 1 1 presentation and a series of one& Exchanges on-one meetings with investors.” 11 Halliburton Co. Oil Services & Equipment 5 0 1 2 2 In addition, Nelson goes on 11 Intel Corp. Semiconductors 5 2 0 1 2 numerous road shows. In the 11 JPMorgan Chase & Co. Banks/Large-Cap 5 2 1 1 1 first ten months of 2010, he vis11 Praxair Chemicals 5 0 2 2 1 ited 18 cities in the U.S. — four 11 Simon Property Group REITs 5 2 2 0 1 of those cities he visited twice 11 Staples Retailing/Hardlines 5 1 0 2 2 — plus four in Europe, two in INSTITUTIONALINVESTOR.COM
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THE 2011 ALL-AMERICA EXECUTIVE TEAM The 2011 All-America Executive Team: Best CEOs
Listed here by industry and sector are the executives who rated highest when buy- and sell-side analysts were asked to choose the top-performing CEOs in their domains. Sector
Buy Side
Sell Side
BASIC MATERIALS
Sector
Buy Side
Sell Side
Oil & Gas Exploration & Production
James Hackett, Anadarko Petroleum Corp.
John Pinkerton, Range Resources Corp.
Andrew Gould, Schlumberger
Merrill (Pete) Miller Jr., National Oilwell Varco
Chemicals
David Weidman, Celanese Corp.
Charles Bunch, PPG Industries
Metals & Mining
Richard Adkerson, Freeport-McMoRan Copper & Gold
Richard Adkerson, Freeport-McMoRan Copper & Gold
Oil Services & Equipment
Paper & Packaging
John Conway, Crown Holdings; R. David Hoover,1 Ball Corp.2
John Faraci, International Paper Co.
FINANCIAL INSTITUTIONS
Aerospace & Defense Electronics
Mark Donegan, Precision Castparts Corp.
Clayton Jones, Rockwell Collins
Airfreight & Surface Transportation
Kirk Thompson,3 J.B. Hunt Transport Services
John Wiehoff, C.H. Robinson Worldwide
Business, Education & Professional Services
Douglas Baker Jr., Ecolab
Electrical Equipment & Multi-Industry
Banks/Large-Cap
James Dimon, James Dimon, JPMorgan Chase & Co. JPMorgan Chase & Co.
Banks/Midcap
Stephen Steinour, Huntington Bancshares
David Payne, Westamerica Bancorp.
Brokers, Asset Managers & Exchanges
Lloyd Blankfein, Goldman Sachs Group
Jeffrey Sprecher, IntercontinentalExchange
Consumer Finance
Jeffrey Joerres, Manpower
Kenneth Chenault, Richard Fairbank, American Express Co. Capital One Financial Corp.
Insurance
David Farr, Emerson Electric Co.
David Farr, Emerson Electric Co.
C. Robert Henrikson, MetLife
C. Robert Henrikson, MetLife
REITs
Engineering & Construction
Alan Boeckmann,4 Fluor Corp.
Alan Boeckmann,4 Fluor Corp.
David Simon, Simon Property Group
David Simon, Simon Property Group
Machinery
Theodore Solso, Cummins
Theodore Solso, Cummins
Biotechnology
Robert Hugin, Celgene Corp.
Airlines
Richard Anderson, Delta Air Lines
Richard Anderson, Delta Air Lines; Maurice Gallagher Jr., Allegiant Travel Co.2
Leonard Bell, Alexion Pharmaceuticals
Health Care Technology & Distribution
David Snow Jr., Medco Health Solutions
Apparel, Footwear & Textiles
Emanuel Chirico, Phillips-Van Heusen Corp.
Emanuel Chirico, Phillips-Van Heusen Corp.
George Paz, Express Scripts; David Snow Jr., Medco Health Solutions2
Life Science & Diagnostic Tools
—5
Jay Flatley, Illumina
Autos & Auto Parts
John Plant, TRW Automotive Holdings Corp.
Gregory Henslee, O’Reilly Automotive
Managed Care & Health Care Facilities
John Byrnes, Lincare Holdings
Stephen Hemsley, UnitedHealth Group
Medical Supplies & Devices
Beverages
Indra Nooyi, PepsiCo
Indra Nooyi, PepsiCo
William Sullivan, Agilent Technologies
Cosmetics, Household & Personal Care Products
Fabrizio Freda, Estée Lauder Cos.
Fabrizio Freda, Estée Lauder Cos.
Marc Casper, Thermo Fisher Scientific; Daniel Starks, St. Jude Medical2
Food
Kendall Powell, General Mills
Kendall Powell, General Mills
Pharmaceuticals
David Pyott, Allergan
Richard Clark,6 Merck & Co.
Gaming & Lodging
Stephen Wynn, Wynn Resorts
Brian Gamache, WMS Industries
MEDIA
Homebuilders & Building Products
Douglas Yearley Jr., Toll Brothers
Donald Tomnitz, D.R. Horton
Robert Iger, Walt Disney Co.
Michael White, DirecTV
Leisure
Robert Kotick, Activision Blizzard
Robert Kotick, Activision Blizzard
Restaurants
Clarence Otis Jr., Darden Restaurants
James Skinner, McDonald’s Corp.
Computer Services & IT Consulting
Francisco D’Souza, Cognizant Technology Solutions Corp.
Francisco D’Souza, Cognizant Technology Solutions Corp.
Retailing/Broadlines & Department Stores
James Sinegal, Costco Wholesale Corp.
Gregg Steinhafel, Target Corp.
Internet
Jeffery Boyd, Priceline.com
Jeffrey Bezos, Amazon.com
Retailing/Food & Drug Chains
—5
David Dillon, Kroger Co.
IT Hardware
Steven Jobs, Apple
Steven Jobs, Apple
Semiconductors
Paul Otellini, Intel Corp.
Paul Otellini, Intel Corp.
Software
Lawrence Ellison, Oracle Corp.
Marc Benioff, Salesforce.com
John Chambers, Cisco Systems
John Chambers, Cisco Systems
CAPITAL GOODS/INDUSTRIALS
HEALTH CARE
CONSUMER
Retailing/Hardlines
Ronald Sargent, Staples
Francis Blake, Home Depot
Retailing/Specialty Stores
Glen Senk, Urban Outfitters
Glenn Murphy, Gap
Tobacco
Louis Camilleri, Philip Morris International
Louis Camilleri, Philip Morris International
Electric Utilities
David Crane, NRG Energy
—5
Integrated Oil
John Watson, Chevron Corp.
Rex Tillerson, Exxon Mobil Corp.
Natural Gas & Master Limited Partnerships
Donald Felsinger, Sempra Energy
Gregory Armstrong, Plains All American Pipeline
TECHNOLOGY
TELECOMMUNICATIONS
ENERGY
1Ball Corp. announced in November 2010 that R. David Hoover will step down as CEO in
January 2011; he will remain chairman of the board.
2Tie.
3In October 2010, J.B. Hunt Transport Services announced that Kirk Thompson will step down
as CEO in January to become chairman of the company’s board.
4In November 2010, Fluor Corp. announced that Alan Boeckmann will step down as CEO in
February 2011; he will remain nonexecutive chairman.
5No CEO met the minimum vote requirement.
6Merck & Co. announced in April 2010 that Richard Clark had stepped down as president and
will step down as CEO by April 2011, in keeping with company’s mandatory retirement policy.
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The 2011All-America Executive Team: Best CFOs
Listed here by industry and sector are the executives who rated highest when buy- and sell-side analysts were asked to choose the top-performing CFOs in their domains. Sector
Buy Side
Sell Side
BASIC MATERIALS
Chemicals
James Sawyer, Praxair
James Sawyer, Praxair
Metals & Mining
Kathleen Quirk, Freeport-McMoRan Copper & Gold
Kathleen Quirk, Freeport-McMoRan Copper & Gold
Paper & Packaging
Scott Morrison, Ball Corp.
Timothy Donahue, Crown Holdings
Aerospace & Defense Electronics
Gregory Hayes, United Technologies Corp.
Gregory Hayes, United Technologies Corp.
Airfreight & Surface Transportation
Kurt Kuehn, United Parcel Service
John Steele, Werner Enterprises
Business, Education & Professional Services
Ronald Jadin, W.W. Grainger
Michael Van Handel, Manpower
Electrical Equipment & Multi-Industry
Patrick Campbell, 3M Co.; Daniel Comas, Danaher Corp.1
Daniel Comas, Danaher Corp.
Engineering & Construction
—2
D. Michael Steuert, Fluor Corp.
Machinery
Patrick Ward, Cummins
Patrick Ward, Cummins
Apparel, Footwear & Textiles
Donald Blair, Nike
Donald Blair, Nike
Autos & Auto Parts
Joseph Cantie, TRW Automotive Holdings Corp.
Robin Adams, BorgWarner
Beverages
Gary Fayard, Coca-Cola Co.
Cosmetics, Household & Personal Care Products
CAPITAL GOODS/INDUSTRIALS
Sector
Buy Side
Sell Side
Oil & Gas Exploration & Production
Marcus Rowland,4 Chesapeake Energy Corp.
Paul Korus, Cimarex Energy Co.
Oil Services & Equipment
Clay Williams, National Oilwell Varco
Mark McCollum, Halliburton Co.; Clay Williams, National Oilwell Varco1
FINANCIAL INSTITUTIONS
Banks/Large-Cap
Douglas Braunstein, Daryl Bible, JPMorgan Chase & Co. BB&T Corp.
Banks/Midcap
René Jones, M&T Bank Corp.
—2
Brokers, Asset Managers & Exchanges
David Viniar, Goldman Sachs Group
David Viniar, Goldman Sachs Group
Consumer Finance
Gary Perlin, Capital One Financial Corp.
Gary Perlin, Capital One Financial Corp.
Insurance
William Wheeler, MetLife
William Wheeler, MetLife
REITs
Stephen Sterrett, Simon Property Group
Stephen Sterrett, Simon Property Group
Biotechnology
Vikas Sinha, Alexion Pharmaceuticals
Vikas Sinha, Alexion Pharmaceuticals
Health Care Technology & Distribution
—2
Jeffrey Hall, Express Scripts
Gary Fayard, Coca-Cola Co.
Life Science & Diagnostic Tools
—2
John Ornell, Waters Corp.
Jon Moeller, Procter & Gamble Co.
Daniel Heinrich, Clorox Co.
Managed Care & Health Care Facilities
Food
Arthur Winkleblack, H.J. Heinz Co.
Donal Mulligan, General Mills
Steven Filton, Universal Health Services
W. Larry Cash, Community Health Systems
Medical Supplies & Devices
Gaming & Lodging
Kenneth Kay, Las Vegas Sands Corp.
Vasant Prabhu, Starwood Hotels & Resorts Worldwide
Thomas Freyman, Abbott Laboratories
Charles Dockendorff, Covidien;5 Todd Schermerhorn, C.R. Bard1
Homebuilders & Building Products
—2
Bruce Gross, Lennar Corp.
Pharmaceuticals
Paul Herendeen, Warner Chilcott5
Frank D’Amelio, Pfizer
Leisure
—2
Thomas Tippl,3 Activision Blizzard
MEDIA
Restaurants
—2
Peter Bensen, McDonald’s Corp.
Michael Angelakis, Comcast Corp.
Robert Marcus, Time Warner Cable
TECHNOLOGY
Retailing/Broadlines & Department Stores
Wesley McDonald, Kohl’s Corp.
Douglas Scovanner, Target Corp.
Computer Services & IT Consulting
Retailing/Food & Drug Chains
—2
J. Michael Schlotman, Kroger Co.
Gordon Coburn, Cognizant Technology Solutions Corp.
Gordon Coburn, Cognizant Technology Solutions Corp.
Retailing/Hardlines
Carol Tomé, Home Depot
Sharon McCollam, Williams-Sonoma
Internet
—2
Patrick Pichette, Google
IT Hardware
Retailing/Specialty Stores
Jeffrey Naylor, TJX Cos.
Lawrence Molloy, PetSmart
Peter Oppenheimer, Apple
David Goulden, EMC Corp.
—2
Semiconductors
Tobacco
Hermann Waldemer, Philip Morris International
Eric Brandt, Broadcom Corp.
Robert Halliday, Varian Semiconductor Equipment Associates
Software
Alternative Energy
—2
Jens Meyerhoff, First Solar
Earl Fry, Informatica Corp.
Earl Fry, Informatica Corp.
Electric Utilities
Allen Leverett, Wisconsin Energy Corp.; Thomas Webb, CMS Energy Corp.1
—2
Andrew Reinland, F5 Networks
Frank Calderoni, Cisco Systems
Integrated Oil
—2
Patricia Yarrington, Chevron Corp.
Natural Gas & Master Limited Partnerships
W. Randall Fowler, Enterprise Products Partners
W. Randall Fowler, Enterprise Products Partners
CONSUMER
ENERGY
INSTITUTIONALINVESTOR.COM
HEALTH CARE
TELECOMMUNICATIONS
1Tie.
2No CFO met the minimum vote requirement.
3In March 2010, Thomas Tippl became chief operating officer of Activision Blizzard; he will
remain CFO until his replacement is named.
4Marcus Rowland stepped down as CFO and as an executive vice president of
Chesapeake Energy Corp. in October 2010.
5Headquartered in Ireland.
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THE SLUG 2011 TKALL-AMERICA EXECUTIVE TEAM
Asia and one in Canada.“A visit to a city usually consists of five or six one-hour meetings with individual investors and a 90-minute lunch with a group of investors,” he says.“We host six to eight visits to our headquarters by individual investors or groups of investors, and we also host 15 to 20 visits to one of our India operations by individual investors or groups of investors.” (Cognizant has facilities in Bangalore, Hyderabad, Kolkata and Mumbai, among other Indian cities.) In each of these meetings, Cognizant’s executive team not only delivers its message but also listens to what analysts and shareholders have to say.“The client feedback-gathering process is always part of our ongoing strategic planning process,” Nelson says. The financial crisis proved advantageous to Cognizant’s expansion strategy. Many companies that cut back on staff to reduce costs turned to providers of outsourcing services to help them manage their workloads. Moreover, the rising ranks of the unemployed provided the company with a larger pool of prospective employees from which to choose. “Talent is a key asset in our business — it’s the way we deliver our services,” D’Souza says. Here again the economic turmoil worked in Cognizant’s favor. “In general, the labor market during 2008 and 2009 was such that it allowed us to find great talent around the world,”he says. In December the company marked another milestone when it hired its 100,000th employee, more than one quarter of whom were hired in 2010. “In our business, when you have client demand, you need to have talent to meet that demand — to scale the business with high-quality people,” D’Souza says. Despite being a U.S.-based company, about 70 percent of Cognizant’s hires come from India, with a large portion working in
“The most challenging part of the deal was trying to complete it during the financial crisis, while AIG was the subject of significant scrutiny.” — William Wheeler, MetLife
global delivery centers. In contrast the bulk of the company’s revenue — some 78 percent — is generated by its business in North America, with 19 percent coming from Europe and more than 3 percent from the rest of the world.This disparity has prompted some critics to accuse Cognizant and other IT outsourcing-services providers of effectively contributing to America’s high unemployment rate, but D’Souza defends his company’s strategy by noting that “the technical talent pool in the U.S. is actually very limited.” In response to this labor shortage, Cognizant has taken part in several initiatives to promote the teaching of technical skills throughout the U.S. education system. D’Souza, along with more than 100 other CEOs of U.S. companies, is part of an organization called Change the Equation, launched in September by President Barack Obama as part of his administration’s Educate to Innovate campaign. Cognizant also donated seed money to D’Souza’s alma mater, Carnegie Mellon University in Pittsburgh, to establish a Center for the Future of Work that conducts research into collaborative ways of working made possible by new technology.
Kroger Co. CEO David Dillon
“It’s our hope that over time we can have a positive impact and come together with other corporations to deepen and broaden the pool of science, technology, engineering and math students in the U.S. and address the shortage of technical talent,” he says. Although it will take a while for these seeds to bear fruit, D’Souza is adamant that Cognizant will maintain its commitment to building a better future — and that’s good news for his company’s shareholders. “Our strategy is to maximize long-term revenue growth, rather than focus on short-term margins,” he says.“We deliberately keep our non-GAAP operating margins in the 19 to 20 percent range — lower than many of our competitors — and every dollar we make above that mark is reinvested back into the business.” EXPANSION THROUGH ACQUISITION HAS ALSO WORKED
well for MetLife; analysts on both the buy and sell sides credit the New York–based insurance company with having the sector’s Best CEO, C. Robert Henrikson, and Best CFO, William Wheeler. In addition, sell-siders say the outfit is home to the Best IR Professional, Conor Murphy, and provides the insurance industry’s best investor relations. Shareholders cheered in March — and drove up MetLife’s share price 5 percent, to $40.90, in one day — when the company announced that it would buy American Life Insurance Co. of Wilmington, Delaware, from troubled insurer American International Group, which was selling assets to help repay its debt to the U.S. government. The Alico acquisition, which closed in November and for which MetLife paid $16.2 billion in cash and shares, boosted MetLife’s customer base from 70 million to 90 million and expanded its international presence from 17 countries to more than 60. “The Alico deal is transformational for us,” says Henrikson, MetLife’s CEO since 2006. “It secures the firm’s reputation as a global powerhouse.” Wheeler, 48, echoes that sentiment.“I am most proud of being able to play an important role in completing a transformational acquisition for MetLife — the largest in its history — that significantly grows the company’s top and bottom lines while exponentially expanding our global reach.” The executives aren’t reluctant to discuss the opportunistic nature of the deal. MetLife had been eyeing Alico for a possible takeover since September 2008, after the U.S. government threw AIG an $85 billion lifeline to prevent its bankruptcy.“Our philosophy is that we should always be in the market and be able to answer for why we are — or are not — interested in an opportunity,” Henrikson says. “We became very focused on Alico because it was a perfect fit for us strategically, and it was a way to accelerate our stated objectives relative to businesses outside the U.S.” Before the financial crisis, he explains, MetLife had been looking for ways to raise its share of non-U.S. business to 20 percent (from 15 percent) of total revenue. With the Alico acquisition, “we were able to, with one step, be totally consistent with our growth strategy, meet our financial objectives and immediately bring us to 40 percent for business outside of the U.S.,” Henrikson adds.“The opportunity not only met but exceeded our objectives.” Not that it was easy. “The most challenging part of the deal was trying to complete it during the financial crisis, while AIG was also the subject of significant scrutiny by the government, investors and the media,” notes Wheeler, who has been CFO since 2003. INSTITUTIONALINVESTOR.COM
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THE SLUG 2011 TKALL-AMERICA EXECUTIVE TEAM The 2011All-America Executive Team: Best IR Professionals
Listed here by industry and sector are the executives who rated highest when buy- and sell-side analysts were asked to pick the leading IR Professionals in their domains. Sector
Buy Side
Sell Side
Elizabeth Hirsch, Praxair
Elizabeth Hirsch, Praxair; Mark Oberle, Celanese Corp.1
BASIC MATERIALS
Chemicals
Metals & Mining
David Joint, Freeport-McMoRan Copper & Gold
Matthew Garth,2 Alcoa
Paper & Packaging
Thomas Cleves, International Paper Co.
Thomas Cleves, International Paper Co.
Akhil Johri, United Technologies Corp.
Amy Gilliland, General Dynamics Corp.; Akhil Johri, United Technologies Corp.1
CAPITAL GOODS/INDUSTRIALS
Aerospace & Defense Electronics
Sector
Buy Side
Sell Side
Electric Utilities
Jeffrey Kotkin, Northeast Utilities
Integrated Oil
David Rosenthal, Exxon Mobil Corp. Glen Donovan, Sempra Energy
Rebecca Hickman, Pinnacle West Capital Corp. Clayton Reasor, ConocoPhillips Dandridge Harrison, Oneok; Roy Lamoreaux, Plains All American Pipeline1
John Colglazier, Anadarko Petroleum Corp. Christian Garcia, Halliburton Co.
Brad Sylvester, Southwestern Energy Co. Christian Garcia, Halliburton Co.
Natural Gas & Master Limited Partnerships
Oil & Gas Exploration & Production Oil Services & Equipment FINANCIAL INSTITUTIONS
Banks/Large-Cap
Airfreight & Surface Transportation
Mickey Foster, FedEx Corp.
Robert Brunn, Ryder System
Business, Education & Professional Services
Michael Monahan, Ecolab
Michael Monahan, Ecolab; Pablo Paez, GEO Group; James Sober, Education Management Corp.1
Consumer Finance Insurance
Banks/Midcap
Brokers, Asset Managers & Exchanges
Ronald Stovall, American Express Co. Ellen Taylor, AmTrust Financial Services Barbara Pooley, Kimco Realty Corp.
Barbara Gasper, MasterCard Conor Murphy, MetLife
Biotechnology
Arvind Sood, Amgen
Health Care Technology & Distribution Life Science & Diagnostic Tools
David Myers, Express Scripts Peter Fromen, Illumina Regina Nethery, Humana Coleman Lannum, Covidien4
Michael Partridge, Vertex Pharmaceuticals David Myers, Express Scripts Peter Fromen, Illumina Regina Nethery, Humana
Electrical Equipment & Multi-Industry
Matthew Ginter, 3M Co.
Matt McGrew, Danaher Corp.
Engineering & Construction
—3
Sam Ramraj, URS Corp.
Machinery
Marie Ziegler, Deere & Co.
Mike DeWalt, Caterpillar
Airlines
—3
DeAnne Gabel, United Continental Holdings
Apparel, Footwear & Textiles
Andrea Resnick, Coach
Pamela Hootkin, Phillips-Van Heusen Corp.
Autos & Auto Parts
Brian Harris, Ford Motor Co.
Glen Ponczak, Johnson Controls
Beverages
R. Jackson Kelly, Coca-Cola Co.
R. Jackson Kelly, Coca-Cola Co.
Cosmetics, Household & Personal Care Products
John Chevalier, Procter & Gamble Co.
John Chevalier, Procter & Gamble Co.
Pharmaceuticals
Food
Margaret Nollen, H.J. Heinz Co.
Joyce Brooks, McCormick & Co.
MEDIA
Gaming & Lodging
Laura Paugh, Marriott International
William Pfund, WMS Industries
Homebuilders & Building Products
Robert Wells, Sherwin-Williams Co.
Frederick Cooper, Toll Brothers; James Zeumer, PulteGroup1
Leisure
Beth Roberts, Carnival Corp.
Richard Edwards, Polaris Industries
Internet
Restaurants
Timothy Jerzyk, Yum! Brands
Matthew Stroud, Darden Restaurants
IT Hardware
Retailing/Broadlines & Department Stores
John Hulbert, Target Corp.
John Hulbert, Target Corp.
Semiconductors
CONSUMER
Retailing/Food & Drug Chains
Carin Fike, Kroger Co.
Carin Fike, Kroger Co.
Retailing/Hardlines
Laurel Lefebvre, Staples
Laurel Lefebvre, Staples
Retailing/Specialty Stores
Amie Preston, Limited Brands
Timothy Johnson, Big Lots
Tobacco
Nicholas Rolli, Philip Morris International
Morris Moore, Reynolds American
Larry Polizzotto, First Solar
Larry Polizzotto, First Solar
ENERGY
Alternative Energy
Lauren Tyler, William Callihan, JPMorgan Chase & Co. PNC Financial Services Group M. List Underwood Jr., James Abbott, Zions Bancorp. Regions Financial Corp. Dane Holmes, —3 Goldman Sachs Group
REITs
Melissa Marsden, ProLogis
HEALTH CARE
Managed Care & Health Care Facilities Medical Supplies & Devices
Robert (Chip) Merritt, Cephalon
John Sweeney, Sirona Dental Systems Robert (Chip) Merritt, Cephalon
Jonathan Rubin, DirecTV
Thomas Robey, Time Warner Cable
David Nelson, Cognizant Technology Solutions Corp. Robert Eldridge, Amazon.com Steven Fieler, Hewlett-Packard Co. R. Kevin Sellers, Intel Corp. Eduardo Fleites, Citrix Systems
David Nelson, Cognizant Technology Solutions Corp. Robert Eldridge, Amazon.com Tara Dhillon, NetApp
Brooks McCorcle, AT&T
Marilyn Mora, Cisco Systems
TECHNOLOGY
Computer Services & IT Consulting
Software
Ron Slaymaker, Texas Instruments Eduardo Fleites, Citrix Systems
TELECOMMUNICATIONS
1Tie.
2In late October 2010, Matthew Garth stepped down as director of Alcoa’s investor
relations to become vice president, finance, for the company’s North American rolled products group.
3No IR Professional met the minimum vote requirement. 4Headquarted in Ireland.
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THE SLUG 2011 TKALL-AMERICA EXECUTIVE TEAM
The 2011All-America Executive Team: Best IR Companies
Listed here by industry and sector are the firms that rated highest when buy- and sell-side analysts were asked to pick the outfits that provide the best investor relations. Sector
Buy Side
Sell Side
Sector
Buy Side
Sell Side
Chemicals
Celanese Corp.
Praxair
Natural Gas & Master Limited Partnerships
Enterprise Products Partners
Enterprise Products Partners
Metals & Mining
U.S. Steel Corp.
Freeport-McMoRan Copper & Gold
Oil & Gas Exploration & Production
Anadarko Petroleum Corp.
—1
Paper & Packaging
Sonoco Products Co.
International Paper Co.
Oil Services & Equipment
Halliburton Co.
Halliburton Co.
BASIC MATERIALS
FINANCIAL INSTITUTIONS
CAPITAL GOODS/INDUSTRIALS
Aerospace & Defense Electronics
United Technologies Corp.
United Technologies Corp.
Banks/Large-Cap
JPMorgan Chase & Co. PNC Financial Services Group
Airfreight & Surface Transportation
FedEx Corp.
Union Pacific Corp.
Banks/Midcap
M&T Bank Corp.
Zions Bancorp.
Ecolab
Manpower
Goldman Sachs Group
CME Group
Business, Education & Professional Services
Brokers, Asset Managers & Exchanges Consumer Finance
Visa
Electrical Equipment & Multi-Industry
General Electric Co.
Danaher Corp.
Discover Financial Services
Insurance —1
URS Corp.
AmTrust Financial Services
MetLife
Engineering & Construction Machinery
Deere & Co.
Cummins
REITs
Simon Property Group
Boston Properties
Airlines
United Continental Holdings
United Continental Holdings
Biotechnology
Apparel, Footwear & Textiles
Coach
Phillips-Van Heusen Corp.
Alexion Pharmaceuticals
Vertex Pharmaceuticals Express Scripts
Ford Motor Co.
Johnson Controls
Health Care Technology & Distribution
Express Scripts
Autos & Auto Parts Beverages
Coca-Cola Co.
Coca-Cola Co.
Life Science & Diagnostic Tools
Illumina
Waters Corp.
Cosmetics, Household & Personal Care Products
Procter & Gamble Co. Clorox Co.
Managed Care & Health Care Facilities
Humana
Humana
Food
H.J. Heinz Co.
CONSUMER HEALTH CARE
H.J. Heinz Co.
Medical Supplies & Devices
Covidien2
Covidien2
Pfizer
Merck & Co.
Time Warner Cable
DirecTV
Gaming & Lodging
WMS Industries
Marriott International
Pharmaceuticals
Homebuilders & Building Products
Sherwin-Williams Co.
Fortune Brands
MEDIA
Leisure
Carnival Corp.
Polaris Industries
TECHNOLOGY
Restaurants
P.F. Chang’s China Bistro
McDonald’s Corp.
Computer Services & IT Consulting
Retailing/Broadlines & Department Stores
Target Corp.
Target Corp.
Cognizant Technology Solutions Corp.
Cognizant Technology Solutions Corp.
Internet
Amazon.com
Google
Retailing/Food & Drug Chains
Kroger Co.
Kroger Co.
IT Hardware
Hewlett-Packard Co.
IBM Corp.
Retailing/Hardlines
Staples
Staples
Semiconductors
Intel Corp.
Intel Corp.
Retailing/Specialty Stores
Tiffany & Co.
—1
Software
Citrix Systems
Tobacco
Philip Morris International
Philip Morris International
Citrix Systems, Microsoft Corp.3
TELECOMMUNICATIONS
—1
Cisco Systems
Cisco Systems
Alternative Energy
First Solar
Electric Utilities
Northeast Utilities
Southern Co.
Integrated Oil
Exxon Mobil Corp.
ConocoPhillips
ENERGY
MetLife would not have been able to finance the acquisition had it not emerged from the market meltdown relatively unscathed, although it sustained heavy losses on its investments. The firm was eligible for assistance from the Troubled Asset Relief Program but declined to participate; instead, MetLife raised $2.8 billion by issuing new shares in the fall of 2008. “We had the size and a broad base of products and services, a healthy balance sheet and the financial acumen — relative to the acquisitions demonstrated in past — to get the deal done,” explains Henrikson, 63.“This put us in the enviable position of being able to accelerate our strategic growth objectives. Alico was an excellent opportunity for us, especially while other companies were seeking ways to raise capital and sell pieces of themselves,” he adds. In October, MetLife gave shareholders an additional reason
1No company met the minimum vote requirement. 2Headquarted in Ireland. 3Tie.
to cheer when it reported third-quarter net income of $286 million, compared with a $650 million loss for the same period the previous year. Operating earnings surged more than 22 percent, to $878 million. To keep investors informed of developments, Henrikson and his team maintain an exhaustive schedule of meetings with individual and institutional clients. “Our investor relations team coordinates meetings with various members of senior management, and a significant amount of time is spent with shareholders,” he says. “This begins with our annual Investor Day and continues with one-on-one meetings, our participation in various industry conferences and calls with analysts each quarter when we release earnings results. On average, MetLife meets with 75 to 80 shareholders and analysts each quarter.” INSTITUTIONALINVESTOR.COM
EUR 400 MM
CHF 250 MM
JPY 9,800 MM
JPY 4,600 MM
Euromarket November 2010
Samurai Market October 2010
USD 74 MM Uridashi Market May 2010
USD 50 MM Uruguayan Market March 2010
USD 100 MM Private Placement March 2010
Swiss Market November 2010
Samurai Market October 2010
ATTRACTING RESOURCES TO FINANCE SUSTAINABLE DEVELOPMENT EUR 100 MM Private Placement March 2010
USD 600 MM Yankee Market July 2010
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THE SLUG 2011 TKALL-AMERICA EXECUTIVE TEAM
REGULAR COMMUNICATION WITH INVESTORS IS ESSEN-
tial to maintaining a successful business, notes David Dillon of Kroger Co., the sell side’s choice for Best CEO in Retailing/Food & Drug Chains; the Cincinnati-based supermarket operator is also home to those analysts’ preferred CFO, J. Michael Schlotman. The buy and sell sides agree that Kroger has the sector’s Best IR and Best IR Professional, Carin Fike. “I enjoy spending time with our shareholders and probably learn as much from them as they do from me,” says Dillon, 59, who was appointed to the top job in 2003. He is also known for his “shopalongs,” during which he accompanies customers while they shop, to learn more about the products they most often purchase and what they like and dislike about their shopping experiences. What Dillon learns through these encounters informs the company’s strategy.“We make all of our decisions from the point of view of our customers,”he asserts. The key to Kroger’s long-term growth has been its commitment to increasing sales through its continual push for lower prices — an approach that hasn’t always won the hearts and minds of shareholders, Dillon says, because the company initially takes a hit on earnings:“It’s a decline that is inevitable as we begin the process of growth in sales.”But lower prices keep customers coming back and eventually increase the volume of sales, he adds.“Our customers say,‘This is where we want to shop,’ so there is an advantage to spending capital in this way,” he insists. The strategy appears to be working: The company reported a
THE NEW
2.4 percent year-over-year increase in same-store sales excluding fuel centers, and a 4.5 percent increase in same-store sales including fuel centers, in the third quarter, which ended November 6. Kroger is now the largest traditional supermarket retailer in the U.S., operating more than 2,400 outlets under the names Baker’s, City Market, Dillons, Foods Co., Food 4 Less, Pay Less, QFC and Ralphs, among others. Kroger also operates more than 780 convenience stores — including Kwik Shop, Loaf ’N Jug, Quik Stop Markets and Tom Thumb Food Stores — 40 food-processing plants and 33 distribution centers. Kroger focuses on organic growth rather than expanding through acquisitions, Dillon says.“That’s not part of our model,” he explains. “Acquisitions are like extra credit — if it’s a good deal we’ll do it, but we don’t need it.” Throughout the economic turmoil, Kroger’s executive team has placed more emphasis on expanding and remodeling existing stores than on building new ones. Many locations have added ready-to-eat food areas that compete with local restaurants. Dillon credits the company’s long-term profitability to management’s continual focus on increasing product sales rather than chasing short- or medium-term gains to increase shareholder value. “True growth over time comes from increased sales at the store level,” he explains. “We’ve had 27 quarters in a row of sales growth — not many retailers that went through the recession can boast such posi-
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tive sales.” In addition, “sales growth increases cash flow, and that translates into growth in earnings and the ability to buy back stock.” Kroger has been aggressively repurchasing its stock since its board of directors authorized a share-buyback program ten years ago. In June the board authorized the repurchase of $500 million in common stock; over the life of the program, the company has invested more than $6 billion to buy back some 280 million shares. In September the retailer announced that it was raising its third-quarter dividend from 9.5 cents to 10.5 cents a share. “During a time when many companies reduced or eliminated their quarterly dividend programs, Kroger’s commitment to rewarding our shareholders through our dividend has remained strong,” says CFO Schlotman, 52. “The move is supported by our solid balance sheet and the substantial cash flow generated by our operations.” The company reported third-quarter sales of $18.7 billion, up 6 percent from the same period one year earlier, and net earnings of $202.2 million, the equivalent of a 14 percent year-over-year increase. (In the third quarter of 2009, Kroger posted a net loss of $874.9 million after the company took a nearly $1.1 billion write-down on its 263-store chain in California, Ralphs, citing that state’s soaring unemployment and real estate crisis. Without the write-down, Kroger’s would have reported third-quarter 2009 earnings of $176.7 million.) Primary responsibility for Kroger’s investor relations’ duties resides with Schlotman, who has been finance chief since 2003, with
day-to-day responsibilities handled by Fike. The team hosts quarterly earnings calls, in which investors may participate via teleconference or webcast, and throughout the year they invite analysts to bring clients to meet with senior management and tour one of the company’s local supermarkets. Kroger’s web site provides extensive corporate fact books geared toward new investors. “We are in the process of making our investor relations and corporate web site more dynamic and informative, to better serve the needs of investors,” Fike notes. ANOTHER COMPANY THAT RAMPED UP ITS INVESTOR
relations efforts as the economy was crashing is United Technologies Corp., which analysts on both the buy and sell sides credit with having the Best CFO in the Aerospace & Defense Electronics sector, Gregory Hayes, and the Best IR Professional, Akhil Johri. They also say the Hartford, Connecticut–based manufacturer of missile systems and aircraft engines outperforms its peers in IR. Beginning in late 2008 and continuing through 2010, UTC’s management implemented a companywide restructuring, with an eye toward reducing overhead and protecting the bottom line at a time of declining revenue. The company eliminated about 18,000 positions and invested roughly $830 million in 2009 and an additional $400 million in the first ten months of 2010 on restructuring. “The focus continues to be on productivity and doing more continued on page 98
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BANKING
IT MAY HAVE BEEN FOUNDED IN 1869, BUT GOLDMAN
Regulatory reform will spell the end of proprietary trading as banks knew it. But bad news for traders could be good news for investors.
By Imogen Rose-Smith
Sachs Group today is the house that Lloyd built. A man of modest roots (his father was a postal clerk) who began his career as a tax lawyer, of all things, 56-year-old Lloyd Blankfein has overseen the transformation of Goldman from a traditional investment bank focused on client-serving businesses to what many critics and even some fans have termed a hedge fund. During Blankfein’s tenure running day-to-day operations at Goldman (which effectively began when he was named COO in December 2003, three years before becoming chief executive), the firm has demonstrated an uncanny ability to generate huge profits trading its own capital in everything from stocks and bonds to commodities, currencies and derivatives. The success of Goldman has not been lost on its rivals, many of which significantly boosted their own proprietary trading and risk-taking activity during the past decade, though not always with similar results. During this transformation gobs of money were made, and Wall Street gained a reputation as a giant casino where the In the wake of regulatory reform, Goldman Sachs CEO Lloyd Blankfein is looking for new ways to make money
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BANKING
traders were winning at the expense of the other poor suckers at the from making the types of big bets that became prevalent in the past table — clients, shareholders and eventually taxpayers. To make mat- decade, the whole system will be safer. The danger, of course, is that by ters worse, when the markets melted down in the fall of 2008 — and limiting the ability of banks to diversify their businesses, lawmakers Goldman was just one of many banks that might have gone bankrupt and regulators are creating concentration risk. If a bank is engaged without a capital infusion from the Federal Reserve — there was no in fewer businesses, a big problem in any one of them could have a getting back traders’ fat paychecks. And so journalist Matt Taibbi profound impact. didn’t so much strike a nerve as ignite the collective synaptic system For sure, proprietary trading didn’t cause the banking collapse. when in a July 2009 article for Rolling Stone he called Goldman The two banks that failed, Bear Stearns Cos. and Lehman Brothers “a great vampire squid wrapped around the face of humanity.” Holdings, did so because they had weighed down their overleveraged Something had to be done. When President Barack Obama signed balance sheets with bad mortgage debt. But many think the riskthe Dodd-Frank Wall Street Reform and Consumer Protection Act taking culture that had taken over banking in the preceding decade into law last summer, he made it illegal for deposit-taking institutions was to blame. In the aftermath of the economic collapse, policymakto engage in proprietary trading. No way was Lloyd Blankfein going ers on Capitol Hill and in the White House increasingly came to view to get paid to gamble with mom and pop’s savings, the reasoning in proprietary trading as a big part of that culture. And they sought the Washington went. counsel of former Federal Reserve chairman Paul Volcker. “Congress has spoken,” says Michael Wiseman, managing partner At 6-foot-7, the 83-year-old Volcker is an imposing Cassandra. For of New York law firm Sullivan & Cromwell’s financial institutions decades few people listened as he fought deregulation and worried group, which during the 2008–’09 crisis advised almost every major about banks’ risky activities. But in November 2008, as the financial financial services firm, including insurance giant American Interna- crisis was gaining velocity, his voice got a boost when then-presidenttional Group, Swiss bank UBS and Goldman Sachs. “There is going elect Obama appointed him chairman of the newly created Economic Recovery Advisory Board. Volcker’s views found their way into to be a change in the banking industry.” Change is sweeping through the global financial services industry. the regulatory reform package through the backing of the White At the same time that lawmakers in Washington were putting the House and a bill co-sponsored by Democratic Senators Carl Levin of kibosh on proprietary trading, on the other side of the Atlantic the Michigan and Jeff Merkley of Oregon. Section 619 of the 2,300-page Basel Committee on Banking Supervision agreed to impose stricter Dodd-Frank Act, better known as the Volcker rule, prohibits depositcapital requirements, raising the minimum common equity that taking banks from engaging in short-term proprietary trading. It also banks must hold to 7 percent under the Basel III accord, which also sets strict limits on how much banks can invest in hedge funds and lifts capital requirements for banks’ trading books to bring them in private equity: just 3 percent of a fund’s assets. line with charges for lending activity (see “The New Art of Central But the former Fed chairman’s triumph could be short-lived. The Banking,” page 62). The net effect, by most early estimates, is that key will be how regulators interpret the Volcker rule. The Financial banks will need to have three times as much capital to support their Stability Oversight Council, which was established by Dodd-Frank, trading operations as they have today. was tasked with studying how regulators should implement the rule. The combination of Dodd-Frank and Basel III limits the ability Depending on what the FSOC finds, the Fed, the Commodity Futures of banks to take risk, though it by no means completely eradicates Trading Commission, the Federal Deposit Insurance Corp., the Secuit. Banks have been lobbying the regulators charged with enforcing rities and Exchange Commission and other regulators charged with Dodd-Frank, hoping for a lighter interpretation enforcing the new rules could decide that almost all of the rules. At the same time, they have begun to of what banks were doing in proprietary trading can prepare for the worst, reorganizing and repositioning continue under the guise of market making or risk toward less risky, more client-oriented businesses management — and this would be a blow to Volcker’s like asset management and investment banking. attempt to lessen risk in the banking system. Analysts expect the changes to result in lower returns Regardless of what happens, no one thinks this is on equity, at least in the short term. Although the the end of risk-taking.“You will always have speculaBlankfein model was great for traders and bank tion,” says Joseph Schenk, CEO of First New York senior management — which increasingly came to Securities and former CFO of boutique investment be one and the same — it came with greater volatility, bank Jefferies & Co. “The question is, what is the most appropriate venue?” Should it be deposithigh compensation ratios and low stock valuations. taking institutions or hedge funds and proprietary By reversing those detrimental effects, the prohibitrading firms like First New York, which currently tion against proprietary trading could in the long trades its partners’ own capital and is planning to run be better for banks, and for their shareholders. open its doors to outside money next year? There is now almost universal agreement that risk, The exodus has begun. In late September news if not exactly bad, is significantly more complicated and daunting than most realized before the crisis broke that George (Beau) Taylor was leaving his — something that bank management, as well as position as global head of commodities trading regulators and investors, might want to remember. at Credit Suisse to form his own hedge fund with The hope that lies at the heart of the new reforms is —Michael Mayo seed money from New York–based alternativeCLSA that if essential banking institutions are prevented investment firm Blackstone Group. A month later
TheVolcker rule makes an effective statement about how the industry should behave, and it gives an additional key to the regulators.
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there was a good deal of excitement when Kohlberg Kravis Roberts & Co. hired a team of nine traders from Goldman’s principal strategies group to set up a new hedge fund unit for the private equity firm. People familiar with what happened say Goldman has been keen to make a bold statement to show its willingness to break up its proprietary trading business and get out of the regulatory crosshairs. Behind the scenes, however, Goldman and other banks have been lobbying hard for a liberal interpretation of the Volcker rule. The stakes are huge. In recent years, Wall Street firms have gotten as much as 20 percent of their revenues from proprietary trading. No wonder that during the first six months of 2010 Goldman spent $3.5 million on lobbying, according to the Center for Responsive Politics in Washington. In the past, banks generally have not broken out proprietary trading when reporting their financial results, and this has made it difficult to determine exactly how meaningful the business has been. Still, it’s clear that trading (including both market making and principal investing) Former Fed chairman Paul Volcker won the battle against proprietary trading has come to dominate revenue at the big banks. In 1999, the year Goldman went public, its revenues were split relatively evenly among its three main businesses: Stanley’s board selected James Gorman, former head of the global Investment banking accounted for $4.4 billion, trading and principal private client business at Merrill Lynch & Co., as its CEO a year ago, investing for $5.8 billion and asset management for $3.2 billion. replacing John Mack (who stayed on as chairman). Jane Gladstone, head of the financial services advisory practice In 2007, Goldman made $7.56 billion from investment banking, $31.23 billion from trading and principal investments and $7.22 bil- at boutique investment bank Evercore Partners in New York, warns lion from asset management and securitization services. This is why that asset management might not be as effective a solution as bank Blankfein and his traders ruled Wall Street. executives currently hope. She says they will find it difficult to comFew if any analysts have a better understanding of Wall Street than pete against large independent asset managers like BlackRock and Charles (Brad) Hintz, who was a former treasurer of Morgan Stanley Fidelity Investments.“Asset managers are a wonderful business, but and Lehman Brothers’ CFO before moving to Sanford C. Bernstein & the banks just might not be the best sole owner of them,” she says. Co. in 2001 to cover the securities and asset management industries. There are those who think the Volcker rule and all the regulatory In November, Hintz, a perennially top-ranked analyst on Institu- reform measures being taken in the U.S. and Europe have not gone far tional Investor’s All-America Research Team, published a detailed enough to curb banks’ risky behavior.“We just had one of the biggest report on the impact of Dodd-Frank and Basel III on trading. By his credit bubbles known to mankind, and Washington is hesitant to reckoning, the business will become meaningfully less profitable, regulate the industry,” says Richard Bernstein, founder and CEO of but he says banks will regroup by moving balance-sheet assets and New York–based investment firm Richard Bernstein Advisors and resources to other, more lucrative areas, such as emerging-markets a former chief investment strategist at Merrill Lynch. “How do you debt and equity and sovereign bonds. To make up for some of the have to bail out an industry and Washington is hesitant to regulate lost revenue, banks will start charging clients more to borrow. At the it? I don’t understand that at all. You would think that they would same time, they are lowering their compensation ratios from their regulate these people like there is no tomorrow.” recently high level of 50 percent. If banks take these steps, Hintz says, Many anticipate that banks will find a way around the proprietary they can make up for the lost revenue from proprietary trading and trading restrictions. “The Volcker rule makes an effective statement other activities that have been restricted by Dodd-Frank, such as about how the industry should behave, and it gives an additional key over-the-counter derivatives trading. to the regulators in pursuing actions, but I think the end result will be As merger and acquisition activity picks up, investment banking much narrower in scope than originally devised,”says Michael Mayo, will once again be a meaningful contributor to the bottom line. a New York–based analyst at CLSA, a unit of Crédit Agricole Securities. Meanwhile, asset and wealth management are starting to look One of the most outspoken critics of the banks and their recent appealing. It is not a coincidence that JPMorgan Chase & Co. CEO behavior, Mayo is a big fan of Volcker. The former Fed chairman Jamie Dimon appointed Jes Staley, previously the head of asset is a personal hero of Mayo’s for his willingness to say and do continued on page 100 management, to run JPMorgan’s investment bank and that Morgan INSTITUTIONALINVESTOR.COM
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DERIVATIVES
Building
House a Better
Financial reform has been met with much fanfare, but will the creation of clearinghouses to bring OTC derivatives under one roof really reduce systemic risk?
By Suzanne Miller
G
ILLUSTRATION BY LUKE BEST
ARY GENSLER, CHAIRMAN OF THE U.S.
Commodity Futures Trading Commission, has a single-minded mission: to meet the deadline imposed by the Dodd-Frank Wall Street Reform and Consumer Protection Act. By July 15, 2011, Gensler has to finalize dozens of new comprehensive rules, culled from 340 of the 2,300 pages of regulatory guidelines in Dodd-Frank, that will reshape the future of trading and clearing in the $615 trillion derivatives market, one of Wall Street’s biggest profit centers. “Everyone wants to say I’m crazy, but this really is doable within the 360 days Congress has directed,” Gensler tells Institutional Investor. Dodd-Frank is the biggest regulatory overhaul since the Glass-Steagall Act separated commercial and investment banking during the Great Depression. One of the key pieces of the legislation is the creation of derivatives clearinghouses, where many of the credit default swaps and other over-the-counter instruments that got the world into
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DERIVATIVES
trouble during the financial crisis will be centrally cleared, settled and monitored. To make his deadline, Gensler has mobilized more than 100 of his staff at the CFTC’s Washington headquarters, establishing teams to focus on 30 different areas, some of which will likely require more than one rule and involve coordinating with the U.S. Securities and Exchange Commission. In fact, he had his first meeting with all 30 team leaders to discuss the process and deadline one day before President Obama signed the bill into law on July 21, 2010. Everyone knew that the teams had to submit memos a few weeks later — even Gensler’s three teenage daughters. “All three of them knew that each of the rule teams had to get a memo to me, and they asked,‘Dad, did they all get them to you?’” he recalls, with a chuckle. Laughter aside, Gensler has acquired a reputation as something of a zealot for reform and transparency in the OTC derivatives market. He’s applied this transparency to the lobbyists from the financial and corporate sectors who have been besieging his office since DoddFrank became official. The CFTC is posting on its web site the names and organizations of everyone who approaches Gensler with input about regulation. In the first 49 days after the law was signed, the CFTC listed 62 public meetings. For all Gensler’s tough-mindedness, though, many onlookers worry that Washington’s grand plan for overhauling the derivatives market and curtailing systemic risk — one of the biggest catalysts for reform — could backfire. Although Dodd-Frank is promoting clearinghouses as a systemic safety net that will prevent future market crises triggered by big bank collapses, critics contend that the clearinghouse model is flawed as currently conceived, especially for credit default swaps. They argue that it doesn’t go far enough in safeguarding financial markets, in part because the Wall Street dealers who are essential to making these clearinghouses work as liquidity providers operate as an elite club focused more on protecting its profits than on safeguarding the broader market. This has led to worries that Washington is lulling the public into a false sense of security. “Clearinghouses are not a panacea and could theoretically default as well,” cautions David Rubenstein, CFO of BlueMountain Capital
“Most of the positions held by AIG would not be clearable even today because they’re nonstandard and illiquid.” — Kevin McPartland, TABB Group
Management, a $4 billion New York–based hedge fund firm that focuses on credit and equity derivatives markets. “Their strength is in large part the strength of their members. If a big member fails, it’s probably because something really bad is happening in the market. And so maybe another member could fail, and then who knows where your collateral really is?” Many think the biggest risk for failure is in the CDS market, which at $32.7 trillion in notional outstanding is more than twice the size of the U.S.’s annual $14 trillion GDP. (“Notional” refers to the value of a derivative’s underlying assets.) CDSs are contracts that are a form of default insurance for corporations and sovereign countries. They also
ClearSailing Europe eyes looser rules than the U.S. The European Commission’s draft regulation on over-the-counter derivatives and market infrastructure, issued in September, has been broadly welcomed by market participants, but the reaction has been muted because many of the crucial details have yet to be settled. The rules are designed to be consistent with the Dodd-Frank Wall Street Reform and Consumer Protection Act. Yet legal experts believe there could be some significant differences by the time the legislation goes into effect at the end of 2012. One likely difference is the result of intensive lobbying by European corporations over the past year. The draft regulation says that nonfinancial companies are only obliged to clear their derivatives contracts
through a central counterparty if the size of their positions is above a certain threshold. It also exempts financial entities trading with nonfinancial entities that do not exceed the threshold. “In this regard, the proposed regulation is less restrictive than the Dodd-Frank Act, which only allows nonfinancial entities to avoid the clearing obligation where they are hedging commercial risk and certain other conditions are met,” says David Felsenthal, a partner at law firm Clifford Chance in New York. It is far from certain, however, what the clearing threshold will be. The EC has said only that in setting the threshold it will take into account “the systemic relevance of the sum of net positions by counterparty per class of derivatives.” The threshold will eventually be determined by the European Securities and Markets Authority, which the EC is establishing to ensure the application of European rules by national authorities. ESMA begins operations on January 1.
have the potential to blow up markets and institutions when things go wrong. That’s what happened in 2008, when CDS-related problems helped capsize American International Group, Bear Stearns Cos. and Lehman Brothers Holdings, and it is why Washington circled the regulatory wagons around derivatives, CDSs in particular. Clearinghouses clear trades, settle trading accounts, collect and hold margin accounts and monitor trading data. Importantly, they step in as a buyer to every clearing member seller and as a seller to every clearing member buyer, serving as the ultimate counterparty for risks that pass through their doors. Until now, clearinghouses were primarily fixtures of the futures market and, notably, helped steer Chicago’s CME Group and London-based LCH.Clearnet Group safely through the Lehman crisis. For regulators, this was further proof that derivatives also should be centrally cleared. However, critics — including academics, analysts, bankers and investors — contend that clearing derivatives will be complicated and fraught with risk. One significant concern is the notorious selfinterest of Wall Street and the dealer banks’ potential to exert undue influence over the rules-writing process. Many will want to hold on to their shrinking pools of income as derivatives transition from the OTC market to clearinghouses and electronic trading platforms, where bid-ask spreads — the price difference between what a seller asks and a buyer offers — will shrink dramatically. A recent research report by Sanford C. Bernstein & Co. says that big banks such as Goldman Sachs Group and JPMorgan Chase & Co. generate roughly 30 percent of their trading revenue from derivatives. JPMorgan chief executive Jamie Dimon revealed at a September 14 investor INSTITUTIONALINVESTOR.COM
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Hedge funds cautiously welcome the new proposals. The London-based Alternative Investment Management Association has praised parts of the EC’s draft, acknowledging the need, as CEO Andrew Baker said in a September statement, for “increased transparency in derivatives settlement” regardless of increased costs to the industry. But AIMA, whose membership represents more than 1,200 hedge fund firms around the world, is also concerned about what it calls “potentially protectionist” implications for non-EU central counterparties that will have to meet tough conditions to serve EU clients. “Non-EU countries will need to show they have a legal and supervisory regime equivalent to that in the EU, which effectively requires EU law to be exported to non-EU countries,” says Sebastian Barling, an attorney at Reed Smith in London. There will be plenty of time to debate this issue further as the EC guides the draft regulation into legislation at what is sure to
be a stately pace. All negotiations related to Group of 20 commitments to financial reform are due to be completed by the end of 2011, and the EC expects the new rules to be fully operational by the end of 2012. A host of technical details has yet to be agreed on. For instance, the draft says that standardized OTC derivatives contracts must be traded on an exchange and cleared through a central counterparty, or CCP, but there is no definition yet of what contracts are to be included. Alberto Pravettoni, head of corporate strategy at LCH.Clearnet Group, the biggest clearer of OTC derivatives in Europe, says this is a crucial issue. “To clear safely, there must be transparent pricing and reasonable liquidity in the contracts being cleared,” he explains. “It is important to establish which OTC contracts are suitable for central clearing.” The EC says the definition will have to be worked out by a combination of CCPs and ESMA. They will have to do so
conference that the creation of derivatives clearinghouses, which he supports for standard contracts, could cost his bank $1 billion a year in lost revenue. Critics worry that Wall Street firms, to protect their interests, will find a way to continue crowding out competitors and control the majority of derivatives volume. This is already the case at LCH. Clearnet, the biggest player in interest rate swaps clearing, and New York–based ICE Trust U.S., which began clearing CDSs in March 2009; both are dealer-driven. Like it or not, dealers are in a position to heavily influence the market, because without them the clearinghouses can’t function. Even Goldman Sachs, in a presentation posted to the CFTC’s web site, warned that the soundness of clearinghouses will come down to the health of their members. “Management of clearinghouse positions in a member default is complicated by diversity of products (across futures, rates and credit derivatives) and requires risk-taking participation of clearing members,” Goldman wrote. In other words, the clearinghouse may be the risk-taker of last resort, but its members must have enough strength and marketmaking skill to cushion it in times of crisis. There are also serious concerns about which derivatives products will qualify to be cleared, because liquidity tends to be very thin for certain ones — in particular, CDSs. What happens if a clearinghouse gets saddled with illiquid derivative contracts that it can’t trade out of when the market nosedives? Conversely, will too many products be left floating around in the OTC market because they’re not liquid enough to qualify for clearinghouses? This could prove a much bigger consideration than concentration risk in clearinghouses, some worry. INSTITUTIONALINVESTOR.COM
with care if they are to carry the U.K. with them: The U.K.’s Financial Services Authority warned in a December 2009 paper that clearing all standardized contracts through CCPs “could lead to a situation where the CCP is required to clear a product it is not able to risk manage effectively.” More clarity is also needed on what OTC derivatives won’t need to be cleared. Those contracts will be subject to higher capital requirements, but the levels have yet to be set. The regulation does not touch on the issue of how the collapse of a central counterparty will be handled; the FSA addressed this in its December paper, arguing that CCPs were of “systemic importance.” This is a concern that LCH.Clearnet’s Pravettoni shares. “The enthusiasm for more OTC clearing must be combined with a real appreciation of the importance of a robust default management process,” he says. “Without this, the danger is that the risk is simply transferred to
the clearinghouse.” Nor is it clear how expensive the new system will be as far as increased compliance costs and CCP margin requirements. Whatever the nature of the regulatory regime that eventually emerges, it is certain to offer more opportunities for existing clearinghouses in Europe, including LCH.Clearnet, which has been clearing derivatives for 11 years and now handles 40 percent of all interest rate swap volumes, with $246 trillion of notional trades outstanding. Pravettoni says his firm is developing a broader array of OTC clearing products, including the first-ever service for foreign exchange derivatives in Europe. Others have identified the opportunities in the growing market. In addition to existing competitors like IntercontinentalExchange’s ICE Clear Europe, LCH.Clearnet is set to face challenges from CME Clearing Europe, Deutsche Börse’s Eurex Clearing and possibly the London Stock Exchange. — Neil Sen
“The politicians say they will prevent another AIG with the new rules,” says Kevin McPartland, a senior analyst with research firm TABB Group in New York. “But most of the positions held by AIG that caused those collateral calls would not be clearable even today because they’re nonstandard and illiquid.” It’s these kinds of outlying risks that concern Jeffrey Michaels, joint head of the fixed-income division for the Americas at Nomura Securities International, which joined ICE Trust as a clearing member in June. Michaels, who is based in New York, opposes clearing exemptions that keep credit risk outside clearinghouse doors, including those for corporate end users, which make up some 10 percent of the market. “The largest systemic risk will wind up with those companies that have the ability to negotiate bilateral thresholds where they may not be posting enough collateral or no margin at all based on their credit rating,” he says. “If you’re going to have a clearing corporation, you should put everyone in it that could possibly cause a systemic problem because of the size of their activity. It would be shortsighted to exclude companies given the amount of debt they have.” Still, regulators admit they’re challenged when it comes to figuring out how much of the market is ultimately clearable. Gensler acknowledges that in the CDS sector, liquidity may be limited to a handful of single-name CDS products in clearinghouses.“The harder part is going to be what the SEC is going to oversee, which is the individualname CDS,” Gensler says.“You could make the case that only the top 100 or 150 names have enough liquidity to be in a clearinghouse. But continued on page 103
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Can central bankers stop worrying about inflation and learn to love the new financial stability culture? By Tom Buerkle
FOR YEARS LEADING CENTRAL BANKS have focused almost single-mindedly on the control of inflation as the bedrock of economic prosperity. Whether they explicitly pursue an inflation target, as is the practice of the Bank of England, the Reserve Bank of Australia and many others, or implicitly do so, as in the case of the Federal Reserve and the European Central Bank, these institutions carefully monitor price and output trends and have developed elaborate models for setting interest rates, all with the paramount goal of achieving low and stable inflation. As Alan Greenspan testified to Congress in the early 1990s, “The most important contribution the Federal Reserve can make to encouraging the highest sustainable growth the U.S. economy can deliver over time is to provide a backdrop of reasonably stable prices, on average, for business and household decision making.”
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In the wake of the financial crisis, however, central bankers are rethinking their goals. Price stability is no longer enough by itself. Indeed, many central bankers now acknowledge that low inflation, and the low interest rates that accompanied it, helped cause the crisis by encouraging banks and investors to take on ever-greater risks in the search for yield — a point many private economists have been making. “I’m on a mission to get people to recognize the important role that monetary policy has played in getting us into this mess,” says Stephen Roach, senior fellow at the Jackson Institute for Global Affairs at Yale University and a former chief economist at Morgan Stanley. The Federal Reserve’s mandate of promoting maximum employment and stable prices “doesn’t cut it when you have low levels of inflation,” he adds. “It biases you to excessively easy monetary policy.” Now central bankers are going back to the drawing board to modify their approach and take on a new role: guarantor of financial stability. If inflation targeting was all the rage in the 1990s, their new mantra is “macroprudential supervision.” Unlike traditional supervision, which aims to ensure the safety and soundness of specific financial institutions, a macroprudential approach seeks to promote the safety and soundness of the entire financial system and to prevent the kind of meltdown that brought banks low in 2008 and nearly crashed the global economy. To that end, central banks and whiz-kid economists are developing new methods for measuring systemic risk by looking at everything from the amount of leverage in the system to trends in credit spreads to the interconnections and shared positions of banks, brokerages and big investors. Central bankers in the U.S. and Europe admit they have something to learn from their counterparts in developing economies about the use of such old-fashioned tools as limiting loan-to-value ratios for mortgage lenders to cool property markets. The Holy Grail of these efforts is to rediscover the art of central banking as defined by William McChesney Martin Jr., who famously described his task as Fed chairman in the 1950s and ’60s as “taking away the punch bowl just as the party gets going.” “This is really a revolution in policymaking,” Paul Tucker, the Bank of England’s deputy governor for financial stability and one of the leading proponents of the new-style central banking, tells Institutional Investor in an interview. This revolution is very much in its early days, though, and faces plenty of obstacles. Consider the goal itself. Financial stability is unassailable in the abstract but devilishly hard to define with any precision. “The great thing about inflation targeting is that you had a clear, quantifiable objective,” explains Charles Goodhart, director of the financial regulation research program at the London School of Economics and a former member of the Bank of England’s Monetary Policy Committee. “You can’t do that with financial stability.” The notion of strengthening the financial system to enable it to withstand shocks — one of the key planks of macroprudential supervision — is almost universally accepted these days. That concept inspired the recent international agreement on higher capital requirements for banks by the Basel Committee on Banking Supervision, which leaders of the Group of 20 nations endorsed in November. A second macroprudential plank — leaning against the financial
cycle to prevent the buildup of asset bubbles — is much more controversial. Under Greenspan, the orthodox view held that central bankers weren’t smart enough to identify a bubble and should limit their intervention to cleaning up after any bust by easing monetary policy. That stance, known as “the Greenspan put,” is now widely believed to have fostered the buildup of risk leading up to the crisis. Today growing numbers of central bankers say they would rather lean against asset prices than clean up after a collapse, but where and when should they act? Risk grows with leverage, to be sure, but are leveraged buyouts priced at 6 times earnings before interest, taxes, depreciation and amortization a sign of excessive leverage, or LBOs priced at 9 times ebitda? At what rate of growth does a housing price boom risk turning into a bust? There are no ready rules for answering those questions. That poses a dilemma for central bankers, most of whom are monetary economists used to relying on elaborate econometric models in making decisions. Are these bankers capable of exercising the gutlevel judgment about economic growth and asset prices that the new stability role requires? And will they be willing to rein in credit despite the inevitably fierce pressure from politicians, homeowners, investors and others determined to let the good times roll? “Taking away the punch bowl is going to be hard enough,” says William White, chairman of the economic and development review committee at the Organisation for Economic Co-operation and Development in Paris and former chief economist at the Bank for International Settlements. “Taking away the punch bowl when asset prices are going up and everybody is getting rich and thinks they’re very smart is really tough.” Central bankers acknowledge the difficulties, both technical and political, that they face in taking on the new financial stability job,
“There has been a fundamental regime shift in terms of the importance to the Fed of taking asset price developments into consideration in the setting of monetary policy.” — William Dudley, Federal Reserve Bank of New York
but they insist they have no other choice. The cost of the recent crisis in terms of government bailouts, moral hazard, loss of economic output and high unemployment is simply too great to go on with business as usual. “There has been a fundamental regime shift in terms of the importance to the Fed of taking asset price developments into consideration in the setting of monetary policy,” says William Dudley, president of the Federal Reserve Bank of New York, in an interview in his wood-paneled office at the bank’s palazzo-style building in Lower Manhattan. “There’s more willingness now to be proactive and try to identify these risks in real time, and then do something about it.” That challenge may seem purely theoretical at the moment. With the U.S. economic recovery losing momentum, unemployment INSTITUTIONALINVESTOR.COM
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rising, house prices falling and stock prices some 20 percent below their 2007 highs, the idea that the Fed will need to act any time soon to prick an asset bubble seems fanciful. Indeed, the economy is so weak and inflation so low that the central bank has embarked on another round of quantitative easing, in which it will buy up to $600 billion of government bonds in a bid to boost asset prices, confidence and growth. Similarly, Europe’s debt crisis looks likely to forestall any tightening moves by the ECB any time soon. “Until the economies that were at the center of the crisis have actually recovered, some of the questions about what policies are going to be used are not going to be germane,” says Stephen Cecchetti, chief economist at the BIS. Yet for many economists, QE2 is all the more reason for the Fed to put greater emphasis on financial stability. The fresh injection of liquidity risks fueling asset price bubbles around the world, if not immediately in the U.S., just as low interest rates earlier this decade helped feed the subprime debacle, critics say. Quantitative easing is “the same prescription that put us into this mess,” says Roach. A macroprudential approach should lead the Fed to be more vigilant about possible bubbles and wind down its unconventional monetary policy sooner rather than later, he adds. THE CONCEPT OF MACROPRUDENTIAL regulation dates back to 1979, when central bankers gathered at the BIS in Basel, Switzerland, to consider ways to restrain the surge in bank lending to developing countries, especially in Latin America. The idea was to focus on the aggregate exposure of the banking system as a whole rather than on individual institutions. No action was taken, though, and the Latin debt crisis erupted three years later. The term came back into vogue after the Asian financial crisis in the late 1990s. The International Monetary Fund developed macroprudential indicators — ranging from the banking sector’s capital adequacy and the growth rate of lending to the current-account deficit — designed to provide early warnings of weaknesses in the financial systems of member countries. Major developed economies launched the Financial Stability Forum, a precursor to today’s Financial Stability Board, to focus on strengthening the financial system through improved data collection and regulation. A number of central banks, beginning with the Bank of England in 1996, had begun publishing regular financial stability reports examining everything from market trends to the risks posed by derivatives markets. Many of these efforts remained largely theoretical, though, with few practical consequences for monetary policy or financial regulation in developed economies. Macroprudential supervision “has been alive and well for 31 years now, but no one knows how to do it,”says David Green, a former U.K. banking supervisor and co-author of a recent book, Banking on the Future: The Fall and Rise of Central Banking, which calls on central banks to pay greater attention to credit growth and financial stability. INSTITUTIONALINVESTOR.COM
The credit crisis has given a fresh impetus to efforts to transform financial stability from a loose concept to tangible policy. The Basel III accord is a notable first step. It will require banks to hold more, and better quality, capital: Common equity capital will rise to 7 percent of risk-weighted assets by 2019, compared with 2 percent currently. That increase should make banks more capable of absorbing losses when shocks hit the financial system. Global capital rules have been around since the first Basel agreement was reached in 1988. What distinguishes the new accord is that it formally incorporates some macroprudential measures. The 7 percent equity capital standard comprises a 4.5 percent minimum and a new capital conservation buffer of 2.5 percent. Although the minimum must be maintained at all times, banks can draw down the buffer to cover losses; regulators hope this will keep credit flowing in a slump. Even more innovative, the Basel Committee is expected to add two more macroprudential measures to the accord by the end of 2010: a capital surcharge for systemically important financial institutions, or SIFIs, and a countercyclical capital charge that can range from 0 to 2.5 percent. The SIFI surcharge, which is expected to apply to perhaps 30 to 40 big global banks, would be a sort of insurance premium that seeks to address the too-big-to-fail problem. The countercyclical charge would require banks to build up additional capital during periods when credit growth exceeds the historical trend, which is typically when banks take the big risks that later become their big losses. Regulators hope the countercyclical buffer will moderate the credit cycle, tempering lenders’ exuberance during boom times and giving them a bigger cushion for bad times. If the countercyclical charge had been in force a decade ago, U.S. banks would have had to build a buffer of 2.5 percent of risk-weighted assets by 2003 — before the subprime mortgage market really took
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off, according to BIS calculations. Spanish banks would have had to do so even sooner, by 2000.“Banks would have faced the recent financial crisis with much stronger capital bases and would have been able to draw on them,” BIS general manager Jaime Caruana said at a recent conference on macroprudential policy in Shanghai. Tighter capital standards alone, even ones that seek to moderate the credit cycle, won’t be enough to safeguard the financial system. Risk is constantly shifting, and the system innovates to get around the rules, so central bankers and other regulators need to sharpen their surveillance capabilities and develop tools to mitigate the buildup of risk. To that end, Western governments have established new institutions to promote financial stability that give pride of place to central bankers. As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the U.S. has established a Financial Stability Oversight Council to identify threats to the financial system and direct regulatory agencies to take action. Chaired by Treasury Secretary Timothy Geithner, the council’s members include Fed chairman Ben Bernanke and the heads of major regulatory agencies, including the Securities and Exchange Commission, the Commodity Futures Trading Commission and the Federal Deposit Insurance Corp. Similar moves are afoot in Europe. With responsibilities similar to the FSOC’s, the new European Systemic Risk Board, chaired by ECB president Jean-Claude Trichet, will hold its first meeting in December. In the U.K. the government is due to introduce legislation in 2011 requiring the Bank of England to set up a Financial Policy Committee, similar to its rate-setting Monetary Policy Committee. Establishing these regulatory bodies is an essential first step toward taking real action, advocates insist. “No one before really had the responsibility and the mandate clearly defined” for financial stability, says ECB vice president Vitor Constancio. “And so no one was accountable. No one moved. Now it will be completely different because someone is accountable. That changes everything.”
“No one before really had the responsibility [for financial stability]. Now it will be completely different because someone is accountable.” — Vitor Constancio, European Central Bank
The FSOC has already made some early moves. At its first two meetings, in October and November, the council issued advance notice of plans to designate certain nonbank financial firms for closer supervision and to declare some financial utilities, such as securities clearinghouses, to be systemically important and subject to tighter scrutiny. In January the council is due to set out detailed guidelines for implementing the so-called Volcker rule limiting proprietary trading by banks. These initiatives are simply carrying out existing provisions of the Dodd-Frank Act, though. Broader changes that could alter the way central banks set policy will require a lot more work by economists and regulators to turn macroprudential supervision from theory into practice. Policymakers acknowledge they have few reliable gauges of systemic risk or agreed-upon rules for containing such risk.
“We’re not even in the position that Don Brash was in in the late 1980s,” says the Bank of England’s Tucker, referring to the Reserve Bank of New Zealand governor who pioneered inflation targeting as a central bank strategy. The first step for central bankers and regulators seeking to control systemic risk is to measure it. The crisis has spawned a cottage industry of risk analysis at central banks and other regulatory agencies and in industry and academia, and new forces are being marshaled in the effort. In keeping with Dodd-Frank, the U.S. Treasury is setting up an Office of Financial Regulation to collect and standardize financial data — everything from lending exposures between banks to derivatives positions held. The European Commission has launched a similar initiative, Forecasting Financial Crises, in which scientists from seven universities and economists at the ECB will try to measure systemic risk and develop models to predict future crises. Some of the work under way is promising, if still some ways from being operational. Economists at New York University’s Leonard N. Stern School of Business have developed a model that attempts to measure a bank’s likely contribution to the banking system’s capital shortfall if a shock — a big drop in stock prices, say, or a spike in credit default swap rates — was to hit the financial system. Among other things, it incorporates a given bank’s leverage and its exposure to correlated assets likely to suffer big losses when other banks are in trouble. “Leverage and concentration of risk have to be the two pillars of any macroprudential approach,” says Viral Acharya, one of the economists involved in the work. The model, which is updated daily on the web site of the Stern School’s Volatility Institute (http://vlab.stern.nyu.edu/welcome/ risk), indicated in early December that Bank of America Corp. and Citigroup posed the greatest systemic risk in the U.S., followed by JPMorgan Chase & Co., Morgan Stanley, Wells Fargo & Co. and Goldman Sachs Group. A rival model dubbed CoVaR, developed by Princeton University economist Markus Brunnermeier and Tobias Adrian of the New York Fed, looks at a given firm’s leverage, its dependence on short-term funding and the volatility of its stock price, among other variables, to predict how distress could spill over to other institutions, causing contagion. These economists believe the authorities could use their models to regulate firms, either by imposing a tax or boosting capital requirements for firms that pose the highest risk. To do that, however, regulators will need much more, and more timely, data on everything from firms’ commercial paper and repo positions to their exposure to rival firms via CDS holdings and currency and interest rate swaps. In contrast to those kinds of bottom-up models, which focus on the contribution of individual firms to systemic risk, other models take a top-down approach, drawing on macro data to indicate when overall market risk may be reaching dangerous levels. Economists at the BIS led by Claudio Borio have focused on the growth of credit relative to the economy, noting that this has historically been the best sign of brewing problems. This indicator will serve as the trigger for the proposed Basel countercyclical capital buffer. The buffer would kick in when the ratio of credit to gross domestic product exceeded its longterm trend by more than 2 percentage points, rising to a maximum of 2.5 percent if the credit-to-GDP ratio exceeded its long-term trend by more than 10 points. Credit patterns vary by country, though, so the indicator would operate as a warning sign rather than an automatic INSTITUTIONALINVESTOR.COM
URALSIB CAPITAL
Interview with Alexei Devyatov, Chief Economist at URALSIB Capital How long do you think the ruble’s downward trend will continue? The ruble depreciation we have been seeing is related to capital outflow from Russia. Sergei Ignatiev, the head of the Central Bank, announced that capital outflow was around $21 billion for the first 10 months of 2010, which is above expectations as most people expected a figure of around zero by the end of the year. Investors have some worries after the extreme weather in the summer and increased uncertainty about the Russian economy. When investors see things are not going as well as expected they react by withdrawing funds, investing money in other countries which look better. I think this is a temporary phenomenon. Things will settle down and we expect a better economic performance for the final quarter of 2010 and for all of 2011. The ruble will settle down and this money will come back. The fundamental factors are for the appreciation of the ruble and we will see this soon. Inflation increased after the severe drought that hit Russia in the summer and seems set to continue, but the Central Bank has been reluctant to raise interest rates to offset the price shock. What are the motives for the bank’s strategy at the moment? Inflation did increase and there has been a significant increase in food prices. That is a normal reaction of the economy to the drought but I also think it is temporary. However, increased inflation is also related to the monetary policy of the Central Bank. Historically, the monetary policy of the Central Bank was aimed at the prevention of excess appreciation of the ruble, which basically means intervention in the foreign exchange and consequent broad money expansion. The Central Bank is keeping interest rates low now, which is a sign of a very soft monetary policy. Basically, the Central Bank wants to provide cheap liquidity, and that is again inflationary. What is your forecast for inflation in the next couple of years? Inflation will increase in the near future. Our forecast for 2011 is 9.5 percent, after hitting 8.5 percent in 2010. We believe it will be somewhat higher in 2012 but then it will
start to come down. The Central Bank has announced that it will take care of inflation in the future. We hope this will actually happen as they have been talking about it since 2005. There has been speculation about the postponement of the sale of ruble eurobonds. Do you think this is likely? I think it is likely. The Finance Ministry’s attitude toward the bond market is very pragmatic. When we need money we borrow; when we don’t need money we don’t borrow. With the current budget performance we see that the deficit is much lower than planned in the budget. The deficit has been 2.1 percent of GDP for the first 10 months of 2010 and in the budget it is around 5.4 percent, so they are in much better shape fiscally. So that means they don’t need to borrow as much as was planned before. What broad effects will a weakening ruble and higher inflation have on the Russian economy? A weaker ruble is good for the economy. That is the standard argument, that it helps exporters and reduces imports. It shifts economic The Finance activity toward domestic Ministry’s attitude production. But I don’t toward the bond expect the downward trend to last very long, so there market is very will not be a significant pragmatic. effect. Higher inflation is troubling because it depresses investment and growth. When inflation is high people switch their investments to short-term high-yield projects, and long-term investment really slows down.
Contact Information URALSIB Capital 8, Efremova Street, Moscow, 119048, Russia www.uralsibcap.ru
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trigger. National authorities would be able to exercise their judgment raised reserve requirements five times in 2010, ordering banks to set about whether and when to require banks to build up their buffers. aside 18.5 percent of their deposits, in a bid to curb the rapid pace of Another indicator, developed by the New York Fed’s Adrian and lending growth. Also in 2010, the China Banking Regulatory ComHyun Song Shin, a Princeton economist, looks at the relationship mission issued a warning to banks to avoid fueling speculative housing between balance-sheet growth and leverage to assess the financial purchases, after mortgage lending surged by 49 percent in 2009. system’s vulnerability. Rising asset prices encourage banks to step up The agency has also mandated that buyers make minimum down their borrowing to acquire more assets, the inherent reason that good payments of 40 percent on second-home purchases. In Hong Kong, times can lead to credit excesses. By charting the growth in repos, where apartment prices have soared by about 50 percent over the one of the main vehicles that banks use to fund their activities, the past two years, the Hong Kong Monetary Authority in 2009 lowered researchers believe they can forecast changes in the volatility risk pre- the mortgage loan ceiling to 60 percent of value for properties worth mium, a gauge of whether the system is becoming more or less stable. more than HK$20 million ($2.6 million), down from 70 percent; in If central banks had been paying closer attention to credit-to-GDP August it applied that loan-to-value ceiling to properties worth more ratios and leverage indicators, they might have acted sooner to avert than HK$12 million. In November the Bank of Thailand imposed the recent crisis or to moderate its impact, says the Bank of England’s loan-to-value limits of 95 percent for low-rise housing and 90 percent Tucker.“The fault lines in the system could have been identified and for condominiums. The Thai central bank also set minimum income reduced, if not eliminated,” he explains. “The erosion of capital requirements for credit card holders to contain consumer lending. and the extent of leverage in the banking system could have been “Emerging markets, especially in Asia, have long used macroprudenaddressed. Do I think we can do better than in the run-up to the crisis? tial measures,” Bank of Thailand governor Tarisa Watanagase said Yes. Do I think we’ll always get it right? Of course not.” at a macroprudential conference at the Chicago Fed in September. There’s a fundamental reason for most credit expansions. The The advantage of such measures is that they focus on the source of Internet really did transform business, even if the price of technology speculative excess rather than slowing the overall economy, as interest stocks got out of hand a decade ago. Subprime mortgage lending rate hikes do. The disadvantage is that they are difficult to implement, continued on page 107 was useful in expanding home ownership before excessive growth and outright fraud laid the seeds of disaster. The key for central bankers is to try to contain excessive credit growth without stifling innovation. Leaning against credit expansions is a bit like taking out insurance, the New York Fed’s Dudley says. If the fundamentals behind the expansion are sound, a slightly tighter central bank stance CUSTOM RESEARCH BY INSTITUTIONAL INVESTOR shouldn’t hurt the economy. If they aren’t, the central bank’s posture could help limit the damage of a bubble bursting. The prized objectivity, research skills and industry PUBLISHER, INTERNATIONAL As they improve their methods for meaknowledge at the heart of Institutional Investor’s Christine Cavolina suring risk, central bankers need to consider publications are now at your disposal. Institutional
[email protected] what policy tools would best contain risk and Investor Market Research will perform, analyze and publish White Papers tailored to your prevent a crisis from erupting. The CommitNEW YORK needs. Our expertise becomes yours–whether tee on the Global Financial System, a BIS arm Joy DeSanto to establish thought leadership, assess market that monitors markets for central bankers,
[email protected] conditions or validate product development– identified an array of tools in a May 2010 allowing you to conserve internal resources and report; they range from setting maximum more economically outsource assignments. C&E EUROPE, RUSSIA & CIS loan-to-value ratios for mortgage lending Lena Mas to imposing debt-service-to-income ratios
[email protected] for consumer lending to varying margin requirements for securities purchases. Even ASIA more draconian, central banks can resort Douglas Mulcock to outright curbs on certain activities — for
[email protected] example, imposing limits on credit growth in particular sectors, such as housing, or restricting foreign currency lending. ONLINE PUBLISHER Western central banks can learn a lot Michael Feinberg
[email protected] from the experience of regulators in emerging markets, notably in Asia, who haven’t hesitated to try to contain credit and asset price booms. The People’s Bank of China
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China’s currency expands creatively to attract investment. By Allen T. Cheng
Bridge
The
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ILLUSTRATION BY PHILIPPE WEISBECKER
CALL IT A NEW KIND OF SECRET SAUCE
or the McMagic of high finance, but when fastfood enterprise McDonald’s Corp. sought capital for new eateries in mainland China, it came up with an ingenious plan, supported by the Chinese government, to sell outside bonds denominated in the Chinese renminbi — a currency not convertible on international markets — then remit the proceeds directly into China. To be sure, the innovative currency loop is a far cry from true convertibility of the renminbi (translation: “the people’s currency”), much less immediate competition to the dollar or euro as a global tender. But the deal signifies broad ambitions by China on the world stage and the willingness of China’s monetary policymakers to be creative in making attractive investments happen. In the case of the fast-food vendor, McDonald’s wanted to open 175 new outlets, but it did not have the necessary capital in renminbi, or
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yuan, the individual currency unit. So the Chinese State Administration of Foreign Exchange, which oversees commercial exchange involving the renminbi, allowed the Oak Brook, Illinois, company to raise money in Hong Kong by selling renminbi-denominated bonds to international investors. In addition to offering new options with its currency, China hopes the action will accelerate the process of turning Hong Kong, the former British possession, into its primary offshore currency trade settlement center.“China is one step closer to allowing foreign companies to have a full range of domestic capital-raising options,” says Hu Yifan, Hong Kong–based chief economist of Beijing-based Citic Securities Co., China’s largest brokerage firm. Since the McDonald’s deal on August 19, other foreign companies have issued yuan-denominated debt in Hong Kong (such instruments are known informally as dim sum bonds, in honor of the local cuisine). On October 21, Manila, Philippines–based Asian
TRANSACTION VOLUMES UNDER THE RENMINBI CROSS-BORDER TRADE SETTLEMENT PROGRAM (RMB bn) 60 50 40 30 20 10 0 Nov. 2009
Jan. 2010
March 2010
May 2010
July 2010
Sept. 2010
Value of renminbi trade settlement Sources: People’s Bank of China, HSBC.
Development Bank raised 1.2 billion yuan ($180 million) in dim sum, a ten-year note with a coupon rate of 2.85 percent. The bond was heavily oversubscribed, snapped up mostly by Asian and European investors hungry to get their hands on China’s first offshore RMB investment products. On November 24, U.S.-based Caterpillar raised 1 billion yuan in a two-year dim sum note for its China ventures. In December the International Finance Corp., part of the World Bank group, sought to raise 100 million yuan with RMB-flavored dim sum. “We plan to use the proceeds,” says Nina Shapiro, IFC’s vice president and treasurer based in Washington, “to invest in Chinese private enterprises.” Many more RMB deals are in the offing. The floodgate of opportunity was opened recently when Beijing took several steps to adapt currency policies to world interest in investing, specifically allowing Hong Kong–based banks to issue yuan through the sale of bonds, Hong Kong depositors to increase
yuan savings by converting up to 20,000 yuan a day, and Hong Kong–registered companies to convert foreign currencies into yuan daily and even to take yuan in lieu of dollars as payment for goods or services sold outside the mainland. With 217 billion yuan on deposit by the end of October, up from 63 billion yuan at the end of 2009, according to the Hong Kong Monetary Authority, Hong Kong has taken substantial steps toward becoming China’s offshore RMB trade settlement center. That said, Hong Kong’s pool of offshore yuan liquidity pales in comparison with China’s 60 trillion yuan on deposit. Nevertheless, the direction is clear: Offshore yuan liquidity will rise rapidly in the years ahead, with Hong Kong as the main offshore trading hub. Since 2008, China has negotiated currency swap agreements with trading partners from Southeast Asia to Latin America, primarily emerging nations. “Demand for the renminbi as a trade settlement currency lies in emerging, not developed, economies,” says Qu Hongbin, Hong Kong–based chief China economist at HSBC Holdings. Emerging markets account for about 55 percent of China’s total trade, compared with 47 percent ten years ago.“We anticipate an increasingly rapid rise of this share,” he asserts. In addition, China also has eased its domestic currency controls, allowing some multinationals to repatriate a portion of profits and foreign institutional investors to convert and repatriate portions of the equity instruments they hold. China is on track to free or nearly unrestricted convertibility of the RMB as well as a more liberalized managed floating exchange rate by 2020, says Citic’s Hu.“I expect no capital control for the trade account by 2020,” she explains. “There should be no daily RMB exchange limit by that time. The Chinese government has made it clear it plans to make Shanghai an international finance center by 2020, and to do so it must make the RMB largely convertible by then.” Only a few limits may remain after 2020, says Hu, who predicts that there still will be a minimum stay requirement for capital raised in China for outflow of dividends. Currently, the currency is allowed to rise or fall by 0.5 percent daily against the dollar. “The central bank will intervene if it thinks the market is too volatile,” she adds. Those who closely watch China’s experiment say many of the mechanisms are in place for the eventual rise of the RMB as a global reserve currency, predicting that as soon as a decade from now the Chinese currency may begin to rival the greenback in global markets. China’s strategy is still evolving, says Hu. “RMB internationalization is a direction, but there is no clear step, pace, phase planned, as far as I know,” explains the former World Bank consultant, who maintains close ties to senior officials at China’s central bank. “It probably follows China’s strategy of ‘crossing the river by touching the stones’ — that is, experiment and observe, then experiment again and observe, and so on until the river is crossed.” Qu of HSBC, however, describes China as having touched three specific stones in its journey to cross the river: one, making the yuan a global trade settlement currency; two, allowing its broad use in international capital markets; and three, the biggest leap of all, allowing it to be converted as an international reserve currency. That crossing may take longer than expected, warns Kwok On Fung, a Tokyo-based portfolio manager who oversees $500 million of investments in the greater China region at Nikko Asset Management Co. “The government knows there are many benefits when INSTITUTIONALINVESTOR.COM
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others take your currency, and the international dent Barack Obama pressed Chinese President Hu prestige that goes with it,” he says. “But at the same Jintao to push the currency toward full convertibility, time, they realize there is a huge cost,” namely, that a point he has repeatedly made with Hu. the government and the people of China will lose Even as the world is pushing China to revalue, control of the renminbi. “I think the Chinese govmany in the West seem to have a short memory, ernment is most afraid of losing control,” he adds. observes Shane Oliver, head of investment strategy “If they internationalize the currency and liberalize, and chief economist at Sydney-based AMP Capital sometime down the road they may face very volatile Investors, one of Australia’s largest asset managers, capital outflow. There is always a risk of that.” with A$97 billion ($95 billion) under management. Economic volatility has a direct impact on politi“America didn’t let its currency float until 1971, cal stability, and the Chinese government loathes any when former U.S. President Nixon ended the gold sort of volatility, says Guan Anping, a Beijing-based standard for the U.S. dollar,” Oliver says.“Australia securities lawyer and former official at the Ministry didn’t let its currency float until 1983 [the Australian dollar was effectively fixed to the British pound and of Commerce. “A freely convertible RMB could later the U.S. dollar, until then]. Both nations floated lead to capital flight or incoming tidal waves of hot money,” he explains.“And the Chinese government their currencies when their per capita incomes were is deathly afraid of this.” Still, officials in Beijing are far higher than China’s. The level of development in determined to internationalize the RMB, says Guan, Western countries was far more advanced than what adding that they are working on building regulatory it is in China today.” — Shane Oliver frameworks to manage the volatility that will come AMP Capital Investors China’s per capita gross domestic product in 2009 when the Chinese currency exchange mechanism is was $3,743 — the 87th highest in the world, accordliberalized in the years ahead. ing to the World Bank — while the U.S. had a per China’s regulators foremost need to gain expericapita GDP of $46,436, the sixth highest. Back in ence in managing a freely convertible currency, 1971 the U.S. had a per capita GDP of $5,361, No. 1 notes Murtaza Syed, the International Monetary among major nations in the world, while China had Fund’s deputy chief representative in Beijing. a per capita GDP of $117, among the poorest in the “China is ready in terms of economic size to have a global currency, world, with a rank of 121. “So you can understand why Chinese are reluctant to accept free but its institutions are not yet ready,” Syed said recently at a conference in Beijing. Even if partial convertibility were achieved in the markets,” Oliver adds. “A lot of these countries that are lecturing coming years, that certainly would signal the end of an era in China, China on having a fixed exchange rate didn’t float their currencies which kept the yuan pegged to the U.S. dollar and strictly controlled until a few decades ago because they themselves didn’t trust the gyracapital flow for decades. In the early decades of the revolution, a tions in the exchange markets. It comes down to politics.” time when the nation operated as a centrally planned economy, Politics can work both ways. Indeed, the executive board of the conducting little trade with Western nations, China pegged the yuan International Monetary Fund recently approved a plan to increase at 2.47 to the dollar. As China reformed economically and opened China’s voting stake to third, behind those of the U.S. and Japan, in up to foreign investors, the Chinese government allowed rapid recognition of China’s rising geopolitical importance. depreciation, pegging the yuan at 8.28 to the dollar from 1994 to “This historic agreement is the most fundamental governance mid-2005, thereby accelerating the nation’s growth to become the overhaul in the fund’s 65-year history and the biggest-ever shift of world’s largest producer of labor-intensive manufactured goods. influence in favor of emerging-markets and developing countries In that decade, China vaulted from the seventh-largest economy in to recognize their growing role in the global economy,” said IMF the world to fourth-largest, according to the World Development managing director Dominique Strauss-Kahn at a news conference Indicators database. In 2010, China eased past Japan to become in early November. Under the IMF system, 6 percent of IMF votthe second-largest economy. ing shares would be transferred to “dynamic” emerging-markets It was under U.S. pressure that China delinked the yuan from countries from industrial economies. The move would vault China the dollar in 2005 and allowed for steady appreciation against a over France, the U.K. and Germany, into the third spot. It would also basket of currencies. When the global financial crisis intensified lift other large emerging powers, including India and Brazil, into the in mid-2008, China repegged the yuan at 6.83 to the dollar. It top ten of the 187-member institution. didn’t allow the currency to appreciate again until June 2010, The IMF’s member countries will vote on the reforms, with 85 ahead of the Group of 20 summit in Toronto, when, again under percent support needed for the changes to pass. Some countries will U.S. pressure, China’s central bank announced that it would allow also require legislative approval, including the United States. Still, for faster appreciation. The yuan currently is trading at about 6.66 the likelihood of the reforms’ passing is high. to the dollar. “We see the rise of the ‘redback,’” says HSBC chief China econoThe yuan and its pace of appreciation has been the key sore spot in mist Qu. “If there is to be a rival to the dollar as the world’s reserve U.S.-China trade relations. The American Congress, finding in China currency in the 21st century, it surely must be the Chinese renminbi.” a convenient scapegoat for U.S. economic woes, has been tinkering China recently surpassed Japan as the world’s second-largest continued on page 108 with imposing tariffs on Chinese imports. In November, U.S. Presi-
A lot of these countries that are lecturing China on having a fixed exchange rate didn’t float their currencies until a few decades ago.
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“We believe that we can service global investors better than our competitors because we truly understand China” HENRY ZHAO
HARVEST FUND MANAGEMENT
A Global Perspective on China Harvest Fund Management Co. was founded in 1999 as one of the first asset management institutions in China. Today, as the largest Sino-foreign asset management joint venture in the world, it is rapidly expanding its international business to offer a global perspective on China.
e
ven by the standards of China’s fast growing asset management industry, the story of Harvest Fund Management is an impressive one. Established in March 1999 with just 30 employees and one fund worth RMB2 billion (US$301 million), Harvest now manages 23 funds as well as several National Social Security Fund accounts, 160 corporate annuities accounts and more than 30 segregated accounts worth in excess of RMB250 billion (US$37 billion). The firm employs more than 450 staff in China and Hong Kong. And its long list of international clients and partners includes some of the best and brightest names in the global industry including Citibank, Siemens, Coca Cola, Prudential UK and Soc Gen. The man who has presided over the transformation of Harvest is Henry Zhao, 44, who has a PhD in economics from Peking University. Since taking the reins in October 2000, Zhao has instilled a new culture within the organization that has dramatically changed the way it does business. “When I became CEO, I decided to make the company more open-minded and forwardlooking,“ he says. “I recruited the best people from industry and the best universities
December 2010/January 2011 Institutional Investor Sponsored Statement
HARVEST FUND MANAGEMENT and I encouraged them to operate in a very professional and prudent manner. Looking back on it, this was a milestone.” Not only did Zhao snap up the most capable portfolio managers, research analysts and risk management professionals, but in an industry where demand far exceeds supply, he has been able to keep them. Harvest’s investment philosophy is well known. The firm relies on a combination of bottom-up and top-down research together with qualitative and quantitative analysis to deliver consistent long-term returns. Its investment teams are now made up of individuals with an extraordinary depth and breadth of experience in both domestic and international securities markets. “We put a premium on excellence, on innovation and on long-term vision,” says Zhao. “This is a pragmatic Western style approach to management. We aim to provide the best solution to clients in any market situation.” Zhao’s strategy paid off in June 2005 when Deutsche Asset Management Asia (DeAM) purchased a 19.5 percent stake in Harvest. Three years later, DeAM increased its equity stake
DeAM to establish international asset management best practices. To support its operations and ensure full compliance, Harvest even boasts the largest data center in the asset management industry in China.
Fast Growth From the Institutional Market The firm has also been quick to take advantage of the burgeoning opportunities offered by China’s fast growing institutional business. It was among the first six fund managers chosen by the Chinese government to manage the National Social Security Fund, which provides basic pension and welfare insurance to millions of Chinese. It was one of the first to receive government authorization to conduct Enterprise Annuity business, a market that is expected to grow exponentially. Furthermore, it has made major inroads into the insurance business and currently services 59 insurance companies, which represent more than 60 percent of China’s insurance market. “China is a big economy with a big population and a very diversified industrial base,” says Zhao. “The transformation of the old economy has created enormous opportunities and challenges for everyone. As an experienced asset manager, we have been able to identify the opportunities and overcome the challenges to offer value added services to clients.” The good news for Zhao is that Harvest’s rigorous approach to 30 percent. Today DeAM has two seats on the Harvest to investment has delivered top-notch results. Since the board and provides technical support and advice. As part of firm’s inception, Harvest’s equity funds and bond funds have their close cooperation, new graduates from Harvest spend returned 22.18 percent and 11.57 percent respectively on an two months working with their counterparts in New York. The training instills an international perspective and new skill sets annual basis. Better still, Harvest was ranked No. 1 by overall that have proven to be valuable in China. equity fund performance in the first half of 2010 against other These days, Harvest is not only the largest of the 33 joint top-tier Chinese fund managers. venture asset management companies in China, but by all Harvest’s latest venture is its most ambitious yet. In September 2009, as part of its drive to boost international business, accounts its most successful. Zhao has worked closely with Harvest set up Hong Kong-based Harvest Global Investments (HGI) as a wholly owned Harvest Fund Management’s AUM (US$bn) subsidiary. The new operation promises to raise Harvest’s profile by bringing its mainland 35.4 34.59 research expertise to global clients. It also puts 35 31.93 Harvest in the unique position of being able to 28.38 offer a global perspective on China. 30 As part of a deal hammered out with its joint venture partner, DeAM agreed to transfer 25 management of its mutual funds employing an Asian equities strategy and a Greater 20 China equities strategy to HGI. A handful of senior asset managers from DeAM have since 13.89 15 moved over to HGI. “This is an exciting new step in our partnership 10 with Harvest,” says Kevin Parker, Global Head of 5.09 Deutsche Asset Management. “They have had 3.82 5 1.8 significant success in developing their business 0.75 0.27 0.34 0.23 in China, and we see great potential for them to apply their expertise in Asia more broadly.” 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010h1 For Zhao, having a Hong Kong presence is
Harvest was ranked No.1 by overall equity fund performance in the first half of 2010 against other top-tier Chinese fund managers.
3 • Institutional Investor Sponsored Statement • December 2010/January 2011
“We strongly believe that global investors need more exposure to emerging markets and to Greater China. We also strongly believe that Chinese investors need to diversify their investments globally.” HENRY ZHAO
a major step toward the global stage. “We believe that we can service global investors better than our competitors because we truly understand China,” he says. “We not only have the traditional long-only strategy, but we are starting to roll our more innovative alternative platforms. In the future, we can apply our expertise of emerging markets elsewhere in the region.” Besides investing in the first hedge fund company on its alternative platform, JT Capital Harvest is looking to deliver high quality products to domestic as well as international investors. HGI provides Harvest with a unique platform from which to grow. Deutsche for its part is upbeat about prospects for the Hong Kong operation. “Harvest is a close and valued partner with whom we see tremendous further opportunity for growth,” says Robert Rankin, CEO at Deutsche Bank Asia Pacific. “They are an example of China’s world-class capability and potential.” In the 15 months since the operation was established, HGI has already shown that it can deliver. At the end of last year, it won a Greater China mandate from a sovereign wealth fund in Asia. That is on top of mandates awarded out of Europe. HGI already has more than US$2.6 billion of funds under management not including its own Qualified Domestic Institutional Investor (QDII) program. “Next year we will grow faster as the infrastructure is now in place and we have secured the ratings,” says Zhao. “We strongly believe that global investors need more exposure to emerging markets and to Greater China. We also strongly believe that Chinese investors need to diversify their investments globally.”
A Bright Outlook for Greater China As the reminbi becomes more international, there seems every likelihood that Hong Kong will become a major testing ground for China’s new capital markets products. Although the trend is already underway, Zhao expects it to accelerate in the coming years. If so, Harvest will be well placed to benefit. “To succeed in this business you need global distribution, you need in-depth knowledge of China’s capital markets and you need global products,” he says. “We are already the largest domestic asset manager in Hong Kong. Now we want to be the best and most trusted asset manager in Greater China.” Despite widespread concerns about the fragile state of the global economy as well as fears that the Chinese authorities will slam on the brakes to stem the latest bout of inflationary pressures, Zhao sees good reason to be optimistic. With quantative easing taking hold in the US and attempts by the Japanese government to loosen their monetary policy, he believes that the outlook remains favorable for equity investors. “I am positive on equity markets,” he says. “The environment is one of excess liquidity. I think that valuation is still reasonable.” Certainly the longer-term outlook for China’s capital markets remains compelling by almost any measure. Last year, Greater China surpassed Japan to become the second largest market in the world ranked by market capitalization. With a new generation of fast-growing young Chinese companies rising up through the ranks, it is only a matter of time before it takes top position. Zhao also points to other growth drivers that look set to transform China’s fund industry. One example is pension funds. These schemes are likely to mushroom when regulations change from a voluntary to a mandatory basis. Penetration of investment products in China currently stands at just 2 percent. That compares with 20 percent in the US. For Harvest, it all adds up to exciting new opportunities both domestically and internationally. And there are other reasons to be upbeat. Currently global asset allocation models are tied to benchmarks like the MSCI World Index, which are weighted by market capitalization. As a result, the US, Europe and Japan account for larger weightings in the index than the faster-growing emerging markets. But eventually this may change. “What is needed is a rethink,” says Zhao. “In China, a good company does not immediately become a big company. The process may take 10 years. We need to help international investors to make the correct choice. That is the role of Harvest on the global stage, to make them understand China.”
CONTACT INFORMATION
April Qi, Institutional Business 16/F China Resources Building; No.8 Jianguomen Beidajie; Beijing 100005, China Tel: (86)10 65215390 Fax: (86)10 65180597 E-mail:
[email protected] www.jsfund.cn December2010/January 2011 • Institutional Investor Sponsored Statement • 4
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CUBA
ubaLibre
A tourist mecca in the making? From left: Postcards of Che Guevara at the Museum of the Revolution in Havana; a street scene in Trinidad; the Academy of Sciences in the capital; the Carbonera Country Club INSTITUTIONALINVESTOR.COM
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As Raúl Castro vows to create new openings for private enterprise, foreign developers are eager for a piece of the action. By Jonathan Kandell FOR A COUNTRY THAT CLAIMS TO WANT TO OPEN its economy after five decades of communism, Cuba has chosen an unlikely poster child for its efforts to attract foreign tourists: Che Guevara. A photograph of the revolutionary leader dressed in combat fatigues and swinging a golf club adorns walls at the Ministry of Tourism and at the Havana offices of some of the foreign companies that are teaming up with the government to develop golf courses, luxury hotels, vacation villas and condominiums. Never mind that Che posed for that photo op to thumb his nose at Yankee capitalists during the 1962 Cuban Missile Crisis. The picture’s message today is that there is nothing counterrevolutionary about golf — or about seeking to lure the game’s well-heeled practitioners from abroad. “The Cubans have been astute in gauging the competitive climate in tourism and coming up with new product offerings to meet foreign consumer demand,” says Robin Conners, president and CEO of Vancouver-based Leisure Canada, a leader among private INSTITUTIONALINVESTOR.COM
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developers planning high-end resorts in partnership with the Cuban government. Foreign companies like Leisure Canada have dreamed about the potential of the Cuban market for years. Now they hope the political conditions are finally right for turning their plans into reality. In August, President Raúl Castro announced that the government would lay off half a million workers — roughly 10 percent of the labor force — by March and open up new sectors of the economy to private enterprise. Also that month, the government declared it would allow foreigners to take out 99-year leases on state property; industry executives regard this measure as crucial for developing high-end tourist resorts in the country. The layoff decision, if implemented, would signal a historic policy shift by this Caribbean nation. Since Castro’s ailing brother, Fidel, led a Communist revolution here in 1959, the government has maintained an iron grip on the economy and remains virtually the sole employer in the country. Now, decades after China and Russia abandoned central planning for their own forms of capitalism, Havana appears to have decided that it too needs to unleash market forces to revive the island’s stagnant economy. “We have to erase forever the notion that Cuba is the only country in the world where one can live without working,” Raúl Castro, 79, said in announcing the layoff plans in a speech to the National Assembly. Is Cuba serious about opening its economy or just making a feint toward capitalism? Observers have their doubts. Consider the regime’s heavy bureaucratic hand. Supposedly to free up the economy, the gov-
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The economic reforms are cause for optimism. Anything that increases the private sector and reduces the role of the state is a favorable development.
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—Andrew Macdonald, Esencia Hotels & Resorts
ernment has designated 178 specific businesses — including family-run boardinghouses, small restaurants, tourist boat rentals, taxi owners and even party clowns — that will be eligible to operate privately under state licenses beginning next year.“This enumeration of private work seems more in tune with a feudal village than a 21st-century country,” wrote Yoani Sánchez, Cuba’s most famous dissident blogger, in September. Private businesses, ranging from small farms to market stalls to barbershops and beauty salons, currently employ just 144,000 workers, and they have no access to credit from the state-owned banking system or to microfinance. It’s hard to see how this tiny private sector can absorb the looming army of unemployed, few if any of whom have entrepreneurial experience.“It is challenging to suggest that the least productive 10 percent of the labor force will become a juggernaut of commercial enterprise,” says John Kavulich II, a senior adviser to the U.S.-Cuba Trade and Economic Council, a New York–based organization that advises U.S. businesses on Cuban affairs.
In short, the new era does not yet appear to be a Cuban version of 1978, the year Deng Xiaoping unleashed market forces in China by allowing peasants to cultivate private plots. Yet Castro’s gesture marks a welcome change after five decades of suffocating state control. “This is no opening of the floodgates, but it may mean the beginning of a new socialist era,” says Ted Henken, an expert on the Cuban private sector who teaches at New York’s Baruch College. If private sector employment is to take off, tourism is bound to play a leading role. The island — the largest in the region — boasts white-sand beaches and expanses of unspoiled nature. Havana itself is a virtual museum of architecture. The old town center, Habana Vieja, features scores of Spanish colonial buildings dating to the 16th century, while Centro, the downtown district, has hundreds of neoclassical, art nouveau and art deco structures. Along with oil exploration and nickel mining, tourism is one of the few areas of the economy open to foreign investment, and it has grown rapidly over the past two decades to overtake sugar as Cuba’s largest source of hard-currency revenues. The sector pulled in $2.1 billion in 2009, compared with $2.88 billion for all the country’s exports of goods and services.“I believe the economic reforms are cause for optimism,” says Andrew Macdonald, chief executive of Esencia Hotels & Resorts, a privately held company based in London that is seeking government approval to develop a $200 million luxury resort east of Havana complete with a golf course, 800 luxury apartments and 100 villas.“Anything that increases the private sector and reduces the role of the state in the economy is a favorable development.” Cuba began developing its tourism industry nearly two decades ago. The country was hit hard by the 1991 collapse of the Soviet Union, which had propped up the Castro regime with subsidies. Cuba’s economic output contracted by a third in the three years after 1991. In a bid to cover the shortfall, the government ordered ministries to devise commercial strategies to help fund their budgets. The Ministry of Education sent teachers to Nicaragua and Venezuela, and the Ministry of Health dispatched an army of doctors overseas to earn hard currency. The armed forces, then under the command of Raúl Castro, plunged into tourism. In 1991 the new Russian government abandoned plans to build a naval base on the coast east of Havana, forfeiting tens of millions of dollars that the old Soviet regime had placed in escrow for the project. Castro’s Ministry of the Revolutionary Armed Forces used those funds to expand its fledgling tourism arm, Gaviota, into luxury hotels, travel agencies, car rentals, marinas and restaurants. The company currently operates 38 hotels. Gaviota’s success has spawned several imitators. The Ministry of Tourism is considering proposals from several joint ventures to develop a dozen golf resorts — this in a country with only one 18-hole course, at Varadero, a beach resort town 86 miles east of Havana. Foreign investors know the wait can be painfully long. “In normal countries joint ventures are quickly created and assume high risks for potentially high profits,” says a Cuban working with a foreign developer. “In Cuba decisions are so centralized and slow that it can take years to form a joint state-private venture. On the other hand, once it is created, the business risks are very low and high profits are almost guaranteed.” Leisure Canada hopes to prove that hypothesis correct. The small company (market cap $31 million) focuses exclusively on the Cuban INSTITUTIONALINVESTOR.COM
PREVIOUS SPREAD: CHE POSTCARDS: DIEGO GIUDICE/BLOOMBERG NEWS; OLD MAN: FABIOLA MOURA/BLOOMBERG NEWS; CUBAN CAPITOL BUILDING: MICHAEL LUONGO/BLOOMBERG NEWS
CUBA
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The Hotel Monte Barreto lobby (left); a Havana plaza
market and has been lobbying the government for more than a decade for the right to develop tourism projects. The company has a ready market: Canadians are avid snowbirds, accounting for 933,000 of the 2.4 million foreign tourists who visited Cuba last year. The U.K. ranked a distant second with 171,800 visitors. The half-century-old U.S. trade embargo continues to keep American companies and tourists out of Cuba, although an estimated 200,000 Cuban-Americans (who are not counted as tourists by either Havana or Washington) visit relatives in Cuba each year. Last year, Leisure Canada finally won approval to set up a 50-50 joint venture with Grupo Hotelero Gran Caribe, a fully owned entity of the Ministry of Tourism. The company plans to break ground in early 2011 on a $200 million, 716-room hotel in Miramar, a Havana district popular with wealthy Cubans and Americans before the revolution that today houses a number of government agencies and foreign multinationals. “Now they are reacting pretty quickly to feedback from us,” CEO Conners says of the authorities. In August, for example, the government announced it would allow foreigners to take out 99-year leases on state property, up from a previous maximum of 50 years. The move followed lobbying by Leisure Canada and Esencia, which regard long-term leases as essential to developing resort properties for upscale foreign tourists. “We explained to our Cuban partners just how important a 99-year lease is for this sort of client and to obtain better financing terms for the project,” says Conners.“Banks view it as virtually full ownership.” The new long-term leases are crucial for Leisure Canada’s other two projects, which are pending approval. The company wants to develop a $130 million luxury resort with 425 hotel suites, condo apartments and villas at Cayo Largo, an islet 50 miles south of Cuba’s main island that has an air force base with a runway large enough for transatlantic aircraft. Even more ambitious, Leisure Canada hopes to build a $900 million resort with a golf course, INSTITUTIONALINVESTOR.COM
marina, hotels, condos and villas at Jibacoa, some 40 miles east of Havana. Both of those projects could take years to get started. The site currently houses a state-run campground and cabins for the Cuban proletariat. Conners is optimistic that economic necessity will ultimately prevail.“Cuba has a large pool of workers available for the hotel construction and service industry,”he says. Groups of people hanging around the Jibacoa village square attest to that fact. Nearby, a bare-chested watchman stands guard at the entrance to the planned development site. After letting a company executive enter the area, he pleads, “Hurry up with the project — and sign me up for the first job.” At the other end of the tourist industry spectrum, family-run bed-and-breakfasts and restaurants are also expected to expand in number as a result of the economic reforms, but that will require new sources of financing. Thus far the state banks that monopolize credit do not lend to the private sector. The most obvious source of foreign capital is the CubanAmerican community.“But will the Cuban government allow somebody in Miami to send a relative in Havana $50,000 to start a business?” asks U.S.-Cuba Trade and Economic Council adviser Kavulich. “And will the U.S. government allow it?” To survive and succeed as a private innkeeper in socialist Cuba demands the sort of entrepreneurial spirit, ingenuity and persistence that Carlos Repilado has displayed over a quarter century. Repilado rents out three rooms to foreign tourists for about $30 a night in a bed-and-breakfast called Carlos&Nelson that he has created in his second- and third-floor apartment in a 1920s Havana townhouse. Repilado, a broad-shouldered 72-year-old who looks two decades younger, began his adult life as a computer programmer for IBM Corp. in the mid-1950s. When the Castros and Che entered Havana triumphantly in 1959, Repilado was among the revolutionaries’ excited sympathizers. IBM pulled out of Cuba in the early 1960s, leaving him without a job, but Repilado took advantage of the new regime’s large cultural affairs budget and found work in the theater, eventually gaining a reputation as a lighting designer. He has worked in Havana and abroad on Cuban theatrical and musical productions, from highbrow European plays to the high-kicking Tropicana Cabaret. But even with his renown, Repilado earns barely double the average monthly wage of $20 in his profession; the B&B provides the bulk of his income. Becoming a jack-of-all-trades during a half century of theater assignments has made him an expert at the home repairs necessary to running a thriving guesthouse. Finding specialized labor and ready-made products is nearly impossible in Cuba.“Here you have to learn to do many things on your own,” says Repilado as he goes about reupholstering an ancient sofa on a hot, humid afternoon. Later in the week he and continued on page 109
The Risk Management Conference, hosted by the Chicago Board Options Exchange (CBOE), is the leading educational forum for users of equity derivatives to learn about new products, strategies and tactics to manage risk exposure and enhance yields. With topics ranging from basic derivatives applications to advanced trading concepts, the RMC is a must for financial professionals who need to stay current with industry trends and learn how to effectively use the latest risk management tools and strategies. Now more than ever, CBOE’s Risk Management Conference is a conference you must attend.
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Sunday, February 27 through Tuesday, March 1, 2011 St. Regis Monarch Beach Dana Point, California For details and registration go to:
www.cboeRMC.com 312-786-8310
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Staying in Style We reveal our annual ranking of the World’s Best Hotels. Page 84
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UBA RESEARCH THE WORLD’S BEST HOTELS 2010 INEFFICIENT MARKETS UNCONVENTIONAL WISD
T
HOSPITABLE ENVIRONMENTS
The past 12 months have been a year to try investors’ souls. What began with hopes of a solid economic recovery, and occasionally offered a hint of something more, ended up producing as much disappointment as promise. The U.S. economy sputtered despite Helicopter Ben’s best efforts, Europe’s debt woes chewed up more of the periphery and began threatening the core, and politics took a bitter turn at the national and Group of 20 levels. That’s enough to make one say, “Get me out of here.” For those so inclined it’s nice to know that the standards of hospitality in the five-star world remain as high as ever. Our ranking of the World’s Best Hotels, beginning on this page, features 100 establishments that stand out for their style, service and know-how. As Harun Özkan, head concierge at the Four Seasons at Sultanahmet in Istanbul, explains, “We try to understand [guests’] feelings and exceed their expectations.” Who could argue with that? — Tom Buerkle
Managing Editor Thomas W. Johnson Senior Editors Tucker Ewing Jane B. Kenney Associate Editors Denise Hoguet Fritz Owens
Cover photo by Ron Starr
THE WORLD’S BEST HOTELS 2010
High Standards for Globe Trotters
Whether new or old, leading hotels stand out by offering refined service in distinctive settings. MANDARIN ORIENTAL TOKYO 178 ROOMS RATES: ¥47,000 TO ¥110,000 ($560 TO $1,320)
T
okyo has long been at the crossroads of modernity and traditionalism. So it seems fitting that a hotel that embodies both — in extremes — finds itself situated at a junction of sorts. For more than 400 years, the neighborhood of Nihonbashi — where the Mandarin Oriental, Tokyo, stands — has been known as the center of Japan. It is the point from which distances between Tokyo and other locations throughout the country are measured. The area’s warren of streets harkens back to the days of old Edo, the capital’s former name. Amid glistening skyscrapers, shopkeepers ply their time-honored wares. Ibasen, which opened in 1590, sells folding fans depicting scenes of daily life from cen-
BEST HOTELS BY CITY AMERICAS
• Atlanta, Four Seasons1 • Boston, Mandarin Oriental1 • Buenos Aires, Palacio Duhau – Park Hyatt • Chicago, Four Seasons1 • Dallas, Ritz-Carlton1 • Honolulu, Halekulani1 • Houston, St. Regis
turies past. Chikusen has been selling kimonos for 170 years. In the vicinity of these iconic stores lies the ultramodern Tokyo Stock Exchange. The Mandarin is a relatively new addition to Nihonbashi’s landscape, having opened in 2005. The establishment has all the 21st century conveniences one would expect from a five-star hotel with a celebrated name. The rooms have high-speed Internet access (wired and wireless), flatscreen TVs and surround sound systems. Meeting and conference facilities abound. The hotel was the first in Japan to offer 360-degree projection capability, in its Grand Ballroom — just one of 14 event spaces available for hire. The eight restaurants and bars in the Mandarin are popular with guests and locals alike. Tapas Molecular Bar, consisting of a eight-seat counter on the 38th floor, takes a scientific approach to pleasing the palate.
• Las Vegas, Four Seasons1 • Los Angeles, Peninsula1 • Mexico City, Four Seasons1 • Miami, Four Seasons1 • Montreal, InterContinental • New York, Mandarin Oriental1 • Philadelphia, Four Seasons • Phoenix, Four Seasons Resort Scottsdale1 • Rio de Janeiro, Copacabana Palace1 • San Francisco, Mandarin Oriental1 • Santiago, Ritz-Carlton • São Paulo, Fasano1
THE WORLD’S TOP 10 HOTELS 2010 RANK
HOTEL/CITY
1
Mandarin Oriental Tokyo
2
Peninsula Beijing
3
Mandarin Oriental New York
4
Four Seasons Hong Kong
5
Four Seasons at Sultanahmet Istanbul
6
Park Hyatt Shanghai
7
Park Hyatt Sydney
8
Four Seasons Miami
9
Peninsula Hong Kong
10
Ritz-Carlton, Central Park New York
Guests partake of a 20-course salute to gastronomic creativity, with bite-size portions served in beakers and test tubes. All of this may be contrived, but it was enough to garner Tapas Molecular Bar a coveted Michelin star. And it’s not the only one. Sense, the Mandarin’s Cantonese restaurant, and Signature, the hotel’s French offering, also received one star each in the 2011 Michelin Guide. This is not to say the food fails to impress at its Italian restaurant, Ventaglio, or at K’shiki, which features cuisines of the East and West. Subtle touches of Mother Earth throughout the building pay homage to the Japanese
• Seattle, Four Seasons1 • Toronto, Méridien King Edward • Vancouver, Four Seasons • Washington, D.C., St. Regis1
ASIA
• Almaty, Hyatt Regency • Bangalore, Oberoi • Bangkok, Sukhothai1 • Beijing, Peninsula1 • Hanoi, Hilton Opera • Hong Kong, Four Seasons1 • Jakarta, Grand Hyatt • Kuala Lumpur, Ritz-Carlton • Manila, Makati Shangri-La
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DOM THE FUTURIST THE CHARTIST CONTENTS INSIDE II TICKER FIVE QUESTIONS PEOPLE THIS MO
GEORGE APOSTOLIDIS
respect for nature. The elevators that deliver guests to the 38thfloor sky lobby are decorated with stripes meant to represent rain. The reception area’s minimalist design has furniture with neutral, earthy tones and a stream of natural sunlight from the towering windows. Sense, the restaurant, plays with the fire element with three horizontal windows of flame. The Mandarin occupies the top eight floors of the 38-story Nihonbashi Mitsui Tower. Although only five years old, the tower is attached to the Mitsui Main Building, a landmark structure with Corinthian columns that was erected in 1929. The hotel’s 157 guest rooms and 21 suites occupy the 30th to 36th floors of the tower. Most are spacious by Tokyo five-star standards, with the smallest room 538 square feet and the largest suite spreading out over 2,691 square feet. All decor follows a minimalist Japanese approach, with a muted color palette and carefully chosen adornments such as isegatas (sheets used for dyeing kimonos) on the walls. Thanks to the sky-high rooms, guests are treated to impressive vistas from all levels. Views to the east look out over downtown and the Sumida River, while in the panorama to the west lies the verdant Imperial Palace grounds and, further on, the skyscrapers
• Melbourne, Park Hyatt • Mumbai, Four Seasons1 • New Delhi, Taj Mahal1 • Seoul, Shilla • Shanghai, Park Hyatt1 • Singapore, Ritz-Carlton, Millenia1 • Sydney, Park Hyatt1 • Taipei, Grand Hyatt • Tokyo, Mandarin Oriental1
EUROPE
• Amsterdam, InterContinental Amstel • Athens, Grande Bretagne
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The Mandarin’s Cantonese restaurant, Sense, gives diners a stunning vista of central Tokyo
of Shinjuku. When the air is clear, typically in winter, Mount Fuji can be glimpsed to the southwest. Mandarin’s the Spa also takes advantage of its scenic views from the 37th floor, offering four private treatment rooms and five VIP spa suites overlooking the
• Barcelona, Arts1 • Basel, Les Trois Rois1 • Berlin, Adlon Kempinski • Brussels, Conrad • Budapest, Four Seasons Gresham Palace1 • Copenhagen, D’Angleterre • Dublin, Merrion1 • Edinburgh, Balmoral • Frankfurt, Westin Grand • Geneva, Mandarin Oriental1 • Helsinki, Kämp • Lisbon, Four Seasons Ritz • London, Ritz1 • Luxembourg, Royal
city. The “vitality pool” and “water lounge” (warm pools with submerged beds) washes up onto a glass facade, and the dry sauna has a full view of the city. The Mandarin will cater to all needs, as one would expect from a top-tier hotel. For a fee
hotel staff will organize cultural programs such as martial art lessons or tea ceremonies. From check-in to check-out visitors experience classic Japanese hospitality in the heart of a city from which all roads lead. — Karryn Miller
• Madrid, Ritz1 • Milan, Four Seasons1 • Moscow, Ararat Park Hyatt • Munich, Bayerischer Hof • Paris, Plaza Athénée1 • Prague, Four Seasons • Rome, Hassler1 • Stockholm, Grand • Vienna, Bristol • Zurich, Widder1
• Istanbul, Four Seasons at Sultanahmet1 • Jerusalem, King David1 • Johannesburg, InterContinental Sandton Towers • Riyadh, Al Faisaliah • Tel Aviv, Hilton2
MIDDLE EAST & AFRICA
Hilton in Tel Aviv and are expected to conclude in March 2011.
• Abu Dhabi, Emirates Palace1 • Cape Town, Mount Nelson • Dubai, Burj Al Arab1
1 Hotel appears on the World’s Best
Hotels 2010 list.
2 Renovations are ongoing at the
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UBA RESEARCH THE WORLD’S BEST HOTELS 2010 INEFFICIENT MARKETS UNCONVENTIONAL WISD
THE WORLD’S BEST HOTELS 2010 RANK
1 2 3 4 5 61 71 81 91 10 111 121 131 141 151 161 171 18 191 201 211 221 23 24 25 26 27 281 291 301 311 32 33 341 351 361 371 381 391 401 41 42 431 442 442 461 47 481 491 50 51 52
HOTEL/CITY
Mandarin Oriental Tokyo Peninsula Beijing Mandarin Oriental New York Four Seasons Hong Kong Four Seasons at Sultanahmet Istanbul Park Hyatt Shanghai Park Hyatt Sydney Four Seasons Miami Peninsula Hong Kong Ritz-Carlton, Central Park New York Peninsula Tokyo Mandarin Oriental Hong Kong Mandarin Oriental San Francisco Four Seasons Seattle Peninsula Los Angeles Plaza Athénée Paris Sukhothai Bangkok Crillon Paris Four Seasons George V Paris Halekulani Honolulu Ritz-Carlton, Millenia Singapore Four Seasons Chicago Four Seasons Mexico City Çırag ˇ an Palace Kempinski Istanbul Island Shangri-La Hong Kong Ritz-Carlton Dallas Four Seasons Resort Scottsdale Phoenix St. Regis Washington, D.C. Four Seasons Las Vegas Four Seasons New York Mandarin Oriental Washington, D.C. Four Seasons Milan Park Hyatt Tokyo Four Seasons Gresham Palace Budapest Widder Zurich Burj Al Arab Dubai Mandarin Oriental Boston Peninsula Chicago Carlyle New York Ritz-Carlton, Georgetown Washington, D.C. Merrion Dublin Rosewood Mansion on Turtle Creek Dallas Montage Beverly Hills Los Angeles Four Seasons Mumbai Les Trois Rois Basel St. Regis Beijing Mandarin Oriental Singapore Mandarin Oriental Miami Shutters on the Beach (Santa Monica) Los Angeles Grand Hyatt Beijing Ritz-Carlton San Francisco St. Regis San Francisco
THE WORLD’S BEST HOTELS 2010 SCORE
96.7 94.1 93.4 93.3 93.0 92.8 92.8 92.7 92.7 92.3 91.9 91.9 91.9 91.8 91.8 91.6 91.6 91.5 91.3 91.3 91.3 91.3 91.2 91.1 91.0 90.9 90.7 90.4 90.4 90.2 90.2 90.1 90.0 89.9 89.9 89.9 89.7 89.7 89.6 89.6 89.5 89.4 89.3 89.3 89.3 89.3 89.2 89.1 89.1 88.9 88.8 88.7
RANK
531 541 551 561 571 581 591 602 602 621 631 641 651 66 671 681 691 701 711 721 731 741 751 76 77 781 791 801 811 821 831 841 851 861 871 881 891 901 911 921 931 941 951 96 971 981 991 100
HOTEL/CITY
SCORE
Bristol Paris Ritz London Plaza Athénée New York Peninsula New York Hassler Rome Ritz-Carlton Istanbul Mandarin Oriental Geneva China World (Shangri-La) Beijing Meurice Paris Beverly Hills Los Angeles Mandarin Oriental Hyde Park London Park Hyatt Paris–Vendôme Paris Taj Mahal Palace Mumbai Ritz-Carlton, Key Biscayne Miami Grand Hyatt Shanghai Fairmont Washington, D.C. Four Seasons San Francisco Phoenician Phoenix Four Seasons Washington, D.C. Fasano São Paulo Grand Hyatt Tokyo Portman Ritz-Carlton Shanghai Baur au Lac Zurich Beverly Wilshire (Four Seasons) Los Angeles Copacabana Palace Rio de Janeiro London NYC New York Emirates Palace Abu Dhabi Ritz Madrid Ritz Paris Taj Mahal New Delhi Peninsula Bangkok Four Seasons Atlanta Jumeirah Emirates Towers Dubai Shangri-La Dubai Claridge’s London Shangri-La Singapore Ritz-Carlton (Four Seasons) Chicago Four Seasons Shanghai Lanesborough London Arts Barcelona Mandarin Oriental Bangkok King David Jerusalem Park Hyatt Zurich Ritz-Carlton, Atlanta Atlanta Dolder Grand Zurich Kempinski Corvinus Budapest Four Seasons at Beverly Hills Los Angeles Oberoi New Delhi
88.6 88.6 88.6 88.6 88.4 88.4 88.3 88.3 88.3 88.2 88.2 88.2 88.2 88.1 87.9 87.9 87.8 87.8 87.8 87.7 87.7 87.5 87.5 87.4 87.3 87.2 87.2 87.2 87.2 87.1 87.1 87.0 87.0 87.0 86.9 86.9 86.6 86.6 86.6 86.5 86.5 86.5 86.5 86.4 86.3 86.3 86.3 86.2
1
Order determined by scores before rounding. Tie.
2
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DOM THE FUTURIST THE CHARTIST CONTENTS INSIDE II TICKER FIVE QUESTIONS PEOPLE THIS MO
The Four Seasons’ Ottoman style evokes Istanbul’s imperial past
FOUR SEASONS AT SULTANAHMET ISTANBUL
65 ROOMS RATES: 574 LIRA TO 9,900 LIRA ($387 TO $6,670)
JAIME ARDILES-ARCE
A
lthough it has been functioning as a hotel for only 14 years, the building that houses the Four Seasons in the heart of Istanbul’s historic Sultanahmet neighborhood has been receiving lodgers for nearly a century. It was built by the Ottomans as a prison in 1918. But in what was truly an extreme makeover, the former penitentiary was lovingly and carefully refurbished and turned into one of Istanbul’s finest luxury hotels. Considering the Four Seasons’ location, just a few steps from the iconic Hagia Sophia and the Blue Mosque as well as next door to a recently excavated Byzantine palace, it makes sense that the hotel should have some INSTITUTIONALINVESTOR.COM
history of its own. “You are in a one-of-a-kind setting when you can step out and find yourself in the middle of history,” says Tarek Mourad, the hotel’s general manager for the past three years. Topkapı Palace, the Ottomans’ first imperial home, is literally around the corner from the hotel, and the sprawling Grand Bazaar is within easy walking distance. “This building is part of the city’s history — it’s not an add-on.” Indeed the hotel — a squareshaped building that wraps around a tranquil inner courtyard — exudes a sense of history. The front façade still has its original decorative blue tiles, made in the city of Kütahya, famed for centuries for its brilliantly colored ceramics. The hotel’s reception and lobby area, meanwhile, is made up of a series of intimate, loungelike spaces connected by high, arching passageways and decorated
with antique rugs and paintings. A cozy piano bar off to the side is redolent with old-world charm, the perfect place to quietly nurse a drink or, on Fridays, to take part in the hotel’s popular weekly Turkish wine and cheese tasting event. Seasons, the hotel’s sole restaurant, also evokes Istanbul’s imperial past, with a specially created Ottoman palace cuisine menu that features opulent entrées such as veal cheek and dried fruits braised in grape molasses, rosewater and bergamot. The restaurant also offers a contemporary menu of pastas, risottos and other Mediterranean dishes. Guest rooms strike the right balance between historical charm and modern comfort. They are decorated with intricately patterned kilims, a type of Turkish flat weave rug, and framed ornamental fabrics; but they also boast modern amenities such as deep-soak bathtubs, high-speed Internet and 42-inch plasma screen televisions. Staying in a repurposed historical building has its advantages. While many of its crosstown rivals have 300 rooms or more, the Four Seasons at Sultanahmet has only 65 rooms and suites, which means guests can count on very personal service. “The fact that we are a smaller hotel gives
“YOU ARE IN A ONE-OF-AKIND SETTING WHEN YOU CAN STEP OUT AND FIND YOURSELF IN THE MIDDLE OF HISTORY.”
us a chance to deal with our guests in a much more detailed way,” says Harun Özkan, the Four Seasons’ head concierge, who has been working at the hotel for 13 years. “Sometimes we spend more than half an hour with a guest when we show them a map. We try to understand their feelings and exceed their expectations.” Özkan and his team of three other concierges are ready to go out of their way for their guests. When one visitor expressed an interest in the custom-made water carafes the hotel puts out in its entrance during the summer months, Özkan tracked down their manufacturer and arranged for four of them to be shipped to the United States. In another case the concierge helped an American guest track down a Turkish acquaintance he hadn’t been in contact with in 40 years. “The luxury that we hope to provide our guests is the kind that stays with the person, and this is done through being taken care of in a way that surpasses your expectations,” says Mourad, the general manager. “In a year from today, I hope our guests remember the interaction they had with our team.” When it comes to making an impression, though, as hard as they work to please their guests, the hotel’s staff may find it difficult to compete with the historical wonders surrounding the hotel. The Four Seasons’ rooftop terrace, for example, provides a jawdropping view of both the 1,500-year-old Hagia Sophia, which seems close enough to touch, and of the waters of the Marmara Sea. On summer evenings the hotel invites a local troupe of whirling dervishes to perform on the terrace, turning it into one of the more magical spots in all of Istanbul. — Yigal Schleifer
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RITZ-CARLTON, CENTRAL PARK NEW YORK
259 ROOMS RATES: $1,295 TO $15,000
S
cott Geraghty wants his establishment to fit its guests like a comfortable pair of shoes. “We are a townhouse hotel, not a skyscraper,“ says Geraghty, general manager of the RitzCarlton, Central Park, in New York. “We’re like family.” Homey coziness is not exactly the prevailing atmosphere outside the Ritz’s door on Central Park South. Milling tourists blend with office workers and sprightly park joggers to create a constant hubbub amid the aromas of Midtown traffic, street vendors’ grills and the horsedrawn carriages for hire across the street. The hotel itself is neither particularly small — 259 rooms over 22 floors — nor time-worn. Ritz took it over in 2001 from the St. Moritz chain and did a gut renovation to make the accommodations fewer but larger. The smallest rooms are 425 square feet large, more spacious than many Manhattan apartments. But Geraghty and his staff have taken a cue from their many film-industry guests, creating a masterful illusion of timeless wealth and cocooned stateliness to soothe the business traveler. Subtle but studied old-world touches do part of the trick. All rooms facing the park come equipped with telescopes and a field guide to birds of New York, for those craving a bit of treetop ornithology before rushing off to their breakfast meetings. In the corridors the 1920s-style house telephones with porcelain handles and brass cradles evoke the Gatsby era. Head chef Ralph Romano emerges at noon each day to march any children on premises across the street to feed the carriage horses.
The Ritz-Carlton’s Lobby Lounge provides an oasis of clubby coziness
A compact, softly lit lobby that admits but does not particularly welcome passing strangers adds to the intimate effect, leaving no spare hall space for gawkers or button-holers to lurk. “You get from the front door to our elevator in 20 feet,” notes hotel marketing director David Taylor. “That has a very big appeal for guests in the entertainment world.” But it takes more than furnishings to maintain five-star townhouse ambience in the heart of Manhattan, says Geraghty, who studied international relations at Lehigh University and cooking at the Culinary Institute of America before joining the Ritz-Carlton from rival St. Regis two years ago. “Satisfying the unexpressed wishes of our guests is our highest calling,” he says. To divine these whims, Ritz employees turn to the Internet, drawing up profiles of soon-tobe-arriving guests and coming up with bespoke extracurricular
activities or amenities to enhance their stays.“We are Google masters,” the general manager boasts. Spotting that a retired military officer was arriving during New York’s Fleet Week, Geraghty arranged a private tour of some of the visiting vessels. A guest with an equestrian passion got an unanticipated trot with New York Police Department mounted police. The Arab sheikhs who frequent the $14,500-a-night Royal Suite on the 22nd floor find prayer rugs awaiting them, as well as room layouts that offer royal family members some privacy from their entourage of cooks, physicians and body guards.“This hotel does a great job understanding the idiosyncrasies of the Middle Eastern guest,” Taylor says. Change comes, too, to the Ritz, albeit gently and around the edges. A formal restaurant on the Sixth Avenue side of the lobby was replaced a few years
back by BLT Market, a bistrostyle restaurant where chef Laurent Tourondel serves a rotating “locavore”menu based on fresh produce from New York– area markets, with dishes such as Parmesan-crusted halibut with braised leeks and polenta in a foie gras sauce. The rooms are equipped with iPod docking stations, and guests can borrow iPads from the front desk. More substantive shifts can be seen in the hotel’s clientele. A few illnesses among the Persian Gulf elite, necessitating long New York hospital stays, helped cushion the impact of the economic downturn, Taylor says. But to offset weakness on the home front, his sales team is venturing deeper into emerging markets — notably Brazil, where a Ritz rep travels once a quarter to woo upscale travel agents. Yet newcomers stay at the Ritz to be part of the tradition, not to change it. At least that is Geraghty’s doctrine. Revenue per room in U.S. luxury hotels crashed by 24 percent in 2009, according to Hendersonville, Tennessee–based Smith Travel Research, and the Ritz-Carlton has had to make some layoffs; but three immaculately groomed concierges still stand on duty at the front desk, ready to cater to guests’ every need. A bluff-looking knot of businessmen hashes out a new contract amid the plush upholstery of the Club Lounge, a second-floor hideaway available to guests for a mere $250. A lady with a French accent weighs the relative merits of a caviar or cucumber facial scrub at the spa, the only one in New York operated by Switzerland’s ultraposh La Prairie. All seems right in the world for those who can still afford it. Stability sells in these turbulent times. — Craig Mellow •• Comment? Click on the Research tab at institutionalinvestor.com. INSTITUTIONALINVESTOR.COM
CHRIS CYPERT
UBA RESEARCH THE WORLD’S BEST HOTELS 2010 INEFFICIENT MARKETS UNCONVENTIONAL WISD
BRAZIL REPORT
SUSTAINABILITY MADE IN BRAZIL
Sustainability is on the agenda of Brazilian policymakers, companies, investors, and consumers. Environmental protection, social responsibility, and corporate governance are not empty mottos. Homegrown institutions and popular demand are spurring businesses to prepare for the future.
B
razil is not just one of the world’s fastest growing economies; it is also a leader in sustainability. The government, private sector and citizens are becoming increasingly aware of the importance of preserving the environment, and results are already apparent. Thanks to its innovative utility companies, Brazil gets 85 percent of its electricity supply from renewable sources. Some 86 percent of the cars sold in Brazil this year had “flex” engines that can run on either gasoline or ethanol. Unlike grain-based ethanols in the U.S. and Europe, which are of debatable utility in reducing carbon emissions, Brazil’s sugar cane ethanol has proven itself a sustainable energy source: during the course of its production and consumption, it emits 90 percent less greenhouse gas than gasoline. In Brazil, a green energy policy is good economic policy: the country will be able
to export most of its recent petroleum discoveries. Better enforcement of policies, in part thanks to the government’s high-tech “Deter” satellite surveillance program, is helping to save the Amazon. Between January and August of 2010, the Amazon lost 264.12 square kilometers to deforestation: too much, to be sure, but down from 756 square kilometers lost in the comparable period of 2008. Policymakers are aiming to steer the economy toward more sustainable practices through a program of incentives and partnerships with local business that is currently under public consultation. Of course 756 Amazon no system of education Deforestation and incentives can be (km2) effective unless the population is open 498 to it, but proof of a sustainable mindset came in the 2010 264 presidential election. In the October 3 first -34% -46% round vote, Green Party candidate Marina Silva 2010 2009 2008 won 19.3 percent. “The Source: INPE (National Institute of Space Research) votes for Marina Silva December 2010/January 2011 • Institutional Investor Sponsored Report • 1
BRAZIL REPORT
are a sign of Brazil’s maturity,” says Luiz Maia, a director of the ANBIMA, the Brazilian Association of Financial and Capital Market Entities, and a partner-director at Tripod Investments, a São Paulo based manager of private equity and venture capital funds. Brazilian companies are aware of the new markets this popular demand is creating. “Sustainability has become a strategic issue. No businessperson can avoid it,” Maia says. Brazilian Investors Look for Sustainability In 2005 the BM&FBovespa became the first exchange in Latin America to have a Corporate Sustainability Index—called ISE, after its Portuguese acronym. Companies that wish to join the ISE must answer a 110-page questionnaire, developed by the research institute Fundação Getulio Vargas in accordance with the United Nations’ Principles of Responsible Investment (PRI). “Companies that do not respect social The ISE started with and environmental investors. “Asset managers questions will die out.” came to us and asked us to develop this index,” explains LUIZ MAIA Rogério Marques, the ANBIMA AND TRIPOD INVESTMENTS BM&FBovespa’s coordinator of equity indices. “They were looking for a way to invest in sustainability.” Only the 200 most liquid companies on the stock market can apply to join the ISE. Last year, 51 companies made the attempt, but only 34 were accepted. Though Marques expects applications to rise significantly in the coming years, the index will be limited to forty names, to make participation a competition and a spur to continued improvement, not just a seal of approval. Sonia Favaretto, the BM&FBovespa’s Director of Sustainability, says companies’ attitudes have changed in 2 • Institutional Investor Sponsored Report • December 2010/January 2011
the five years since the ISE was launched. “They have come to understand that sustainability is about risk management,” she adds. “And it’s a way to attract consumer and investor interest. Investors do not want to be exposed to the dangers of environmental disasters or corporate governance failures.” The BM&FBovespa expects to launch an ETF linked to the index in 2011. Maia from ANBIMA says many Brazilian socially responsible investment (SRI) funds
already use it as a benchmark. ANBIMA’s data shows that, as of November 1, Brazilian SRI equity mutual funds had R$1.9 billion ($1.1 billion) under management. This number appears modest, but in Brazil’s equity mutual fund market it is significant. By comparison, actively managed funds using the Bovespa complete market index as their benchmark had R$20.2 billion ($12 billion) in assets, and small cap equity funds had R$2.5 billion ($1.5 billion). Álvaro Camassari, director of the national technical committee for sustainability at the Brazilian Association of Closed Pension Funds (ABRAPP), says the larger pension funds in Brazil see the value of sustainable investing because they must produce returns for decades to come. ABRAPP’s members have over R$530 billion ($315 billion) in assets under management, “Previ, Petros, Funcef, and the big banks’ pension funds have all signed commitments to PRI and act consistently with these principles,” says Camassari. “They often use their ownership stakes to win seats on company boards and implement movement toward sustainability.” He is optimistic that, with time, this tendency will spread to his organization’s smaller members too. Lucy Sousa, national president of Brazil’s Association of Capital Market Analysts and Investment Professionals (APIMEC), says pension funds’ demands are having an impact on her organization’s members. “Analysts are increasingly including sustainability criteria in their valuations and reports, since pension funds, who are among their biggest clients, demand it,” she says. Governing for Shareholders “Strong corporate governance is the base of sustainability,” Favaretto from the BM&FBovespa says. (continued on page 6)
Photographer: Paulo Fridman/Bloomberg via Getty Images
A tractor harvests sugarcane stalks on the farm of Pedra Agroindustrial S/A near Ribeirão Preto.
CPFL ENERGIA
CPFL Energia: Rich Dividend Payouts and Sustainable Growth CPFL Energia is a giant, the largest private sector electricity company in Latin America’s largest economy. Based in Brazil’s most developed state, São Paulo, CPFL is responsible for 13 percent of power distribution and 16 percent of sales to “free” consumers —those who buy electricity on the open market— throughout the country. Strong revenue means rich payouts for CPFL’s shareholders: R$1.4 billion ($824 million) in dividends over the last 12 months, a yield of 8.6 percent. This value creation is the result of CPFL’s strategy of long-term, consistent growth. Since its IPO in September 2004, CPFL has paid R$7.1 billion ($4.2 billion) in dividends to its shareholders. In a world where investors, governments, and consumers are all demanding green energy, CPFL stands out. Ninety-six percent of its 2,222 MW in installed generation capacity is hydroelectric—a renewable, carbon-free energy source. With the completion of 14 projects currently under construction, mostly in renewable sources, CPFL’s generation capacity will increase 26 percent in the next three years and CPFL will become the second largest private player in the Brazilian electric energy generation segment. Growing Capacity at 32 Percent a Year While Reducing Environmental Impact Brazil is growing, its economy needs energy, and the world climate is changing. CPFL has found a successful formula to meet these challenges. “By growing with strong economic fundamentals, environmental sustainability, and social inclusiveness, we minimize risks and create competitive advantages for our investors,” says CEO Wilson Ferreira Jr. CPFL has added more than 2000 MW of generating capacity since 2000, achieving a remarkable annual growth rate of 32 percent in that time, all from renewable sources. By renovating seven small hydroelectric plants, CPFL increased generation capacity by 39 percent (11.2 MW) without any additional impact on the environment. It has built six new hydroelectric dams (1271 MW of generation capacity) with a high level of environmental efficiency: 30.6 MW per square kilometer flooded, versus a national average of 1.96 MW. CPFL is diversifying beyond hydroelectric power. It already has a plant producing electricity from sugar cane bagasse and has four more biomass plants under construction for a total production capacity of 230 MW. It is building eight wind parks that will generate 218 MW, and it is studying generation from solar power, waste products, and miniature hydro plants with
especially small environmental footprints. It is even exploring the commercial potential of electric cars and motorcycles, of which it already has a small fleet. Winning Prizes for Low Carbon Emission and Excellent Corporate Governance CPFL is the electricity generation company with the lowest carbon intensity in the world in conventional generation of power, according to a study published this year by Trucost, a consulting group based in the United Kingdom. This award came from of a study of over 100 energy companies all over the world. “It reinforces CPFL’s competitive advantage in a low carbon world,” says Ferreira. CPFL is one thousand times more carbon efficient than the lowest-ranked company on the list, a Chinese utility. CPFL was the only Brazilian electricity company to be part of Brazil’s official delegation to the 2009 Copenhagen climate conference, and it is one of a CPFL is the select few companies to be in the electricity Bovespa’s Sustainable Business generation Index (ISE) every year since the company with index’s founding in 2005. the lowest The international consulting group carbon intensity Management and Excellence (M&E) in the world. gave CPFL two awards this year: one as Latin America’s most sustainable company—considering both social/environmental impact and corporate governance—and the other as the third most transparent of all the companies listed on the São Paulo Stock Exchange, Bovespa. Ever since its IPO, CPFL has participated in the listing tiers of the Bovespa and the New York Stock Exchange with the most stringent requirements for corporate governance: the Novo Mercado and ADR level 3. CPFL is proof that caring for the environment and creating value for shareholders is not a contradiction, but a recipe for success.
CONTACT INFORMATION
CPFL Energia / Investor Relations Area (55 19) 3756.6083
[email protected] www.cpfl.com.br/ir
Dividend Growth: 2H 2004 -1H 2010 (Values in R$ million) 10.9% 9.1%
9.6%
9.7%
8.7%
8.6% 7.6%
6.5%
7.3%
722
7.9% 774
719
612
602
606
572
1H08
2H08
1H09
498 3.7%
7.6%
842 655
401
140 2H04
1H05
2H05
Declared Dividends
1H06
2H06
1H07
2H07
Dividend yield (%)
Sponsored Statement • December 2010/January 2011
2H09
1H10
CEMIG
Cemig: Rapid, Responsible Growth in Brazil’s Booming Economy Brazil’s Largest Integrated Electricity Company has a Flawless Balance Sheet and Pays Generous Dividends. Skillful Capital Allocation Ensures Continued Strong Growth.
Cemig’s Irapé hydroelectric plant in Minas Gerais
Cemig is Brazil’s Number 1 integrated power utility. The company has 67 power plants, 6,875 MW of installed capacity, and 474,000 km of distribution lines—enough to circle the earth 10 times— spanning a concession area larger than the country of France or Texas State. The utility is creating value for shareholders, growing EBITDA 90 percent over the last five years while paying out at least 50 percent of the net income in dividends each year. Dominant and Diversified “We are a key player in every segment of the power industry in Brazil, and we see growth opportunities in all of them,” Djalma Bastos de Morais, Cemig’s CEO, tells investors. Cemig is responsible for 12 percent of the electricity distribution, 7 percent of the power generation, and 10 percent of the power transmission in Brazil. The company’s strength in all three segments provides an ideal combination. Stable revenue from the heavily regulated transmission and distribution sectors translates to low risk. The free market in power generation provides excellent potential for profit growth.
“Our strong revenue stream means we have capital to grow the company and steady cash flow to pay out generous dividends, year after year,” says Luiz Fernando Rolla, CFO. This year the company will pay out R$931 million ($548 million), for a yield of just over 5 percent. Long-term, Cemig plans to increase its market share in all three segments to 20 percent, building on the company’s record of success in greenfield projects and as an industry consolidator. “Ever since Cemig was founded 58 years ago, we have been a successful acquirer. The Brazilian power industry is still dispersed, but it is consolidating rapidly. We project that in the future five or six power companies will dominate the country, and Cemig will be in a leading position among them,” says Morais. Morais emphasizes that the company has no deadline for achieving its goal of 20 percent market share in all segments. Its top priority is careful capital allocation, looking for good opportunities while maintaining its excellent balance sheet. The balance sheet for Q2 2010 shows net debt of only 2.2 times EBITDA, with only 1.3 percent of that debt in foreign currency. Net revenue for the same period was R$2.9 billion ($1.7 billion), and the company ended the quarter with R$3.8 billion ($2.2 billion) of cash on hand. Growing Opportunities in a Growing Country “We are the right company in the right place at the right time,” says Morais. “Brazil is one of the world’s fastest growing countries, and we’re positioned to grow with it.” Brazil ended 2009 with a GDP of $1.6 trillion—the eighth largest GDP in the world, and the biggest in Latin America—of which more than $124 billion was revenue for the power industry. GDP is expected to grow 7.5 percent in 2010, and an average of 5 percent a year for the next 5 years. As Brazil’s poor move up into the middle class and increase their power consumption, electricity demand will grow faster than GDP. “Brazil needs huge investment in the power industry, and Cemig will be part of this movement,” Morais promises. The federal government’s growth acceleration plan (PAC) will funnel $65 billion to develop power generation and $15 billion for power transmission between 2011 and 2014. In the short term, CFO
Sponsored Statement • December 2010/January 2011
Largest Integrated Utility in Brazil
Rolla says, acquisitions can be the most efficient way to grow, but in the long term, careful investment in new projects will provide excellent returns. Cemig’s biggest current greenfield project, a partnership in the 3,150 MW Santo Antonio hydroelectric power plant in the northern state of Rondonia, is ahead of schedule and will begin commercial production in December 2011. Cemig is present in 20 Brazilian states and dominates the country’s most profitable segment, free consumers. These large, mostly corporate consumers purchase power on the open market. Cemig is able to hold a large share of this market because its national presence permits it to meet the needs of big companies with a presence in multiple states. Morais cites as an example a major Brazilian steelmaker with operations in five separate states, for which Cemig will be the sole power supplier by 2014. “Being a national supplier is a competitive advantage for us, as we provide exclusive solutions to our customers” he says. Many of Cemig’s long-term contracts with free consumers are coming up for renewal in the coming years, just as strong demand is driving up prices. Best-in-Class Corporate Governance Fair treatment of minority shareholders is embedded in the company’s bylaws, structure, and philosophy. Six out of the board’s fourteen directors are appointed by minority shareholders, and the interests of the controlling shareholder, the state of Minas Gerais, are aligned with all shareholders. “Minas Gerais is one of the fastest
Djalma Bastos de Morais, CEO
Luiz Fernando Rolla, CFO
growing, most investor-friendly states in Brazil,” says Morais. “All of the shareholders want the company to grow sustainably and keep paying out dividends.” Bylaws guarantee financial discipline and the return of cash to shareholders. At least 50 percent of earnings must be paid out in dividends. No more than 40 percent of EBITDA can be used for Capex. Net debt must be lower than 2.5 times EBITDA and 50 percent of the company’s capitalization. Exceptions to those limits must be approved by shareholders, under specific reasons such as a major accretive acquisition. Cemig’s shares have the highest liquidity of any Brazilian utility,
with an average daily turnover of R$43 million on the Bovespa and $33 million on the New York Stock Exchange. It has 117,000 individual and institutions share owners in 44 countries. Moody’s, Fitch, and Standard & Poor all rate Cemig’s excellent debt position, including investment grade from one of them. To keep its balance sheet strong as it acquires smaller rivals, Cemig has partnered with leading equity investment funds. “The funds provide the capital, and we provide the know-how to run the assets, improve governance, and create synergies,” CFO Rolla says. “It’s a way for us to grow while preserving capital for other opportunities.” One such partnership is behind Cemig’s recent acquisition of an increased stake in the Rio de Janeiro utility Light, which will help Cemig profit from Rio’s massive infrastructure upgrade, as the city prepares to host the 2014 World Cup and the 2016 Olympics. Sustainability Now and for the Future Cemig is a leader in green energy. Renewable sources provide 98 percent of its power, and future growth should also come from renewables. The company has 800 MW of greenfield wind projects and 6,000 MW of greenfield hydro projects under study. It currently holds the German consulting company Oekom’s top “Prime” rating for corporate responsibility. It is the only Latin American utility present in the Dow Jones Sustainability Index every year since 1999. Last year it became one of only three Brazilian companies, and the only Latin utility, to be chosen for the Global Dow Index. CEO Morais is proud of this last honor. “Dow Jones picked companies from around the world that it expects to be important not just next year, but for the next 50 to 100 years. We’re taking the steps now to ensure this prediction comes true.” With its aggressive growth plans and skillful capital allocation, its dominant presence in one of the world’s most dynamic economies, its renewable energy sources, and a proven record of growing revenue, profits, and dividends sustainably, Cemig is on its way to a bright future. Contact Information Agostinho Faria Cardoso
[email protected]
Sponsored Statement • December 2010/January 2011
BRAZIL REPORT
(continued from page 2) The issues, however, are different from those in most developed markets. “The issue here is not alignment between management and shareholders,” says Heloisa Bedicks, superintendent of the Brazilian Institute of Corporate Governance (IBGC), an NGO that guards its independence fiercely. “Since almost all Brazilian companies have a controlling shareholder group that “(With the Reference determines management, Form), no longer can the question is how to align a CEO avoid liability the controlling shareholder’s by claiming he or she interests with those of was not informed.” minority shareholders.” In many of Brazil’s biggest and LUCY SOUSA, APIMEC best-known companies, that controlling shareholder is the state. “Brazil has made a lot of progress in guaranteeing minority shareholder rights in the last decade, and even in the last year,” Bedicks says. While work still remains, Bedicks says that at the start of the last decade two events set listed companies on the path to better governance. In 2000, the Bovespa instituted special listing tiers for companies with superior governance; 93 percent of IPOs have been listed on these tiers since 2004. In 2001, Congress changed Brazil’s Companies Act to empower minority shareholders, encouraging common shares over preferred, and giving preferred shareholders the right to vote in certain circumstances. One of the criteria for a spot on the Novo Mercado, the most stringent of the three listing tiers, is that all of a company’s shares be common. Formerly, the dominant practice in Brazilian companies was for the controlling shareholder to own the majority of common shares, then sell preferred shares to raise funds for operations without
6 • Institutional Investor Sponsored Report • December 2010/January 2011
having to share power. The Novo Mercado also demands tagalong rights for minority shareholders in the case of a change of control, at least 20 percent independent board members, annual balance sheets in accordance with either U.S. GAAP or the IFRS, and rules for disclosing securities trades involving controlling shareholders. The CVM, Brazil’s Securities and Exchange Commission, has steadily increased requirements for transparency, perhaps most significantly at the end of 2009, when it mandated, starting in 2010, a new statement it calls the Reference Form, which replaced the old annual report. The Reference Form requires detailed information about a wide range of policies including risk management, ownership structure, management compensation, shareholder assemblies, and the company’s CEO must sign the form and attest to its accuracy. “No longer can a CEO avoid liability by claiming he or she was not informed,” says Lucy Sousa of APIMEC. Environmental and Social Action Many individual Brazilian companies are going beyond the basic requirements, especially when it comes to environmental sustainability and social responsibility. Mining giant Vale spent $1.1 billion between 2007 and 2009 on environmental projects. Satellite surveillance funded by Vale watches for illegal deforestation and alerts the authorities; conservation projects protect over 10,000 km2 of nature preserves in Brazil, Indonesia, and New Caledonia; and a private equity fund (FIP) with funds from Vale, the BNDES development bank, and pension funds aims to make money through reforestation projects. According to the United Kingdom based NGO, Carbon Disclosure Project, Vale has the lowest carbon intensity of any major mining company in the world. Petrobras has become a major producer and distributor of biofuels, and is investing in second generation biofuels made from agricultural waste. In 2009 the Project company spent $1.1 Tamar, billion on environmental sponsored by Petrobras, projects. Corporate protects the Knights, a Canadian coastlines magazine about social where endangered responsibility and sea turtles sustainable development, feed and chose Petrobras (out spawn. of 3000 companies studied) as one of the one hundred most sustainable companies in the world. This year is the fifth straight year the company has been chosen for the Dow Jones Sustainability Index.
reduce environmental impact. As part of its “sustainable pork farming” program, registered with the United Nations, it has introduced bio-digesters into its Rio Verde agricultural complex, the biggest in Latin America, Sonia Favaretto, and is in the process of Director of Sustainability adding them to all its at the pork operations. The BM&FBovespa bio-digesters convert methane—a greenhouse gas—and other waste products into clean energy and natural fertilizers. Another program, to purify and reuse water, has cut water use throughout the company by 30 percent. JBS Friboi, the world’s largest meat processor, is also the world’s first to have greenhouse gas emission reduction projects approved by the United Nations’ Clean Development Mechanism program. In these projects, the company treats and recycles waste products, using biofuels both to generate electricity and power its trucks. The airline Gol joined the Greenhouse Gas Protocol in May, a system to measure and reduce all such emissions. The “(Pension funds) often use their plan, executive vice president ownership stakes Fernando Rockert de Magalhães to win seats on says, is both to contribute to company boards mitigating climate change and and implement anticipate the “rigid demands” he movement toward sustainability.” thinks are coming to international aviation. Suzano Papel e Celulose ÁLVARO CAMASSARI ABRAPP has demonstrated that for every ton of carbon emitted in the production and transport of its paper, 3.8 tons of carbon are absorbed by the trees it plants. For the growing number of environmentally conscious Brazilian consumers, the company even offers a “Carbono Zero” line of paper products. Its competitor Fibria focused its sustainability efforts over the past year on reducing the carbon footprint not only of its own operations, but also those of its supplier. All of these companies are aware that sustainable practices need not come at the expense of the bottom line, nor are they an uncertain, long-term investment. “Consumers prefer products from socially responsible companies. Talented employees want to work in them,” says BRF Brasil Foods CEO José Antônio do Prado Fay. “Sustainability has become a competitive advantage.” ● “(Companies) have come to understand that sustainability is about risk management, and it’s a way to attract consumer and investor interest.”
Programs such as Cemig’s Projeto Conviver and CPFL’s Energy Efficiency Program spend tens of millions of reals each year helping poorer communities save energy through education and by donating energy efficient appliances to replace older models. CPFL estimates these programs can reduce poorer families’ energy consumption (and monthly bills) by up to 35 percent. Cemig has shown that its program reduces poor families’ energy bills by an average of R$18 ($11) a month—a significant sum in communities where many earn the minimum wage of R$116 ($68) a week. Eletrobras’s latest Sustainability Report demonstrates that its conservation programs—which focus not just on families, but also on getting municipal governments to use power efficiently in areas ranging from streetlights to office buildings—saved the country’s electricity consumers R$3.3 billion ($1.9 billion) in 2009. The major Brazilian banks, such as Itaú and Bradesco, have signed the IFC’s Equator Principles, a set of rules to ensure that their project finance is restricted to projects that are socially responsible and environmentally sound. Itaú, which has its own, more stringent social and environmental risk control policies, publishes an inventory of its operations’ greenhouse gas emissions and, to reduce these emissions, it not only has an aggressive recycling program, it even operates a power plant that generates all its power from biochemical gases emitted by waste. Bradesco has added a department of socioenvironmental risk analysis, which reports to the executive credit committee when the latter considers loan requests. Bradesco spent more than R$380 million ($223 million) on social and environmental causes last year, including projects to protect and restore the Amazon and Atlantic rainforests. Brasil Foods has established a series of programs to
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continued from page 39 of the debt.“A lot of our discussions revolved around the terms of the reverse break fee,” Evans notes. Reverse break fees, virtually unheard-of before the crisis, are now commonplace, but this was the first time they figured in a big deal. TPG agreed to pay $275 million, almost 10 percent of its total equity commitment, if it failed to follow through on the transaction. Deutsche’s fee was based entirely on a successful deal and marked the bank’s first payday since it began working with IMS in 2007. “A lot of time and effort went into the relationship,” says Sachdev, who recently moved to JPMorgan. “But it was worth it because the TPG deal was the best possible outcome for shareholders.” Other banks in on the action included Foros Securities, the boutique launched by Jean Manas, former M&A boss for Deutsche Bank Americas. Manas worked on the IMS account with Sachdev but quit the bank before the deal. — D.R.
7.
EDUARDO MESTRE, MICHAEL PRICE AND TEAM / EVERCORE PARTNERS When Frontier Communications Corp. asked Evercore Partners to advise it on acquiring some 4.8 million access lines from Verizon Communications, Evercore’s senior team resolved that the $8.6 billion all-stock transaction would not echo previous deal failures in the telecom sector. Earlier consolidation plays had been beset with integration problems, and the acquiring company had too often been left weakened. Evercore’s Michael Price — a senior managing director and head of the firm’s technology and telecom group — and vice chairman Eduardo Mestre understood the company
and the sector well. Mestre, 61, had known Frontier CFO Donald Shassian for more than a decade, having worked with him on the sale of Southern New England Telecommunications Corp. to SBC Communications in 1998. Stamford, Connecticut–based Frontier was being tracked by an undisclosed third party while it sought a deal with Verizon, so Evercore and co-adviser Citigroup felt extra pressure to maximize value for shareholders. Their strategy called for Verizon to create a separate entity, SpinCo, which held the assets in the 14 states that were subject to the takeover. After clearing SpinCo’s $3 billion of debt, New York–based Verizon spun the entity off to shareholders, and SpinCo immediately merged into Frontier. “One of the hardest aspects of this transaction was to analyze what the combined company would look like when the business we were buying did not exist as a separate entity,” Price says. Achieving the right capital structure was key to guaranteeing a successful transaction
estimates that JPMorgan and Barclays Capital, which acted as joint advisers to Verizon, earned a combined $36.8 million. — D.R.
8.
PAWAN TEWARI AND TEAM / GOLDMAN SACHS Pawan Tewari is not known as “Bid-’em-up Pawan,” but that’s what he did in advising 3Com Corp. on its $3.2 billion acquisition by Hewlett-Packard Co. The Goldman Sachs technology banker, with George Lee, Ryan Limaye and Colin Ryan, helped push HP to boost its offer three times in less than three months. The final bid of $7.90 per share was 53 percent more than the upper estimate of HP’s initial $5.15 offer. For that, Tewari and his team won $41 million in fees, according to securities filings. Tewari’s group achieved such stellar value creation for 3Com as a result of its
“The tactics were specifically designed to acquire the company at the lowest possible price. Kraft succeeded by sticking to its initial path.” — Antonio Weiss, Lazard, adviser to Kraft Foods on its $22.4 billion takeover of Cadbury
and avoiding the pitfalls of previous deals. Price, 53, says the advisers did this by ensuring that the combined company’s balance sheet would approach investment-grade and that the systems conversions were well understood. To get things right, they reserved the option to delay closing. “We had the comfort that Frontier was a large company with an experienced management team that had been through acquisitions before,” Price recalls. “The improvement in the dividend payout ratio contributed to the improved financial condition of the enlarged Frontier.” Evercore kept the senior team of Mestre, Price and managing director Daniel Mendelow on the account; Mestre describes this as a hallmark of his firm.“Overall, this transaction typified the Evercore approach in that we assigned three senior people to the client and they worked through the problem from inception to completion,” he says. Evercore and Citi each received $18 million, according to Freeman & Co. Freeman
deep understanding of the Marlborough, Massachusetts–based networking provider’s businesses. Based in San Francisco, Tewari has been a key adviser to 3Com for more than a decade. His team counseled the company on its acquisition of U.S. Robotics Corp. in 1996 and its spin-off of Palm in 1999. Most important, Tewari grasps 3Com’s relationship with Chinese networking giant Huawei Technologies Co. — a key aspect of the HP takeover — better than anybody else. He was lead adviser on all 3Com transactions with Huawei, including a joint venture in 2003, 3Com’s subsequent buyout of Huawei’s stake in 2006 and a failed attempt to take 3Com private by Bain Capital and Huawei in 2008. With help from Goldman’s Hong Kong team, Tewari stressed 3Com’s strength in China during the negotiations with HP. A tour of 3Com’s R&D facilities in Beijing and its Chinese headquarters in Hangzhou helped persuade the computer maker to boost its offer to $6.75 per share. After further talking up China, where it has a hefty share of the INSTITUTIONALINVESTOR.COM
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enterprise networking market, and the synergy potential for HP — and after two more price hikes — 3Com agreed to a deal.The final number was almost double 3Com’s share price before HP’s initial offer. Morgan Stanley managing directors Kamal Ahmed and Michael Wyatt advised HP, earning $32.5 million in fees, according to Freeman & Co. — X.J.
9.
JOSEPH MODISETT AND TEAM / MORGAN STANLEY Two years ago, Morgan Stanley got its hands dirty defending Mississauga, Ontario–based Biovail Corp. in a proxy fight with its controversial founder. The successful outcome against Eugene Melnyk ensured that the bank would be the pharmaceuticals company’s go-to adviser for its merger with bigger rival Valeant Pharmaceuticals International. “We were advising Biovail in 2009 when the company started talking to Valeant about possible commercial agreements on certain products,” says Joseph Modisett, 34, a managing director in health care banking at Morgan Stanley.“Those discussions then evolved as the benefits of a merger became clear.” Morgan Stanley had a strong historical relationship with Biovail chief executive William Wells, who retained the firm shortly after taking charge in 2008. Wells knew he would need a bank with a thorough understanding of the company’s structure if Biovail was to cut a deal with Valeant. Although Canadian, Biovail was registered in Barbados and enjoyed a corporate tax rate of less than 10 percent, which gave it a competitive edge despite its size. With a market capitalization of $2.3 billion, it was dwarfed by $3.9 billion, Aliso Viejo, California–based Valeant. Biovail had to find a way to structure the deal as a merger of equals, or it would lose its tax status. Morgan Stanley’s team drew on its years of experience to come up with a plan. Mergers of equals are usually all-stock deals, says Michael Boublik, the bank’s chairman of M&A for the Americas. “But given the disparity in size, we needed to find a way of bringing the two companies together while maintaining a majority ownership position for Biovail shareholders,” he notes. The solution was to pay those shareholders an appropriate premium and give Valeant INSTITUTIONALINVESTOR.COM
shareholders a predeal equalization dividend of $1.3 billion to bridge the market-value gap. This would reduce Valeant’s size and bring Biovail up to the 50 percent threshold needed for a merger. To avoid any risk of leaks, Boublik and Modisett brought Whitner Marshall, head of North American leveraged finance, onto the deal. Morgan Stanley provided almost half of the required $3 billion in the form of senior secured credit facilities, with the rest coming from Goldman Sachs. The facilities also had to fund repayment of existing Valeant debt. “The share prices of both companies rose when the deal was announced, which is highly unusual in a merger of equals and demonstrates that shareholders understood the value that was being created,” Boublik says. “The combined company achieved greater scale, diversity, significant synergies and an efficient corporate tax structure.” The involvement of Morgan Stanley’s leveraged finance arm ensured that the firm earned advisory and financing fees. Its total fee was $21.7 million, according to Freeman & Co. Goldman Sachs, co-adviser to Valeant, earned an estimated $24.5 million for investing as a principal, while Jefferies & Co., another Valeant adviser, scooped up an estimated $15 million. — D.R.
10.
STEVE MILLER AND TEAM / BANK OFAMERICA MERRILL LYNCH BofA Merrill Lynch’s involvement in the $7.1 billion sale of Sybase to SAP this past May is a lucrative example of how consistency of coverage and personnel pays off in banking. Steve Miller, co-head of enterprise and communications technology at BofA Merrill Lynch, and Jack MacDonald, who was recently promoted to co-head of Americas M&A, joined Merrill Lynch as part of the same recruitment intake in 1995. Both became members of the technology investment banking group, which built a reputation for persistence, good strategic advice and team stability. Miller,41,won the Sybase account nine years ago by cold-calling the Dublin, California– based technology giant. He gained Sybase’s trust through convertible bond deals and his advisory role in the 2006 acquisition of Mobile 365, a mobile messaging provider. In 2005, Merrill signed a formal engagement
letter that made it the enterprise and mobile software developer’s adviser of choice. The team and the relationship survived Merrill’s acquisition by BofA in September 2008. “There are seven senior partners in our technology team who have been together for a decade, and that is something that is appreciated by clients,” Miller says. Sybase and German business software provider SAP were also on familiar terms in the run-up to the transaction. John Chen, CEO of Sybase, and William McDermott, co-CEO of SAP, had a long working relationship before striking a commercial partnership two years ago to extend SAP’s applications to wireless by leveraging Sybase’s mobile platform. During the first quarter of 2010, the pair discussed a deal. Then in April, McDermott called Chen to tell him that SAP was ready to make a formal offer. Miller and MacDonald, who were lead advisers to Chen along with Harry McMahon, an executive vice chairman of BofA Merrill, formed part of a sixmember team that also comprised Michael Altmin, a vice president; David King, a managing director in investment banking; and Xuxia Kuang, an associate. Sybase rebuffed SAP’s initial offer of $61 a share, as well as an improved $64 offer, forcing SAP to make a third and final bid of $65. “Once we got to $65, the board’s view was to continue along the road with SAP with a view to being able to make a decision as quickly as possible,” Miller says. Before negotiations entered the home stretch, in the wake of the European sovereign debt crisis, SAP adviser Deutsche Bank came back in May and tried to recut the deal at about $63. “It was a difficult time in the markets,” MacDonald recalls.“The euro was falling off a cliff, so we had to work pretty much round the clock for two weeks to finalize the transaction at $65 a share.” SAP’s attempt to lower the price made sense to Sybase and did not threaten the deal. Financing was in the bag, and Chen and McDermott saw a deal at $65 as the most logical option. Miller has since stayed on good terms with SAP. After it wrapped the deal, BofA Merrill advised the company on a private placement of $500 million, and the bank still covers SAP on both sides of the Atlantic. — D.R. •• Comment? Click on Banking & Capital Markets at institutionalinvestor.com.
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continued from page 53 with less,” says
Hayes, 49, who took on the role of CFO in September 2008 — just as world financial markets were imploding in the wake of the bankruptcy of Lehman Brothers Holdings in the U.S. “What’s important in all of the restructuring is that roughly two thirds of those costs are not coming back, even when volume does come back. So, when those revenues do return, we’re going to see a very strong margin expansion.” The initiatives also enabled the company to free up cash so it could make strategic acquisitions and develop what CEO Louis Chênevert calls “transformational technologies.” In March, UTC completed its $1.8 billion takeover of General Electric Co.’s electronic-security division, and in September announced that one of its helicopters — the Sikorsky X2 — broke the
around 6 or 7 percent in emerging markets,” he points out. “We are very well positioned to more than double our emerging-markets revenue over the next ten years.” Hayes says much of UTC’s expansion in developing economies will come from merger and acquisition activity; the company has earmarked $1.5 billion for M&A projects in 2011.“Mergers and acquisitions are a big strength of UTC’s,” he says.“As we think about it going forward, a bigger piece of our M&A dollars is going to be spent in emerging markets, because that’s where growth is going to come.” The executive team at Freeport-McMoRan Copper & Gold would likely agree. The Phoenix- based mining concern, which buy- and sell-side analysts alike say has the Metals & Mining sector’s Best CEO, Richard Adkerson, and Best CFO, Kathleen Quirk, continues to enhance shareholder value thanks to its precrisis acquisition of Phelps Dodge Corp., which operated copper mines in Africa and North and South America.The acquisition made Freeport — the sector’s Best IR Company, in the estimation of sell-side analysts, and home to its Best IR Professional, David Joint, according to money managers — the world’s largest publicly traded copper producer. “The idea of putting the companies together was to make a much larger, geographically diverse, very strong company
“A bigger piece of our M&A dollars is going to be spent in emerging markets, because that’s where growth is going to come.” — Gregory Hayes, United Technologies Corp.
world record for helicopter speed by reaching 260 knots. UTC’s executive team is also focusing on growth in emerging markets. Ten years ago sales in China accounted for about $500 million of the company’s total annual revenue; by 2010 the figure had catapulted to $3 billion. Hayes says that of the company’s projected $54 billion in total revenue for 2010, nearly 20 percent will come from emerging markets — almost double its share in 2000. “Think about where growth is going to come over the next ten years: gross domestic product growth is relatively modest in Western Europe and the U.S., but GDP growth is
focused on copper,” says Quirk, 46, who has served as Freeport’s CFO since 2003. Before the merger, Freeport had been operating in just one location — the enormous Grasberg complex in Indonesia, which is the world’s largest gold mine and third-largest copper mine. “We had a feeling going into the merger that the deposits that Phelps Dodge had in the U.S. and in South America would reveal more potential through drilling,” Quirk says. “We confirmed through our exploration activities that there were indeed more reserves than had been recorded. We had opportunities to expand, and we were very excited about those opportunities.” However, those exploration opportunities
came to a shuddering halt in the latter half of 2008, when the Lehman bankruptcy sent shock waves throughout the global economy. “Our world turned upside down,” recalls Quirk. Copper prices plummeted from a mid2008 high of more than $3.50 a pound to less than half that amount by the end of that year. The price plunge spooked some investors, who worried about the risks associated with Freeport’s dependence on one product; about 75 percent of the company’s annual mining revenues are attributable to copper. However, Quirk and the other members of Freeport’s management held firm in their belief that demand for — and profit to be made in — copper would be strong. “One of the reasons we put these companies together in the first place is we have a very positive view on the outlook for copper,” she says. “We know just how hard it is to develop new supplies of it.” The challenge was to make sure investors shared that view and would stand by the company. “We didn’t know how long the situation would last, so we took steps very aggressively to cut costs and capital spending,” Quirk explains. “We also had to suspend our dividend.”All of the changes the company implemented were “with a view toward wanting to preserve our assets for what we thought would be a much better time for our principal market of copper,” she adds. Fortunately, the good times returned much sooner than expected. Copper prices began to bounce back in mid-2009, thanks primarily to strong demand coming out of China, but Quirk says it made sense to maintain their crisis strategy until demand for copper was more globally distributed and could be seen in Europe and the U.S. too, rather than only in emerging markets. “In our business it’s not as easy as flipping a switch when it comes to adjusting output,” Quirk says. “We didn’t want to be in a situation of going out and making commitments to hire people again and then having a doubledip recession or some other sort of a setback. We didn’t want to miss opportunities, but we also wanted to make sure we were prudent.” Today, Freeport is back in full-scale expansion mode. By restarting idle capacity at mines in the U.S. where production had been suspended during the downturn, and by optimizing its mines in Africa and South America, Freeport will be able to increase copper output by about 500 million pounds a year, Quirk says. In October, INSTITUTIONALINVESTOR.COM
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the company announced that it was able to reach a resolution with the government of the Democratic Republic of Congo regarding a contract review there, and that the resolution opens the door for future expansion of Freeport’s stake in the Katanga province’s Tenke Fungurume copper and cobalt mine, which the company has been operating since March 2009. That mine represents less than 10 percent of Freeport’s copper reserves, but the company hopes to double production at the site. The company had reinstated its dividend program in October 2009, after a ninemonth suspension, and in early December 2010 announced a special $1-per-share dividend, payable at the end of that month. At the same time — as the price of copper continued to soar, topping $4 a pound — Freeport declared a two-for-one stock split effective February 1 (for shareholders on record as of January 15). “Volatility is just part of the landscape of what we deal with,” Quirk says. “We can’t predict prices, so we don’t run our business day to day based on what prices are doing. We run our business over the long term, and we think that’s the best way we can generate value for shareholders.” To maximize shareholder value in turbulent economic times, the executive team at Cisco Systems opted to focus on developing new products and services rather than scaling back its operations. In fiscal 2010, which ended July 31, the San Jose, California–based computer networking equipment manufacturer launched more than 400 offerings — that was in addition to the 350 or so introduced in the previous fiscal year — and allocated between 13 and 15 percent of total annual revenue to research and development in each of those years. Cisco — which both the buy and sell sides agree provides the Best IR in the Telecommunications sector (the two sides also say it has the Best CEO, John Chambers, while the sell side says it has the Best CFO, Frank Calderoni, and Best IR Professional, Marilyn Mora) — consolidated resources so it could focus on the three areas of specialization that clients deem most important: collaboration, data center virtualization and video capabilities. The company has made a concerted effort to keep shareholders up to speed, according to Laura Graves, Cisco’s head of global investor relations. INSTITUTIONALINVESTOR.COM
“As our business is changing, it’s important for us as a management team to communicate with investors along the way and let them know what we’re doing,” says Graves, who has been with Cisco for six years.“During the downturn, IR people could have gone in one of two directions. They could have said less; that would have been really easy.The tougher road is the way we tried to go. We tried to tell investors as much as we knew, when we knew it.” The true test of this philosophy of transparency is bad news: Will a company’s executive team maintain its commitment to full disclosure when the news is not good? Cisco Systems recently faced just such a test. In early November, Chambers, who has been CEO since 1995, announced a curtailed earnings forecast, predicting less than 5 percent growth in the company’s fiscal 2011 second quarter, which ends January 31. One of the main dampeners for the company has been budget cuts across the public sec-
pened,” she explains.“You have to be willing to take time to talk them through it.” Graves says the process requires communicating through several channels, including an earnings call, appearances by the CEO and CFO on various news channels, an online video from the company’s executives, one-on-one phone calls and meetings and access to various department heads within Cisco — not just its top executives. “I’ve worked in IR for 20 years, and I’ve been at companies where the management team says,‘Put it out in the press release, and we’ll have a conference call’ — and that’s it,” she asserts.“But here we believe that it’s good investor relations to understand that every investor hears differently, learns differently, thinks differently.” She also points to Cisco’s share-buyback program as a way the company has “shown support for the stock during a challenging period.” Following Chambers’s gloomy
“The only way people can measure our company’s success is if they really understand the challenges that we’re facing.” — Laura Graves, Cisco Systems tor, the client base that accounted for about 22 percent of Cisco’s business in the first quarter. Chambers, 61, explained that state government orders had fallen 48 percent in the company’s fiscal 2011 first quarter. The gloomy forecast knocked the wind out of an otherwise-breezy first-quarter earnings call. Cisco reported a 19 percent increase in revenue over the same period one year earlier, to nearly $10.8 billion, and an 8 percent gain in earnings, to more than $1.9 billion. Nonetheless, its share price tumbled more than 12 percent in after-hours trading on the day of the announcement. Graves says that the role of the IR team following such news is not only to remain open and honest, but also to understand the psychology of the market and stick with investors through the various stages inherent in the process of hearing — and ultimately absorbing — the news. “On the day of the earnings announcement, when the stock is trading so quickly, it’s difficult for investors to take a deep breath and really understand exactly what hap-
earnings forecast, the company announced it would boost its stock-repurchase program by $10 billion. Ultimately, it makes the most sense to be transparent about the obstacles that a company is facing — and not just because doing so helps investors make the right decisions: The company’s image will benefit too, she explains. “The only way people can measure our company’s success is if they really understand the challenges that we’re facing,” she adds. “You have to hope that how we overcome those challenges is what’s rewarded by the market.” There has been no shortage of challenges facing corporate leaders over the past couple of years, but the members of the 2011 AllAmerica Executive Team have demonstrated their talent for triumphing in the face of adversity — which is why analysts on both the buy and sell sides have deemed them the best of corporate America. •• Comment? Click on Research at institutionalinvestor.com.
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continued from page 57 what is politically
unpalatable but economically necessary. But Mayo is skeptical about how the Volcker rule, along with the whole regulatory reform package, will work in practice. “Merely because Dodd-Frank is 2,300 pages doesn’t necessarily mean the industry will be more appropriate in its behavior,” he says.“Dodd-Frank could have been 23,000 pages and it wouldn’t make any difference, because the industry will always be one step ahead in managing around regulations.” In the current climate banks are downplaying the importance of speculation to their bottom lines. It took an incredible moment of amnesia for Citigroup CEO Vikram Pandit to tell Congress back in March that “my perspective is that proprietary trading is not a meaningful part of what we do as a bank. I don’t think banks should be using capital to speculate.” While at Morgan Stanley in 2005, Pandit had been keen to take on more risk with that firm’s balance sheet. During the past decade Citi itself had some extremely significant proprietary trading units, including Westport, Connecticut–based commodities business Phibro. So important was Phibro to Citi’s bottom line that its head, Andrew Hall, received a 2009 pay package of $100 million. The reason Phibro is no longer a part of Citi is that the bank, after its U.S. government bailout, could no longer honor Hall’s contract and was forced to sell the unit. DURING THE FEBRUARY SENATE BANK-
ing Committee hearings on the rule that bears his name, Volcker got a surprising ally in the form of an old foe: John Reed. The ex-CEO of Citi, now retired, was unstinting in his view that proprietary trading and the culture it fosters should have no place at a commercial bank. “It’s not that I feel these functions shouldn’t exist,” he told Congress. “I would
simply separate them from institutions that are the deposit takers and basically the traditional lenders for much of the economy.” Although during his tenure in the 1990s as CEO of Citicorp Reed was not actively involved in lobbying Washington, by virtue of his job he was associated with the movement that, at least to Volcker’s way of thinking, contributed to the whole problem in the first place. That decade a group of high-level Wall Street executives lobbied for the repeal of the Glass-Steagall Act, the 1932 law that separated commercial and investment banking. In 1998, Reed sold what was already the U.S.’s biggest bank to Sanford Weill’s Travelers Group to form behemoth Citigroup, correctly betting that Glass-Steagall would soon be repealed. Travelers owned investment banking firm Salomon Brothers, which Weill had acquired in 1997 and merged with his Smith Barney business. Salomon had been known for its particularly aggressive proprietary traders, immortalized in the Wall Street classic Liar’s Poker. In that book, author Michael Lewis recounts his time at Salomon in the 1980s, when John Meriwether and his band of fixed-income arbitrageurs ruled. In 1993, following a Treasury bond pricing scandal, Meriwether and his team resigned from Salomon and founded hedge fund firm LongTerm Capital Management. For four years, LTCM (which included Nobel Prize–winning economists Robert Merton and Myron Scholes) prospered. But in August 1998 its highly leveraged portfolio fell 44 percent after Russia defaulted on its sovereign debt, and it had to be bailed out by a consortium of 14 big banks and Wall Street firms brought together by the Federal Reserve Bank of New York to avoid a complete market meltdown. Volcker, then chairman of the New York investment bank J. Rothschild, Wolfensohn & Co., had been vigorously opposed to the repeal of Glass-Steagall. The LTCM debacle was precisely the type of systemic crisis he had feared, and in its wake he continued to lobby hard for maintaining the separation between deposit-taking institutions and investment banks. But the forces for deregulation, including then–Treasury secretary Robert Rubin and his deputy and successor, Lawrence Summers, won the day: In November 1999, Glass-Steagall was repealed. “The financial sector lost its way,” says investment adviser Bernstein, who has long
opposed the repeal of Glass-Steagall, even when he was at Merrill Lynch.“It is no longer fulfilling its major role: to aid the capital formation process.” During the past decade banks weren’t just using their balance sheets for proprietary trading; they were also using them to make private equity investments and hold inventories of syndicated loans. In a lowinterest-rate environment, where spreads were narrow and commissions continued to fall, banks understood that they could make more money investing and trading their own capital than lending it out. At the time, everything seemed to make a lot of sense. “Because of the confidence in them, banks and investment banks had extremely good access to low-cost funding, so they were able to run extremely high leverage ratios,” explains Michael Litt, chief investment officer of Darien, Connecticut–based hedge fund Arrowhawk Capital Partners. According to Bernstein’s Hintz, in 2000, Goldman Sachs had a leverage ratio of 17.2 times, meaning that the firm’s assets were 17.2 times its capital base. That same year, Merrill Lynch had leverage of 22.7 times and Morgan Stanley, 21.9. By the first quarter of 2008, Goldman’s leverage ratio had jumped to 27.9 times, Merrill’s to 28.5 and Morgan Stanley’s to 32.8. Although much of the capital went toward placing securitized loans and making principal investments, an increasingly significant percentage went to proprietary trading, particularly in fixed income, currencies and commodities, better known as FICC. “Because of banks’ market making, they had a potential advantage in the effectiveness of their proprietary trading,” says Litt, explaining the attraction of the business. One of the unintended consequences of repealing Glass-Steagall was to put trading on steroids. “You asked me why trading exploded,” says former Citicorp CEO Reed, 71, in an interview with Institutional Investor. “Profit.” But, says Reed, the short-term bonus-driven mentality of a trading institution is very different from that of a banking institution.“An aggressive trading culture is very difficult to control within the context of a bank,” he says. “That is why culturally it’s important to keep proprietary trading separate from the commercial banks.” In 1981, Goldman Sachs acquired commodities broker J. Aron & Co., where BlankINSTITUTIONALINVESTOR.COM
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fein had recently started working as a gold trader. The deal propelled Goldman into the commodities business. By the mid-2000s, FICC trading had become an important profit center, not just at Goldman but at all of the major banks. One indication of just how much Wall Street had come to rely on proprietary trading is the change in value at risk, or VaR, which measures how much a bank can lose in any given day. Between 1999 and 2009, Goldman’s VaR skyrocketed nearly 800 percent, from $25 million to $218 million. Citigroup’s trading VaR jumped from $52 million in 2000, the year Reed retired, to $319 million in 2008. The trading VaR of Deutsche Bank, which has long had a deep bench of proprietary traders, tripled between 2002 and 2008, from €42.4 million (then worth $43.2 million) to €122 million ($164.1 million). (Deutsche exited proprietary trading at the end of 2008.) Proprietary trading comes in two forms. There are pure proprietary trading units, which have no client-facing responsibilities and operate completely separate from the rest of their institutions; teams like this include the quantitative-based QT group at Goldman Sachs and the Process Driven Trading unit at Morgan Stanley. Then there is the proprietary trading that takes place within client businesses as part of their marketmaking function; many asset-backed-trading desks on Wall Street fall into this category. Banks argue that this second type performs a valuable function and should be allowed to continue. The proximity of client and principal businesses is one of the reasons proprietary trading has been vilified in some corners. The concern — and it is a legitimate one — is that proprietary traders will use the information about client orders to trade in front of them, benefiting themselves at a cost to clients. In March 2004, London-based Deutsche Bank broker-dealer subsidiary Morgan Grenfell & Co. was fined £190,000 ($343,900) by the U.K.’s Financial Services Authority for frontrunning clients by trading in seven stocks (including Euromoney Institutional Investor majority owner Daily Mail and General Trust). That decision spurred a debate over the question of how banks should balance the relationship between client and proprietary businesses and added to the growing sense that they might not always be acting in the best interest of clients. INSTITUTIONALINVESTOR.COM
Meanwhile, proprietary traders were deciding that they would like some clients of their own; they hoped to make more money by trading off a larger capital base. In 2004, Citigroup turned its successful proprietary trading unit, Tribeca, originally Travelers’ bond arbitrage desk, into a client-facing business, using $100 million of Citi’s own capital to fund it. The next year, UBS spun out a team from its fixed-income proprietary trading unit to form Dillon Reed Asset Management. Not everyone on Wall Street believed that investment banks should operate like Goldman. But bucking the trend could be a career-altering decision, as Philip Purcell found out. Purcell, a onetime McKinsey & Co. consultant, became CEO of Morgan Stanley following its 1997 merger with his company, brokerage firm Dean Witter Reynolds. Although earnings increased under Purcell, by the middle of the next decade some senior management members, as well as
executives had declined to talk in specifics about proprietary trading because the firm didn’t break it out from its other businesses, but now that the practice was being banned, Goldman had more reason to address it. This was not lost on CLSA analyst Mayo, who had also been listening to the White House press conference. What percentage of your business, he inquired of Goldman CFO David Viniar, is proprietary trading? “If you take our pure, walled-off prop business that has nothing to do with clients, you are talking about a number that probably in most years is 10-ish type of percent, plus or minus a few percent,”Viniar responded. “So 10 percent of the total revenues?” Mayo asked. “In that range,” Viniar conceded. Viniar very deliberately spoke only about walled-off trading. If proprietary trading desks with a client-related function were also
“Reform is going to create lower return on equity and much less volatility. Investors will be willing to pay a higher multiple.” — Kevin Conn, MFS Investment Management
some former Morgan Stanley executives, felt he lacked strategic vision; they also wanted the firm to make more-aggressive use of its balance sheet. Matters came to a head in June 2005. Vikram Pandit, who then was running investment banking at the firm, refused to back Purcell when a powerful group of eight former Morgan Stanley executives began calling for the CEO’s dismissal. Pandit and his loyal cohort, John Havens, promptly left the firm and formed their own hedge fund, Old Lane Partners (later acquired by Citi for $800 million). Purcell resigned and was replaced by former CEO Mack — just in time to ramp up Morgan Stanley’s proprietary risk in its fixed-income trading division, which led in late 2007 to $9.6 billion in write-downs on large mortgage-related losses. THE WHITE HOUSE CHOSE TO MAKE
its announcement proposing the Volcker rule on the morning of January 21, 2010, at the same time that Goldman Sachs was holding its fourth-quarter earnings call with analysts and investors. In the past, Goldman
included, that 10 percent figure would be much higher, probably 20 percent or more for Goldman, according to some estimates. Hintz believes that walled-off proprietary trading accounts, on average, for 10 to 15 percent of banks’ total sales and trading revenue. The loss of that revenue, combined with reduced profits from OTC derivatives trading — the bulk of which will now be cleared and settled by central clearinghouses as a result of DoddFrank (see “Building a Better House,” page 62) — will lead to a roughly 280-basis-point drop in pretax profit margins for aggregate sales and trading, Hintz predicts. But the real kicker is the change in leverage. Hintz estimates that regulatory reforms will limit banks’ gross leverage ratios to 15 times capital. Based on historical returns, he reckons those changes should reduce the return on equity of trading units by 45 to 50 percent, pushing the ROE of sales and trading below banks’ cost of capital. In other words, the broker-dealer part of the business will no longer be profitable. “Fundamentally, our analysis certainly indicates that it is going to be very difficult for
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any major capital markets player to generate returns substantially above its cost of capital in its trading book,” says Hintz. All this, of course, means less money. Kevin Conn, an investment officer and financial services sector portfolio manager with $204 billion, Boston-based MFS Investment Management, says banks will see their ROE drop from 15 to 16 percent to about 13 percent. Other investors are more negative, believing that ROE could fall to 9 percent or lower. But Conn anticipates some positives too: The move out of the volatile business of proprietary trading will likely improve stock valuations. “Investors like certainty; they like consistent, stable growth models,” Conn says. “Reform is going to create lower return on equity and much less volatility. And investors will be willing to pay a higher price-toearnings multiple.” Conn is more concerned that U.S. banks might become less competitive globally if
developed market equities and investmentgrade corporate bonds. By optimizing their balance sheets, Hintz estimates, bank trading units can increase their revenue yield on net assets by 10 to 15 percent. With banks unwilling to commit capital to low-margin businesses, spreads will widen. That will pose a problem for borrowers, but one of the issues that caused the credit crisis was banks’ willingness to park so much debt on their highly leveraged balance sheets. “Regulators don’t want the banks, through their ability to leverage their balance sheets, to determine the price of risk assets,” says Arrowhawk Capital’s Litt. One thing is clear: Wall Street compensation will go down. “There will never be another $50 million guy at a bank,” says First New York CEO Schenk, referring to the legion of traders who took home eightfigure bonuses during the past decade. Many anticipate that Goldman will find a way to be the exception, but not institutions like Citi
“The financial sector lost itsway. It’s no longer fulfilling its major role: to aid the capital formation process.” — Richard Bernstein, Richard Bernstein Advisors
foreign-domiciled banks are not subject to the same regulatory restrictions. Unlike nonU.S. financial institutions, U.S. banks are subject to the Volcker rule wherever they operate.“U.S. banks will be regulated by U.S. regulators no matter what,” says Sullivan & Cromwell’s Wiseman. U.S. banks have always had an uncanny ability to find ways to make money. Hintz anticipates that under Dodd-Frank and Basel III, banks will have to become more efficient in how they deploy their capital. In his November research report, he argued that after letting some of their more regulatorysensitive businesses run off and “throttling back” on securitization — moves that will achieve a 10 percent permanent improvement in regulatory capital efficiency — “the balance sheet optimization will begin.” To Hintz’s mind, the “new optimal” balance sheet of Wall Street will include a large sovereign debt book, bigger portions of emerging-markets equity and debt, and much smaller commitments to low-margin business like money markets, preferred stock,
or Bank of America Corp., which acquired Merrill Lynch at the height of the crisis. As the banks reorganize their brokerdealer operations and sell off inventory, their other business lines will begin to play a more prominent role. Investment banking is already coming back. Goldman Sachs made $1.2 billion from investment banking in the third quarter of 2010. Its broker-dealer business still makes more — $6.38 billion in the third quarter — but while sales and trading net revenues were down 36 percent from the third quarter of 2009, the investment bank’s net revenues improved by 24 percent. For the first nine months of 2010, Goldman ranked No. 1 in worldwide completed and announced mergers and acquisitions, according to Dealogic, as well as in common stock offerings, according to Thomson Reuters. Many banks are turning to asset management to make up for some of the lost revenue from proprietary trading. The appeal is obvious: The business boasts a steady revenue stream and, in the case of alternative investments like hedge funds and private
equity, high fees. Although Morgan Stanley recently sold hedge fund firm FrontPoint Partners, JPMorgan’s Dimon has made it clear he intends to keep his bank’s hedge fund business, Highbridge Capital Management. Goldman, meanwhile, is keen to build Goldman Sachs Asset Management, which manages $677 billion, to a size that will rival $1.3 trillion Pacific Investment Management Co. and $3.45 trillion BlackRock. In a sign of how much asset management’s standing at banks has already changed, GSAM’s net revenue for the third quarter of 2010 was $1.4 billion — more than the net revenue of Goldman’s investment bank. There is no guarantee that banks’ love of asset management will be reciprocated. “It’s a tactical solution,” warns CLSA’s Mayo of the move to build asset management. “Don’t confuse a tactical solution with an effective strategy. As a general rule, the pure players are in a league of their own versus the bank-owned asset management businesses. And if you haven’t run your asset management business well up until this point, why are you going to start running it better now?” In the aftermath of the Volcker rule, at least one bank, JPMorgan, has moved proprietary traders into asset management. The hope is that these traders will be able to raise outside funds; under the Volcker rule there is a limit to how much the banks can stake them. But Ilana Weinstein, CEO of New York–based executive recruitment firm IDW Group, who works with top hedge funds and bank trading desks, doubts the move will last. “It’s only a temporary fix,” she says. Traders who successfully make the transition eventually will most likely branch out on their own or join outside hedge funds, where the economics are more attractive. Those who fail to raise funds will either move back into the friendly confines of the broker-dealer or drop out of the industry entirely. For its part, Goldman began moving proprietary traders into asset management in 2007. Blankfein’s firm and Wall Street may be better for the changes under way, but only when the next financial crisis arrives will lawmakers and regulators know for sure if their new banking system is any safer. •• Comment? Click on Banking & Capital Markets at institutionalinvestor.com. INSTITUTIONALINVESTOR.COM
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continued from page 61 that’s going to be the SEC’s determination.” ICE Trust, which was created by the IntercontinentalExchange (ICE), contends that it may eventually be able to clear as many as 300 single-name CDSs. The interest rate swaps market, which at $350 trillion notional outstanding is the single biggest OTC derivatives sector, is far more liquid and transparent than the CDS market. Even so, it includes complicated products that dealers say aren’t easily standardized. Gensler’s 30 teams have been huddling with the SEC, the Federal Reserve, the Federal Deposit Insurance Corp. and the Treasury Department since late July. Although the SEC will oversee many aspects of the Dodd-Frank reform, including oversight for swap-security products such as single-name CDSs, the CFTC will bear the bulk of responsibility in implementing the new derivatives rules. Those rules will cover a broad range of issues, from the basics of defining what a swap is to making sure there’s enough price transparency and liquidity in every derivatives product group to determining how much margin, collateral and capital that clearinghouses need to demand from dealers and clients. Last, there are worries that clearinghouses could try to undercut one another to win new members and users — for instance, by charging less collateral and initial margin. This is more of a concern in the interest rate swaps market, which is vastly bigger than the CDS market and already has a gathering crowd of up-and-coming competitors, including CME; International Derivatives Clearing Group (IDCG), which is majority-owned by Nasdaq OMX Group; and the Singapore Exchange. Collateral is what helps keep clearinghouses and their members safe, serving as a financial backstop when liquidity dries up in the broader market. Getting the collateral equation right will be one of the big INSTITUTIONALINVESTOR.COM
challenges for derivatives clearinghouses in coming months — a challenge that regulators are looking at closely as competition heats up. If clearinghouses require users to put up too much collateral, they risk choking off liquidity and driving more of the derivatives activity into the less regulated OTC market, which will continue to exist under DoddFrank. Conversely, if they charge too little collateral and margin, that could backfire during times of financial crisis. Looking beyond the rules themselves, many worry whether the SEC and CFTC have the capacity and staying power to police such a vast new empire.The SEC is still under fire for oversight failures in the 2008 crisis. And the CFTC, with a workforce of 670, is seriously understaffed for its new job.“We estimate we’ll need about 1,130 people to do this,” Gensler says.“So we need over 400 more people.” That means more money, which the government has yet to earmark. “I’m not going to be bashful,” Gensler adds. “I’m going to be very public about the need for funding. Congress can certainly choose to support it, and I hope they will. But if they don’t, come the fall of 2011, it’s going to be a challenge.” IN THE U.S. DERIVATIVES HAVE BEEN
around since the Civil War, when merchants began buying and selling contracts to hedge the risk of future changes in the prices of corn, wheat and other grains on a central exchange. In 1936, Congress passed the Commodity Exchange Act, which required the government to regulate futures and options trading and led to the eventual creation of the CFTC. In 1981 the over-thecounter derivatives market was born when IBM Corp. and the World Bank did the first interest rate swap, agreeing to exchange fixed-rate for floating-rate payments. Swaps are essentially bilateral bets on the direction of interest rates, currencies, company debt or commodity prices that trade between private parties outside the scrutiny of regulators. The OTC derivatives market took off in the 1990s and by 1998 had swelled to some $80 trillion in notional value, dwarfing the exchange-traded futures and options market, which was just $13.5 trillion, according to the Bank for International Settlements. A large part of the OTC growth this past decade was fueled by credit default swaps, which helped transform bond trading into a highly leveraged business.
A CDS is a contract between two counterparties in which the buyer makes periodic payments to the seller for promising protection on a bond or loan. JPMorgan is generally credited with inventing the CDS in 1997 as a way to protect itself against tens of billions of dollars in loans that it had accumulated. The idea seemed simple enough: A third party would assume the risk of the debt going bad and in exchange would receive regular payments from the bank, similar to insurance premiums. That would let the bank remove the risk from its books and free up reserves and was an extension of what banks had already been doing to hedge against fluctuations in interest rates and commodity prices. The CDS market quickly grew from $180 billion in notional value in 1997 to almost $55 trillion by June 2008. Bankers seized upon CDS trading as a way to earn easy premiums, free up capital and shed risk from their books. As a general rule, CDS sellers don’t post money up front when they enter a contract; they only pony up if the credit defaults or goes bankrupt. When that happens, the cost of coverage can jump exponentially — what’s known as “jump to default.” Still, financial firms can hedge this risk by buying CDS protection even as they sell protection to someone else. That way, when a bond defaults, they get money back as they pay out, effectively netting their loss. By 2007, with credit risk priced at historical lows, many financial firms were selling buckets of CDSs as insurance to cover exotic financial instruments linked to subprime mortgages. When the mortgage market unraveled, however, those, like AIG, that hadn’t hedged both sides of their CDS bets demonstrated just how dangerous these instruments can be when things go wrong. AIG, for its part, made two cardinal errors. First, it was long CDS exposure — a whopping $377 billion worth — meaning that it hadn’t hedged the protection it had sold to firms that had piled into toxic subprime-mortgage-related debt. Second, it didn’t reserve capital to cover that exposure if something went wrong. When Goldman Sachs and others came knocking for big margin payouts to cover spiraling losses, AIG didn’t have the money. If not for a $180 billion bailout by the U.S. government, AIG would have collapsed beneath its enormous CDS exposure, with potentially dire consequences for the global economy.
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AIG became the poster child for why the OTC derivatives market needed to be more closely regulated. Meanwhile, Lehman Brothers, which did collapse, showed how clearinghouses could be part of the solution. On September 15, 2008, the morning that Lehman filed for bankruptcy, LCH.Clearnet woke up with $9 trillion in interest rate swaps from Lehman — trades it was able to unwind at no cost to itself.The clearing model had worked in one of the worst financial crises in history. Within weeks of the Lehman bankruptcy, the Federal Reserve Bank of New York gave major bank dealers marching orders to form a clearinghouse for CDSs. ICE was one of the first to respond to that call. Formed in 2000 to trade and clear energy contracts, the exchange launched ICE Trust in March 2009 with a group of ten Wall Street dealers to focus exclusively
at least $5 billion in tangible net worth and an existing swaps desk — pretty much blocking out all but the biggest Wall Street firms. Edmonds says such rules have been critical to ensure that members are able to manage outsize risks when markets hit the skids. For his part, Gensler, who is tackling his new job with the fervor of the converted, says he won’t tolerate anyone hiding behind the excuse of risk management. “I respect it; I understand it’s profitoriented,” he says of Wall Street. “But my job is different. It’s to comply with the law and to best promote the transparency of the markets.” Transparency is an issue that Gensler and other regulators are articulating in the new rules — and one of several concerns that have kept Edmonds’s team in constant contact with Washington. The 41-year-old
“A five-year contract might be pretty liquid initially, but in two to five years there’s no guarantee that it will be.” — Jeff Gooch, MarkitSERV
on CDS clearing. About five months earlier, CME — the world’s largest derivatives exchange — and Chicago-based hedge fund firm Citadel Investment Group had announced their own plans to establish an electronic platform that would enable users to trade and clear CDSs. The Fed’s call for a CDS clearing solution is part of a broader outcry among regulators and politicians to clear all derivatives, and has attracted the attention of new players that want to grab a piece of the pie in other sectors, such as interest rate swaps; they include IDCG, Germany’s Eurex Clearing and Brazil’s BM&F Bovespa. The biggest competitor for interest rate swaps clearing is LCH.Clearnet, Europe’s largest independent clearinghouse. ICE Trust president Christopher Edmonds has emerged as an unlikely champion for Wall Street dealers and something of an antihero to Gensler. The crusading CFTC chairman, who spent 18 years at Goldman Sachs, is determined to claw back Wall Street’s power, while Edmonds is resolute to preserve it. They have clashed, for instance, over ICE Trust’s exclusive membership requirements, which call for prospective members to have
Edmonds, who began his career at Louisville, Kentucky–based APB Energy in 1997 and was most recently CEO of clearinghouse IDCG, is worried that the new rules for clearing derivatives could end up looking too much like those that govern futures. “Clearing OTC derivatives is not exactly like clearing futures,” he says.“It’s not apples to apples. It would be incredibly dangerous for us to try to create a systemic environment where one size fits all, because what we could miss in the interim could be catastrophic.” Gensler has extolled the futures model for helping clearinghouses sail through the Lehman crisis. There are 126 futures commission merchants registered with the CFTC. Most FCMs can be members of the clearinghouses. LCH.Clearnet, which has applied to use the FCM model, used only 30 percent of Lehman’s initial margin to close out positions, indicating that it was well margined for the loss of a top dealer. CME was also able to liquidate Lehman’s entire futures options portfolio without sustaining any losses. But this model doesn’t necessarily work for all derivatives, especially CDS contracts, which can vary dramatically in liquidity. ICE Trust has a lot in common with its
Wall Street members. It’s the only for-profit clearinghouse that shares revenue with its members, which include Bank of America Merrill Lynch, Barclays Capital, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs Group, JPMorgan, Morgan Stanley and UBS. Unlike other clearinghouses, it is registered as a bank and therefore is regulated by the Federal Reserve as well as by the SEC and now, under Dodd-Frank, the CFTC — a challenge that Edmonds has been tackling since he joined in February of this year. Analysts expect the CDS clearing business to become an increasingly important part of publicly traded ICE’s profit model in the months ahead. UBS analysts Alexander Kramm and Christopher Johnson estimate that CDS clearing could generate some $200 million to $300 million in revenue for ICE, and 8 to 13 percent of its total estimated earnings by 2012. Edmonds has already presided over a period of rapid growth. CDS clearing volume at ICE Trust has swelled to $8.3 trillion from just $4 trillion in notional value and $258 billion of open interest since he arrived — a far cry from the $236 million in CDSs that has been cleared at CME. Life was easier, he admits, at IDCG, a young interest rate swaps clearinghouse that is regulated by the CFTC and conforms to a more traditional, futures-style platform. “I understand the core principles of that model and went to bed every night very comfortable in the world I lived in,” Edmonds says. At ICE, he adds,“I walked into running a bank, and that doesn’t necessarily pair well with running a clearinghouse.” Keeping his Wall Street members happy is just one of those challenges. Most are in no mood to yield ground to outsiders when it comes to parting with market share and profits. The top five bank dealers, all at ICE, command 95 percent of the notional amount of CDSs bought and sold in the market.“We have to be realistic,” TABB’s McPartland says. “These are for-profit companies, and, yes, they’ll be working with federal global regulators to reduce systemic risk. But they also need to make money for shareholders, so they will craft models that work for them.” In a sense, that’s what LCH.Clearnet has already managed to do under CEO Roger Liddell, a former Goldman Sachs veteran. Over the past 11 years, in its SwapClear arm, LCH.Clearnet has carved out a 40 percent INSTITUTIONALINVESTOR.COM
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market share in interest rate swaps by confining its membership to a small cadre of global and Wall Street banks.Although LCH. Clearnet has a nascent clearing business for CDSs in France, it is fighting to maintain its far more important dominance in clearing interest rate swaps as CME and smaller newcomers like IDCG advance. It could have a tough time holding that position, however, if Gensler forces clearinghouses that operate in the U.S. to loosen their membership rules. LCH.Clearnet will be forced to go along with the new rules if it wants some of the U.S. buy-side business — a potentially significant slice of the derivatives pie that some analysts put at about $20 trillion. At the same time, like ICE Trust, LCH.Clearnet is fighting to preserve its own strict membership requirements, which Liddell says are essential to managing risk through market crises. The clearinghouse is 73 percent owned by dealers and requires $5 billion in net tangible capital as well as an existing $1 trillion swaps book. Michael Davie, CEO of SwapClear, has warned that bank dealers may quit as clearing members if they are forced to water down membership requirements and risk management rules. CME, which was founded in 1898 as the Chicago Butter and Egg Board and today operates the world’s largest futures clearinghouse, has had headaches of its own, though not because of its membership requirements, which call for just $500 million in capital. In September 2009, CEO Craig Donohue scrapped the electronic trading platform that CME was developing with Citadel and announced that the new initiative would instead focus solely on clearing CDSs. “We moved away from the execution platform because there isn’t sufficient demand for it,” Donohue told Institutional Investor a few weeks later. “Change is hard.” Critics say that CME miscalculated how hard the bank dealer community would strike back when the Chicago exchange joined forces with Citadel CEO Kenneth Griffin to launch a CDS trading platform. “The battle for CDS clearing supremacy was won and lost without even engaging the dealer community because of the Citadel connection,” explains the head of futures at one large broker-dealer. In a preemptive strike, the Wall Street dealers that balked at the CME-Citadel electronic trading system withheld liquidINSTITUTIONALINVESTOR.COM
ity for the clearing platform — a problem that persists today. Although CME signed up major founding members from the buy side — including AllianceBernstein, BlackRock, BlueMountain, Citadel, D.E. Shaw Group and Pacific Investment Management Co. — it has yet to get much beyond its prelaunch stage.That could change if it succeeds in offering cross-margining of OTC products with benchmark futures. More recently, on October 18, CME scored an important victory when it began clearing interest rate swaps with the backing of five key buy-side firms: BlackRock, Citadel, Fannie Mae, Freddie Mac and Pimco. It’s also working with ten dealers, including Goldman and JPMorgan. BEYOND ISSUES OF MEMBERSHIP AND
market share, there is one more pressing question: Can the clearinghouse model work for CDSs? Although the model was successful for interest rate swaps during the Lehman crisis, CDSs carry an entirely different set of risks. The CDS market is much smaller and more specialized, and less liquid and transparent, than the interest rate swap market. CDSs also have the potential for much larger losses because of their link to default; that’s why they require much higher levels
five-year contract might be pretty liquid initially, but in two to five years there’s no guarantee it will be. Once those contracts are in the clearinghouse, they’re not coming out. So the clearinghouse needs to collect information that will support the measurement of that risk. That raises the question, how do you measure liquidity? Honestly, measuring liquidity is very hard, because it comes and goes.” It’s uncertain how clearinghouses will deal with the additional liquidity risk for CDSs, especially given the scarcity of regular price information. There are simply far fewer trades in the CDS market than in the futures market, where price information for natural gas, crude oil and other highly liquid commodities is available at any time. Data repositories like DTCC list some 1,000 liquid single-name swaps, but in reality very few of them trade with any frequency. ICE Trust mutualizes risk among its members: The pool of banks acts as a financial backstop for the clearinghouse. Critics say that mutualizing CDS risk among a handful of banks, no matter how well capitalized, poses a systemic problem. Scott Hill, CFO of parent ICE, counters that ICE Trust has more than enough capital to cope with the failure of any two of its largest dealer members.
“I’m going to be very public about the need for funding. If Congress doesn’t support it, it’s going to be a challenge.” — Gary Gensler, Commodity Futures Trading Commission
of capital. Analysts estimate that cleared CDS transactions will likely be margined at 5 to 10 times the current level of other OTC derivatives. (A typical ten-year, $1 billion interest rate swap has a margin of roughly 3 percent of its notional value, depending on the clearinghouse.) Much will depend on how regulators define liquidity, which tends to be very thin beyond the CDS indexes. CDS single-name contracts trade infrequently, and many of them have five-year maturities and tend to grow less liquid over time. “The clearinghouse has got risk with all open positions, so those have to be covered,” cautions Jeff Gooch, CEO of MarkitSERV, a joint venture between London- and New York–based Markit Group and Depository Trust & Clearing Corp. that provides global OTC derivative transaction processing. “A
“The first big step forward is that the Titanic never leaves the dock with too few lifeboats,” Hill says, referring to the capital strength of existing members. ICE Trust backtested its CDS risk management system against positions on September 11, 2008, when Lehman was teetering on the brink of bankruptcy. Hill says the clearinghouse would have survived without dipping into the guarantee fund, which is basically a last-resort capital cushion for defaults. “We’re looking at a situation where the Titanic runs into an iceberg, backs up and hits another one,” he explains. “It’s the two largest clearing firms that go down.” Hill says both regulators and third-party independent reviewers have been impressed by ICE’s risk simulation. “So we have tested it to make sure that not only do we have
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enough lifeboats, but we probably have more than enough to get us through,” he adds. Still, it’s the word probably that makes some people nervous. Nobody knows for sure what will happen when the next crisis comes along. “If ICE is assuming two banks go out of business, that’s fine. But how much CDS is on their portfolios, and how negative is the profit and loss of those CDSs?” asks Robert (Bo) Collins, a private money manager and former president of the New York Mercantile Exchange. “If you have a bank go out of business, that’s one thing. But if they lose $5 trillion, you have a problem.” Moreover, ICE Trust backtested its model with CDS indexes, the most liquid part of
negotiate a margin requirement up front on a trade that is typically stable for the life of that trade. The clearinghouse, however, reserves the right to change the margin requirement. Though MacDonald says clearinghouses don’t have the motivation to do this randomly or to just one participant, it’s something that worries him. “It’s part of my job to make sure our firm has sufficient liquidity,” MacDonald says. “And we do have to think about it differently in the cleared model than in the bilateral model.”Another big obstacle, he says, is that not many products are available for clearing as yet. “It’s hard to transition to a cleared market when everyone’s system is set up for
“It would be incredibly dangerous for us to create a systemic environment where one size fits all.” — Christopher Edmonds, ICE Trust
the CDS market. Some wonder what would happen if there was a meltdown in the single-name sector, where liquidity tends to be much thinner. Others downplay this concern, saying that clearinghouses like ICE Trust monitor concentration risk and would demand collateral increases before risk levels got too dangerous. The concern is that margin requirements could shoot higher for clearinghouse clients when the market melts down — at a time when clients can least afford to meet them — forcing those unprepared into default. ICE Trust has been working to address these worries. In August it rolled out a margin calculator that allows clients to figure how much margin they might need for clearingeligible instruments in their portfolios under a range of different risk scenarios. Corry Bazley, director of sales and marketing for ICE, says the new tool tells the client how much the initial margin amount would be and then breaks it down into the components of the CDS market, crunching data for spread volatility, the expected loss due to default, liquidity measures tied to the cost of unwinding CDSs, interest rate risk and concentration risk. Still, even those who support the clearinghouse model have concerns, including Ted MacDonald, treasurer of hedge fund firm D.E. Shaw, a major user of CDSs. In the OTC market, he explains, buyers of protection can
a bilateral market,” he adds. “So I think it’s going to be many years to get it to [a more liquid] state.” It will take time because a clearinghouse simply can’t afford to take on swaps it can’t trade out of quickly in a market meltdown. ICE Trust’s Edmonds says there’s a larger universe of CDSs that his firm can clear over time — about 300 single names, versus the 89 it handles today — but this will involve getting regulators more comfortable with the potential risks. “We don’t believe the high-yielding CDS names are as risky as some of the regulators have defined them,” he says. “We think it’s an issue of price transparency, and we can help with that.” That may be wishful thinking, depending on how tough regulators get as they develop far-flung rules covering liquidity, membership and the many other issues that will shape the future of clearinghouses and, importantly, the safety of the market. It is still unclear how effective regulators can be in making the derivatives market liquid, transparent and less risky — not to mention how they will tackle the onerous job of policing hundreds or thousands of new clearinghouse members and client entrants in coming months. Gensler says the CFTC will probably have hundreds of swaps dealers to register, doz-
ens of swap execution facilities and some additional clearinghouses to process, and will have to regulate those it already has in a new way. He also anticipates having five to ten swap-data repositories for price and transaction monitoring. “We’re going to have a lot more registrants and a lot more to do,” he says. It’s hard to imagine bank dealers passively sharing their shrinking pie with newcomers that regulators let through the clearinghouse door. Certainly, history is littered with stories of Wall Street dealers that have found ways to prevail against the odds when it came to protecting their turf. Two years ago, for example, the derivatives exchange Eurex (owned by Deutsche Börse and SIX Swiss Exchange) launched a CDS futures platform in Europe, but it failed to get any traction because it didn’t get support from the dealers, says one exchange trader who worked on the project. In 2008, CME attempted to launch FXMarketSpace, a forex trading platform that failed because the dealers killed it, contends the exchange trader, who spoke on condition of anonymity. And, of course, dealers helped derail CME’s effort to launch a trading platform with Citadel. So while most market participants agree that clearinghouses will likely lower derivatives risk by bringing more collateral and transparency to the system, there’s potential for the bigger plan to unravel — that is, the plan to protect the market from another derivatives-linked meltdown. After all, even after the CFTC and SEC write their rules, Gensler will have to go hat in hand to Congress looking for fresh funds to hire some 400 new professionals. With budget cuts in the air following the recent midterm elections, getting that funding is far from certain, and without it, Gensler and the CFTC will face a serious problem policing their vast new territory. And even if the CFTC manages to hire everyone it needs, it still faces an uphill battle. After all, Wall Street has been chastened many times before, only to find new ways to beat the system. It’s Wall Street’s knack for reinventing itself, as much as anything else, that the CFTC and the SEC will need to watch in coming months. •• Comment? Click on Risk/Tech/Regulation at institutionalinvestor.com. INSTITUTIONALINVESTOR.COM
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continued from page 69 at least in the West.
Intellectually, most Western central bankers resist the idea of administrative controls as inherently anti–free market.The Bank of England imposed a ceiling on bank lending, known as“the corset,”in the 1970s in a bid to contain inflation, but the Thatcher government discarded that as one of its first market liberalization moves in the early 1980s. The idea of turning the regulatory clock back to the ’70s is anathema today, says former supervisor Green. Targeting specific sectors for lending restraints also risks a political backlash. In May the Bank of Israel was attacked for keeping young couples out of the housing market after it told banks to set aside loanloss provisions for mortgages in which buyers made down payments of less than 40 percent. In 2006 the Federal Reserve sought to slow commercial real estate lending
The ultimate central bank tool, of course, is setting interest rates. The Fed, the ECB and others raise rates in good times to slow the economy and contain inflationary pressures, and lower them in bad times to promote borrowing and growth. But the idea of using interest rates to promote financial stability is the biggest area of controversy among policymakers. The consensus view, espoused by Greenspan and Bernanke, is that interest rates are too blunt a tool to be used to restrain credit. Bank of England chief economist Charles Bean presented a paper in August at the Kansas City Fed’s annual conference in Jackson Hole,Wyoming, that asserted that to dampen house price growth early in the boom, the Fed would have had to begin hiking rates in 2003, one year earlier than it did, and would have had to boost them to a peak of 7.5 percent in 2006, 2.25 percentage points above the actual high point. Such a policy would have had some impact on housing — home prices would have peaked 7.5 percent lower than they actually did — but it also would have reduced the economy’s output by 3.3 percent over the period. Few central bankers find that trade-off attractive. Even officials at the ECB, which unlike the Fed doesn’t have a mandate to promote growth and views credit expansion as a potential harbinger of inflation,
“Ultra-low interest rates are no free lunch. Maybe there are benefits, but there are certainly costs. Do the benefits outweigh the costs? I don’t think they do.” — William White, OECD
because of concerns about overexposure among small and midsize banks.“There was so much blowback, including from members of Congress who said,‘What are you doing? This is perfectly good lending,’” says Donald Kohn, senior fellow at the Brookings Institution, who was vice chairman of the Fed’s Board of Governors at the time. The Fed ended up watering down its stance to merely issuing guidance to supervisors to scrutinize banks more closely if commercial real estate lending exceeded 300 percent of capital. The problem with macroprudential tools is that“it will be very, very difficult to push the button in good times,”says the BIS’s Caruana. INSTITUTIONALINVESTOR.COM
caution against using interest rates to prick asset bubbles.“Monetary policy is not going to be compromised by pure financial stability considerations,” says the ECB’s Constancio. Still, the heavy costs of the financial crisis and the fact that it followed a period of exceptionally low interest rates by the Fed are convincing more economists and policymakers that central banks should lean against the credit cycle in setting rates. The OECD’s White has been pushing that view since 2003. He contends that very low rates fuel speculative activity, cause the misallocation of capital — for example, to unsustainable housing booms — and create
an expectation among investors that the central bank will bail them out in times of trouble.“Ultra-low interest rates are no free lunch,” he says. “Maybe there are benefits, but there are certainly costs. Do the benefits outweigh the costs? I don’t think they do.” Yale’s Roach puts it even more bluntly. “What I want is a Fed that’s willing to impose a sacrifice on the U.S. economy if the financial stability mandate is violated,” he says. Sure, higher rates might have slowed the U.S. economy’s growth rate to about 2.75 percent from 3.5 percent, he acknowledges, but that’s a price worth paying.“The alternative is the 10 percent unemployment rate we have today,” he says. No Fed official talks about financial stability in those terms, but increasingly there are signs that some key members are open to leaning against the credit cycle in setting interest rates. In a recent speech to the National Association for Business Economics, vice chairman Janet Yellen said the Fed shouldn’t rule out raising interest rates to curb credit booms, a view that the New York Fed’s Dudley shares. “I would not want to argue that it is never appropriate for monetary policy to take into account its potential effect on financial stability,” Yellen said. “Regulation is imperfect. Financial imbalances may emerge even if we strengthen macroprudential oversight and control.” The crisis has changed the thinking of many central bankers, and the establishment of new bodies like the FSOC promises to elevate the importance of financial stability considerations. But changes in actual policy are likely to evolve at a very slow pace. Many central bankers worry that there isn’t yet a broad enough social consensus in most Western countries for restraining credit in the name of financial stability, notwithstanding the crisis and its painful aftermath. It took the ravages of 1970s inflation, and the determination of former Fed chairman Paul Volcker, to persuade most people that central banks should concentrate on fighting inflation.“It took decades to get a consensus on price stability,”Jean-Pierre Landau, deputy governor of the Banque de France, told the Chicago Fed conference.“Maybe in 40 years we’ll have the same kind of consensus on financial stability.” •• Comment? Click on Banking & Capital Markets at institutionalinvestor.com.
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CHINA
continued from page 73 economy, and it may
pass the U.S. in the next 20 years. “We may be on the verge of a financial revolution of truly epic proportions,” he adds. BUT UNTIL THAT EPIC TIME, COMPA-
nies that want to get quick clearance from China’s foreign exchange administration should avoid projects in real estate and steel — categories in which authorities are wary of hot money chasing speculation —and investment in restricted areas such as China’s defense contractors, says Derek Sulger, a founding partner at Shanghai-based Lunar Capital Management, a private equity firm that has $225 million in assets under management. “There’s no problem in getting approval to remit into China for businesses classified as ‘allowed’ or ‘encouraged,’” he adds, noting that his firm is managing investments in eight Chinese private companies. “The process takes 30 to 90 days and is generally straightforward.” Another variant of RMB-denominated debt, known as panda bonds, permits foreign issuers to raise capital within the mainland. Leaders in Beijing so far have allowed only two foreign firms — the ADB and IFC — to issue pandas. Since 2005 the IFC has issued two bonds, raising a total of 2 billion yuan; the first has a ten-year maturity and a 3.4 percent annual coupon rate, and the second has a seven-year maturity and yields 3.2 percent. The ADB also raised 2 billion yuan through two bond issues, the first in 2005 with a ten-year maturity and 3.34 percent annual coupon rate and the second in 2009 with a ten-year maturity and 4.2 percent rate. “We fully intend to broaden the panda bond experiment beyond just multilateral development agencies,” said China’s central banker, Zhou Xiaochuan, at an Institutional Investor conference in Beijing on November 16.
For now dim sum seems a quicker bet. Why? China wants Hong Kong to prosper as China’s offshore RMB trade settlement center, says Sundeep Bhandari, regional head of global markets in northeast Asia at Standard Chartered. “Chinese companies seeking public listings strengthened Hong Kong dramatically in the 1990s,” he notes. “RMB bond sales could have a similar effect in the years ahead as many foreign companies hoping to expand in China will seek to raise such bonds in Hong Kong.” Already, companies are advancing the McDonald’s model. Emil Nguy, chairman of Hong Kong–based hedge fund Income Partners Asset Management (HK), says he is working with such banks as Deutsche Bank and Standard Chartered to raise up to $1 billion for a fund dedicated to investing only in RMBdenominated products. “We believe there’s definitely high demand for this fund,” says Nguy, who is targeting global institutional investors and high-net-worth individuals. Shanghai, Hong Kong’s main competition for foreign investment, has its own RMB plans. Hu Ruyin, head of research at the Shanghai exchange, confirms that his bourse is planning to allow foreign compa-
have been eager to get involved in renminbi cross-border trade,” says HSBC’s Qu, who predicts that at least half of China’s trade flows with emerging-markets countries could be settled in renminbi within a few years, up from less than 3 percent now. Further, predicts Qu, nearly one third of China’s total trade could be settled in renminbi by 2015. “The renminbi trade settlement scheme is triggering a chain reaction in China’s capital markets,” Qu wrote in his landmark November report, “The Rise of the Redback.” As he explained: “Rising demand for the renminbi overseas is smoothing the path for Chinese corporations to invest abroad with the renminbi. As renminbi trade revenue accumulates outside China, so too will the path be smoothed for foreign companies wishing to invest in China with the renminbi.” No doubt there are obstacles, not least the possible disintegration of China’s powerful economic engine. “There’s talk about China’s economy collapsing in heaps of bad debt, due to speculative high real estate prices,” says AMP economist Oliver, who visits China’s
“We see the rise of the ‘redback.’ If there is to be a rival to the dollar as the world’s reserve currency in the 21st century, it surely must be the Chinese renminbi.” — Qu Hongbin, HSBC Holdings
nies to list foreign shares in the near future. “China is aiming to be an economic giant,” Hu says. “To be an economic giant, China must also be a financial giant. To be a financial giant, China must have open capital markets that are integrated with the world.” Also on the drawing board: provisions to allow foreign branches of Chinese financial institutions to issue RMB-denominated offshore investment products. Bank of China International Holdings, China Construction Bank Corp. and Citic Securities International Co. may be permitted to offer everything from structured products to index-linked investment funds. “It will be another milestone in the process of RMB internationalization,” says Citic Securities’ Hu. “Sniffing the potential for business, banks — especially multinational ones —
major cities regularly. “I see no signs of an impending collapse. I see signs of rising house prices, but I don’t see toxic debt like those that exist in the U.S. Most Chinese paid huge down payments for their properties. There is no oversupply, not with a population like China’s. I think the China story will keep rolling on.” Oliver recounts his visits to a recently opened shopping center in Beijing. Two years ago the shops were empty, while today “every shop has two to three people in it.” Not surprisingly, there’s no dollar menu at the outlets with the Golden Arches. At this home of the Big Mac, the yuan is king. •• Comment? Click on Global Markets at institutionalinvestor.com. INSTITUTIONALINVESTOR.COM
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CUBA
continued from page 81 a friend will stanch a leak in the 20-foot-high ceilings and repair the wooden window shutters that have been lashed by tropical storms. Repilado became an innkeeper through luck, skillful bargaining and a Rolodex of foreign contacts. With aging parents and aunts to care for, he traded his own small apartment and theirs for the large duplex apartment, which had been occupied by a friend whose growing family required more than one residence. This is the usual horsetrading that goes on in Cuba, where there is no legal right to sell one’s dwelling and where there has been almost no urban residential construction for 50 years. Repilado’s relatives moved in with a bounty of heirlooms that later turned his B&B into a comfortable living museum of armoires and tables with matching carved wood chairs, European paintings and sepia photographs, porcelain statuettes and alabaster chandeliers. After his parents and aunts died, Repilado began to offer free lodging to foreign theater colleagues. When a 1985 government decree authorized a limited number of B&Bs in private homes, he opened his residence to paying guests recruited through the grapevine of his acquaintances abroad. Now there are 138 B&Bs — known as casas particulares — in Havana and more than 200 nationwide, according to the Casa Particular Association. But few have lasted as long as Repilado’s. In a country where hardly any innkeepers speak foreign languages, his serviceable English has allowed him to expand his guest list to Canadian, British and even U.S. travelers. Only a robust occupancy rate enables Repilado to survive the onerous taxes and fees that scuttle dozens of casas particulares every year. Like other guesthouse keepers, he hopes the government’s reforms will include lower fees and taxes.“But until now we have heard nothing,” he says. He must pay the INSTITUTIONALINVESTOR.COM
government about $300 a month in guesthouse fees regardless of how many clients arrive. And taxes rise steeply depending on his occupancy rate. Other casas particulares are known to underreport income or secretly rent unauthorized rooms.“But I’m not going to do anything that is against the law — it’s just not worth it,” says Repilado. Determination and serendipity in the face of a hostile state bureaucracy have also been keys to success for restaurateur Omar González Rodríguez. Lean, angular and white-haired, the 64-year-old González bears an uncanny resemblance to the late Gregory Peck in the lead role of Old Gringo, which is why he named his Havana restaurant after the 1989 film based on the Carlos Fuentes novel.“We met when Mr. Peck came to Cuba for a film festival, and he did say we looked like each other, except he was a head taller,” recalls González. González opened Gringo Viejo 15 years ago in a basement in Havana’s Vedado neighborhood, right after a 1995 decree allowing entrepreneurs to go into the restaurant business.These private restaurants, known as paladares (from the Spanish word for “palate”), were permitted only 12 seats each and had to be located in the owner’s home and staffed only with family members.They were prohibited from serving lobster and beef, which were available only in state restaurants catering to foreigners. Taxes were steep and have continued upward, ensuring that the government takes well over half of reported profits. Little wonder that after reaching a peak of more than 200 paladares a decade ago, the number has dropped to fewer than 100 today. González has made the most of his cramped, windowless dining space.The room is unexpectedly splendid, lined with photographs of prominent diners and a poster of Peck in Old Gringo. There are exposed racks of imported wines against the walls. A flatpanel television above the bar plays a video of Aretha Franklin belting out “Respect.”The menu offers dozens of main courses, mostly pork and chicken dishes. All the clients are foreigners, including a Chinese family, an Italian couple and two German friends.At the equivalent of $15 to $30 a meal, Gringo Viejo is far beyond the reach of ordinary Cubans. González was a graphic designer by training and made a living by producing handmade sandals and wallets as well as metal sculptures, one of which hangs in his paladar.
The dining area used to be his workshop, in the basement of his home. “At night friends would come by because they knew there was always a bottle of rum,” says González. When the decree permitting private restaurants was announced, González opened his paladar with encouragement from his friends. He hired his son as bartender, his daughter as chief waitress and other relatives as cooks and assistant servers. González himself enrolled in cooking and wine-tasting classes. His idea was to infuse traditional Cuban dishes with European and Asian ingredients. Today one of Gringo Viejo’s most popular entrées is a typically Cuban pork cutlet topped with fried quail eggs and a soy-based sauce, with flash-fried bok choy and bean sprouts on the side. “I’m always experimenting with recipes, and then I turn them over to the cooks,” says González. A government decree issued in October allows paladares to expand to 20 seats, hire employees who aren’t related to the owner and, finally, serve lobster and beef. But the measures don’t evoke much enthusiasm among private sector advocates. “They are just enough to survive,” says Baruch College’s Henken. “Obviously, the government doesn’t want paladares to become full-scale restaurants and compete against the state.” Becoming too well known and successful can incite a government backlash. Only last year the authorities shut down one of the top paladares, El Hurón Azul, because the owner had purchased forbidden luxury imports, including a refrigerator and a stove. González is savvy enough to navigate these political shoals. But he does complain that it is hard to compete with government-owned restaurants that have no capacity restrictions and lower costs. He is optimistic, however, that the government will expand its tepid reforms.“Joblessness will push the growth of paladares,” he predicts. His son, the bartender, is already planning to start his own tapas bar. For now, González would be content if he was permitted to expand his paladar to the cramped terrace, located between the street and the basement entrance, to accommodate a barbecue grill and a smoking area.“After a meal, people should be allowed to enjoy a good Cuban cigar,” he says. •• Comment? Click on Global Markets at institutionalinvestor.com.
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LINA CHEN
Painful Medicine
INEFFICIENT MARKETS UNCONVENTIONAL WISDOM THE
businesses use to discount future cash The Fed’s latest round of quantitative easing could have flows — making future cash flows some unpleasant side effects. more valuable BY VITALIY KATSENELSON today — and that is what the Fed is betting on. In practice, however, the fickle source of lowered interest rates is not lost on businesses. Rising debt on government and Fed balance sheets and overheating moneyprinting presses OVER THE NEXT don’t generate confidence eight months, the about future cash flows. High Federal Reserve will government debt eventually conduct QE2 — leads to higher taxation, higher quantitative easing, interest rates and lower growth. the sequel — buying So the Fed’s action may have $600 billion worth of long-term an impact opposite to what it Treasury bonds in the open intends. Also, at some point market. That’s close to 7 perquantitative easing will have cent of all Treasuries in public to be followed by quantitative hands, or about the amount of uneasing, as the Fed will have to debt the U.S. government will sell all those bonds (unless they issue during that time period. are held until maturity), which The Fed has already taken will bring higher interest rates. short-term rates down to QE2 is like a drug prescripzero, pushing income-seeking tion that comes with a list of investors and savers to higherside effects that are often worse yielding, higher-credit-risk, than the disease it is supposed higher-duration-risk bonds. to treat. It is difficult to know all Now, with the magic of the side effects and unintended QE2, the Fed wants to drive consequences of QE2, but it may long-term rates down to result in a substantial decline in heretofore-unseen levels and the dollar, stagflation and lower economic growth. Paradoxipush investors in any Treasurcally, QE2 may actually result ies toward higher-risk assets: in much higher interest rates — junk bonds, real estate, stocks investors expecting much higher and commodities. The Fed also hopes (all it can do at this point) inflation will demand them. that low interest rates will The Fed’s manipulation of nudge businesses to invest and interest rates creates a longto hire. That’s unlikely. term problem for the economy. The value of any asset is the Because rates are set behind present value of its future cash closed doors by the 12 members flows. In theory, lower interest of the Federal Open Market rates decrease the number that Committee, the free market is INSTITUTIONALINVESTOR.COM
not allowed to discover what interest rates should be. The result is not that different from what’s happening in China, whose Communist government has been under attack by Western politicians, the media and even yours truly for manipulating its currency. We are all well aware that the renminbi is undervalued relative to the dollar and the euro, but the Chinese government won’t let the free market know by how much. Government intervention (be it Chinese or U.S.) creates excesses that are not allowed to self-correct and thus lead to bubbles. QE2’s possible success worries me more than its failure, because it will come with all the side effects I just mentioned, plus newly created stock mar-
“ ”
QE2’s success worries me more than its failure.
ket and real estate bubbles. The paper wealth created by these bubbles will vanish when they burst (as bubbles always do), wealth will be destroyed, and consumers will find themselves further in debt. The Fed could take a lesson from Japan. From 2001 to 2006 the Bank of Japan pursued its own version of QE, creating a bubble in Japanese bonds that deflated, but failing to lift the economy out of stagnation. Unlike the Fed, the Bank of Japan recently stopped hiding its
true intentions of propping up the equity market, announcing that it will be buying Japanese exchange-traded funds and real estate investment trusts. Unfortunately, the Fed’s toolbox is missing a must-have instrument to fix the current problem: the “do nothing” tool. This very important tool would let the economy heal itself, even if unemployment stayed at 10 percent for a while and housing prices declined to their true level. However, such a scenario is unlikely because it requires pain, and Americans have little tolerance for pain (after all, the most prescribed drug in the U.S. is the narcotic Vicodin, a painkiller). This is why, regrettably, as the effects of QE2 wear off (assuming they succeed at all), they are likely to be followed by QE3, QE4 and so on. The U.S., like Japan, will be trapped in an environment of low rates. If the Fed succeeds and creates a bubble in stocks and other asset classes, investors’ true time horizons and discipline will be put to the test. But when the bubble bursts, the money will flow to its rightful owners. The Fed doesn’t want you to be in cash; it wants you to reach for yield and speculate — but don’t. In the absence of good investment opportunities, the worst thing you can do is take advice from the Fed. •• Vitaliy Katsenelson is CIO at Investment Management Associates in Denver and author of The Little Book of Sideways Markets. Comment? Click on Global Markets at institutionalinvestor.com.
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INEFFICIENT MARKETS
UNCONVENTIONAL WISDOM THE FUTURIST THE CHARTIST C
LINA CHEN
Pardon the Disruption
sive. They are not. Many alternative Hedge funds are just one more investments simply technological innovation that deliver a more should improve the asset refined expression management industry. of the same risk BY CHRISTOPHER HOLT factors found in traditional actively managed investments. By distilling these risk factors, alternative investments are like technologies that allow investors to construct morecustomized and, in many cases, moreTHE MASS MEDIA’S optimized portfolios. interest in the hedge This isn’t the first time that fund industry has new technologies have enabled exploded over the such a fundamental reorgapast few years. Invari- nization of industries. In the ably, the coverage has mid-1930s a young economist focused on the absolute outper- traveled from England to formance or underperformance the U.S. to study a seemingly of hedge funds and other simple question: Why does alternative investments — as if the corporation exist? After asset management were a horse researching some of America’s race between traditional invest- largest companies, he conments (long-only equities and cluded that corporations exist fixed income) and alternatives to manage business processes (hedge funds, private equity, that are simply too difficult or real estate and commodities). expensive to coordinate on the This black-and-white narra- open market. That economist was Ronald Coase, and he tive has broad appeal because it pits the familiar against the went on to win the 1991 Nobel unfamiliar — the safety of Prize for economics. Coase found that as new crowds versus idiosyncratic risk. But asset management is technologies reduced search not an either/or proposition. and transaction costs, periphInstitutional investors know eral business processes could be outsourced. The emergence of this and have maintained their allocations to alternaa rubber industry, for example, allowed early-20th-century tive investments in the face of redemptions by retail investors. automotive companies to The dissonance between sell their rubber plantations. institutional and retail invesSimilarly, technologies such tors has its roots in a popular as the telephone, computers misconception that alternative and eventually the Internet and traditional investments effectively eroded the gravare somehow mutually excluity holding the corporation INSTITUTIONALINVESTOR.COM
together. The result was what authors Alex Lowy, Don Tapscott and David Ticoll have called the “business web” — a loose federation of companies assembled on an ad hoc basis with a bespoke objective. The emergence of a vibrant alternative-investment industry has had a similar impact on institutional portfolio management. Investors can now assemble the risk exposures that best match their own liabilities, best reflect their own market views or are delivered by their preferred alpha-creating manager. As refined sources of beta, exotic beta and alpha, alternative investments essentially deliver the off-the-shelf components that allow investors to create their own value propositions rather than buy what
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Convergence will define the coming decade.
amounts to a prepackaged and somewhat arbitrary combination of risk factors delivered by traditional active management. Asset managers are responding to this opportunity by broadening their product suites. Traditional asset managers now offer hedge funds and hedge-fund-like products, while alternative managers are complementing their offerings with long-only products. This has resulted in pressure on hedge fund firms. Just as e-business transformed from a set of stand-alone dot-coms
into a ubiquitous business process, so too is the alternativeinvestment sector changing from a set of pure-play hedge fund companies into just another line of business at generalist asset management firms. Many agree that this convergence of traditional and alternative will define the coming decade in the asset management industry. Policymakers have added fuel to this trend by taking tentative steps to bring alternative asset regulation in line with traditional asset regulation. Institutional investors have begun to organize themselves around common risk factors instead of superficial labels such as “hedge funds” (witness the ongoing debate at CalPERS about the appropriate classification for hedge funds). Even compensation schemes have begun to converge as institutional investors have put pressure on hedge fund fees. Despite the mass-media narrative, alternative investments cannot and should not be viewed as either better or worse than traditional investments — regardless of their relative performance. Instead, they should be seen simply as a technology that drives the ongoing evolution of portfolio management by disrupting the status quo. And, as history shows us, that’s always a good thing. •• Christopher Holt is director of the CAIA Institute, a research initiative of the Chartered Alternative Investment Analyst Association. Comment? Click on Exchanges & Trading at institutionalinvestor.com.
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UNCONVENTIONAL WISDOM
THE FUTURIST THE CHARTIST CONTENTS INSIDE II TICKER FIV
Fair Pay BY JEFFREY KUTLER
BANKERS BY NOW
are pretty much resigned to suffering the punitive consequences of the great meltdown. Capital, liquidity and leverage requirements will tighten, some trading activities will be constrained, and prudential supervision will ratchet up. But for some executives, the postcrisis scrutiny of — and potential restrictions on — how they are compensated still stings. While they may be ready to accept and comply with, for example, the U.S. Dodd-Frank Act’s shareholder “say on pay” provisions, and with even further-reaching U.K. and European rules and guidelines that are to take effect soon, high-ranking financial industry executives bristle at government intervention in an aspect of their jobs that they have always regarded as a free-market prerogative. The distortions and excesses of the recent bubble are undeniable. “Conflicts of interest and the way CEOs are compensated are at the heart of this financial catastrophe that has wiped out trillions of dollars in assets and millions of jobs,” Hershey Friedman, professor of business and marketing at Brooklyn
College, and Linda Friedman, professor of statistics and computer information systems at the Graduate Center of the City University of New York, wrote in the summer 2010 issue of the Capco Institute’s Journal of Financial Transformation. The prevailing ethic was “as long as there was money to be made, virtually no one said anything” about downside risks in the housing market, the collapse of which reverberated disastrously around the world. John Taft, CEO of Royal Bank of Canada’s U.S. wealth management business and chairman of the Securities Industry and Financial Markets Association, concedes as much: “I think most people would acknowledge that poorly designed compensation was a contributor to the excesses that got us into trouble.” At Sifma’s annual meeting in November, U.S. Securities and Exchange Commission chairman Mary Schapiro said,“Compensation based on short-term numbers has to change.” But what is the appropriate and effective policy response to inappropriately outsize pay? Will the Dodd-Frank-mandated disclosure of the relationship between total CEO compensation and the median of all company employees, or the U.K. tax on bank bonuses, abolish bad behavior and better align the incentives of executives with the interests of their marketplaces and shareholders? Such measures bring no guarantees, because there is no defined connection between the
sanction and the desired outcome. Short of direct governmental control over wages — a nonstarter virtually the world over — compensation is an elusive target. It is tied to, among other tangible and intangible factors, politics and behavior, which are hard-to-regulate aspects of human nature. “At some point, you have to fall back on the character of the people involved in running financial institutions and the culture of those organizations,” says Taft. “You have to rely on them not to reward behavior that is excessively risky. That is not to say that compensation can’t be better designed.” The professors Friedman asserted in their study that “the global financial crisis would not have occurred if executives
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Compensation based on shortterm numbers has to change. — Mary Schapiro, SEC
were truly ethical.” If compensation is not easy to legislate, then ethics is surely impossible. There are indications, too, that policymakers missed some key subtleties. René Stulz, who holds the Everett D. Reese Chair of Banking and Monetary Economics at Ohio State University, and Rüdiger Fahlenbrach, Swiss Finance Institute assistant professor at École Polytechnique Fédérale de Lausanne, published a paper in July 2009 exploring the “poor-incentives explanation of the crisis.”They
“uncovered no evidence supportive of the view that better alignment of incentives between CEOs and shareholders would have led to better bank performance.” John Core and Wayne Guay, accounting professors at the Wharton School of the University of Pennsylvania and avowed skeptics of proposed compensation regulations’ ability to achieve their objectives, wrote in January 2010 that “current regulations are based on arguments that U.S. CEO pay is too high and performance incentives too low” — assertions that “do not appear wellsupported by evidence.” University of Minnesota Law School professor Richard Painter is no less convinced that a lopsided incentive system is implicated in poor management quality and decisions, but he favors a behavior-based corrective. Collaborating in research with law school colleague Claire Hill, Painter proposes making highly paid employees personally liable in cases of insolvency and deferring pay in the form of assessable stock that would be exposed to company failures. “I would just federally require it,” says Painter. Short of that, clients or corporate governance advocates could push for it. Either way, this wellaimed idea has an elegance that reflexive regulatory reactions have lacked. •• Jeffrey Kutler is editor-in-chief of Risk Professional magazine, published by the Global Association of Risk Professionals. Comment? Click on Risk/Tech/Regulation at institutionalinvestor.com. INSTITUTIONALINVESTOR.COM
LINA CHEN
Create an ethical culture, and reasonable compensation rules will follow.
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TIONAL WISDOM THE FUTURIST THE CHARTIST CONTENTS INSIDE II TICKER FIVE QUESTIONS PEO
INDEX OF ADVERTISERS Arab Bank . . . . . . . . . . . . . . . 9
Franklin Templeton . . . . . . Cover 2
Barcap . . . . . . . . . . . . . . . . . 3 Itau . . . . . . . . . . . . . . . . . . . . 31 Blackrock . . . . . . . . . . . . . . 49
FOCUS SERIES Brazil Report . . . . . . . . 89-95 Cemig CPFL Energia
ITG . . . . . . . . . . . . . . . . . . . . 33 Bloomberg . . . . . . . 27, 29, 52, 53, Cover 3
Kellogg’s . . . . . . . . . . . . . . . 17
BNP Paribas . . . . . . . . . . . . . 4
Prudential . . . . . . . . . . . . 6, 25
CAF . . . . . . . . . . . . . . . . . . . . 51
RBC . . . . . . . . . . . . . . Cover 4
Daiwa . . . . . . . . . . . . . . . . . 11
Sungard . . . . . . . . . . . . . . . 13
China Construction Bank . . . . . . . . . . . . . . . . 21 Harvest Fund Management . . . . 74-77 URALSIB Capital . . . . . . . 67
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VENTIONAL WISDOM THE FUTURIST
Dollar Effect
THE CHARTIST
CONTENTS INSIDE II TICKER FIVE Q
Source: BCA Research (www.BCAresearch.com).
DEPRECIATION OF THE U.S. DOLLAR remains de facto monetary policy of the Obama administration. A weak greenback bolsters America’s manufactured goods for export while punishing many of it trading partners, such as Canada and Britain, because of their relatively stronger currencies. Meanwhile, the country exporting the largest volume of goods into the states, China, rides the U.S. depreciation wave. Its currency, the renminbi, is linked to the dollar, which means that when the dollar swoons China must adjust its reserves to keep the renminbi pegged at the same relative value. From that linkage flows the odd sequitur that a weak dollar creates an artificially cheap renminbi, the currency of the fastest-growing major economy in the world. The impact doesn’t stop there. To stay competitive with China in exports, other Asian nations must intervene to prevent their currencies from rising against the dollar and thus taking their economies out of trade contention. So who are the winners? Clearly, the countries that refuse to play the war games, neither linking nor heavily regulating. Among the pacifists: the euro, the Australian dollar and the Swiss franc, outperformers all. — The Editors INSTITUTIONALINVESTOR.COM
NIGEL HOLMES
The flagging greenback forces Asian nations to intervene to stay competitive.
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