Summary of business news and analysis

Hedge fund investor activism and takeovers,R Greenwood,M. Schor, HBS 2007

Key findings:

• Hedge fund activist that that call for an asset sale generate in average the highest returns, both at the announcementdate and in the long run
• Activism actually seems to increase the likelihood that an undervalued target is ultimately acquired
• Activism is mainly focused on smaller firms, normally having little analyst coverage and underperforming relative to other firms in their industries
• With hedge funds growing, targets get bigger
• Hedge funds invest in undervalued companies often clearly with the objective that the targets are bought. Hedge fund returns are biggest if targets are taken over within 18-months of the activist filing
• A longer-term relationship with the target is normally less attractive for hedge funds as those vehicles need to post a high return for their investors within a short time period
• There might be the possibility, as hedge funds have a short term horizon, that they are willing to accept takeover offers that might not fully reflect the overall value of the target

As you know there is an emotional debate in the private equity scene about the taxation of carried interest.

Private equity fund managers normally receive carried interest. This is the the right to a specific share (often 20 percent) of the profits earned by the fund.

Under current law, the managers of most private equity funds pay tax on their carried interests at the 15 percent rate that applies to long-term capital gains, instead of the 35 percent rate that applies to ordinary income. This attracted criticism by political forces who believe that carried interests are a compensation for services and should be taxed as ordinary income.

M.S.Knoll from University of Pensylvania is the first who tried to calculate the impact of a change of tax policy reg. carried interest:

The Taxation of Private Equity Carried Interests: Estimating the Revenue Effects of Taxing Profit Interests as Ordinary Income, M.S.Knoll, Univ. of Pennsylvania Law School, August 2007

The Residential Mortgage Market and Its Economic Context in 2007, Mortgage Bankers Association, January 2007

This link gives access to a report by the Mortgage Bankers Association (MBA) about the mortgage market in the US and international economic trends. It provides valuable statistical data about the development of the US mortgage market. It was published before the subprime loan crisis. A potential increase of delinquency rates is mentioned.
MBA recommends in the report that policy makers should be cautious with policy interactions:

• We would strongly caution policymakers to avoid any regulatory or legislative actions that would impede the ability of the market to respond to changes in underlying economic conditions or continue to be innovative in creating credit solutions for borrower needs. An important role of public policy should be to facilitate efficient markets, as these will ultimately benefit consumers.

The Financial Economists Roundtable (FER) is a group of senior financial economists who meet periodically. The Roundtable focuses on microeconomic issues in investments, corporate finance, and financial institutions and markets, both in the U.S. and internationally. It is a forum for intellectual interaction. The FER distributes statements to relevant policy makers and media with the aim to raise the level of public and private policy debates

In 2005 the FER issued a statement on hedge funds, which might be worth to be read:

Statement of the Financial Economists Roundtable on hedge funds, Stanford, Nov. 2005

In the recommendations the FER comes also to following conclusion:

• "Regulators should vow not to bail out hedge funds. The FER believes that banking regulators should not rescue hedge funds. No one or two hedge funds pose systemic risk, though an individual failure might temporarily disrupt the market. The prospect of free government bail-out insurance creates adverse incentives for speculative behavior. Expressing a no bail-out policy would reduce those incentives. While tail risk is a problem, we do not foresee likely scenarios in which the monetary authority would need to intervene in its capacity as lender of last resort."

In this posts context we also refer to the last contribution of Becker/Posner regarding the question whether central banks should intervene during this financial crisis:

The Becker Posner Blog

How can CFOs create value in uncertain time?, CFO.com, London

• Look at the long term interests of company's stakeholders
• Understand your options regarding cost of equity
• Focus on the long run when making investment decisions
• Get ready for risk by implementing state of the art internal control, education and ethical standards
• Do not follow the crowd

100 fastest growing Tech Companies (CNN Money)

How they were ranked:

• More than 2,000 tech companies that have been publicly traded on a U.S. stock exchange for at least three years, have a market capitalization of at least $50 million, and have had positive operating cash flow over the past 12 months were screened.
• The resulting list was ranked by Zacks Investment Research of Chicago
• Financial criteria used were growth in revenue, profit, and operating cash flow during the past three years, and the 12-month stock return as of Dec. 31, 2006.
• Cash flow growth counts for 40 percent of a company's ranking. Each of the other criteria counts for 20 percent.

”The institutional memory hypothesis and the procyclicality of bank lending behaviour” Allen N Berger, Gregory F Udell, Bank for International Settlement, January 2003

Some key findings:

• Lending activity behaviour appears to be highly procyclical. Lending tends to increase significantly during a business cycle expansion and then fall considerably during a downturn, which likely accentuates the business cycle
• Loan performing problems seem to stay a low levels until near the end of an economic expansions and the to rise dramatically during the subsequent downturn
• The procyclicality of bank lending behaviour may exacerbate the business cycle
• A hypothesis for the cyclical behaviour of lending activity may be that institutional memory deteriorates over time, meaning that bank officers sills decline with time elapsing since that last credit crisis which had to be solved
• In expansion phases the credit standards may be eased which might simultaneously go along with a deterioration in the capacity of bank management to discipline its loan officers
• Further, it may be optimal for bank management and bank stakeholders to allow this to occur in equilibrium, because the imposition of blunt instruments involving raising prices or rationing credit may destroy bank-borrower relationships that might otherwise be very profitable over the long run

Researchers see for example following measures for banks avoiding bad credits:

• Expose junior officers to more loan work-outs early in their careers in order to improve their learning experience
• Banks might allocate more seasoned officers than they otherwise would to loans
  that have not shown problems for a sustained period to look for more subtle indicators of future
  difficulties

“When Do Stock Market Booms Occur? The Macroeconomic and Policy Environments of 20th Century Booms” , Michael D. Bordo, David C. Wheelock, St. Louis Fed, St. Louis, September 2006

The study shows that stock market booms reflect both underlying macroeconomic conditions and specific economic policy action.

• Stock market booms typically arise during cyclical recovery and strong GDP growth
• Many stock market booms were followed by large declines in real stock prices, if not outright market crashes, and a slowing of economicactivity.
• Booms typically arose when inflation was low and declining, and ended within a few months of an increase in the rate of inflation.
• During the interwar period, the timing and extent of stock market booms in several
  countries bore a close relationship to exchange rate policies
• Stock market booms tended to be roughly in sync across countries throughout the 20th
  Century.
• Stock market returns were more highly correlated across countries during boom periods than at other times.
• The average correlation was especially high during the late 1920s and 1980s-90s, when financial markets and capital flows were comparatively unregulated and financial markets were to a high degree internationally integrated
• Stock market booms have been closely related to monetary policies Furthermore, international economic policies, such as capital controls and exchange rate pegs,
  and financial regulation affect the linkages between domestic economic performance and
  stock markets.

"Corporate Finance in the Euro Area", European Central Bank, May 2007

The European Central Bank (ECB) has published a comprehensive study about the Corporate Finance in European countries. The study mainly covers the analyses of the financial position of non-financial firms, having a focus on external financing. It aims at showing the sector and country specific peculiarities.

Some key findings are:

• The introduction of the Euro was an important structural event having affected the financial markets of the Euro area by increasing the size and motivating cross border activity
• EMU has broadened the corporate bond market and increased the size of the equity market
• Financial innovations lead to new products and consequently the role of intermediaries. For example securitization and the increasing use of credit derivatives have caused commercial banks leaving their traditional lenders role and to become originators and sellers of credit risk and consequently contributing to an efficient risk allocation mechanism
• The role of private-equity in providing finance and management has substantially expanded during the past years
• The growing importance of private equity and hedge funds has affected the governance of corporations in the Euro area. The ECB states that it is not clear whether this influence has been positive or negative
• The importance of venture capital funds remains still limited.
• Basle II has triggered an increase in credit ratings of SMEs
• Credit ratings are likely to influence management of firms and contribute to more transparency and better financial management of firms
• It is likely that the lower concentration of credit risk on banks will make them less vulnerable to shocks.....
• ...... "however it cannot be ruled out that episodes of mispricing of credit risk may be followed by abrupt ajdjustments, which may pose new challenges to the stability of the financial system."

New York Republican and congressman Tom Reynolds, an opponent of raising taxes on carried interest, has launched the Blog "From Wall Street to Main Street". The blog is said to be ghostwritten by his communications director L.D. Pratt. The blog mainly conains links to carried interest issues.

"The Economic Case for Private Equity", M.C.Jensen, Harvard Business School, The Monitor Company, SSEP, February 13, 2007

In a Private Equity conference at HBS this year Prof. M. Jensen pointed out that private equity is "best thought of as a new and powerful model of General Management."

Key elements of the presentation are:

• Private Equity funds have grown to an important global force today. Morgan Stanley estimated in 2007 that Private equity funds represented 25% of global mergers and acquisition activity, 50% of leverage loan volume, 33% of the high yield bond market, and 33% of the initial public offerings market.
• Private Equity generally implements Strategic Value Accountability much better than the public corporation
• Private Equity avoids much of the out-of-integrity gaming and lying that dominates the relations between public firms and capital markets.

Some challenges:

• Managing growing complexity through growth
• Agency costs of overvaluation: real value might be destroyed through the costs of overvaluation

A Comparison of US Real Estate Trusts and German Real Estate Investment Entities, R.T.Black (Giorgia State), N. Rottke (EBS), M. Becker (U.of. Regensburg),Wiesbaden, 2006

Key findings:

• Lack of reliable data and transparency, unimportance of the segment (EUR 4 billion of real estate corporations with 90% of correlation to the DAX30-companies) and lack of time series (only reliable data back to 1996) makes a comparison difficult to impossible
• Only segment which can be compared is open-end real estate mutual funds
• US has better regulatory environment for Real Estate Investment Trusts (REITs) and can be a role model for Germany
• A German REIT would only have a real chance if it is fully competitive internationally and constructed to the needs of the target investors. International investors will only invest in a product that conforms to the international standards
• Consequently, most important would be the regulation to this investment vehicles outside the investment law. For international investors this would mean that the German real estate market would be opened to them as they were not allowed to invest in fund-products that are regulated by local investment law

That time an almost visionary conclusion of the researchers was:

"It should also be clear that German REITs will not be the savior of incustry corporations with junk real estate. If this non-investment-grade real estate is put or added to German REITs, the vehicle will not be a success in the long run, because the change of investment form does not mean that the underlying real estate shouldn't have a certain level of quality." (quote from paper linked above

MarketObservation is a platform from practioners for practitioners. It tries to link real market development with academic thinking. Latest developments in the real estate market show that that rightly choosen academic thinking can add a lot of value to decision making in business.

We have seen a list in a blog entry in the statistics and rankings session showing currently the biggest buy out firms as ranked by Forbes. All of these firms are US based.

The question arose whether also a VC firm could sooner or later make it in a top ten list of a ranking by size. By researching information about scaleability of both buy out- and VC-firms we found the paper "The Economics of Private Equity Funds" by A. Merick and A. Yasuda from the University of Pennsylvania, The Wharton School, Department of Finance , July 2007

Key findings are:

Fund managers earn revenue from a variety of fees and profit-sharing rules. Researchers build a model to estimate the expected revenue to managers as a function of these rules, and they test how this estimated revenue varies across the characteristics of our sample funds.

There are major differences between venture capital (VC) funds and buyout (BO) funds

• In general, BO fund managers earn lower revenue per managed dollar than do managers of VC funds
• But BO managers have substantially higher present values for revenue per partner and revenue per professional than do VC managers
• BO managers build on their prior experience by raising larger funds, which leads to significantly higher revenue per partner and per professional
• While prior experience by VC managers does lead to higher revenue per partner in later funds, it does not lead to higher revenue per professional, as due to the intensity target firms have to be assisted, more people have to be hired
• Both VC and BO are labor-intensive, high value-added,and high-rent industries that show major differences:
• The median BO fund in the study's sample makes 2.4 investments per partner. This range of 2-3 firms per partner appears to be fairly stable across the inter-quartile
  range
• BO deal partners devote around 50 percent of his/her time on the company
  during the first several months after the transaction. After that period they still devote about 10% to 15% to the target
• Once a BO manager is successful in handling $100M-size companies this way, the same skill can be applied to managing substantially bigger companies without a complete elimination of excess performance
• This is in sharp contrast to the VC business:
• VC funds invest by definition in a small firm, with valuation of no more than $25-50M in case of early-stage VC. Their goal is to hold these firms until they are mature enough to have an exit value of $150-$200M or more
• The median VC fund in the research's sample makes 5 investments per partner, which seems to be fairly stable across the industry
• The valueadded of a venture capitalist includes screening firms based on technology, business model, and management team, helping the founder team to hire key personnel etc. etc. Such skills are not directly applicable to more mature firms that are much larger and already in possession of core management skills
• Consequently, when successful VC firms increase the size of their fund, they cannot just scale up the size of each firm they invest in without dissipating their source of rent

Forbes lately ranked todays leading private equity firms. Attached link to CNN Money shows short profiles of the top ten firms as ranked by Forbes. These firms are:

• The Blackstone Group
• KKR
• The Carlyle Group
• Texas Pacific Group
• Bain Capital
• Providence Equity Partners
• Apollo Advisors
• Warburg Pincus
• Cerberus
• Thomas H. Lee

We lately heard market participants predicting that investors might flee into gold as stock markets got very volatile and unpredictable in the short term. It might be important to get some more information on the determinants of the gold price. The The World Gold Council has published the report
"Short-run and Long-run Determinants of the Price of Gold", Eric J. Levin, Robert E. Wright, June 2006.

Key findings are:

• There is a long-term one-for-one relationship between the price of gold and the general price level in the USA. More specifically, a one per cent rise in US inflation raises the long-term price of gold by an estimated one per cent.
• A one percent increase in the long-term price of gold for a one percent rise in the general US price level lies within the 95 percent confidence interval.
• There are short-run deviations from the longrun relationship between the price of gold caused by short-run changes in the US inflation rate, inflation volatility, credit risk, the US dollar trade-weighted exchange rate and the gold lease rate.
• It takes about five years for the long-term relationship between the price of gold and the general price level to be restored following any shock that causes a deviation in this long-term relationship.
• There is no significant correlation between changes in the price of gold and the world's inflation and inflation volatility as well as the world's world income and gold’s ‘beta’ (particularly gold’s correlation with the S&P500 index).
• Gold is profitable as a long run inflation hedge for investors in countries whose currencies depreciate against the dollar by more than the difference between the country’s and the U.S.’ inflation rate. The major gold consuming counries have been overrepresented (e.g. India, China, Turkey, Saudi Arabia, Indonesia).
• U.S. wealth holders should profit from holding gold if the dollar deprecation will lower the price of gold to investors outside the U.S., which will raise their demand for gold and thus raise the dollar price of gold or if dollar depreciation will raise U.S. inflation. Gold would then act as an inflation hedge.

Source: World Gold Council

In previous posts either in the behavioral finance or the stock market sector we have dealt with the herding phenomena of investors and consequently with information cascades. Information cascades are a situation where individuals, based on observations of others, make the same choices ignoring their private signals. The individual for its own is still a rational decision maker. However, when a cascade occurs the cascade effect is so overwhelming that every individual might take the wrong action even if it would be able to make the right choice individually.

An information cascade can be interrupted by certain public information or unusual signals. This might for example be information released by the Fed.

As mentioned, information cascades have become an important topic in the discipline of behavioral finance. In financial markets such cascades can create excessive price movements in certain segements or the market as a whole.

Information cascades are not only an economic phenomena but are also of importance in politics and sociology. In this respect the Cato Institute published an excellent article by Pierre Lemieux, University of Quebec:

"Following the Herd", P. Lemieux, University of Québec, Winter 2003-2004

Key elements of the article are:

• Cascade theory explains, within a rational-choice framework, why large numbers of people think and behave in the same way.
• When incorrect cascades develop, bad public policy will follow.
• False cascades are often fragile. However, even if they are false, reputational concerns may make them more resilient and may tip a social system into inertia or into revolution.
• Special interests also make cascades more resilient to the extent that they can manipulate them.
• One way interest groups manipulate public opinion is by rewarding certain types of opinion or behavior
• Cascades are only one of the factors that influence what people think and how they behave, and which public policies follow.
• Long-term ideology and political and bureaucratic processes interact with cascades.

"THERE ARE GOOD REASONS TO BELIEVE THAT FALSE CASCADES, EVEN SUPPORTED BY SPECIAL INTEREST, CAN BE REVERSED BY FREE SPEECH, INDIVIDUAL LIBERTY AND THE DISPERSION OF POWER IN SOCIETY."

...so much to the excursion and the wonderful article of P. Lemieux. Have a nice weekend!

Long-Run Performance Evaluation of Journalists' Stock Recommendations, A. Kerl, A. Walter, Univ. of Tuebingen, Jan. 10, 2007

In linked paper researchers from Tuebingen University dealt with the question of the long-run performance of stock recommendations issued by journalists in German Personal Finance Magazines. Key findings are:

• Evidence is found that journalists provide significant investment value with their recommendations
• Strong evidence is found for sell recommendations containing high investment value
• Buy recommendations contain generally only little investment value at best
• This is not the case for specific buy recommendations, such as recommendations on value stocks and stocks with a positive performance prior to the publication

Once again, you can hardly go wrong with value stock in the long run...

Real Estate Booms and Banking Busts: An International Perspective, R.J. Herring, S. Wachter, Wharton, July 1999

In linked paper the authors explain how real estate cycles and banking crises are related. The paper is from 1999. However, it seems to us that mechanics do not change substantially and that we can always try to learn from historical events.

Key findings of the authors are:

• Real estate cycles and banking cycles may occur independently but they are correlated in a remarkable number of instances
• During the Asian financial crisis, the most seriously affected countries first experienced a collapse in property prices and a weakening of the banking systems before experiencing their exchange rate crises
• Countries where banks play a more dominant role in real estate markets and hold a greater percentage of assets are the most severely affected during such a crisis

Good Dollars Chasing Bad Dollars: The Impact of Venture Capital Funding On Industry Stock Returns, T, Loughran, S. Shive, Univ. of Notre Dame, May 1, 2007

Key findings:

• Venture capitalists play an important role in the U.S. economy. Between 1980 and 2005 a total of US$394.2 billion has been invested in non-public companies
• Quite a number of these investments enabled young firms to issue public equity at relatively high valuations.
• Venture Capital investments in non-public young companies seems to have a negative significant impact on valuations and operating performance on comparable industry firms that are already quoted at a stock exchange. This seems to be the case in bubble and non-bubble periods
• Consequently, money poured into non-public firms creates stronger potential competitors for public firms

MarketObservation:
An interesting question would be whether this findings are als applicable when entrepreneurial non-public sectors are compared with much bigger industry players. Such bigger players have the resources necessary to enhance their technology portfolio through taking over promising young companies. Conglomerates such as Cisco have built their strength also through takeovers of young technology platforms initially financed by VC's. Active consolidators' stock prices might behave differently. This would be a subject for further research.

Private Equity Waves, H. Smit, W. van den Berg, Tinbergen Discussion Papers, Erasmus Univ. Rotterdam, August 2006

Key findings:

• Private equity investments tend to evolve in waves
• Waves can be triggered by very favorable financing instruments (e.g. junk bond market in 1980's), waves of corporate restructuring and very favorable economic conditions
• As private equity is less transparent than public markets the benefits of this asset class can not be instantly observed by all agents
• Private equity shows a cyclical pattern: investment flows into the industry tend to increase after periods of good performance and to decrease after periods of poor performance
• Waves end when negative externalities from over-investment become transparent to the market (e.g. growing default rates)
• Better informed agents (managers) build up excess rent at the beginning of positive periods until lesser informed agents mimicking investments start a cascade. There is a heterogeneity among agents. Information about value creation is flowing from the best informed investors to the leas informed investors.
• Established agents having an information advantage tend to invest first, before the excess rent has built up whereas less informed agents tend to invest at the end of the wave at less favorable conditions