:: The Park Paradigm ::

Markets for the Digital Generation

I have long thought that the gigantic mega-financial institutions of the late 20th/early 21st century significantly overshot the synergies and economies of scale ostensibly underpinning their business model, to find themselves firmly positioned in the realm of diminishing returns and unmanageable complexity. The foundations of this thesis are built on my interpretation of the application of Coase’s Theory of the Firm in the context of massive advances in ICT (Information and Communications Technology) and the business of modern finance. (Indeed, more recently I have articulated this thesis at the Park Paradigm with respect to the specific examples of Citigroup and ABN Amro.)

I’m not suggesting that no economies of scale make sense in banking or financial services more generally, only that they are subsumed by complexity within these ‘integrated’ financial behemoths. I even have some sympathy for the seductive logic underlying integrated business models, however in my view the theoretical benefits of an integrated model - while possibly intellectually robust on paper - are impossible to exploit in reality. It ignores what I describe as corporate entropy: ie in any corporate process there exists an inherent tendency towards the dissipation of useful energy.

Indeed - sticking with the chemical analogy and without writing a book about it - it would be fair to say that giant bank mergers are at best an (intrinsically unstable) intermediate product in the reaction coordinate and to make any sense need to be followed by a subsequent division into multiple new end products (which individually release the benefits of economies of scale and synergy without the instability engendered by excessive complexity.) So Citigroup (or UBS or HSBC or RBS/ABN Amro, etc…) should naturally “decay” to form multiple specialist firms that are more focused and efficient than the multiple firms that had been combined first to form these giants. Until now however, it seemed that my point of view was not shared by many (any?) of the leaders of these mega-institutions, nor more generally by senior executives in the industry.

So I hope you will understand why I was exhilarated to read Luqman Arnold’s recent letter to the Board of UBS, in particular his thoughts on the integrated model:

Still, there are two clear disadvantages of the integrated model:

• Increased complexity, which places a greater demand on the competence of the Board and management, as has been amply demonstrated by the proprietary trading losses
• Conglomerate and complexity valuation discount and potential contamination of the valuation of the most valuable business, Wealth Management, by the lower rated and more volatile business, Investment Banking.

I’ve never had the pleasure of meeting Mr. Arnold but the little I know about his new venture Olivant (gleaned almost entirely from press coverage and their website) lead me to believe that we share (at least some significant) views of how both to best structure what I would call a modern merchant banking operation - combining operational advice with investments - and the latent problems and opportunities of the current financial services industry paradigm.

Share This

I have to admit I am not exactly shocked that the Park Paradigm isn’t required reading in Redmond. In fact I’m not even sure it renders in IE. (Do you get fired - or worse - if caught using Firefox at Microsoft?) But obviously Steve B. and his non-exec boss Bill G. have either not read my back-of-the-envelope suggestion on what to do with the company, or have chosen to ignore it. Perhaps they had a look, called up a couple of their favorite bankers, and were put off by the fact they hung up when asked to price up a $100bn term acquisition facility… (Fair enough, December 2007 was always going to be a tough month to cobble this kind of deal together. )

So instead of making the company leaner, more focused, less complex, easier to manage and more appropriately capitalized, they decided to go a different way. More bloat, less focus, more complex, harder to manage and inefficiently capitalized. Hey why not? It’s a plan.

Since writing my suggestion in October, Microsoft has announced the acquisitions of Multimap, Fast Search and now Yahoo. The first two of these three fit the typical Redmond acquisition m.o. :

…Microsoft’s problem isn’t that they have bought bad companies with bad technologies at bad prices. Mostly just the opposite. There are a lot of very smart people at Microsoft, starting at the top. They have bought many really interesting companies with really neat technologies and incredibly smart people. And then they kill them. They don’t mean to. But it is unavoidable. The corporate antibodies in a giant like Microsoft inevitably end up overwhelming the acquisitions (which especially given that by the nature of the industry, most are very young and very fast growing, innovation-driven companies that have not had time to evolve any defenses against mature mega-corporation antibodies. Don’t feel bad Bill, it’s not a Microsoft thing, it’s a Fortune 100 thing. The nature of your business (technology) just exposes you more is all.

The Yahoo acquisition is a bit different, both in scale (ie needle moving, not just a couple weeks free cash flow) and in the sense that it is a mature, struggling big(gish) company (as opposed to a fast growing entrepreneurial start-up); in many respects similar to Microsoft (with the small difference of not having a Windows/Office cash cow equivalent puking money week in week out.)

So is the Yahoo deal fundamentally dumb? Not necessarily. Indeed it isn’t by any means a complete surprise given previous approaches and widespread speculation and commentary on the idea. (I admit to having traded small amounts of Yahoo from the long side over the past 9 months or so basically looking to bet on this deal. I am somewhat pissed off that I was not in the trade when it actually happened.) The logic in this merger is less typical Silicon Valley and more Rust Belt in the sense that it is two mature ex-growth companies with leading market positions looking to rationalize - combine cost centres, share customers, extract “synergies” of course - and to generally give management something to keep busy with for a few quarters so they don’t have time to worry about strategy. Clearly Microsoft and Yahoo have many complimentary, overlapping and duplicative products and technologies so the scope to do some worthwhile and value producing old fashioned consolidation and restructuring is definitely there. For instance, I suspect it would make a lot of sense to use Fast technology for all of their search products going forward.

So fine buy Yahoo. My previous advice stands. In fact it becomes even more pressing - more complexity to unwind, more assets to regroup intelligently and spin off before they are completely absorbed in the giant corporate goo. That said, the numbers won’t look as good (except to the lucky Yahoo shareholders who have been bailed out.) But hey that’s what happens when you pay $45bn for $700mn of earnings and crummy operating cash flow. Which is of course what happens when you have money burning a hole in your proverbial corporate pocket because of a ridiculously under-leveraged capital structure…

One of the reasons I think the Microsoft situation is so interesting is that it is a particularly good metaphor for the “paradox of growth” facing many (most? all?) giant mega-corporations, including - and perhaps more relevant to many of this blog’s readership - the world’s financial services giants (banks, insurance companies, securities firms, exchanges, etc….) Citigroup may be the current poster child for this but this should be cold comfort for many of their peers and competitors. The single-minded pursuit of growth eventually always runs up against the law of large numbers. I figure it boils down to two fundamental limiting factors - diminishing returns on scale and exponentially increasing management complexity.

The optimal size (past which these limiting factors start reducing value faster than growth adds value) will of course be different by industry and activity and even by firm, but will exist all the same. Once this point is reached, it behooves management - and I would say especially the non-executives who are by definition supposed to be able to see the forest for the trees - to react and adjust accordingly. This could be by divestitures, de-mergers, recapitalisations, etc. Unfortunately for many reasons, the management of public large-cap companies typically are geared only to “go forward” and this type of behavior is too often an anathema. Indeed some of the great successes of private equity have imo been due to their ability to manage without concern for growing any line except the return-on-capital-employed line, and so to dispassionately dismantle overly complex and wrong-sized companies.

So should I buy Microsoft shares? If there was a chance that Bill & Co. would implement some variation or other on my suggestion, I would say yes. If they continue with business as usual? No way. Probably a reasonable short. Maybe the right position is short the underlying share and long OTM calls? Is this the right position to have in [fill in favorite large financial institution here] as well?

Share This

A couple days ago I was travelling and so had time to read the FT in some detail, including the extended reporting on the ongoing Northern Rock saga and in particular the government guaranteed refinancing scheme floated by GS/the Chancellor. Basically, the idea is to refinance a big chunk of Northern Rock’s assets via a bond issue secured on these assets, enhanced with an explicit government guarantee. Many commentators have questioned this solution as a (bad-for-the-taxpayer) compromise between nationalization (politically embarrassing to Brown) and an entirely private solution (highly risky, with failure a real possibility and so equally politically embarrassing.) The quick-and-dirty analysis is that in this scenario, the government keeps all the (financial) downside, but gives up the upside if the rescue/restructuring is successful. The fact that the plan seems to include warrants (or some similar provision) for the government tacitly endorses this view (while hardly mitigating the potential outcome.)

Rather than dwell on the overall pros & cons of the proposed plan (which has been amply and eloquently done in many other places,) I just wanted to take a moment to take issue with the likely details of how such a structure would be executed. As it stands, it would seem a bond (or series of bonds) maturing in 3 or 4 years would be issued with a government guarantee. I’m not in the market anymore, but read that such securities would likely be sold at around Libor flat, which sounds reasonable and that the issuer would pay the government for it’s guarantee (ie the government is acting like a monoline insurer in this instance.) When the UK Treasury issues bonds directly - ie Gilts - at these maturies, they would be priced at around Libor -70 bps.) S0 for the Treasury to be equally well off, the issuer would need to pay an insurance premium of 70 bps on the amount guaranteed to the Treasury, or in this case c. £600mn. Of course this does not take into consideration whether or not the assets (Northern Rock mortgages, etc.) being financed are ‘good’ risks nor what it would cost to finance them without the government guarantee. Even if you accept the premise that the market is temporarily irrational and that the whole point of this government sponsored refinancing is to bridge this market dislocation, the ‘historical’ market cost of refinancing these assets would be signficantly above Libor flat. This difference should also be factored in to the insurance premium paid to the Treasury.

I hope I am wrong and that the winning package chosen by the Treasury includes a premium that is commensurate with the risks and the extra costs of using the Government’s balance sheet in this way, but my fear is that politics trumps economics and that UK taxpayers will end up taking on a substantial liability without being fairly compensated. Exactly the kind of thing that happens when you start confusing other people’s money (entrusted to you to manage) as being your own.

I hope I am wrong and the bid the Treasury ultimately accepts includes a commercially adequate insurance premium

Share This

The two things (in finance) that interest me most are market structure and capital structure. To date, the discussion on the Park Paradigm has centred far far more around the former. I’ve been meaning for some time now to redress that balance but two (well three if you count procrastination) things have got in the way. Firstly I’m still not sure at exactly what assumed level of knowledge I should pitch the discussion; discussion of capital structure can be somewhat daunting for non-specialists. Not so much because it is intrinsically difficult to grasp but more just in terms of knowing the jargon and having spent the time to learn some basics in terms of the building blocks of finance and what makes up a balance sheet. Secondly because as an “approved person”, regulated by the FSA and working for a large financial institution, I need to be cautious about providing anything that might vaguely be perceived as “investment advice” even though this blog is clearly written in a personal capacity and does not reflect the views or opinions of the firm I work for and nothing I write should be construed as investment advice and these are just my personal opinions and ask your mom before doing anything anyways and I didn’t want to have to append a 3 page disclaimer to every post. Phew…

So to tackle the first issue, I’m going to assume a basic introductory university level knowledge of finance and perhaps lean on wikipedia a bit more than usual to link to definitions, so as not to turn this into a tutorial on basic finance. As for the second point I will emphasize that any reference I might make to specific companies or industries should not be regarded as anything other than personal opinion and that no one should infer any explicit or implicit advice is contained therein.

So disclaimers aside, what was the spark that got me (finally) to have a go? Microsoft. As you all know a company that has been - even more than usually - in the news recently. Specifically I’ll draw your attention to two items: their announced share buyback and an editorial by David Kirkpatrick on Microsoft’s new approach to competition and openess.

David opens with:

In the early years of the U.S. Justice Department’s antitrust assault on Microsoft in the 1990s, I occasionally opined that, for better or worse, Microsoft (Charts) was likely to end up as some sort of regulated utility. I saw Microsoft’s Windows as central to modern life, and believed that something so critical would inevitably come under governmental oversight.

Rob Cox of breakingviews.com sums up the logic behind the buyback thus:

Microsoft has shocked the market with its plans to buy back $20bn worth of its stock in a tender offer next month. The software giant has already returned $23bn to shareholders through dividends and stock buybacks over the past 12 months. And one can’t forget its $32bn special dividend two years ago. It’s pretty clear even the group itself now realises it is ex-growth.

I first started writing this post in July (!) , in the mean time John Plender actually wrote in the FT (with a different spin - ie private equity - but similar underlying logic imo) something similar to what I was going to write (apologies, stupid FT behind a firewall stuff):

Private equity folk could do wonders with Microsoft
By John Plender
Published: August 17 2006 18:54 | Last updated: August 17 2006 18:54
As leveraged buy-outs go, the recently announced $33bn deal to buy HCA, the US hospitals group, is rated the biggest ever. Now, NTL, the heavily indebted European cable group, looks set to go the same way for an eye-popping $20bn. With private equity investors gobbling up bigger and bigger chunks of the corporate world, fuddy-duddies worry that quoted equity will shortly become extinct. The usual party-poopers see a bubble and warn that hubris will soon lead to nemesis. For them, over-ambitious private equity folk deserve their status, shared with hedge funds, as the new bogeymen of the western world.

Anyhow… where was I? What these various commentators are getting at is the following: Microsoft’s capital structure is completely innappropriate for it’s underlying business. It still has the balance sheet (ok slightly less with the buybacks and dividend but still…) of a risky fast growing knowledge-based services company: ie large (enormous) cash balances and equity-only financing. Against this however is a mature and robust (granular and stochastic) business throwing off gigantic and regular cashflows. Corporate finance 101 question: ‘How should such a company be financed?’ Answer: With debt! Now whether that is via on balance sheet leverage (a la Plender’s private equity LBO) or off-balance sheet (securitised - a la bank securitizing the regular cashflows of mortgage or credit card repayments) is a second order question.

Indeed this is the case for any ‘utility’-like business. The problem is I think that there seems to be an irrational aversion to being labelled as a utility…mature. It’s as if the business establishment only values growth companies (and their management.) Obviously this is changing and is (part of) the giant opportunity that folks like KKR and Blackstone and the other giants of private equity discovered and have been feasting on for the past 20 years to the benefit of their investors and the economy alike. But the importance of getting this right goes beyond - in some industries - just having the optimal and most efficient (thus profitable) capital structure. It can fundamentally alter the competitive behavior, for better or worse, of companies.

Indeed I was prodded into finishing this post by reading Gordon’s post on the behavior of US telcos. Here is an example of an industry who’s capital structure is driving nonsensical (at an economy-wide level) behavior. As network providers, even better - regulated - network providers, they should be funded by debt. Indeed, the core infrastructure should be securitized and spun out of the vertically integrated groups. As Gordon points out their rabidly defensive and rent-seeking behavior is a natural if cynical reponse to their business environment and - I would add - their capital structure. With all that equity sloshing around on their balance sheets needing to be fed, they have to extract monopoly type rents via rationing. There is no way to isolate the true cost of the infrastructure from the rest of the balance sheet. The optimal solution is to have a separate network company funded by debt with open-access and - where natural monopolies exist - a regulator to set prices (based on ensuring a decent economic return and continuing investment and innovation.) If that sounds complicated, the UK has been quite successful in implementing this kind of model, for instance in water services. So the question is, when is Guy Hands going to bid for at&t and break it up?

(Comments and criticism welcome, but can I just say up front that I acknowledge my analysis - as presented in this short blog post - is oversimplified and incomplete; basically I ask you to indulge the somewhat shoddy exposition and attack (or endorse) the fundamental idea, for which in contrast I have complete confidence and stand behind fully.)

Share This