Interview Guide By: Andrew Iu
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Table of Contents Contents
Table of Contents........................................................................................................ 1 I. Inefficient Markets .................................................................................................... 3 Credit Crisis - The Essentials - New York Times......................................................... 3 Other Credit Crisis Notes .................................................................................... 8 The Origin of Financial Crises - George Cooper ........................................................ 22 The Return of Depression Economics - Paul Krugman ................................................ 25 The Crash of 2008 and the New Paradigm for Financial Markets - George Soros ................ 30 The Ascent of Money - Niall Ferguson ................................................................... 33 The (Mis)Behaviour of Markets - Benoit Mandelbrot .................................................. 46 I. Technical Knowledge ................................................................................................ 49 Comparison of Valuation Techniques - Personal Notes ............................................... 49 Comparable Companies Analysis - Investment Banking by Rosenbaum & Pearl .................. 51 Precedent Transactions Analysis - Investment Banking by Rosenbaum & Pearl .................. 56 Discounted Cash Flow Analysis - Investment Banking by Rosenbaum & Pearl .................... 58 Leveraged Buyouts - Investment Banking by Rosenbaum & Pearl .................................. 63 Leveraged Buyout Analysis - Investment Banking by Rosenbaum & Pearl......................... 70 M&A Sale Process - Investment Banking by Rosenbaum & Pearl .................................... 73 Acing the Finance/IB Interview - Wall Street Prep .................................................... 78 Investment Banking Overview - UBS ..................................................................... 83 M&A Valuation Overview - JP Morgan .................................................................... 88 Building Technical Understanding - ACQUIRE........................................................... 93 Goldman Sachs eLearning Modules ....................................................................... 99 Other Notes ..................................................................................................103 II. Introduction to Recruiting ....................................................................................... 105 Introduction..................................................................................................105 The Banks ....................................................................................................105 About Investment Banking Interviews ..................................................................106 The Intangibles That Make the Difference .............................................................107 Practical Tips That Will Make Your Life Easier ........................................................108 II. Interview Questions - Technicals............................................................................... 109 General Valuation...........................................................................................109 Valuation Scenarios ........................................................................................111 Valuation Building Blocks ..................................................................................112 Comparable Company Analysis ...........................................................................113 Precedent Transaction Valuation ........................................................................115 Discounted Cash Flow Modelling .........................................................................116 Leveraged Buyout Modelling ..............................................................................120 Mergers and Acquisitions ..................................................................................123 Financial Statement Analysis .............................................................................127 Capital Structure, Capital Raising and Cost of Capital ...............................................133 Portfolio Management......................................................................................136 Fixed Income Securities ...................................................................................137 Derivatives ...................................................................................................140 Currencies....................................................................................................141 Special Situations ...........................................................................................142 Other Questions .............................................................................................143 Brain Teasers ................................................................................................145 Definitions ...................................................................................................146 II. Interview Questions - Fit ........................................................................................ 147 Marketing Yourself .........................................................................................147 Banking Commitment ......................................................................................147 School and Career Plans ...................................................................................147 Work and Team Experiences .............................................................................147 Personality and Character ................................................................................148 Strengths and Achievements .............................................................................148 Failures and Weaknesses ..................................................................................149 Other Skills and Interests .................................................................................149
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The Recruiting Process ....................................................................................149 Questions for the Interviewer ............................................................................149 II. Interview Questions - Markets .................................................................................. 150 Education .....................................................................................................150 News and Markets ..........................................................................................150 Transactions .................................................................................................150 Companies and Investments ..............................................................................150 Commodities & Currencies ................................................................................151 Interest Rates................................................................................................151 Credit Crisis ..................................................................................................151 Industry Events and News .................................................................................151 Other Concepts..............................................................................................151 II. Interview Questions - Firm & Industry ........................................................................ 153 Industry Understanding ....................................................................................153 Bank Understanding ........................................................................................153 People and Relationships ..................................................................................153 III. Appendix 1 - Vault Guide ....................................................................................... 154 The Financial Services Industry ..........................................................................154 Mergers and Acquisitions ..................................................................................156 Valuation Techniques ......................................................................................160 Equity Analysis and Portfolio Management.............................................................170 Bonds and Interest Rates ..................................................................................173 Currencies....................................................................................................177 Derivatives ...................................................................................................179 III. Appendix 2 - Other Terms & Concepts ....................................................................... 183 The Finance Industry.......................................................................................183 Investment Banking ........................................................................................185 Private Equity ...............................................................................................186 Fixed Income Securities ...................................................................................187 Mergers and Acquisitions ..................................................................................196 Hedge Funds .................................................................................................200 Derivatives ...................................................................................................204 III. Appendix 3 - Websites ........................................................................................... 206 III. Appendix 4 - Finance I&II Summary ........................................................................... 207
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I. Inefficient Markets Credit Crisis - The Essentials - New York Times Introduction Crisis erupted in Fall of 2008 o Credit squeeze had begun about one year before ―The channels of credit, the arteries of the global financial system, had been constricted.‖ ―Regulators who sat on the sidelines for too long are now eager to rein in Wall Street‘s bad boys.‖ Wall Street‟s firms essentially transformed themselves into giant hedge funds September 16, 2008: Federal Reserve agreed to an $85bn bail-out of AIG (American International Group) September 22, 2008: Goldman Sachs and Morgan Stanley transformed themselves into bank holding companies o Subject to far greater regulation (JP Morgan has 70 regulators on staff every day) o Higher capital requirements o Gained access to full array of Fed lending facilities September 25, 2008: Washington Mutual, the nation‟s largest savings and loan institution, was seized and sold to JP Morgan for $1.9bn Origins Crash of the technology bubble lead to lower interest rates Lower interest rates: o Supported housing demand (and price rises in housing) o Permitted mortgage refinancing o Lead to the deterioration of credit standards o Spawned complex financial instruments for pooling mortgages and diversifying risk Defaults and delinquency rates began rising in 2006 but the pace of lending did not slow The Crisis Takes Hold June 2007: collapse of two Bear Stearns hedge funds heavily invested in the sub-prime market o “Bear Stearns told clients in its two battered hedge funds late yesterday that their investments, worth an estimated $1.5 billion at the end of 2006, are almost entirely gone.‖ MBSs quickly became toxic A rising number of foreclosures accelerated the decline in housing prices March 2008: Bear Stearns is sold to JP Morgan, with the Federal Reserve assumed $30bn of its liabilities under the terms of the transaction o JP Morgan paid $270m in stock for Bear Stearns Sales, Failures and Seizures Sept. 7, 2008: Fannie Mae and Freddie Mac are nationalized Sept. 14, 2008: Lehman Brother‟s failure 3
Federal Reserve summoned Wall Street leaders and insisted they rescue the investment bank o ―One observer briefed on the situation described the session as a ―game of chicken‖ between the government and the heads of the major banks.‖ o Bank of America, Barclays and HSBC were interested in purchasing Lehman Brothers, but only with the support of government guarantees o ―We didn‘t have the powers,‖ Mr. Paulson insisted, explaining a decision that many have since criticized — to allow Lehman to go bankrupt. By law, he continued, the Federal Reserve could bail out Lehman with a loan only if the bank had enough good assets to serve as collateral, which it did not. Sept. 14, 2008: Bank of America acquires Merrill Lynch Sept. 16, 2008: American International Group is nationalized o Initial bail-out of $85bn o Additional bail-out investments brought the total value to $150bn o March 1, 2009: AIG reported a loss of $61.7bn - the largest quarterly loss in history o Ultimate bail-out representation: 80% ownership in AIG holding company $60 bn loan $40 bn in preferred shares $50 bn to purchase toxic assets o Financial disaster caused by a small AIG unit that conducted business in financial derivatives December 2008: CIT receives a $2.33bn bailout o
The Government‘s Bailout Plan Sept. 17, 2008: investors push treasury yields to near-zero rates as a flight-to-safety gripped financial markets Sept. 18, 2008: Henry Paulson introduced a three-page, $700 billion bail-out proposal document to congress o Congress amended the plan to include new: Oversight structures Limits on compensation Options for the government on ownership in the companies it bailed out o Sept. 29, 2008: Congress rejected the proposal 228-205, with an insurgent group of Republicans leading the opposition 133 Republicans turned against President Bush to join 95 Democrats in opposition of the Bill Oct. 1, 2008: A revised bill is passed by Congress and the Senate o The new Bill includes tax break provisions Oct. 5, 2008: European nations respond o Germany passed legislation to insure all private savings accounts o Bailouts were arranged for: Hypo Real Estate - German Lender Fortis - a large banking and insurance company Oct. 6, 2008: The Federal Reserve launched a plan to purchase commercial paper Continued Volatility Oct. 8, 2008: central banks simultaneously cut interest-rates by 50 basis points o Federal Reserve o European Central Bank o Bank of England o Bank of Canada o Swedish Central Bank 4
o Swiss Central Bank o Chinese Central Bank Oct. 13, 2008: the Treasury announced a plan to invest $250bn in banks o The plan would steer funds to stronger bankers to precipitate another round of bank mergers and consolidations
Oct. 17, 2008: a statement is made at a JP Morgan conference that the $25bn recapitalization will not be used to expand JP Morgan‘s loan book Currencies: The turmoil caused an upheaval in currency markets: o The Dollar and the Yen appreciated as investors sold emerging market currencies o The carry-trade was unwound, making Japanese exports expensive Commodities: oil tumbled amid the slumping global economic outlook o Oct. 24, 2008: OPEC cut production to curb the declining price Oct. 29, 2008: the Fed cut rates to a mere 1% o The Bank of England and ECB followed suit in early November Oct. 29, 2008: the Treasury and the FDIC began work on a proposal to apply bail-out funding to relieve banks that agreed to reduce mortgage payments Nov. 6, 2008: executives of Detroit‟s big-three develop a case for Federal support for the struggling auto-makers Nov. 14-15, 2008: leaders of 20 major countries met to discuss coordinated action; the group agreed to work more closely but thornier questions were put off until the next year
The Crisis and the Campaign ―The weakening stock market and growing credit crisis appeared to benefit Mr. Obama, who tied Mr. McCain to what he called the failed economic policies of President Bush and a Republican culture of deregulation of the financial markets.‖ Three days following Obama‟s election, he convened a meeting with his top economic advisers and called for quick passage of an economic stimulus package Other issues facing Obama: o Automakers‟ pending bankruptcy o Rolling back the Bush tax cuts o Expansion of health care coverage Deeper Problems, Drastic Measures December, 2008: US economy officially declared in a recession o Unemployment at 15-year high o Inflation had virtually halted December 16, 2008: Fed announced: o Reduction in interest rate to practically zero 5
It would deploy its balance sheet to fight the recession The Fed increasingly is playing the role of a commercial bank ―Since late August, the Fed has expanded its balance sheet from about $900 billion to more than $2.2 trillion, creating $1.3 trillion that did not exist to replace some of the trillions wiped out by falling house prices and vengeful stock markets. The Fed has taken troublesome assets off the hands of banks and simply credited them with having reserves they previously lacked.‖ ―For decades, businesses and consumers feasted relentlessly, as if gravity, arithmetic and the tyranny of debt had been defanged by financial engineering.‖ o
A New Administration February 10, 2009: New Treasury secretary proposed a new $2.5tn plan ($350bn from the government‟s original bail-out plan and the remainder from private investors) that included: o 1) Public-private rescue plan called the bad bank o 2) Additional capital injections Banks would be subject to additional regulations 3) Broadening of financing program initially intended to be $200m to $1tn to o purchase securities backed by consumer loans The program was also expanded to include commercial and residential MBSs o Program was questioned on lack of specificity A stress test was performed on 19 of the nation‟s largest banks to determine the adequacy of their capital cushions February 18, 2009: o ―unraveling homeownership, the middle class and the American Dream itself.‖ o $275bn plan to permit Americans to refinance their mortgages o This plan made no consideration for under-water mortgages o Components: 1) refinancing available for those without enough equity 2) incentives to bankers to adjust the terms of mortgages 3) increase the credit available (providing $200m to Fannie and Freddie)
New Fears, New Lows, Then New Hopes 6.2% decline (annualized) in GDP in Q4/08 Countries began to erect trade barriers as conditions worsened Conditions improved and Wall Street warmly received Geither‟s new plan for asset purchases G20 leaders pledged $1.1tn for developing nations A Crucial Moment for Banks and Automakers Major banks became profitable in Q1/09 (although this resulted largely from one-time gains and creative accounting) 10 of the 19 banks stress tested required additional capital; if common equity could not be raised in public markets, the government offered to convert its preferred share holdings into common equity Auto-makers bankruptcies: o Chrysler was forced into bankruptcy and eventually forged an alliance with Italian automaker Fiat, after failing to appease bondholders o GM also entered bankruptcy but exited the processes surprisingly quickly o The speed of the restructuring stunned the legal community One Year Later, Signs of Recovery June: 10 big financial institutions repay TARP funds, including: 6
o Goldman Sachs o American Express o JP Morgan Regulatory overhaul proposal: o 1) raising the amount of the financial cushion that institutions must hold o 2) conflict-of-interest rules for credit-rating agencies o 3) holding-requirement for banks: a portion of mortgages issued must be held on-balance-sheet o *These measures would largely be enforced through the Federal Reserve o ―Collective responsibility means no responsibility‖
Other Topics: Bailout Plan o 1) Overview TARP backed by presidential candidates, George Bush and Democratic leadership in congress, but not by the republicans In the three months after the TARP was passed by congress, Paulson handed out $350bn in capital injections, rather than purchasing toxic assets In the spring of 2009, Geithner moved to combine the remaining TARP funds ($350bn) with private funds to create a “bad bank” to purchase $2.5tn in toxic assets In June, the Treasury allowed 10 banks to repay TARP funds Ultimately the government earned $19bn on loans made to banks o 2) The TARP Plan o 3) Capital Injections No strings were attached to the bail-outs - the banks were not required to increase loans as a result of the bail-outs The last component of the first round was provided to GM and Chrysler o 4) The Second Round The second-round of funding was tapped to increase injections to both Citigroup and Bank of America o 5) The Geithner Plans 1) Stretch remaining $350bn with Fed‟s ability to print money 2) Creation of “bad banks” to absorb assets 3) $75bn initiative to permit deliquent home-owners to repay mortgages 4) Stress testing of the 19 banks Citi-group converted the government‟s preferred shares into common stock 6) Public-Private Partnership o In June, this plan became obsolete as it became clear that not enough banks would sell their toxic assets o 7) TARP Repayment 10 banks repaid their TARP funds in the summer BoA became the 11th and Citi-group is still attempting to raise the required capital The net loss on TARP would be $42bn (including auto-maker losses) Auto Industry Bailout o GM After emerging from restructuring, brands such as Hummer, Pontiac and Saturn were closed GM‟s best assets, including the Chevrolet, Cadillac and GMC brands, are held by a company called Vehicle Acquisition Company Owners: 7
61% federal government Remainder: o Canadian government o Health care trust of the United Auto Workers union o Bondholders o Fiat now owns Chrysler, along with the federal government and the United Auto Workers o Ford set aside $25bn in a turn-around fund before the recession began Ford still lobbied for assistance for its competitors, arguing their bankruptcy would have a ripple effect on suppliers Federal Reserve o 1) How the Federal Reserve Works Federal Reserve established in 1913: Seven-member board 12 regional banks - intended to make the flow of credit even across the country Open market operations affect the federal funds rate, which serves as the basis for other rates Commercial banks can borrow directly from the Fed at the nearest regional bank, using the so-called discount window; the discount rate is linked to the federal funds rate o 2) The Fed and the Credit Crisis New tools to control the economy (with near-zero rates): Quantitative easing Buying MBSs (from Fannie and Freddie) Buying commercial debt (commercial paper) Buying consumer debt The Fed‟s balance sheet has ballooned to $2tn, from $900bn, as a result of these programs 3) A More Public, More Powerful Role o
Other Credit Crisis Notes How Does the Credit Crisis Impact You
Individuals use credit to: o Make big-ticket purchases (houses, cars, college tuition); and o Small purchases (via credit card) Business use credit to: o Investment in assets o Support operations Governments use credit to pay for longer-term projects (school improvements, highway repairs, etc.), which they finance by issuing bonds against future tax revenue
The Securitization of Loans Over the last decade, credit was increasingly securitized. Banks would pool together many different loans and then sell securities, based on the rights to the payments from the loans in the pool, to outside investors. The most common securitized loan was an MBS (mortgage-back security), based on residential mortgages Other loans were increasingly securitized: o Car loans o Student loans o Credit card debt 8
Large Financial Institutions Fail Overnight Large financial institutions failed because they could not find sufficient capital to cover mortgage related losses (holding MBSs) As mortgage-related losses mounted, customers began pulling out of brokerage accounts with Merrill and Lehman, concerned about the safety of their assets Confidence in the Health of Financial Institutions Drops, Causing Credit Freeze Among Banks With the sudden collapse of firms that were, until their demise, considered strong and healthy, lending amongst banks froze. As a result, LIBOR (london inter-bank offered rate) reached all time highs of 6.88% on September 30 (which accounts for the enormous TED spread) Other Credit Sources
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Due to Lehman‟s failure, two money market mutual funds imploded as a result of their exposure to Lehman debt. o This was unprecedented given that, between 1971 and 2008, only one money market mutual fund had failed With enormous withdrawals from money market mutual funds, short-term corporate borrowing costs skyrocketed
As the economy worsens, more consumers will default of loans (particularly mortgages), which will lower the value of financial assets (like MBSs) and constrain lending conditions further. o Tighter lending conditions will perpetuate the downward economic spiral as financing becomes more expensive for businesses (driving up the cost of doing business) and consumers (reducing aggregate demand)
Municipal bond offerings have also been impaired due to lower investor interest and higher costs o As a result, infrastructure spending will also fall (this implies that fiscal policy will be working with one hand tied behind its back).
Averting Financial Crisis Summary Suffering firms made common decisions: o The use of complex, hard-to-value financial securities o Large speculative positions underwritten by borrowed funds, or leverage o The use of off-the-books entities to remove risky trading activities from the balance sheet of major financial institutions
Federal reserve effort to-date includes: o Underwriting the rescue-through-acquisition of Bear Stearns o Loaning $85 billion to AIG (in exchange for an 80% equity stake) o Placing Fannie and Freddie in government conservatorship, with the Treasury pledging to stand behind the $5 trillion in bonds the two firms sold or guaranteed
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o o
The enactment of a $700 billion bail-out package to purchase troubled mortgage-backed securities to shore up bank balance sheets The Fed‟s announcement to enter the commercial paper market as a buyer of short-term corporate debt (ABCP)
Introduction The sub-prime market was both small and was anticipated to collapse: „when the rapid rise in housing prices stopped in 2007 The Underlying Financial Problems
The subprime crisis triggered as reassessment of financial risk that encompassed other markets, including: o Leveraged loans (risky bank loans equivalent to high-yield „junk‟ bonds, often made in support of corporate takeovers or buyouts) o Takeover financing o Credit derivatives o Commercial paper
Market participants became reluctant to extend credit because: o They cannot be confident of the borrower‟s financial condition (due to illiquid financial securities) o They are unsure what their own assets are worth This has led to tightness in: o Interbank lending markets o Business and consumer credit markets
Valuation risk engenders an atmosphere of uncertainty regarding the value of both borrowers‟ and lenders‟ assets. Valuation risk stems from: o use of complex financial instruments o practice of moving risk financial speculation off the books
SIVS Structured Investment Vehicles (SIVs) were one mechanism which embodies all three of the above factors SIVs enabled banks to speculate on the difference between short and long-term interest rates by purchasing long-term investments (mortgage-backed bonds) via financing from short-term instruments (asset-backed commercial paper) The operation was profitable so long as long-term interest payments exceeded short-term financing costs
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Profits were distributed to: o The sponsoring bank via advisory fees o The holders of subordinated debt and equity in the SIV
SIVs held mortgage-related securities rather than mortgages themselves. o These securities were pools of loans o Financial engineers bundled mortgage-backed bonds into pools of securities called collateralized debt obligations (CDOs) o CDOs were carved into various tranches with the most risky (and therefore hardest to sell) tranches being carved up again and repackaged into a so-called CDO squared
SIVs found that they were no longer able to sell the commercial paper that supported their assets Sponsoring banks were forced to either: o Move the SIV onto its balance sheet; or o Supply a line of credit
What Makes a Financial Crisis?
Initial State 12
ASSETS
LIABILITIES
Reserves - 100
Deposits - 1000
Loans - 1000
EQUITY - 100
Asset values fall ASSETS
LIABILITIES
Reserves - 100
Deposits - 1000
Loans - 990
EQUITY - 90
Retirement of deposits (debt) to restore leverage ratio to 10x ASSETS
LIABILITIES
Reserves - 0
Deposits - 900
Loans - 990
EQUITY - 90
Sale of assets to restore reserve ratio to 10x ASSETS
LIABILITIES
Reserves - 90
Deposits - 900
Loans - 900
EQUITY - 90
Model 1: During credit market contractions, a self-perpetuating leverage cycle develops: as capital loses value, firms sell their assets (and hence shrink their balance sheets). These sales make bank balance sheets even weaker, forcing more asset sales in order that a given target leverage ratio is maintained. Model 2: The cost of borrowing is inversely related to a firm‟s net worth; as asset values fall, borrowing costs therefore rise. The combination of these two models implies that shocks to financial firms can have disproportionate impacts on real economic activity Term Auction Facility The Term Auction Facility (TAF) conducted a series of auctions of short-term loan funds to banks, accepting as collateral the same wide variety of assets that can be used to secure discount window borrowing „Provision of liquidity lowers interest rates, which is good for borrowers and for interestsensitive economic sectors such as housing, but not for savers, because rates of return on conservative investments like bank CDs and money market funds are depressed. It could be argued that the Fed appears to be rescuing those who caused the problem at the expense of others who had nothing to do with it.‟ 13
Supplying liquidity to banks may not translate into greater lending in the real economy if credit risk concerns are constricting lending. Treasury‘s ‗Super-SIV‘ Proposal
A number of large banks met with Treasury officials to design a „super-SIV‟ which would purchase the assets of smaller SIVs o the super-SIV, called the Master Liquidity Enhancement Conduct (MLEC) would be financed in the same was smaller SIVs - with commercial paper o The expectation was that the endorsement of the Fed, along with the backing of large financial institutions, would encourage investors to purchase the superSIV‟s commercial paper The MLEC concept was announced on October 15, 2007 in a joint press release from J.P. Morgan Chase, Bank of America and Citigroup The plan was abandoned when the three largest Japanese banks refused to participate As SIVs were moved onto the balance sheets of sponsoring banks, the falling values of the mortgage assets became one more source of pain
Provision of New Capital to Financial Institutions
The alternative to selling assets and retiring liabilities for a bank attempting to maintain optimal leverage ratios is to raise new capital Before Bear Stearns, not large financial institutions required the US government to purchase equity stakes; they were able to the raise the funds themselves, often through sovereign wealth funds o Funds operated by China, Singapore, Abu Dhabi and other countries have taken large equity stakes in Citigroup, Merrill Lynch, Morgan Stanley and other firms „As market perceptions of Bear Stearns‟ weakness grew, it became unable to borrow and its customers sought to retrieve their invested funds. The Fed was unwilling to allow the firm to collapse, since a liquidation would have meant the dumping of billions of dollars in mortgage-backed and other securities on the market, at a time when demand was low. The resulting fall in prices would have exacerbated the balance sheet problems of other institutions, perhaps triggering further collapse.‟ Fannie and Freddie were placed in conservatorship under the Federal Housing Finance Agency (FHFA), in which the FHFA has full powers to control assets and operations of the firms o This conservatorship implies that the U.S. taxpayer now stands behind $5 trillion of GSE-issued debt The Treasury Department said that it would lend $85 billion to AIG o AIG, in addition to being one of the largest providers of traditional lines of insurance, was a leading participant in the market for CDSs (Credit Default Swaps) In the after math of the Lehman bankruptcy and the bailout of Fannie and Freddie, AIG was exposed to significant CDS losses TARP was created to slow (and eventually stop) the downward leverage cycle
Commercial Paper October 7, 2008 - the Fed creates the Commercial Paper Funding Facility Reuters - A Credit Crisis Timeline
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September 14, 2008 - Lehman Brothers files for bankruptcy protection and rival Merrill Lynch agrees to be taken over by Bank of America
September 16, 2008 - the Federal Reserve Bank of New York will lend up to $85 billion to AIG and will receive warrants for 79.9% of the company‟s equity
September 19 and 20, 2008 - Paulson and Bush ask Congress to pass a bill allowing the Treasury to purchase billions of dollars of toxic assets from bank balance sheets
September 21, 2008 - Goldman Sachs and Morgan Stanley convert to bank holding companies
September 22, 2008 - Japan‟s Nomura Holdings buys the Asian operations of Lehman. It later also acquires its European investment banking operations
September 26, 2008 - Washington Mutual is closed by the U.S. government, in by far the largest failure of a U.S. bank, and its banking assets are sold to JPMorgan Chase for $1.9 billion
October 3, 2008 - House of Representatives passes the bailout plan
October 3, 2008 - Wells Fargo says it has agreed to buy Wachovia for about $16 billion, thwarting a planned Citigroup deal
October 7, 2008 - Iceland is forced to prop up its currency, take over Landsbanki, its second-biggest bank and ask Russia for a loan of 4 billion euros to avoid „national bankruptcy‟
October 8, 2008 - the U.S. Fed leads a coordinated, global round of emergency interest rate cuts. China, the ECB and central banks in Britain, Canada, Sweden and Switzerland also cut rates.
October 14, 2008 - the U.S. says it is injecting $250 billion into U.S. banks
October 16, 2008 - UBS and Credit Suisse, Switzerland‟s two largest banks, are to receive billions of Francs of emergency funding from the government and other investors to shore them up against the crisis
October 24, 2008 - PNC Financial Services Group agreed to purchase National City Corp. in a government-supported $6 billion deal
October 27, 2008 - Iceland‟s central bank boosts interest rates by 6% to support its ailing currency
October 30, 2008 - Japan unveils a $51 billion package of spending to support its economy and Germany plans a range of steps worth up to $32 billion to boost business
October 31, 2008 - Japan cuts its interest rate for the first time in 7 years. Barclay‟s announces it will raise $12 billion in capital
November 4, 2008 - Obama wins the U.S. presidential election
November 9, 2008 - China launches a stimulus package worth nearly $600 billion
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November 10, 2008 - the U.S. government restructured its bailout plan of AIG, raising the package to $150 billion
November 13, 2008 - Germany is in recession and China‟s industry output growth is at its weakest in seven years. Adding to the gloom, the OECD cuts its forecasts for the U.S., Japan and euro zone, seeing a tumble into recession for all three
November 17, 2008 - Japan slips into recession with France close behind
November 23, 2008 - The U.S. government agrees to a $306 billion rescue plan for Citigroup, under which it will shoulder some losses from toxic debt in the latest attempt to bolster the financial services industry
November 25, 2008 - The U.S. Federal Reserve unveils an $800 billion plan to buy mortgage-related debt and back consumer loans as it tries to revive the lending market
November 26, 2008 - China slashes interest rates 108 basis points and the European Union plots a 200 billion euro stimulus package
December 4, 2008 - central banks in Europe slash their benchmark interest rates by record amounts
December 5, 2008 - the US economy suffers its worst monthly job losses since 1974
December 9, 2008 - Canada‟s central bank cuts its interest rate to a 50-year low of 1.5%. Japan sinks deeper into recession than previously thought, raising fears the country is facing its longest contraction ever
December 11, 2008 - proposed bailout of the U.S. automakers fails
December 16, 2008 - the Fed slashes the key interest rate to 0% to 0.25%.
December 19, 2008 - Bush authorizes $17.4 billion in emergency loans to faltering car makers
December 30, 2008 - investors pull a net $32 billion from hedge funds in December, making 2008 the first year on record that the industry‟s assets have not grown
Wikipedia - Subprime Mortgage Crisis When USA house prices began to decline in 2006-2007, mortgage delinquencies soared, and securities backed with subprime mortgages, widely held by financial firms, lost most of their value. The result has been a large decline in the capital of many banks and GSEs, tightening credit around the world. Summary Economic problem manifesting itself in liquidity issues in the global banking system owing to foreclosures which accelerated in the US starting in late 2006. The crisis began with the bursting of the US housing bubble and the high default rates on subprime and other adjustable rate mortgages (ARM) made to higher-risk borrowers with lower income or lesser credit histories. Loan incentives and rising housing prices encouraged borrowers to assume mortgages, believing they would be able to refinance at more favorable terms. With the drop in housing prices, refinancing became more difficult
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Defaults and foreclosure activity increases dramatically as ARM interest rates reset higher Mortgage brokers were the first to be hit Major financial institutions have written down approximately $379 billion as of May 21, 2008 Owing to a form of financial engineering, many mortgage lenders passed mortgage payments and credit risk to third-party investors. Mortgage-back securities Collateralized debt obligations Individuals and institutions holding these securities suffered significantly Because of the lack of loans, housing demand declined and inventories ballooned. This pushed housing prices down and halted new home construction. Subprime lending refers to the practice of making loans to borrowers who do not qualify for market interest rates, owning to various factors like income level, credit history, employment status, etc. Background
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The decline in housing prices and the rise in interest rates in 2006-2007 made refinancing more difficult, causing many homeowners to default on their mortgages Default and foreclosure increased as: Easy initial terms expired (on subprime mortgages) Home prices failed to rise ARM interest rates reset higher Credit Risk
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CDS were created to ensure MBSs, which further diffused credit risk
Causes Inability of homeowners to make mortgage payments Poor judgement by the borrower and/or lender Mortgage incentives such as „teaser‟ rates that later rise significantly Declining home prices which made refinancing more difficult Innovations in securitization which spread risk more broadly
Risk Type Credit risk (risk of default) - though traditionally accepted by the bank extending the loan, securitization innovation spread risk to third-party investors (through MBSs and CDOs) Asset price risk - valuation of CDOs and MBSs for „mark-to-market‟ accounting is difficult because of the complexity of the instruments Valuation is derived from both the collectibility of subprime mortgage payments and the price on a liquid market (the two of which are interrelated). As collectibility falls, trading of such instruments falls, thereby reducing the liquidity of the market Investors have faced large losses as a result of the write-downs in these securities Liquidity risk - companies rely on short-term funding markets for cash to operate; they access these markets through commercial paper instruments and structured investment vehicles However, MBSs and CDOs are often used as collateral to back lending in these markets Because of the decline in the value of these securities, investors have become unwilling to invest in these markets
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Counter-party risk - major investment banks and other financial institutions have taken significant counter-party positions in credit derivative transactions, some of which serve as a form of credit default insurance. Effects on Corporations and Investors Bank corporations: banks must write down mortgages which become uncollectible. This may lead banks to seek additional funds to maintain capitalization requirements Reduce lending Mortgage lenders and REITs: these entities face risks similar to the banks. Additionally, they require new financing through CDOs Commercial paper backed by mortgages Special purpose entities (SPE): Structured Investment Vehicles issue commercial paper to purchase securitized assets such as CDOs. The Causes in Finer Detail Housing: Subprime lending generated housing demand and therefore fueled housing price increases (and hence consumer spending). Some homeowners refinanced their homes with lower interest rates or took out a second mortgage against the value added and used the funds for consumer spending US household debt as a percentage of income rose to 130% in 2007, up from 100% a decade earlier.
Borrowers: easy credit and the assumption that housing market would continue to appreciate lead borrowers to obtain ARMs they could not afford past the incentive period. Once home prices fell marginally, refinancing became more difficult and many defaulted on their mortgages as rates reset 20
Many borrowers were also fraudulent in loan and mortgage applications Financial institutions: The subprime credit spread (risk premium) actually declined between 2001 to 2006. ARM mortgages often allowed the borrower to pay only the interest during the initial period Payment option loans allowed unpaid interest to be added to the premium Securitization: process of offering investment instruments as collateral to third-party investors MBSs are a product of securitization Rating agencies improperly assigned investment-grade ratings to MBSs MBSs were created mainly by GSEs and investment banks Since issuers no longer held the mortgages (and were therefore exposed to none of the risk), they had incentives to lower underwriting standards to support volume SIVs were used to speculate in MBSs off the balance sheet
Mortgage Brokers: act as an intermediary who sourced mortgage loans on behalf on individuals or businesses They have big financial incentives to sell complex, ARMs because they earn higher commissions. Mortgage underwriters: underwriters determine if the risk of lending is acceptable under certain parameters. Underwriters made heavy use of automated risk analysis systems Government: some economists blame the subprime debacle on regulators who failed to curb subprime lending
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Credit Rating Agencies: under scrutiny for giving investment-grade ratings to securitization transactions (CDOs and MBSs) based on subprime mortgage loans. High ratings were justified by credit enhancements such as Overcollateralization Credit default insurance Critics argue that a conflict of interest exists since crediting rating agencies are paid by the firms that organize and sell debt to investors (ie, investment banks) Central banks: The intervention of the Federal Reserve Bank of New York on behalf of LTCM (Long Term Capital Management) encouraged large financial institutions to assume more risk under the assumption that the Federal Reserve would intervene on their behalves The low interest rates set by the Fed encouraged the run-up in housing prices
The Origin of Financial Crises - George Cooper
Introduction Central banks engage in a preemptive, asymmetric monetary policy Efficient market argument - markets allocate resources efficiently Intervention creates a sub-optimal state Markets are inherently stable and will revert to an efficient state after an exogenous shock Different behaviours of speculators and consumer are the first indication of the fallacy of inherently stable markets The EMH remains the strongest counter-argument to the bubble-pricking proposition presented to central bankers in an apparent asset bubble Corrective action is only employed after the bubble bursts Minsky Moment - point at which credit cycle turns from upward momentum to downward momentum Financial instability hypothesis argues that financial markets create internal dynamics that result in: Credit expansion / contraction Asset price inflation / deflation These destabilizing forces are two-fold: Speculation: demand driven by a lack of supply Leverage-Driven: demand driven by asset price changes Banking model: Borrow at short-term rates and lend at long-term rates Competitive pressure drives short-term rates higher Creates a propensity to take risky, longer-term loans Prisoner‟s dilemma drives run-of-the-bank phenomenon Financial markets are influenced by past price / volume data (events are not independent non-zero serial correlation)
Efficient Markets and Central Banks? The Fed perceives its role to be to prevent excessive credit contraction; the ECB is the opposite The ECB also focuses heavily on money-supply growth (M3 statistics) Bankers employ Gaussian distributions in their models The options industry slices the distribution and packages risk LTCM disproved the EMH by: Making unusual profits Collapsing as the result of a market anomaly Non-normal distributions are (largely) the result of central bank intervention
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Another destabilizing force is the fiat money system, which creates an inflationary bias in hands of government bureaucracy Asset bubbles and credit bubbles inflate in tandem Efficient market doctrine reigns supreme when asset prices are rising Interventionism is the sentiment of economists during the contraction Money, Banks and Central Banks Inflation Competitive markets create disinflation (not inflation) History: 1) Barter: Barter exchange cannot have inflation 2) Gold Exchange: Under a gold-exchange system, there can be inflationary and deflationary cycles but no propensity toward inflation (because the gold can be used as a store of value) o Monetary debasement permitted an inflationary tendency o Governments debased currencies to avoid financial distress o This process was time-consuming and therefore rare o Inflation is simply a retrospective taxation 3) Certificates: issuance of certificates against gold allowed bankers to expand the money supply o Because each bank issued its own notes, the banks became intricately connected o Hence, a single run on the bank resulted in a systematic crisis o This leads to an amplification process - an additional layer of instability upon the gold currency instability During positive economic times, credit would expand; this would very quickly contract in the case of a bank run o There is still no secular basis toward inflation 4) Central Banks: central banks became the lenders of last resort to stem crises o Task 1: Central banks will lend to distressed institutions or seize them (depending upon the quality of their loan book) and unwind their positions o The original purpose of central banking was to act as a lender of last resort o Financial instability caused central banking (and not vice versa) o Central banking creates a perverse incentive structure: Depositors are not rewarded for depositing at the safest bank Bankers are not compensated for managing risk This problem is called moral hazard This incentive structure places conservative banks at a competitive disadvantage o In return for central bank protection: 1) Commercial banks agreed to print a single currency (certificate) 2) Gold was accumulated in the central bank This practice allowed the central bank to control the money supply (printing of currency) This also allowed central banks to generate inflation - this is almost the cause of continuous inflation Governments would announce “devaluations” where they altered the convertibility of certificates 5) Removing Gold: after the gold standard was removed, governments could continuously print money without embarrassing devaluation announcements Central banks are placed at arms-length from the government to prevent excess printing of currency It was not possible to get stagflation (inflation and poor economic performance) 23
Task 2: The central bank was therefore given the task of controlling inflation, as well as stabilizing the banking industry A constant inflation rate (2%) is beneficial because: It generates a retrospective tax It easier to decrease wages in real terms by holding them constant The central bank has greater latitude to cut rates Task 3: central banks are expected to regulate demand with monetary policy The industrial revolution was made possible via consumer credit arrangements (i.e., installment contracts) This made the role of managing borrowing rates extremely important Encouraging borrowing increases bank leverage (in conflict with the first objective of central banks) Economists accept the Keynesian notion of fiscal stimulus but reject its underpinnings - the inefficiency of markets Stable and Unstable Markets Once disturbed, asset markets, credit markets and capital markets have a tendency toward expansion or contraction Relationship between asset prices and credit creation: 1) loans are collateralized with assets; hence, 2) an appreciate in asset prices decreases the leverage of a position; hence, 3) asset price appreciation increases lending if leverage remains constant; hence, o This is called home-equity withdrawal in the case of housing market asset bubbles 4) since greater credit availability yields higher asset prices, there is a feedback loop between asset prices and credit expansion This process also works in reverse It leads to the break-down of the indirect relationship between asset prices and demand; under leverage, higher prices yield higher demand (because credit becomes more available) o Psychological reinforcement: in goods markets, goods are purchased for consumption; assets are purchased for investment. A price appreciation leads to a confirmation of an investment thesis and hence improves confidence
Deceiving the Diligent There is a two-way relationship between the economy and asset prices; this is another source of instability Time and again the observation that these leverage ratios are dependent upon rising asset prices is missed; even up to the very peak in the recent housing bubble Analysis of individual household balance sheet relies on the assumption that there is a liquid market for the house; this analysis therefore cannot be used for macro-economic predictions Paradox of thrift: savings lead to a slowing of economic activity and hence more savings This is another cyclical force Leverage indicators: Compare growth rate of asset prices / leverage with economic growth rate Stock of debt, relative to the economy Coverage ratios (Income / interest)
On (Central Bank) Governors Credit cycles should be allowed to operate, both in their expansion and contraction phases, with policy response being applied symmetrically In reality, policy responses are weak during the expansion and strong during the contraction Minsky Meets Mandelbrot 24
Efficient markets require a normal distribution (i.e., security returns are based upon the same random process which governs coin flips) Today‟s quantitative risk systems are based upon this assumption “Proverbial Chocolate Teapot - it works only when you‟re not using it.” Returns distributions are based upon historical data; if this historical sample is taken from a period of expanding credit, the data‟s shape will not accurately predict the behaviour of returns during a contraction There is empirical evidence of memory in markets The reservoir of memory is the balance sheets of investors “Fat tails” and the clustering of large returns (positive and negative) around short-term periods skew reality from the models we have The tendency for models to increase their risk assessment after a contraction is another selfreinforcing negative phenomenon (and vice versa) Beyond the Efficient Market Fallacy We have been twisting the facts to match the theory; we must twist theory to match the facts We must accept short-run, nominal fluctuations “We favour capitalism in an expansion and socialism in a contraction.” Socialist policies: 1) Accepting debt onto state balance sheet 2) Printing money for those in debt 3) Spending money in other areas of the economy This ultimately results in printing money (a retroactive tax on the prudent) to bail out the ignorant Shift the “central bank‟s policy from targeting consumer price inflation to that of targeting asset price inflation. Put differently, the central bank would be moving its focus from management of inherently unstable goods markets to inherently unstable capital markets.” Options for the current situation: 1) Free market route 2) When in trouble double Foster another asset bubble 3) Inflation Print money to fund debt Recent rally in gold, oil, food prices is an indication of this strategy both being deployed and anticipated
The Return of Depression Economics - Paul Krugman ―The central problem has been solved‖ Some believe modern macro-economics has solved the problem of the business cycle The rise of Asia‟s capitalist economies made Marxism less defensible Revolutionaries were able to operate only with the support of Moscow‟s weapons, training camps and money The humiliating failure of the Soviet Union destroyed the socialist dream Capitalism is secure because no one has a plausible alternative By the 1960s, the US had gone so long without a recession conferences were held entitled “Is the Business Cycle Obsolete?” Energy crises of 1973 and 1979 Recessions are a strange concept if one accepts that markets are efficient Baby-sitting co-op example: Baby-sitting coupons = currency Baby-sitting earned coupons; going-out used-up coupons 25
When there are too few coupons in circulations, couples become nervous about going-out and are anxious to baby-sit; this sends the baby-sitting economy into a recession Increasing the number of coupons in circulation cures the recession Central banks are modern coupon issuers Excessive coupon issuing (i.e., quantitative easing) results in inflation and inflationary expectations (which are self-reinforcing) The 1970s, low-wages were enough to allow developing economies to compete in world markets This markedly improved the economies of these countries Warning ignored: Latin America‘s crises Mexico up from the 1980s o Institutional Revolutionary Party wanted to modernize Mexico with domestically-developed industries (i.e., protectionist policies) o In the 1970s, Mexico‟s economy entered a feverish boom fed by oil discoveries o This lead to excessive borrowing from willing foreigners and ultimately financial distress o Through frantic emergency loans and resturcturings, most countries avoided out-right defaults o Ultimately, Mexico‟s debt was replaced with “Brady bonds”; this stemmed foreign investor panic and allowed Mexico to return to regular governmentbond yields Argentina‟s break with the past o Protectionism fostered inefficient enterprises, which became a sinking fund for public funds and lead to deficits o The debt crisis hit Argentina as hard as the rest of Latin America By 1989, the nation was suffering from hyperinflation (3,000%+) In order to put an end to the inflationary cycle, a currency board was instituted Argentina had renounced its right to print money Argentina also negotiated a “Brady deal” Mexico‟s bad year o A current account deficit must be financed (via simple accounting) by the sale of assets (government assets or private sector assets) o An excessively high peso was pricing Mexico out of world markets o The Tequila crisis: Devaluation is a way to stimulate exports Devaluation must follow two rules: 1) devalue enough - do not allow speculators to believe further devaluations will ensue 2) following the devaluation, the government must show it has everything under control Mexico did neither well and a massive capital flight resulted Panic was reinforced by the fact that Mexico has borrowed in American dollars In Argentina, this capital flight triggered a run-on-the-bank Argentina‟s central bank could not act as the lender-of-lastresort because it had restricted itself from printing pesos US Treasury provided a $50bn credit line to Mexico Japan‘s trap Japanese industry produced less in 1998 than it produced in 1991 Economic growth was directed by the government, with bank loans and import licenses flowing to favoured industries o This lead to the notion of “Japan Inc.” 26
Japan would built industries domestically, via the above policies, and then unleash them upon world markets Japanese firms formed keiretsu - groups of allied firms around a bank In the early 1990s, there was a real estate bubble o Square mile below the Imperial Palace was worth more than California o This bubble was financed with the kind of leverage which results only from the moral hazard problem of banks and their “shadow bank” counter-parts When this bubble collapsed, even zero-interest rate policies were insufficient to stimulate spending o Analogy of baby-sitting co-op with winter and summer months - use interest rates to level the circulation of coupons o Just as effective is devaluing coupons if they are held until the summer - this is called inflation “The Great Depression in the United States was brought to an end by a massive deficitfinanced public works program, known as World War II.” Fiscal responsibility, related to an aging population, sent the economy further into recession One theory to explain Japan‟s liquidity trap was the broken state of its banking industry the legislature passed a $500bn bank rescue plan o
Asia‘s crash Thailand became an industrial centre in the 1980s The fall of communism reduced the perceived risky of Asian investments o Investment funds coined the phrase “emerging markets” as they ballooned to facilitate the flow of capital to Asia Thai “finance companies” borrowed in foreign currencies, converted these currencies to the local currency (the baht) and channeled funds to entrepreneurs and other business people o This put tremendous up-ward pressure on the baht o The central bank had a fixed exchange rate and therefore had to accrue significant amounts of foreign currency o This central bank interventionism allowed credit to continue to balloon o Moral hazard again developed in these “finance companies” - implicit government guarantees resulted in excessive risk-taking and a resulting credit bubble Eventually, this system broke down (as always) and foreigners began withdrawing capital o This lead to severe down-ward pressure on the baht o The central bank had to prop-up the baht by buying back baht with foreign exchange reserves o Eventually, the central bank would run out of reserves, at which point it had two options: 1) raise interest rates to support the currency - likely amplifying the economic slow-down 2) devalue the baht - this would make many finance companies insolvent because they had borrowed in foreign currency o Hedge funds quickly began betting against the currency When Thailand went into distress, foreigners withdrew capital from the entire “emerging markets” area, since these funds were channeled through grouped funds o This resulted in the Asian currency crisis Policy perversity Asian economies responded to the crisis with fiscal austerity - the opposite of Keynes‟ prescription A fictional international monetary system: o Globo - global currency 27
The boom-bust cycle of the world as a whole be controlled by not for individual regions o Country currencies While individual boom-bust cycles could be managed, exchange-rate volatility made trade difficult This volatility was amplified by currency speculators o Adjustable pegs Left too much room for speculators to attack weak currencies o Currency regimes: 1) floating Control over monetary policy but business volatility 2) fixed Stable exchange rates but no control over monetary policy 3) adjustable Requires the limitation of capital flows (speculation) to operate correctly Stemming investor panic is the only way to avert a currency crisis o International economic policy became an exercise in amateur psychology The IMF became the “lender of last resort” to governments o Loans from the IMF were typically accompanied by fiscal austerity clauses
Masters of the universe The only reason hedge funds have capital is to convince counter-parties to conduct business with the hedge fund Exchange Rate Mechanism (ERM) - way station on the way to a unified European currency Quantum Fund (George Soros‟ hedge fund) took out $15bn in credit lines in British pounds o The fund short-sold the currency o George Soros also interviewed with the financial press, arguing the currency would soon be devalued o Britain dropped the peg after spending billions to support the currency Hedge funds played a similar game with Hong Kong: o These funds short-sold stocks and then converted the proceeds into American dollars If the currency remained pegged, interest rates would have to rise and this would put downward pressure on stocks If the currency was devalued, the funds made money of their short position in the currency o Again, the short-sales were ostentatious (conducting in large block trades) o The Hong Kong Monetary Authority deployed its funds to buy stocks This caused losses and margin calls against the hedge funds Hedge funds did not anticipate this reaction from the HKMA because Hong Kong was regarded as the paragon of free markets Russia offered very high interest rates to retain its currency‟s value o Hedge funds entered this market o When Russia defaulted, the market for Russia debt became illiquid again o The Federal Reserve engineered the bail-out of the most famous casualty LTCM Greenspan‘s bubbles Greenspan was “the Maestro, the Oracle, the senior member of the Committee to Save the World.” Paul Volcker brought inflation under control by breaking inflationary psychology with tightmoney policies During the Greenspan era, Americans learned to use information technology Greenspan was responsible for two bubbles: 28
o 1) stocks o 2) housing Lenders relaxed their practices during the housing bubble for two reasons: o 1) they came to believe in ever-rising home prices o 2) lenders did not hold the loans themselves This was achieved via securitization Constructed through CDOs Alan Greenspan himself declared that any major decline in home prices would be “most unlikely”
Banking in the shadows Before the creation of the Federal Reserve, “trusts” evolved to be bank-like institutions that accepted deposits but were not subject to reserve requirements or capital ratio requirements The panic of 1907 was the result of the collapse of one of these trusts; JP Morgan engineered a plan to increase reserves to with-stand the on-slaught The Glass-Steagall Act separated banks into two kinds: o Commercial banks (accepted deposits) Received access to the Fed discount window Had limitations of risk-taking Deposits were insured by tax payers o Investment banks (did not accept deposits) Savings and Loan institutions failed in 1980s - a special institution from providing home loans Auction-rate securities: o One per week an auction was held for investors who wanted to withdraw funds; the interest rate was set by these auctions o This allowed investors to access their money on a short-term basis and provide the borrowing with long-term funding security - this is exactly what a bank does o This process allowed investors to bypass regulators In early 2007, the combined value of assets of the 5 largest: o Investment banks was $4tn o Bank holding companies was $6tn Commercial paper was issued by SIVs to purchase long-term securities (including MBSs) In 1999, the Glass-Steagall Act was repealed, allowing commercial banks to get into the investment banking business and hence take on more risk The sum of all fears The actual servicing of loans was left to loan servicer, which had neither the resources or the incentives to engage in mortgage restructuring Practically anyone who bought a house during the bubble now has negative equity, even if they put in 20% equity Subprime-related losses triggered a de-leveraging cycle in the shadow-banking industry o Both auction rate securities and commercial paper markets evaporated Bernanke introduced the notion of deploying the Federal Reserve‟s balance sheet into noncommercial bank arenas The implosion Lehman Brothers resulted in an unwinding of the carry trade, which put enormous upward pressure on the Yen and downward pressure on other emerging market currencies Lack of “policy traction” is a major problem The return of depression economics Baltic Dry index collapsed during crisis - international trade shut-down
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“The true scarcity in Keynes‟s world - and ours - was therefore not of resources, or even of virtue, but of understanding.” “Some people say that our economic problems are structural, with no quick cure available; but I believe that the only important structural obstacles to world prosperity are the obsolete doctrines that clutter the minds of men.”
The Crash of 2008 and the New Paradigm for Financial Markets - George Soros Setting the Stage For 31 consecutive months after 9/11, the short-term inflation-adjusted interest rate was negative Pension funds, mutual funds and off-balance sheet SIVs, hungry for yield, consumed CDOs Half of all American GDP growth in the first half of 2005 was housing related Between 2000-2005, Greenspan estimated that 3% of consumption was financed with home equity withdrawal By 2005, 40% of all homes purchased were meant to serve as investments or second homes Securitization increased risk, instead of reducing it, by spreading it across the financial system Mortgage supply chain: o Mortgages sourced by brokers o Housed by thinly-capitalized mortgage bankers o Repackaged by investment banks o Held by institutional investors after approval by rating agencies CDSs allowed banks to diversify portfolio risk rather than buying and selling loans Specialized credit hedge funds acted as unregulated insurance companies As CDOs declined in value, SIVs went insolvent and ABCP markets froze Investment banks were also sitting on large loans to finance LBOs; normally these would be repackaged and sold as CLOs, but the collapse of the CDO market closed the CLO market as well Trouble in the monoline insurance companies, which traditionally insured municipal bonds but had ventured into structured products, caused the municipal bond market to be disrupted Reflexivity in Financial Markets “”there is a two-way connection between thinking and reality which, when it operates simultaneously, introduces an element of uncertainty into the participants‟ thinking and an element of indeterminacy into the course of events. I call this two-way connection reflexivity.” One of the key postulates of equilibrium theory is perfect knowledge - however, because of reflexivity, perfect knowledge cannot exist Economists assumed supply and demand curve are independently given - which is illogical because both depend on participants‟ expectations in financial markets The crux of reflexivity is that market prices can influence the fundamentals o The change in fundamentals may then reinforce the biased expectations in an initially self-reinforcing but eventually self-defeating process This “short-circuit” may take many forms: o 1) the conglomerate boom of the 1960s: higher shares prices allowed firms to make cheap stock acquisitions, which improves EPS (accretion) and therefore further increased share price Based upon the misconception that a company should be valued according to its EPS growth, regardless of how that growths is financed Soros calls this “equity leveraging” o 2) Real Estate Investment Trusts: “it starts with the overvaluation of the early mortgage trusts that allows them to justify the overvaluation of issuing 30
additional shares at inflated prices; then come the imitators, who destroy the opportunity. The scenario ends in widespread bankruptcies.” o 3) The International Banking Crisis of the 1980s: the creditworthiness of foreign debtors was assessed by so-called debt ratios, which turned out to be influenced by bankers willingness to lend to foreign debtors (and the associated commodity boom) “It only happens when the prevailing bias finds some kind of short circuit that allows it to affect the fundamentals. This is usually associated with some form of leveraged debt or equity.” Financial crises also bring about regulatory reform; hence, financial markets and regulators are also bound by a reflexive relationship Banks have observed that returns are distributed according to a “fat-tail” shape - the reason for these fat tails is reflexive relationships
The Super-Bubble Hypothesis Periodic crises that have affected the financial system: o 1) international banking crisis of 1982 o 2) savings and loan crisis of 1986 o 3) the portfolio insurance debacle of 1987 o 4) the failure of Kidder Peabody in 1994 o 5) the emerging markets crisis of 1997 o 6) the failure of LTCM in 1998 o 7) the technology bubble in 2000 The US housing bubble must be understood in the context of a greater “super-bubble” o The most common misconception that has fueled bubbles in the past is notion that willingness to lend does not influence collateral value o Ratings agencies became overly generous because they based their analysis on historical data where housing prices were always rising o By 2006, Moody‟s revenues from structured products were on par with revenues from its traditional ratings business The super bubble has evolved out of a different misconception - faith in the market mechanism o Financial markets do not necessarily tend toward equilibrium o The super bubble contains three major trends: 1) long-term trend toward credit expansion This is largely the result of the morally hazardous behaviour that has developed since the Great Depression (with the bailout support of government institutions) 2) financial globalization Because the USD is the international reserve currency, the savings of the periphery have been “sucked up” by the US - in essence, the US consumer has become the motor of the global economy This has resulted in a chronic current account deficit 3) financial innovation as the result of deregulation Private equity funds and hedge funds delivered an increase in leverage Autobiography of a Successful Speculator “When the convertibility of the dollar into gold was suspended on August 15, 1971, the dollar remained the main currency in which central banks kept their reserves.” “I moved to the US in 1956...I belong to the first generation of hedge fund managers. There was not more than a handful of us when I started.” “Then came the oil shock of 1973, and the money center banks became involved in the recycling of petro-dollars.” 31
“The strong dollar attracted imports, which helped to satisfy excess demand and to keep down the price level. A self-reinforcing process was set into motion in which a strong economy, a strong currency, a large budget deficit, and a large trade deficit mutually reinforced each other to produce non-inflationary growth.” “the crisis of 1982 was the first time that the strategy of bailing out the debtors was applied on an international scale...rescue packages were put together for one country after another. Typically, commercial banks extended their commitments, the international monetary institutions injected new cash, and the debtor countries agreed to austerity programs designed to improve their balance of payments.” “Banks in the US were granted greater freedom to make money. Practically all the restrictions that had been imposed on them in the Great Depression were gradually removed...the separation of investment banking and commercial banking faded until it disappeared altogether.” “The excessive use of portfolio insurance turned a stock market downdraft into an unprecedentedly steep drop in October 1987.” “the rating agencies...came to relay on the calculations provided by the issuers of those instruments.” “Central banks do respond to price and wage inflation but do not feel called upon to prevent asset price inflation.” “The investment community was sharply divided between old fogeys like me and a younger generation who knew how to use the new instruments and techniques and believed in them.”
My Outlook for 2008 China is beginning to rival the US as the primary investor in Africa minerals and energy assets China will challenge the US for supremacy sooner than most expect The rate of growth in China will be supported by negative real-interest rates The sovereign wealth funds of oil-producing nations will become increasing important Some Policy Recommendations “Credit creation is by nature a reflexive process. It needs to be regulated in order to prevent excesses.” “In other countries borrowers are personally liable, while in the US lenders usually have no recourse other than foreclosure.” Securitization limits flexibility: “servicers resist rewriting mortgages because one tranche inevitably will take a deeper hit than others, and servicers are accountable to all tranches simultaneously.” The Crash of 2008 “An independent money market fund held Lehman paper, and,since it had no deep pocket to turn to, it had to “break the buck” - stop redeeming its shares at par. This caused panic among depositors, and by Thursday a run on money market funds was in full swing.” Losing on a long position reduces risk exposure, while losing on a short position increases exposure; as a result, there is a tendency to be long over short “bear raids in which the shorting of stocks and buying of CDSs mutually amplified and reinforced each other.” An Economic Recovery Program Mortgage originators were compensated on volume and are not penalized for underwriting poor mortgages (because they sell them) - this leads to a perverse incentive structure “While financial markets become global, the authorities remained national.” 32
The US has veto power over the IMF and the World Bank
My Outlook for 2009 “The emergence of a new world power is a very dangerous process. Twice it has led to world war in which the emergent power was defeated. The transition from the UK to the US was the exception.” “both Russian rulers and the Russian public harbour a deeply felt resentment towards the West for the way they were treated in their times of trouble.” “The ECB is likely to wide up with greater regulatory powers.” The Fate of the New Paradigm “both the EMH and the AMH proceed by analogy, applying to the social sphere an approach that was successful in another field - the EMH draws on Newtonian physics, the AMH on evolutionary biology...whenever we acquire some useful knowledge, we tend to extend it to areas where it no longer applies.” We must study financial markets in a non-scientific way, irrespective of the resulting loss of prestige for the economics profession Conclusion The political derivative of equilibrium theory is market fundamentalism The boom-bust process is asymmetric: long on the way up and short on the way down
The Ascent of Money - Niall Ferguson Introduction History of Western Civilization is marked by hostility toward the financial services industry - rooted in the idea that those who make their living providing financial services are somehow parasitical on the “real” economy For centuries, financial services have been disproportionally provided by members of religious or ethnic minorities The evolution of credit and debt was as an important a technological innovation in the rise of civilization as any China has become America‟s banker - the Communist creditor and capitalist debtor - a change of epochal importance The evolution of finance has exploded in recent times (ex: the notional value of OTC derivatives at the end of 2006 was $400 trillion) The great repression - although the National Bureau of Economic Research pronounced a recession in December 2007, American consumers continued to spend and investors continue to push equity indices higher Six vital elements of the credit crisis: o 1) High leverage on American and European balance sheets o 2) The securitization of some of the following types of securities: Mortgages Credit cards LBO loans o 3) Monetary policies focused on consumer price inflation instead of financial asset bubbles o 4) The American insurance industry (AIG) branched out into derivatives markets o 5) Politicians on both sides of the Atlantic aimed to increase home ownership o 6) The financing of the current account deficit by China with trillions of dollars in reserves Two thirds of Americans do not understand the concept of compound interest Poverty is the result of a lack of financial institutions, not an abundance
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Dreams of Avarice The Money Mountain No communist state has found it practical to dispense with money The Inca Empire was moneyless - it, like Communism, organized an economy dependent on harsh central planning and forced labour When the Spanish conquered the Inca Empire, they discovered “Cerro Rico” - literally the rich hill - a mountain of solid silver ore o The Spanish recruited workers from the surrounding villages to work in “a mouth of hell, into which a great mass of people enter every year and are sacrificed by the greed of the Spaniards to their “god”” o Thousands of African slaves were also imported o The “rich hill” yielded 45,000 tons of pure silver to be transformed into bars and coins in the Casa de Moneda (mint) “The Roman system of coinage outlived the Roman Empire itself. Prices were still being quotes in terms of silver denarii in the time of Charlemagne, king of the Franks from 768 to 814.” Demand for money in the Middle East and southern Mediterranean trained metals away from Europe o The crusades were partially a response to this problem Spain‟s new found wealth provided the entire continent with a monetary stimulus o This caused inflation, or a “price revolution”, in Europe between 1540 and 1640 o In England, the cost of bread rose by 7x during the time - a large increase by medieval standards The Spanish failed to understand that money is not metal, it is trust inscribed Where it is inscribed is irrelevant: on silver, on clay (as in ancient Babylon), on o paper on an LCD monitor o It is not a coincidence that the root of credit is credo, the Latin for “I believe” The lending system of ancient Babylon was evidently quite sophisticated o Debts were transferable o Borrowers were expected to pay interest - a concept that arose from the natural increase in a herd of livestock Loan Sharks Fibonacci published The Book of Calculation which explained the concept of fractions and the calculation of present value Venice became Europe‟s lending laboratory because of proximity to Asian nations o It is no coincidence that the Merchant of Venice is staged in Venice o As in the play, the obstacles to finance were not economic but cultural The Third Lateran Council in 1179 excommunicated Christians who lent money at interest o Dante envisioned a special part of the seventh circle of Hell for usurers Jews were exempt from this rule o The Venetian authorities designated an area of the city for Jews to conduct their lending business o Buildings grew seven stories high to accommodate the growing Jewish population Shakespeare‟s play illustrates three important concept about modern money-lending: o 1) the power of lenders to charge extortionate interest when credit markets are under-developed o 2) the importance of courts o 3) the vulnerability of minority creditors to backlash by a hostile debtor who belongs to the ethnic majority Gerard Law, a loan shark in the poor, English town of Glasgow, charged a rate of 25% per week 34
The Birth of Banking The Medici were foreign exchange dealers The Vatican was an ideal client because of the different coinage flowing through its coffers The Medici also offered a bill of exchange service to merchants (equivalent to modern day letters of credit) The Medici bank was diversified, with branch mangers actually hold partnership stakes in the enterprise (unlike other monolithic Italian banks) The Rome branch was soon posting ROE of 30%+ By 1459, Giovanni‟s son Cosimo de‟ Medici effectively was the Florentine State The Medici banking system became a model for later European models (ex: The Amsterdam Exchange Bank) o The Amsterdam Exchange Bank was a way for merchants to settle debts with different currencies o The bank maintained close to a 100% reserve ratio The expansion of the money supply was pioneered by Stockholms Banco in 1657 The word bankruptcy comes from banking - it literally means the breaking of the bank “Cursed with an abundance of precious metal, mighty Spain failed to develop a sophisticated banking system, relying instead on the merchants of Antwerp for short-term cash advances against future silver deliveries” The Evolution of Banking The evolution of the banking industry is not unlike natural evolution: o 1) Recurrent mutation o 2) Speciation (creation of new kinds of firms) o 3) Punctuated Equilibrium (crises would determine which firms survive) The Bank of England gradually developed a monopoly on note issuance in 1826 o Notes were backed by a gold The Fed was not established until 1913 o Until then, the US had run an experiment in wholly free banking: Low capital requirements Low barriers to entry o Many small banks was a recipe for financial disaster o The introduction of deposit insurance greatly stabilized the industry A gold standard stabilized trade but forces central banks to choose between: o 1) regulating capital movements o 2) restricting monetary policy President Richard Nixon closed the gold “window” in 1971, severing the link between currency and the metal Bankrupt Nation Ability to walk away from unsustainable debts is a unique feature of American capitalism Initially designed to engender entrepreneurism o But today, 98% of bankruptcies are non-business ―Breaking the link between money creation and a metallic anchor had led to an unprecedented monetary expansion.‖ The prime cause of the crisis of 2008 was the rise and fall of “securitized lending”, which allowed banks to broker but not hold loans Of Human Bondage Introduction Bond markets began 800 years ago in the Italian city-states
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Bond markets set interest rates for the rest of the economy (because governments are considered the safest credit risks) o Bonds markets pass judgement on the fiscal and monetary policies of governments every day o In a crisis, bond markets can end up dictating government policy (ex: Greece); this is ironic because they are supporters of government policy in good times
Mountains of Debt War was the father of the bond market The Italian Renaissance gave birth to the bond market o Italy city-states in Tuscany (Florence, Sienna, Pisa) hired military contractors to fight wars o Florence maintained dominance, despite large deficits (=50% of GDP), by borrowing from its wealthier citizens o These debts were transferable - in other words, holders could sell bonds o Most of the subscriptions were accounted for by the wealthy elite - hence, the bond market was politicized and the government had an incentive to repay creditors (since the government was operated by the debtors) Venetian wars in Lombardy and the Ottoman Empire were also debt-financed, except these wars drove the cost of borrowing unsustainably high in Venice, grinding business to a halt The Spanish and French crowns sought to raise money in the same way, except that had to use towns as intermediaries o Whereas towns had incentive to honour debts (because the debts were locally held), absolute rulers did not While a thriving bond market developed in London (dominated by “Consol” bonds), Paris had no such financial innovation - this divergence would have profound political consequences Nathan Rothschild was the manager of the London branch of the Rothschild‟s banking network The Battle of Waterloo was the culmination of military standoffs between Britain and France for more than two decades; however, the battle also tested the mettle of two different financing systems: one based on plunder (Napoleon) and the other on debt (Britain) Between 1793 and 1815, the British national debt grew to 2x the economy‟s output Nathan played an important role by utilizing his credit network to supply British allies with payment in the form of gold bullion o When Napoleon returned from exile, the Rothschilds hoarded gold in anticipation of greater transaction volume o When the British won the Battle of Waterloo, the Rothchilds exchanged their gold for British consol bonds and made a fortune on the subsequent rally This move solidified the dominance of the Rothchilds in the bond market, and soon had new clients - French, Prussian, Russian, Austrian, Neapolitan and Brazilian governments seeking to tap the bond market o The Rothschild would underwrite bonds, acting as principals, but remit payment only once installments had been received from buyers; the spreads charged were large and generous o Nathan took pride in dealing only “investment grade securities” o The family also performed currency arbitrage, acted as a private banker, and invested in insurance, railways and mines o A great strength of the banking network was the ability of the buyer of a bond to claim interest at any Rothschild location Populist writer ‗Coin‘ Harvey would depict the Rothschild bank as a vast, black octopus stretching its tentacles around the world Driving Dixie Down 36
The confederate army financed its military endeavours with cotton-backed bonds; these bonds retained their value for the simple reason that, every military setback increased the price of cotton o Moreover, the South restricted the supply of cotton to make it even more valuable o More than 80% of the cotton imports into Britain, the food of the textile industry, came from the Southern United States o This security‟s value depended, however, on the ability of investors to take possession of the cotton o With the fall of New Orleans and the establishment of a Naval Blockade, this ability to take possession was erased As investor confidence collapse, the South was forced to print money to finance war expenditures o Inflation ran to 4,000% in the South, compared to 60% in the North
The Euthanasia of the Rentier The rise of savings banks, which were mandated to hold government bonds as a primary asset, gave the poor some indirect access to the bond market o Still the bond market was fundamentally driven by the economic elite in 19th century The Entente powers in the early 20th century (WWI) could issue bonds in the United States or through-out the capital-rich British empire; meanwhile, the Central powers relied on domestic capital In the 1921, Germany was saddled with a huge external debt worth 3x national income o The annual rate of inflation reached 182 billion % in Germany as the printing press ran its course o This “leveling” of the debt mountain affected the upper-class with significant investments o This was called the “euthanasia of the rentier‖ o ―all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless.‖ Argentina‟s social structure did not support price stability: o Owners of capital were attracted to deficits and devaluations o Sellers of labour grew accustomed to a wage-price spiral o Bondholders were foreigners In the 1989: o The Argentinean government froze banks and exchange houses to prevent the currency collapsed o The World Bank froze lending to Argentina o The austral fell 64% against the dollar Because debts were dominated in USD, Argentina could not print its way out of the devaluation o The national bankruptcy nearly brought down Barings - the both the Rothschilds engineered a bailout fund The Resurrection of the Rentier Structural drivers of inflation: o Trade union density has fallen o Loss-making state industries have been privatized o The investor base of public debt and other fixed income securities has expanded to include all strata of society (through pension funds and savings institutions) o Aging society which demands fixed-income securities and preservation of purchasing power 37
Blowing Bubbles Introduction “the company set out to construct a gas pipeline from Bolivia across the continent to the Atlantic coast of Brazil, and another - the longest in the world - from the tip of Patagonia to the Argentine capital Buenos Aires...those who aspired to span continents need the company.” “in the four hundred years since shares were first bought and sold, there has been a succession of financial bubbles.” “bubbles are more likely to occur when capital flows freely from country to country...finally, and most importantly, without easy credit creation a true bubble cannot occur.” “nothing illustrates more clearly how hard human beings find it to learn from history than the repetitive history of stock market bubbles.” The Company You Keep John Law of Edinburgh was the “most distinguished controller of the treasury of the kings of the French” and also “an ambitious Scot, convicted murderer, a compulsive gambler and flawed financial genius.” The story of the company began a century before Law in the efforts of Dutch merchants to control the lucrative Asian spice trade Journeys to Asian were long and perilous, so the sharing risk, legal separation and raising large sums of capital was required o The Dutch authorities merged the spice companies into a single entity (the “VOC”) in 1602 under a single charter o The scale of the enterprise was unprecedented and subscriptions to the Company‟s capital were open to all Dutch residents The 1612, the VOC was not liquidated, as promised in the original corporate charter, and hence investors had no choice put to sell their stock to recapture their principal; thus the stock market was born o A forward market also quickly developed for VOC shares o “With its quadrangle, its colonnades and its clock tower, this first stock exchange in the world looked for the world like a medieval Oxford college.” o “Once Dutch bankers started to accept VOC shares as collateral for loans, the link between the stock market and the supply of credit began to be forged. The next step was for banks to lend money so that shares might be purchased with credit. Company, bourse and bank provided the triangular foundation for a new kind of economy.” A series of transparency issued lead to restructuring; eventually the VOC was required to pay a 12.5% dividend (practically making the company equivalent to the present-day income trusts) The company systematically expanded Dutch power, driving: o The British from the Banda Islands o The Spaniards from Ternate and Tidore o The Portuguese from Malacca It also entered the financial services business (for Europeans abroad) as well as the commodity exchange business (Japanese silver and copper for Indian textiles and Chinese gold and silk) “As late as 1760, the company still accounted for 3x the amount of British shipping.” “The striking point, however, is that there was never such a thing as a Dutch East India Company bubble.‖ The First Bubble
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In the 18th century, the wars of Louis the XIV had pushed the government to the brink of bankruptcy Law established the Banque Generale in May 1716, which was authorized to issue notes payable in gold and silver coins o Louis the VX declared that Banque Generale notes should be used to pay taxes (enforced by the government) In 1717, a new “Company of the West” (Compangie d‟Occident‟) was granted a monopoly on commerce in Louisiana o Shares in the company were sold to investors of every economic class o Law became the leader of the company The Banque Generale became the Banque Royale in December 1718 - in effect, the first French Central Bank o The transition from coins to paper money had been initiated In May 1719, the Company of the West acquired the East India and China companies, forming the “Mississippi Company” o In September, the Company lent the crown 1.2bn livres to repay its debts o The Company had ultimately transformed the poorly managed public debt into the equity of the Company Law‟s stimulus provided the necessary to move the French economy out of recession Law had become the majority shareholder in the Company o Law therefore continued to expand the monetary base to drive up the share price o “It was as if one man was simultaneously running all five hundred of the top US corporations, the US treasury and the Federal Reserve System” o By the summer of 1719, investors were “generously assisted by the Banque Royale, which allowed shareholders to borrow money, using their shares as collateral; money they could then invest in more shares.” o “They sell estates and pawn jewels to purchase Mississippi.” “It was in these heady times that the word millionaire was first coined.” “Louis XIV of France had said „L‟etat, c‟est moi‟: I am the state. John Law could legitimately say „L‟economie, c‟est moi‟: I am the economy.” When the Mississippi company‟s share price began to decline, Law opened an office at the Banque Royal to purchase shares at a fixed price o However, this required the printing of more notes and hence inflation o Some people began to anticipate a devaluation in the notes‟ value and hence withdrew gold and silver coins o Law obsessively tinkered with the gold/silver exchange rate for the banknotes o Law was effectively converting shares into bank notes Angry crowds gathered outside the Banque Royale as the banknotes exchange ratio was decreased o Law escaped but was brought back by the French monarchs to fix the problem when he returned the stock market rallied On October 10, the government was forced to reintroduce the use of gold and silver in domestic transactions “Laws‟ bubble and bust fatally set back France‟s financial development, putting Frenchmen off paper money and stock markets for generations.” In contract, the South Sea Bubble was less ruinous for England because its architect, John Blunt, never controlled the Bank of England o The South Sea company was set-up to convert government debt (created to fund the War of the Spanish Succession) into the equity of a company that had been chartered to monopolize trade with the Spanish Empire in South America o The Bubble Act was designed to restrict new company floatations
Bulls and Bears
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During the Great Depression: o US output collapsed by a third o World trade shrank by 2/3s as trade barriers and tariffs were erected o Unemployment reached 25% o The US stock market declined 89% The crash of the stock market in October, 1929 is difficult to explain o Page I of the New York Times on the day before Black Thursday featured articles about the fall of the French premier Aristide Briand and a vote in the US Senate about duties on imported chemicals o Roosevelt argued that all Americans had to fear was “fear itself” The power of labour unions restricted the ability of company to reduce wages as prices fell There was a proliferation of institutions known as investment trusts, designed to capitalize on the stock market boom “The Bank of the United States, which accounted for more than a third of the total deposits lost. The failure of merger talks that might have saved the Bank was a critical moment in the history of the Depression.”
A Tale of Fat Tails “if stock market movements followed the „normal distribution‟ or bell curve...an annual drop of 10% or more would happen only once every 500 years, whereas on the Dow Jones it has happened about once every five years” The task force on the great depression blamed much of the stock market decline on the “portfolio insurance strategies” of institutional investors Source of Moral Hazard: There was no great depression in the 1990s, following the crash of 1987, large as a result of the willingness of the Fed to “serve as a source of liquidity to support the economic and financial system” “Greenspan felt it was not for the Fed to worry about asset price inflation, only consumer price inflation.” The Japanese experience: “a conscious effort by the central bank to prick an asset bubble ended up triggering an 80% stock market sell off and a decade of economic stagnation.” “Traders had begun to speak of the “Greenspan put” because having him at the Fed was like having a “put” option on the stock market.” The events of 9/11 forced Greenspan to lower overnight lending rates to just 1% in June, 2003 Enron was a kind of “Energy Bank” o Enron was the 4th largest company in America in 2000 o Employed 21,000 people o “In tapes that became public in 2004, Enron traders can be heard asking the El Paso Electric Company to shut down production in order to maintain prices.” o “Skilling had risen to the top by exploiting new financial techniques like markto-market accounting and debt securitization.” o “The audited balance sheet had understated the company‟s long-term debt by $25bn.” The Return of Risk The Big Uneasy Hurricane Katrina revealed the flaws of an insurance system which divided the responsibility of wind insurance, provided by private insurers, and flood insurance, provided by the government Scruggs, an advocate for New Orleans residents, alleged that the insurers (principally State Farm and All State) were trying to renege on their legal obligations...detailed meteorological research showed that nearly all the damage...was caused by the wind hours before the floodwaters struck.”
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When insurance fails, is the only way to nationalize natural disaster insurance, creating an open-ended liability for governments? The earliest forms of insurance were likely burial societies, that provided resources to the members widows and orphans o Such societies remain the only form of financial institution in some of the poorest parts of East Africa
Taking Cover Two Scottish ministers deserve credit for creating the firm insurance fund in 1744 “Bottomry - the insurance of merchant ships‟ „bottoms‟ - was where insurance originated as a branch of commerce.” “It was not until the 1350s that true insurance contracts began to appear, with premiums ranging between 15 and 20 percent of the sum insured, falling below 10% of by the 15th century” o In the late 17th century, something like a dedicated insurance market began to form in London Life insurance also existed in the medieval ages o Florentine bankers wrote insurance contacts on the life of the pope, the doge of Venice and the King of Aragon However, these insurance systems were not based on a quantitative way of measuring risk “Robert Wallace was hard drinker as well as a mathematical prodigy”. He and Alexander Webster argued that “rather than merely having ministers pay an annual premium, which could be used to take care of widows and orphans as and when ministers died, they argued that the premiums should be used to create a fund that could then be profitably invested. Widows and orphans would be paid out of the returns on the investment, not just the premium themselves. All that was required for the scheme to work was an accurate projection of how many beneficiaries there would be in the future, and how much money could be generated to support them.” Insurance funds were soon set-up across the English-speaking world Insurance funds were even used to protect the widows of soldiers who died fighting Napoleon No one anticipated that insurance funds, and their relatives pension funds, would soon become some of the largest investors in the world From Warfare to Welfare The state achieves the ultimate economies of scale in insurance: cover every citizen from birth to death 1) the extending of voting power to all classes of society and 2) the mass destruction of WWI made the welfare state an attractive financial alternative o Universal insurance also removed costly advertising The “warfare-welfare” state offered social security in return for military sacrifice o “Japan had achieved security for all - the elimination of risk - while at the same time its economy grew so rapidly that by 1968 it was the second largest in the world.” o The individualism of the West turn the public insurance industry into a system of state handouts which skewed economic incentives, providing no reward for the high income earners who were forced to pay, in some cases, marginal tax rates above 100% One of the most pronounced economic trends of the past 25 years has been the dismantling of the welfare state The Big Chill In Chili, the public pension system had severed the link between effort and reward
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Reforms focused on property rights - instead of a mandatory deduction of their income, Chileans were required to save privately with a pension company o Not only did this give citizens a feeling of ownership, but it also increased the savings rate, giving the economy a shot in the arm “America‟s welfare system is ill prepared to cope with a rapid increase in the number of claimants. But this is precisely what Americans face as the members of the so-called “Baby Boomer” generation, born after WWII, begin to retire.” o “The cost of Medicare alone will absorb 24% of all federal income taxes by 2019”
The Hedged and the Unhedged The 9/11 terrorist attacks resulted in insurance losses of between $30-58bn; these, like the Hurricane Katrina losses, resulted in government subsidies/support to insurance companies The origins of hedging are agricultural; it was not until the 1970s that future contracts were written on interest rates and currencies There are also derivatives for extreme weather conditions, which insurance companies buy from specialized hedge funds o The notional value of weather derivatives in 2006 was about $45bn o These are called cat bonds Safe as Houses Introduction The game of Monopoly was originally introduced to expose the exploitive nature of the landlord-tenet system The single most important source of funds for entrepreneurship in the US is a mortgage on the business owner‟s house Half of GDP growth in 2005 was housing-related The US is the world‟s first property-ownership democracy, with between 65-83% of householders owning their house The Property-owning Aristocracy In the past, suffrage was closely related to property ownership Aristocrats took advantage of property ownership to finance conspicuous-consumption lifestyles o Banks, insurance companies and other financial institutions were attracted to mortgages as seemingly risk-less investments The advent of universal suffrage did not mean universal property rights: as late as 1938, less than a third of US housing was held by occupants Home-owning Democracy Before the 1930s, about 40% of American householders owned their house The spread between corporate debt and mortgage rates was 2%, compared with 0.5% in the last 20 years In a riot in Detroit during the Great Depression, five men were killed by American authorities While some societies tended toward totalitarianism, the Roosevelt administration pioneered the concept of property-owning democracy o Roosevelt introduced deposit insurance to protect the mortgage market o He also established many government-sponsored mortgage enterprises to support the mortgage market o Fannie Mae, established in 1938, issued bonds and used the proceeds to buy mortgages from savings and loan institutions o It is during this time that the suburb was born
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o o
“From the 1930 onwards, the US government was effectively underwriting the mortgage market, encouraging lenders and borrowers to get together” Freddie Mac was setup to create competition in the mortgage market
From S&L to Subprime “What follows is a story not so much about about real estate as about surreal estate.” The high inflation rate in the 1970s and the hard-money policies of Volcker damaged the savings and loan industry o Losses on mortgage assets from inflation o Loss of depositors due to higher returns on money market securities The response by Washington was financial regulation o S&Ls could invest in anything - stocks, junk bonds, commercial real estate, etc. o S&ls could pay any return on deposits, but these deposits were still federally insured Furthermore, S&Ls could raise capital from $100k certificates of deposits, which were brokered by middlemen o This created a clear moral hazard - “the best way to rob a bank is own one.” S&Ls constructed enormous commercial and residential complexes on short-term debts o Ultimately, the federal entity that insured deposits was insolvent o 500 S&Ls collapsed or were forced to close down Bond traders at Salomon Brothers purchased these mortgages as the S&Ls collapsed; they repackaged the mortgages into MBSs and sold their first in June 1983. It was the dawn of a new era of American finance. o In 1980 only 10% of the home mortgage market had been securitized; by 2007, it had risen to 56% o This process severed the emotional connection between mortgage bankers and homeowners (as in It‘s a Wonderful Life) Significantly, a disproportionate number of subprime borrowers belonged to ethnic minorities In October 2002, President George W. Bush said “We want everybody in America to own their own home.” o Lenders were pressed not to ask subprime debtors for full documentation o Fannie Mae and Freddie Mac were pressured to support the subprime market o Mortgage bankers sold their mortgages en masse to Wall Street bankers who repackaged and sold the mortgages in CDO tranches, endorsed by Moody‟s or S&P as AAA credit quality “Sellers of these „structured products‟ boasted that securitization was having the effect of allocating risk „to those best able to bear it‟. Only later did it turn out that risk was being allocated to those least able to understand.” As soon as property markets slipped, 100%-mortgage-owners found themselves insolvent and the property market quickly deteriorated with over-supply Half a trillion dollars worth of CDO tranches had been sold in 2006 Hedge funds that had specialized in the equity-tranches of the CDOs were the first to suffer (i.e., Bear Stearns hedge funds) The amount of leverage in the system amplified problems: o 1) hedge funds, which had borrowed from banks o 2) SIVs, off-balance sheet bank entities, that relied in commercial paper markets to fund long-term CDO assets The regulatory agency that oversaw Fannie and Feddie had encouraged the institutions to undertake more subprime assets by reducing their capital ratios to just 5% of assets House prices are “sticky” on the way down because owners dislike reducing prices As Safe as Housewives
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Lack of property rights in poor nations prevent households from borrowing against their homes Owners generally take better care of their property than tenants “It‟s not owning property that gives you security; it just gives your creditors security” “Women are actually a better credit-risk than men” Micro-finance organizations are providing home loans to impoverished areas Housing represents two thirds of the average US household‟s asset portfolio
From Empire to Chimerica Introduction Economists predict China will surpass the US economy by 2027 o Challenges include 1) the demographic effects of the one-child policy and 2) the environmental fall-out from their industrial revolution Dramatically different legal and regulatory environments have deterred financial integration between the East and West until recently The outbreak of WW1 made exchange rates go haywire, as foreign investors simultaneously attempted to repatriate their investments o The Great Depression saw the rise of investment barriers as countries attempted to control exchange rates Economic Hit Men The USD has replaced the gold standard as the international reserve currency The guardians of the new world financial order are the IMF and the World Bank “In the 1960s, US public sector deficits were negligible, but large enough to prompt complaints from France that Washington was exploiting its reserve currency status in order to collect seigniorage from America‟s foreign creditors by printing dollars, much as medieval monarchs had exploited their monopoly on minting to debase their currency.” Debtors countries to emergency loans were required to deregulate markets, including capital markets - this made “hot money” hot again The rise of the hedge funds is one of the most important changes in the finance industry since WWII o George Soros pioneered the concept of borrowing from investment banks to amplify returns LTCM sold long-dated options on American and European stock markets on the premise that these options were overpriced by the Black-Scholes model o People started called LTCM the Central Bank of Volatility o “At peak, they had $40m riding on each percentage point change in US equity volatility” o By the calculations of LTCM‟s managers, it would take a ten-sigma move to destroy LTCM‟s capital base (despite leverage 31:1 debt to equity) The Russian debt default drove volatility indices to 45% (implying indices would move 3% per day for the next five years) o In quant-speak, all correlations went to one o LTCM lost $1.8bn in one month (44% decline) The FED of NY brokered a $3.625bn sale of LTCM to Wall Street investment banks LTCM‟s models worked with just five years of data. “If models had gone back even eleven years, they would have captured the 1987 stock market crash” “When once they were the preserve of „high net worth‟ individuals and investment banks, hedge funds are now attracting growing numbers of pension funds and university endowments” Chimerica
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When the Chinese wanted to attract foreign capital, they insisted that it take the form of FDI, instead of “hot money” bank lending “the best way for China to employ its vast population was through exporting manufactures to the insatiably spendthrift US consumer. To ensure that those exports were irresistibly cheap, China had to fight the tendency for the Chinese currency to strengthen against the dollar by buying literally billions of dollars on world markets part of a system of Asian currency pegs hat some commentators called Bretton Woods II.” “by selling billions of dollars of bonds to the People‟s Bank of China, the United States has been able to enjoy significantly lower interest rates than would otherwise have been the case.” “The East Chimericans did the saving. The West Chimericans did the spending. The Chinese imports kept down US inflation. Chinese savings kept down US interest rates. Chinese labour kept down US wage costs.” “The more China was willing to lend to the United States, the more Americans were willing to borrow. Chimerica, in other words, was the underlying cause of the surge in bank lending, bond issuance and new derivative contracts that Planet Finance witnessed after 2000. It was the underlying cause of the hedge fund population explosion. It was the underlying reason why private equity partners were able to borrow money left, right and centre to finance leveraged buyouts. And Chimerica - or the Asian „savings glut‟, as Ben Bernanke called it - was the underlying reason why the US mortgage market was so awash with cash in 2006 that you could get 100% mortgage with no income, no job or assets.” By the end of 2007, sovereign wealth funds had accumulated $2.6tn in assets The acquisition of resources assets by China, notably in Africa, has an unnerving imperial undertone The average career of a Wall Street CEO is 25 years - which means most executive on Wall Street do not have financial memories that extend before 1985
Afterword: The Descent of Money The heuristic biases of investors plays a role in financial market volatility o A loss has about 2.5x the impact of a gain of equivalent magnitude o Availability bias - we base decisions on information that is readily available o Confirmation bias - we look for evidence that confirms our theses o Affect heuristic - preconceived value judgements interfere with our assessment of costs and benefits o Overconfidence - we overestimate our abilities Darwinian evolution analogy o 1) genes - information is stored in organizational memory o 2) spontaneous mutation - i.e., innovation o 3) competition o 4) mechanism for natural selection through the mobility of capital o 5) co-evolution (ex: primer brokers and hedge funds) Hedge funds, private equity companies and sovereign wealth funds are all relatively recent organizations The financial equivalent to reproduction is earning a reasonable ROE and encouraging imitation However, financial markets are guided, in some sense, by regulators, whereas natural evolution occurs in a vacuum If off-balance sheet commitments are included, BoA‟s leverage ratio was 134:1 in September of 2008 Without the boost from home equity withdrawals, the US GDP growth rate during Bush‟s presidency would have been around 1%
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“A direct consequence of all these new expenditures will be a huge increase in the government deficit, which is set to exceed 12% of GDP or 44% of total federal expenditure in 2009. Not since WWII has the gap between expenditure and tax revenue been so wide. The mystery at the time of writing is who exactly will buy the $1.75tn of new US bonds. The Chinese, faithful to the Chimerican partnership? American householders, suddenly converted to thrift? Of the Fed, armed with the monetary printing press?”
The (Mis)Behaviour of Markets - Benoit Mandelbrot
Part One: The Old Way Risk, Ruin and Reward
The probability of the 29.2% decline on October 19, 1987 was 1 in 10 50 Stock markets are not predictable but risk follows patterns Bachelier extended probability theory into French government bonds – this was the birth of modern finance theory Financial orthodoxy based on two assumptions: o Price changes are independent – price changes actually have memory o Prices changes are normally distributed – the curve is “fat-tailed” Volatile volatility – volatility is large and clusters non-uniformly across time Markets react to endogenous (inner workings) as well as exogenous (news) forces Markets create spurious patterns
By the Toss of a Coin or the Flight of an Arrow
Modern finance theory is based on Gaussian distributions, which do not account for very large fluctuations that displace the mean The standard finance model is not “wild” enough
Bachelier and His Legacy
Bachelier started with the notion that French government bonds were fairly price and therefore securities markets were a “fair game”, like flipping a coin This is the foundation of the efficient market hypothesis – securities are fairly priced at all times and reflect all relevant information
The House of Finance
CAPM, MPT and Black-Scholes are all models that depend on Bachelier‟s work o MPT relies on standard deviation to compute the “market portfolio” o CAPM relies on the market portfolio for the relevance of beta o Black Scholes depends on continuous, measurable risk to value the “time value” of the option
The Case Against the Modern Theory of Finance
Volatility surface – surface showing implied volatilities and how they vary with options variables Assumptions of the EMH: o People are rational – counter-argument: behavioural finance o Homogenous expectations – counter-argument: example of a fundamentalist and a technical analyst interacting o Price changes are continuous o Normal distribution and independence of events Momentum effect discredits independence of events
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LTCM demonstrates that, in a crisis, all independence fails: correlation goes to one
Part Two: The New Way The Mystery of Cotton
The standard deviation of cotton prices continued to shift over time The income curve is not symmetric but rather “fat bottomed”
Long Memory, from the Nile to the Marketplace
Correlations are strongest in the short-term – plotting all of the correlations from shortterm to long-term yields a rapidly falling curve “Human nature yearns to see order and hierarchy in the world. It will invent it where it cannot find it.” Securities markets tend to vary in “H”, as the author calls it, which measures the persistence or “memory” in a market o An H = 0.5 implies data points are independent; H > 0.5 implies persistence o This observation demonstrates that securities markets are not i.i.d. – independent and identically distributed
Noah, Joseph and Market Bubbles
Noah represents large market movements / anomalies (measured by alpha – a statistical tool the author created) Joseph represents persistence in prices (measured by H, the Hurst Coefficient) The author assets that these two forces mix together to influence financial market movements
Part Three: The Way Ahead Ten Heresies of Finance
1) Markets Are Turbulent 2) Markets Are Very, Very Risk – More Risk Than the Standard Deviation Theories Imagine 3) Market “Timing” Matters Greatly. Big Gains and Losses Concentrate into Small Packages of Time o In the 1980s, 40% of the positive returns came from 0.5% of the time 4) Prices Often Leap, Not Glide. That Adds to the Risk. o Continuity is a fundamental assumption of modern finance theory 5) In Markets, Time is Flexible 6) Markets in All Places and Ages Work Alike 7) Markets Are Inherently Uncertain and Bubbles Are Inevitable 8) Markets Are Deceptive o “People want to see patterns in the world. It is how we evolved.” 9) Forecasting Prices May be Perilous, but You Can Estimate the Odds of Future Volatility o Volatility clusters – one cannot predict price movement directions but one can predict magnitudes 10) In Financial Markets, the Idea of “Value” Has Limited Value
In The Lab
Problem 1 – analyzing investments Problem 2 – building portfolios o Standard beta analysis underestimates beta by 6% 47
Problem 3 – valuing options o Implied volatilities differ across option characteristics (time, strike) o Different departments of a bank commonly use different option pricing practices Problem 4 – managing risk o VAR is based on Brownian motion assumptions
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I. Technical Knowledge Comparison of Valuation Techniques - Personal Notes Comparable Companies Analysis Pros: Market-based o Reflects market‟s growth and risk expectations Relativity Quick and convenient Current Useful for minority investments Reveals vulnerable targets Learning o Offers opportunity to learn about industry landscape Cons: Market-based o Skewed during periods of market irrationality Absence of relevant comparables o May not be able to identify pure play comparables Potential disconnect from cash flows Company-specific issues o Failure to capture strengths, weaknesses, opportunities, threats Unrealistic - does not take account of: o Control premium o Synergies Screening Dimensions: Operating Analysis Industry / sector Product mix Distribution channels Customer / supply chain positioning Ownership dispersion o Dual class structure Industry position (leader / middle / bottom) Seasonality / cyclicality Financial Analysis Size Margins Return on investment Growth Credit profile Precedent Transactions Analysis 49
Pros: Market-based Current Relativity Simplicity Objectivity Trends o Opportunity to identify key deal drivers and dynamics Cons: Market-based Time-lag o Occurred in the past and may therefore not be representative of prevailing market conditions Existence of comparable acquisitions Availability of information o Transactions that occur at a divisional level will not have associated financial statistics Wide variance o Each deal has different circumstances and multiples reflect this Acquirer‟s basis for valuation o Premium is determined by 1) expected financial performance 2) expected synergies and the LTM multiple may therefore be irrelevant Discounted Cash Flow Analysis Pros: Cash flow based Market independent Self-sufficient o DCFS are particularly important when pure plays are unavailable Flexibility o Permits the integration of synergies and scenarios Cons: Dependence on financial projections False sense of security o Sophistication makes the DCF analysis feel like a science Sensitivity to assumptions Terminal value Assumes a constant capital structure o Does not provide flexibility to change capital structure over time Leveraged Buyout Analysis Pros: Floor value o Sets a minimum bid price for strategic buyers Stapled financing package o Provides financing package assumptions to sponsors approached in M&A sale process DCF-based 50
o
An extension of existing DCF model and therefore relatively simple to implement
Cons: Debt markets o Highly dependent upon the condition of debt markets Assumptions o Laden with assumptions because it is based upon DCF model Financial distress o Does not directly take account of the costs of financial distress, which becomes more likely under the LBO model
Comparable Companies Analysis - Investment Banking by Rosenbaum & Pearl Introduction Core of the analysis is selecting a comparable company universe These comparables are then benchmarked against one another P/E is broadly used beyond wall street, but EV/EBITDA is employed by bankers because it is neutral: o Capital structure differences o Tax regime differences o Depreciation policy differences It is important to diligently footnote key sources and assumptions during the process Step 1 - Select the Universe of Comparable Companies The first source to consult for comparables is senior bankers For companies without a clear set of comparables, bankers seek peers outside of the core industry with similar business characteristics: o Ultimate customers are the same o The independent product is ultimately the same o Companies are influenced by the same cycles and patterns 1) Study the target o Analyze traditional sources of information or CIM 2) Identify key characteristics of the target o Business profile Sector Products and Services Customers and End Markets Customers - determine the supply chain positioning of the target o Diversity of the customer base is also important End markets - the ultimate consumer that drives the supply chain o A company‟s performance is affected by the behaviour of its end market Distribution Channels Some businesses sell at multiple levels of the distribution channel Geography o Financial profile Size Market valuation - enterprise value, market capitalization, etc. Financial statistics - revenue, EBITDA, net income, etc. 51
Businesses of similar size are similar in other represents: o Economies of scale o Purchasing power o Pricing leverage o Trading liquidity of stock Profitability Analysis of key margins Growth Profile Determine growth drivers: o Organic growth o Acquisition-driven growth Return on Investment ROA ROE ROIC Credit Profile Liquidity Leverage Coverage Rating agencies 3) Screen for comparables o Sources of comparables: SIC Run Databases - CapIQ, Thomson Reuters, Bloomberg, etc. Discussion of competitors in MD&A Initiating coverage report Proxy statement for recent merger (“merger proxy”) Analyze the fairness opinion - this will contain a comparables table
Step 2 - Locate the Necessary Financial Information Key sources of information: o SEC filings 10-K 10-Q 8-K Proxy Statement Equity research reports o Research reports Consensus estimates o Press releases o Financial information sources 1) Size o Market Valuation Widely used metric - calculate the % of the 52-week high/low the current share price accounts for Compare this with peer groups Look for trends and outliers Fully diluted shares outstanding (“FDSO”)• share price = equity value FDSO = basic shares outstanding + in-the-money options / warrants + in-the-money convertible securities A) Adjusting for in-the-money options: Treasury Stock Method o Incremental shares from options/warrants =
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If( closing price > weighted average strike of issue, # of common stock, 0) Less: (# of common stock issued from options • w.a. strike) / closing price This quantity represents the number of shares retired from the option proceeds B) Adjusting for in-the-money convertible securities o Conversion price - effective strike price on convertible security o I) If-Converted If closing price > conversion price, issue stock # = outstanding value / conversion value This convertible debt must now be excluded from the calculation of net debt (since it is assumed the convertible is now an equity claim) Remember to adjust net income by adding back the after-tax interest associated with the convertible security Accounting convention requires the target to test the EPS under the assumption that 1) the convertibles are converted according to the above rules 2) the convertibles are not converted; the more diluted EPS is used o II) Net Share Settlement Only the excess of the closing price over the conversion price results in the issue of new shares (i.e., treasury stock method treatment) Incremental shares = [(Closing price conversion price) • # of embedded options] / closing price Enterprise value = Equity value + total debt + preferred stock + minority interest - cash and cash equivalents (as well as investments) A company‟s enterprise value is independent of capital structure decisions except in cases where a high-degree of leverage has resulted in: o 1) limitations on growth o 2) perceived higher risk of financial distress Financial Statistics o Sales Gross Profit EBITDA EBIT Net Income 2) Profitability o Gross margin o EBITDA margin o EBIT margin o Profit margin 3) Growth o Calculate growth using CAGR (compounded annual growth rate) 4) Return on Investment o Return on invested capital = EBIT / (avg. net debt + equity value)
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o Return on equity = net income / avg. shareholders‟ equity o Return on assets = net income / avg. total assets o Dividend yield = (most recent qtr. dividend • 4) / share price 5) Credit Profile o Leverage Times-EBITDA ratios: Total Debt / EBITDA Net Debt / EBITDA Senior Debt / EBITDA Debt / (EBITDA - capex) Debt-to-capitalization = debt / enterprise value o Coverage EBITDA / interest expense (EBITDA - capex) / interest expense EBIT / interest expense o Rating agencies
Step 3 - Spread Key Statistics, Ratios and Trading Multiples “Spreading” comps refers to calculating key statistics 1) Standardization of comparables: o Calculate LTM o Calendarization of company financials Adjust financial statistics to conform to a calendar year end o Adjustments for non-recurring items Process known as “scrubbing” or “sanitizing” Typical charges: Restructuring events Losses on asset sales Changes in accounting principles Inventory write-offs Goodwill impairment Extinguishment of debt Losses from litigation settlement It is important to determine whether an event is non-recurring - what is recurring for one business may not be recurring for another When adjusting for non-recurring items, it is important to consider tax For EBIT / EBITDA: o Gross-up all after-tax items (ex: extraordinary items) o Do not apply tax to pre-tax items (ex: gain/loss on asset sale) For after-tax statistics (ex: net income): Apply taxes to pre-tax items o Adjustments for Recent Events o Examples: M&A transactions Financing activities Conversion of convertible securities Stock splits Share repurchases 2) Calculation of Key Trading Multiples o (Equity multiple) Price-to-earnings multiple: Remember that this multiple is not independent of: Capital structure decisions Accounting policies governing depreciation 54
Non-recurring items Note that: Equity value / net income = Price / Diluted EPS o **This ratios align because equity value has always been “diluted” by adding the affect of convertible and option conversion Enterprise multiples: EV / EBITDA EV / EBIT This may be useful for businesses with high capex requirements EV / Sales Useful for businesses without strong / positive earnings (ex: high growth technology companies) Industry specific multiples: Enterprise multiples: o EV / Access Lines Telecom o EV / EBITDAR Casinos Restaurants Retail o EV / EBITDAX “EBIT before depreciation, depletion, amortization and exploration expense” Natural gas Oil and gas o EV / Production Capacity (in units) Metals and mining Natural resources Oil and gas Paper and forest products Utilities EV / Reserves o Metals and mining Natural gas Oil and gas o EV / Subscriber Media Telecommunications o EV / Square Footage Real estate Retail Equity multiples: o Price / book value Financial institutions Homebuilders o Price / funds from operations o Price / net asset value Financial institutions Real estate
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Step 4 - Benchmark the Comparable Companies Additional screening process to find a smaller set of truly comparable companies Bankers hone in on a select set of comparables to establish a precise valuation range 55
1) Benchmark the Financial Statistics and Ratios - screen peers for consistency across financial statistics and ratios 2) Benchmark for Trading Multiples - remove outliers from valuation process
Step 5 - Determine Valuation High and lows of the universe provide further guidance in terms of a potential ceiling or floor Only a few peers ultimately serve as the basis for valuation Apply the high, low and median to determine a valuation range
Precedent Transactions Analysis - Investment Banking by Rosenbaum & Pearl Introduction Not uncommon to consider deals with targets in different sectors, but related by: o End consumer o Distribution channel o Financial profile In general, the most recent transactions are the most relevant (because they reflect the current corporate asset market sentiment) Transaction comparables trend to provide a higher multiple because: o Control premium - acquirers pay a premium to conduct corporate decision making o Synergies - acquirers‟ willingness-to-pay is augmented by synergies Synergy: expected cost savings, growth opportunities, and other financial benefits that occur as a result of the combination of two businesses The transaction analysis output page includes: o The transaction type: Is the target/acquirer public / private? Purchase consideration (cash/stock/mix) Premium paid (relative to select prices) Step 1 - Select the Universe of Comparable Acquisitions Primary source - senior bankers Secondary source - M&A databases, merger proxies, news runs, etc. 1) Screen for comparable acquisitions o Screening sources: Target‟s M&A history Target universe of comparable companies Merger proxies Equity and fixed income research reports 2) Examine other considerations o Market conditions Technology bubble - stock used as primary acquisition currency Credit bubble - financial sponsors WTP increased o Deal Dynamics Strategic buyer v. financial sponsor Strategic buyers are able to pay more because of: o Synergies o Lower cost of capital / IRR threshold Motivations Sponsor situation: if the acquisition is a bolt-on acquisition, WTP may be increased 56
Financial distress: corporations in distress may divest assets at a below-market price to accelerate the process Sale process and nature of the deal High premiums o Many prospective buyers o Hostile situations Low premiums o Merger of equals - both parties forego premium in partnership Purchase consideration Stock deals tend to have lower valuations because the premium is realized in conjunction with the anticipated synergies, after the deal closes
Step 2 - Locate the Necessary Deal-Related and Financial Information 1) Public targets o Proxy statements Background and terms of the deal Description of the financial analysis underlying the fairness opinion A copy of the definitive purchase/sale agreement Summary of the pro forma financial data o Schedule TO / Schedule 14D-9 Recommendation from target‟s board of directors in a hostile situation Registration Statement / Prospectus o Document associated with the issuance of new shares o Schedule 13E-3 Additional information provided in a going-private transaction o 8-K Filed within four days of the transaction announcement o 10-K and 10-Q o Equity and Fixed INcome Research 2) Private Targets o Stock-deals have more information (particularly when more than 20% of the outstanding stock is issued) o News-run are an important source of information Step 3 - Spread Key Statistics, Ratios and Transaction Multiples Input page includes: o Purchase price o Form of consideration o Target financial statistics Differ from comparables in two ways: o Premium paid o Transaction multiples calculated on a LTM basis prior to the acquisition 1) Equity value = offer value o Identical calculation except price is the offer price o In cases where less than 100% of the equity is purchased, the offer value must be grossed up to calculate the implied equity value o Assumes all in-the-money options are exercised at the offer price Assumes that all unvested options and warrants vest upon a change of control (this typically reflects actual circumstances) 2) Purchase Consideration o 2A) All Cash A taxable event is triggered in a cash-deal o 2B) All Stock 57
Exchange ratio = offer price / acquirer share price Fixed Exchange Ratio Number of shares issued remains constant Offer value is variable More common Links target and acquirer share price, hence sharing risk Collar - structural protection for target shareholders to mitigate volatility risk in the acquirer‟s share price Floating Exchange Ratio Number of shares issued fluctuates to ensure a consistent offer price o Movements in the acquirer‟s share price do not affect the value of the deal Number of shares issued is a function of an average of the acquirer‟s share price This structure is usually employed when the acquirer is significantly larger than the target 2C) Mixed Deal o 3) Enterprise value = transaction value o The acquirer assumes the target‟s net debt / refinancing o Hence, transaction value is calculated in the same manner as enterprise value 4) Multiples - calculated on a LTM basis 5) Premium paid o Refers to excess of offer price over unaffected share price o Premium is often calculated based upon several days‟ closing price (to avoid the affect of information leakage) 6) Synergies o Public acquirers often provide synergy guidance o Synergy adjusted multiple: EV / (LTM EBITDA + synergies)
Step 4 - Benchmark the Comparable Acquisitions Examination of: o Key financial statistics of the targets acquired o Circumstances surrounding deal Step 5 - Determine Valuation Like a comparable company analysis, bankers focus on a few similar transactions Red Flag - transaction multiple is below public comparable company valuation
Discounted Cash Flow Analysis - Investment Banking by Rosenbaum & Pearl Introduction Advantages: o Market-neutral (unaffected by market aberrations) o Valuable when there are no comparable / pure-play companies o Provides flexibility required to analyze target under multiple scenarios Disadvantages: o WACC and terminal value have a substantial impact on output o Therefore, a DCF is viewed as a range of valuations o This range is determined via a sensitivity analysis Step 1 - Study the Target and Determine Key Performance Drivers Information typically provided in the form of a CIM (confidential information memorandum) 58
I) Study the target o Sources of information MD&A of most recent 10-Q and 10-K Management outlook (the “management case”) Confidential Information Memorandum II) Determine key performance drivers o Internal: New stores/facilities New products New customers Operational improvements Working capital efficiency Etc. o External: Acquisitions End market trends (understand ripple-effect through supply chain) Consumer buying patterns Macro-economic factors Legislative/regulatory changes Etc.
Step 2 - Project Free Cash Flow Projection of the company‟s unlevered free cash flow Projection period of typically five years; variations depend upon: o Sector o Stage of development o Predictability of FCF Goal is to project FCF until the firm reach‟s a “steady state” FCF is independent of capital structure - it is available to all capital providers I) Considerations for Projecting Free Cash Flow o Historical performance is a reliable indicator except for companies in highlycyclical industries or for very young companies o It is more appropriate to build long-term models for young companies which will not mature for some time o Case types: Management case - five year projection by management team Base case - adjustments made to management case by bankers Used as basis for various scenarios (up/down) Analyst consensus - used when management case is unavailable Usually only available for 2-3 year period II) Projection of Sales, EBITDA, EBIT o Sales projections Use of industry and consulting reports for sector trends Highly cyclical businesses may require adjustment for underlying commodity The terminal year must represent a normalized value (neither a high nor a low in the cycle) Sanity check for sales against: Historical growth rate Peer estimates Sector / market outlook Sales projections must be supported by growth in underlying infrastructure: PP&E
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Working capital investments Etc. COGS and SG&A Projections Typically taken as a margin of sales Note that COGS must be carefully estimated because it serves as the basis for: o Inventory roll-overs o A/P roll-overs EBITDA and EBIT Projections Common approach is to hold margins constant according to analyst expectations III) Projection of FCF o Tax projections Typically assume a marginal tax rate of 35-40% Actual margin tax-rate is used as a reference o Depreciation Often buried in COGS and SG&A Use the explicitly stated value in the statement of cash flow Methods of forecasting depreciation and amortization: 1) assume as a % of o sales or o capex (based on a replacement ratio) 2) build a PP&E schedule based upon capex schedule and calculate depreciation from this PP&E schedule These methods will often not result in meaningful differences o Amortization Represents a decline in value in intangible assets: Non-compete clauses Copyrights Licenses Patents Trademarks Intellectual property o Capex Base case provided by historical levels; deviations caused by: Strategy Sector Phase of operations Typically driven by sales (since PP&E investments are required to drive sales) o Net working capital Current assets Accounts receivable Inventory Prepaid expenses and other current assets Current liabilities Accounts payable Accrued liabilities Other current liabilities Growing companies typically have rapidly growing inventories (to support accelerating sales) Approaches to modelling NWC: 1) % of sales o Justification: NWC investment required to drive sales 60
o Used when COGS is unavailable 2) efficiency ratios employed to predict NWC items: o Accounts receivable - driven through days A/R (avg. A/R / Sales) • 365 Driven by: Customer leverage Worsening customer credit Collection system Change in product mix o Inventory - driven through days inventory ((avg. inventory) / COGS ) • 365 Inventory turns = COGS / avg. inventory Lower inventory turns improves a business by: Reducing unavailable cash Reduces the probability of inventory: o Theft o Damage o Obsolescence o Prepaid expense and other current assets - driven as a % of sales o Accounts payable - driven through days A/P ( (Avg. A/P) / COGS ) • 365 Companies aspire to “push-out” borrowing relationships o Accrued liabilities and other current liabilities Includes: Salaries Rent Interest Taxes Also projected as a % of sales
Step 3 - Calculate the WACC Calculate of the cost of capital based upon capital structure In a sum-of-the parts analysis, each division has a separate WACC based upon pure-play cost of capital I) Determine Target Capital Structure o Hierarchy of information: 1) Management targets 2A) Historical capitalization 2B) Peer capitalization o WACC continues to decrease until an optimal capital structure is reached, after which the marginal costs of financial distress exceed the marginal benefit of the tax shield from debt
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II) Estimate the Cost of Debt o Cases: 1) firm is at its optimal capital structure Cost of debt is calculated from a blended yield on outstanding debt instruments o Private debt - consult with in-house DCM team o Public debt - calculate YTM 2) firm is not at its optimal capital structure Peer YTM / cost of debt employed Credit rating method: o 1) available credit rating = add spread to treasury of appropriate maturity o 2) synthetic credit rating constructed III) Estimate the Cost of Equity o The historical returns on equity include both: Capital gains yield Dividend yield o CAPM assumes investors are compensated for systematic risk only o The risk-free rate is based upon a long-term treasury: 10 years is a typical proxy Bankers may use longer-term treasury yields if available Market risk premium o Based upon historical risk premiums Between 1926 and 2007, market risk premium was about 7.1% Equity risk premiums differ from 4-8% on wall street Most investment banks have a standard equity risk premium employed across the bank for consistency o Beta 62
1) Beta 2) Beta
is available (publicly traded) Bankers prefer to use the predicted beta where possible is unavailable (privately held) Determine the average unlevered beta for the peer group (apply the unlevering formula based upon the market values of the peers) Relever the beta based upon the target‟s capital structure
Size Premium Smaller companies often afford a premium because of liquidity Hence, a size premium is often added for small companies in proportion to market capitalization IV) Calculate WACC o
Step 4 - Determine Terminal Value Represents the value of the firm that results when performance normalizes Two methods: o Exit multiple method (EMM) o Perpetuity growth method (PGM) It is common to show the implied growth rate as a function of: o 1) the exit multiple o 2) the WACC I) Exit Multiple Method o Ensure a normalized multiple (not the result of a cyclical high or low) II) Perpetuity Growth Method o Check the growth rate against the multiple and vice versa
Step 5 - Determine Valuation Commonly sensitized variables: o Sales growth o Margins o WACC o Exit multiple / perpetuity growth rate (these are synonymous at a fundamental level) I) Determine Valuation o Take the present value of the UFCF @ WACC II) Estimate the Equity Value o Deduct net debt from enterprise value (and any other non-equity claim) to determine equity value o To determine equity value per share, it is important to calculate the fullydiluted shares outstanding; this will create a circular reference: The value per share is required to determine which options/convertible bonds are in-the-money (and hence the number of fully diluted shares outstanding) The FDSO is required to calculate value per share Apply the iteration function in excel to solve this problem III) Perform Sensitivity Analysis o Sensitivity analysis is a testament to the fact that DCF modelling is an art not a science
Leveraged Buyouts - Investment Banking by Rosenbaum & Pearl Introduction The ultimate purpose of a leveraged buyout is to realize an acceptable return of 20%+ Typical composition of an LBO transaction: 63
o Debt: 60-70% of transaction value o Equity: 30-40% of transaction value A strong asset base increase the amount of bank debt available to the borrower (which has the lowest cost of capital) Free cash flow is used to: o Repay debt o Provide capital for bolt-on acquisitions Appropriate financing structures balance: o 1) the retirement of debt o 2) the growth needs of the business o Investment bankers play a critical role in constructing this structure by: Arranging and underwriting debt Determining an acceptable resulting purchase price Investment banks provide post-closing services to sponsors: Future MA& activity (bolt-on acquisitions) Refinancing opportunities Traditional exit events: o Sale to strategic o Recapitalization o IPO
Key Participants Financial Sponsors o Financial sponsors include: Private equity firms Merchant banking divisions of investment banks Hedge funds Venture capital funds Special purpose acquisition companies o The vast majority of the capital employed by these sponsors is raised from: Public and corporate pension plans Insurance companies Endowments Foundations Sovereign wealth funds Wealthy families / individuals Invested capital is organized into funds established as a limited partnership o The general partner, or sponsor, manages the partnership The limited partners served as passive investors o Sponsors often specialize in various types of transactions: Distressed companies Roll-ups Corporate divestitures Etc. o Sponsors are staffed according to their strategy (ex: certain consultants are staffed from various investment strategies) o Due diligence is the process of learning as much as possible about all aspects of the target to confirm or discredit information critical to the sponsor‟s investment thesis: Business Sector Financial Accounting Tax Legal 64
Regulatory Environmental Investment Banks o Entry: develop and market an optimal financing structure o Exit: sponsors use investment banks to market their portfolio o Following credit committee approval, the investment banks are able to provide a financing commitment to support the sponsor‟s bid Commitment offers funding for debt portion of the transaction under proposed terms and conditions Terms - interest rate caps Conditions - acceptable level of equity Elements of the financing commitment: Commitment letter for the bank debt and a bridge facility (if the bonding financing cannot be achieved by the time the deal consummates) Engagement letter the sponsor engages the investment bank to underwrite the issue Fee letter sets out the various fees paid to the investment for the financing o Investments banks: Hold a portion of the revolving credit facility and syndicate the remainder (as well as term loans) Sell, without a commitment to hold, high-yield bonds and other mezzanine debts Bank and Institutional Lenders o Banks provide capital for: Revolvers Amortizing term loans o Banks consist of: Commercial banks Savings and loan institutions Finance companies Investment banks o Institutional lenders provide capital for longer tenored, limited amortization term loans o Institutional lenders consist of: Hedge funds Pension funds Prime funds Insurance companies Structured investment vehicles (ex: collateralized debt obligations) o Prospective lenders attend a group meeting, called a bank meeting, organized by the lead arrangers o As lenders initiate their own internal credit process, they will ask the arrangers for additional information Bond Investors o Consist of: High-yield mutual funds Hedge funds Pension funds Insurance companies Distressed debt funds CDOs o Bond investors receive one-on-one meetings in a road show o Bond investors receive an offering memorandum (OM): 65
Preliminary term sheet (excluding pricing) Description of notes Key business information Target Management o Work closely with bankers on the preparation of marketing materials o A strong management team can create tangible value by reassuring investors of the stability of the business o Management equity involvement: Roll meaningful existing equity claim into purchase price Receive option compensation package May compromise up to 15% of the equity value in the business o Management buyout When an LBO is originated by the target‟s management team Targets with sizable management ownership are strong MBO targets
Characteristics of a Strong LBO Candidate Strong cash flow generation o Debt investors require a business model capable of supporting periodic debt repayments o Cash flow stability drivers: Mature or niche business Established customer base Stable end market Established and recognized brand name Long-term sales contracts o Cash flows must be stress-tested Leading and defensible market positions o Entrenched customer relationships o Brand name recognition o Superior products and services o A favourable cost structure o Scale advantages o Other barriers to entry Growth opportunities o Organic growth potential o Bolt-on acquisition opportunities o A strong growth profile is particularly important if the company is IPO-destined o Growth can also drive “multiples expansion” o Sponsors may opt not to maximize leverage to permit flexibility for growth Efficiency enhancement opportunities o Reducing corporate overhead o Stream-lining operations o Reducing head-count o Rationalizing the supply chain o Implementing new management information systems o These best practices are often achieved by hiring industry consultants Low capex requirements o Limited investment needs o Differentiate expenditures for: 1) Maintenance capex 2) Growth capex Strong asset base o 1) a strong asset base improves attractiveness in the leveraged loan market (more bank debt reduces the cost of capital) o 2) a strong asset base serves a barrier to entry 66
Proven management team o Success in implementing in measures or integrating acquisitions o Align incentives - grant management a meaningful equity stake
Economics of an LBO IRR drivers: o Projected cash flows o Exit multiple o Financing structure More debt yields the tax-savings affect of interest Primary Exit / Monetization Strategies o Multiple expansion via: Increase in target size / scale Meaningful operational improvement Repositioning of the business toward higher-value segments Sale of business o Sale to a strategic buyer (higher premium) o Sale to another sponsor (lower premium) Initial public offering o Post IPO, the sponsor typically retains the largest equity stake in the business o Full exit will be obtained through follow-on equity offerings o Does not afford the sponsor full monetization Dividend recapitalization o Targets raises proceeds through additional debt financing o Pays shareholders a dividend LBO Financing: Structure Cost of capital tends to be directly related to flexibility (more restrictions = a lower cost of capital) In 2008, the typical EBITDA multiple paid for a target was 9.1x, composed of: o Senior debt / EBITDA = 4.1x o Subordinated debt / EBITDA = 0.8x o Equity / EBITDA = 4.0x Sources of capital o Bank debt Bank debt typically bears interest at LIBOR + spread This debt is therefore floating The spread is a function of the credit quality of the borrower First Lien Secured Debt Revolving credit facility o Permits the borrow to draw varying amounts up to a specified aggregate limit o The borrowings can freely be repaid o Typically arranged by investment banks and syndicated to commercial banks and finance companies o A nominal annual commitment fee is charged on the undrawn portion of the facility o This is the least expensive form of financing o Revolving credit facilities have first priority claim on certain assets Assets include tangible and intangible assets Asset-based lending facility o Secured by first claim on current assets: 67
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Accounts receivable Inventory o Typically issued by businesses with significant working capital needs o ABL borrowing base: Borrowing base = (%receivables)(eligible receivables) + (%inventory)(eligible inventory) + ... o Most regularly report collateral o Working capital is easier to monetize in the event of bankruptcy As a result, the spread over LIBOR narrows on ABL facilities Term loan facilities o Term loans, when non-investment grade, are called leveraged loans o Structured as a first lien debt obligation o Requires periodic principal repayments (amortization) o A term loan is fully funded on the date of closing o Additional borrowings cannot be drawn o Types: Amortizing term loans Referred to as Term Loan A (“TLA”) Substantial principal is repaid throughout the life of the loan TLAs are often the cheapest term loan Syndicated to commercial banks and finance companies o Revolvers and TLAs are often syndicated as a package Typically “co-terminus” (ending at the same time) as the revolver Institutional term loans Referred to as Term Loan B (“TLB”) Typically sold to institutional investors Non-amortizing with bullet-payment at the loans completion (nominal principal repayments) Provide higher coupons (i.e., higher spread) Tenor of 7 years is typical Second Lien Term Loans Floating rate loan that is secured by a second priority Second lien lenders are entitled to repayments from the proceeds of collateral after such proceeds have fist been applied to the claims of first lien lenders, but prior to any application to unsecured claims Typically sold to hedge funds and collateralized debt obligations High-yield debt High-yield bonds Non-amortizing Bull-repayment Fixed coupon rate
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Structured as: o Senior unsecured o Senior subordinated High-yield bonds have non-call features that can negatively impact a sponsor‟s exit strategy PIK - payment in kind o Allows issuer to provide additional notes in substitution of cash interest o Allows issuer to preserve cash in times of need o May be particularly important during early years of the LBO, when interest payments are heaviest (from the revolving credit facility and term loans) Bridge loans Investment banks provide this temporary instrument until permit debt can be issued (long-term, high-yield debt) Bridge loan interest typically rises the longer the loan is outstanding Lead arrangers typically seek to syndicate bridge facilities Mezzanine debt Highly-tailored solution Allows the borrower to “stretch” the leverage of the business May be a substitute for high-yield debt when: Markets for high-yield debt are unavailable The company is too small to secure high-yield debt Can be structured to provide equity-up-side Includes convertible debt and preferred stock Equity contribution Includes: Contributed equity of management o Typically accounts for 2-5% of equity o Encouraged to align incentives Sponsor‟s equity contribution Can also include the equity contribution of many o sponsors in a club deal
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LBO Financing: Selected Key Terms Security o Refers to specific assets pledged by the borrower of a debt instrument Seniority o Contractual subordination Contracts are structured to make some debt subordinate to other debt o Structural subordination Debt in holding company (which owns the entire equity claim in the operating company) is structurally subordinate to the debt of the operating company Maturity o Shorter tenor debt has a lower cost of capital o Order of maturity (shortest to longest) Revolvers Term loans Bonds Coupon o Floating or fixed o Bank debt (quarterly payments) o Bonds (semi-annual payments) 69
High-yield debt is usually priced at the treasury rate plus a spread Call protection o Mitigates reinvestment risk Call premiums which decline as maturity approaches are employed to protect bondholders against calls First-lien bank debt has no call protection o Covenants o Bank debt Covenants Affirmative covenants (perform certain actions) Regular financing reporting Maintaining assets, collateral or other security Maintaining insurance Complying with laws Paying taxes Negative covenants (cannot perform certain actions) Limitations on debt Limitations of dividends/stock repurchases Limitations on liens Limitations on disposition of assets (ex: sale and lease back) Limitations on investments Limitations on mergers and consolidations Limitations on prepayments of, and amendments to, certain other debt Financial maintenance covenants Senior debt / EBITDA Total debt / EBITDA EBITDA / interest expense Cash flow / fixed charges Maximum capital expenditures o High-yield covenants Restrictive covenants are only mobilized if the company fails a ratiotest
Leveraged Buyout Analysis - Investment Banking by Rosenbaum & Pearl Introduction LBO analysis is used to craft a viable financing package Deal team: o Leveraged finance o Capital markets (DCM) o Sector coverage Once the sponsor selects the desired financing structure, the deal team presents the selection to the bank‟s internal credit committee for approval LBO analysis is also used to calculate the implied purchase price for a target given: o Return threshold (IRR) o Financing structure o Exit multiple Step 1 - Locate and Analyze Necessary Information Organized sell-side process: o CIM o Data room o Management presentations In the absence of an organized process, utilize public sources of information 70
Step 2 - Build the Pre-LBO Model Obtain preliminary financial projections in CIM I) Build Historical and Projected Income Statement through EBIT o Income statement is built out only until EBIT Interest and net income are irrelevant given the recapitalization The line items between EBIT and net income are intentionally left blank Filled in with the completion of a debt schedule The projection period is usually 7-10 years to match the longest tenored debt o instrument o Cases: Management case - given in the CIM Base case - more conservative case developed by the deal team Stress cases - used to test the ability of the sponsor to support the debt level Sponsor case - the operating scenario ultimately presented to the sponsor and employed in the marketing of the debt instruments Sponsor model - combination of the sponsor case and the sponsor‟s selected financing package II) Input Opening Balance Sheet and Project Balance Sheet Items o Additions to balance sheet line items: Financing fees - capitalized and amortized over time Financing structure - line items for each financing element New revolving credit facility Term loans High yield bonds o An adjustments column is employed to reconcile the pro forma balance sheet and the existing balance sheet III) Build Cash Flow Statement through Investing Activities IIIA) Operating Section o Net income is initially overstated because it does not include: Interest expense Amortization of financing charges Working capital adjustments will not change after the LBO o IIIB) Investing Section Projected capex are typically sourced from the CIM Bankers often drive capex from sales o IIIC) Financing Section Line items are included for the withdrawal/repayment of debt instruments Step 3 - Input Transaction Structure I) Enter Purchase Price Assumptions o Based upon an offer price per share multiplied by the number of fully diluted shares outstanding (offer value) II) Enter Financing Structure into Sources and Uses Sources - total capital used to finance the purchase o Revolving credit facility Term Loans High-yield debt Equity contribution (sponsor) Rollover equity Cash on hand o Uses - items funded by capital sources 71
Equity purchase price Repay existing bank debt Tender / Call premiums Financing fees Other fees and expenses o These must balance o The uses of funds will slightly exceed the implied transaction value of the target (as a result of financing fees) III) Link Sources and Uses to Balance Sheet Adjustments Columns o Equity-related adjustments: Goodwill = Offer value less Pre-LBO equity value Post LBO equity value = Equity investment less transaction expenses o Adjustments: Assets Add: financing charges Add: goodwill Less: cash Liabilities Add: new debt structure Less: old debt structure Shareholders‟ Equity Add: new equity investment Less: old equity value Less: transaction expenses o *Note that goodwill is first allocated to PP&E and other long-term assets to realized their fair value before goodwill is capitalized This write-up effect is creates a tax-deductible situation o Financing charges are amortized in a straight-line fashion over the life of the obligation Financing charges are typically calculated as a % of the size of each debt instrument Ex: 1.75% for revolving credit facility syndication 1.75% for Term Loan B Etc.
Step 4 - Complete the Post-LBO Model I) Build Debt Schedule o Debt schedule is organized from most to least senior o A forward LIBOR curve supports the debt schedule Bank debt is typically based upon LIBOR plus a spread Forward LIBOR curve is typically sourced from Bloomberg o Cash available for Debt Repayment The sum of cash from operations and investing activities Payment hierarchy: 1) Mandatory debt repayments on term loan tranches 2) Optional debt repayments (typically revolving credit facility) o In the case that the FCF of the business in negative, the revolving credit facility is drawn on to close the funding gap o A fixed financing fee is paid on the revolving credit facility 3) High-yield is not prepayable without a penalty and the entirety of the debt is repaid upon maturity of the debt
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o Call protection is used to penalize early retirement The average interest expense is employed to calculate interest expense in the LBO model Debt is averaged out and an interest is applied to this average quantity II) Complete Pro Forma Income Statement from EBIT to Net Income o Cash interest expense Interest expense on each debt instrument (excluding PIK interest) Commitment fee on undrawn credit facility Other administrative fees o Total interest expense Cash interest expense Amortization of deferred financing charges PIK interest o Net interest expense Total interest expense Less: interest income (earned from accumulated cash - begins to accumulate after mandatory and optional debt repayments have been fulfilled) III) Complete Pro Forma Balance Sheet IV) Complete Pro Forma Cash Flow Statement o Mandatory and optional debt repayments (from debt schedule) are applied to the financing section of the cash flow statement o We assume a cash sweep - i.e., cash does not begin to accumulate until optional and mandatory sources of debt repayment have been exhausted o
Step 5 - Perform LBO Analysis I) Analyze Financing Structure o Calculate credit statistics in each projection year: Leverage ratios Coverage ratios o Credit statistics should improve over time o An improving credit profile supports the thesis that the target can support the proposed leverage level II) Perform Returns Analysis o IRR is calculated based upon the terminal equity value (assuming no interim cash flows) o IRR should be sensitized to key variables: Entry multiple Exit multiple Time of exit Leverage level Equity contribution % Operating assumptions Margins Growth rates Key value drivers III) Determine Valuation o LBO analysis is used to provide a reference point for strategic bidders to frame their bids IV) Create Transaction Summary Page
M&A Sale Process - Investment Banking by Rosenbaum & Pearl Introduction
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Strategic alternatives: o Sale of all or part of the business o Recapitalization o An initial public offering o Continuation of the status quo Identify the client‟s objectives from the outset and tailor a process accordingly Sale processes: o 1) Broad auction Neutral toward prospective buyers Maximizes the competitive dynamics of the process o 2) Targeted auction Approach a select group of buyers o 3) Negotiated sale Deal-team tasks: o Valuation of business via: Comparable companies Precedent transactions DCF LBO analysis o Additional analysis of willing-to-pay of strategic buyers based upon accretion/dilution analysis o Sell-side bankers may also be called upon to render a fairness opinion
Auctions Auctions have draw-backs including: o Information leakage (to competitors) o Deleterious affects on employee morale o Collusion amongst bidders o Tainting coming from a failed auction In the later stages of the auction, a senior member of the deal team typically negotiates directly with prospective buyers Hence, senior bankers must have: o Negotiation skill o Relationships o Sector knowledge Auction types: o Broad auction Maximize the universe of prospective buyers More up-front organization and marketing due to the larger number of buyer participants in the early stages of the process Advantages: Competitive dynamics Reassures the Board of Directors that it has fulfilled its fiduciary duty Disadvantages: Difficult to preserve confidentiality Unsuccessful outcome “taints” target Risk that competitor may participate to gain access to: o Information o Key executives o Targeted auction Specific buyers approached based upon: Synergy potential Financial capacity
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Greater risk of “money left on the table” The traditional auction process is: o Structured with two-stages o Between 3-6 months in duration
Organization and Preparation I) Identify seller objectives and determine appropriate sale process o Develop a process road-map based upon client objectives II) Perform sell-side advisor due diligence and preliminary valuation analysis o In-depth sessions with management o A comprehensive understanding of the business and management‟s vision is important before constructing marketing materials o Provides key assumptions underlying the sell-side‟s financial model o Prepares a valuation range based upon above techniques o Also perform accretion/dilution analysis to assess WTP of strategic buyers o A financing package may be developed to support the sale of the target Used to frame LBO analysis Credit team will conduct a separate due diligence III) Select buyer universe o Strategic buyer considerations Potential synergies Financing capacity: Size Balance-sheet strength Risk appetite Accretion/dilution analysis Acquisition history Effects on: Customers Suppliers Anti-trust implications o Financial buyer considerations Investment strategy / focus Sector expertise Fund size Track record Fit with existing portfolio Potential for bolt-on acquisitions Fund life-cycle Ability to obtain financing IV) Prepare marketing materials o IVA) Teaser Brief one or two page synopsis of the target, including: Overview Investment highlights Summary of financial information o IVB) CIM Detailed written description of the target (often 50+ pages) Contents: Executive summary Investment considerations Detailed information about the target o Sector o Consumers
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o Suppliers Financial projections and underlying assumptions (5-year horizon) o Sell-side advisor must gain comfort that these projections are defensible under buy-side scrutiny List of additional bolt-on acquisitions o Frame target as a growth platform *May be modified for certain strategic buyers (to protect the target from competitors) V) Prepare confidentiality agreements o Governs the sharing of confidential company information Return of confidential information - return/destruction of all materials one auction process is terminated Standstill agreement - prevents hostile situations: Unsolicited offers Attempts to control the board of directors
First Round Contact prospective buyers o Scripted telephone call o Delivery of teaser and CA Negotiate and execute confidentiality agreements with interested parties Distribute CIM and initial bid procedure letters o Maintain contact with bidders, providing additional information o Buy-side advisors play a critical role in helping their client, whether a strategic buyer or a financial buyer, assess the target from a valuation perspective and determine a competitive initial bid price o Bid procedure letter States the date and time interested bidders must submit a non-binding bid Defines exact information required: Purchase price and consideration form (stock v. cash) Treatment of management and employees Key conditions to signing and closing Prepare management presentations o Rehearsal process may be time-consuming and intense o Presentation format is similar to CIM but more concise o Provide additional insight Set up data room o Comprehensive detailed information about the target is gathered and organized o Documents: Financial reports Industry reports Consulting reports Customer and supplier lists Labour contracts Purchase contracts Description and terms of outstanding debt, lease and pension obligations Environmental compliance certificates o Access granted to buyers that move forward after the first round Prepare stapled financing package (if applicable) o Targeted toward financial sponsors Receive initial bids and select buyers to proceed to second round
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o o
Decide which buyers are serious about making a binding bid Valuation: A break-even item allows the sell-side advisor to determine the maximum a strategic buyer would be willing to pay based upon: Synergy assumptions Financing assumptions This tool can be used to persuade the bidder to increase their offer
Second Round Conduct management presentations o Present investment opportunity o Bankers usually accompany management o A chance to get an idea of “fit” between acquirer and target Facilitate site visits Provide data room access o Serious bidders enlist a full team of: Accountants Attorneys Consultants Other specialists o To analyze the company data and confirm or reject an investment thesis Distribute final bid procedure letter and draft definitive agreement o Outline date and guidelines for submitting a final, legally binding bid package Purchase price details Mark-up draft definite agreement Evidence of committed financing and information on financing sources o Definitive agreement Legally binding contract between buyer and seller expressing the terms of the deal May include break-up fees Receive final bids Negotiation Evaluate final bids o Consider: Offer value Consideration Terms of deal Confidence in buyer Negotiate with preferred buyers Clear up confirmatory diligence items o o Firm up key terms (particularly price) o Encourage one bidder to differentiate itself Select winning bidder Render fairness opinion (if applicable) o Particularly relevant when stock of the target is widely held o Includes complete valuation analysis Receive board approval and execute definitive agreement Closing Receive necessary approvals o Anti-trust regulator approval o Shareholder approval One-step merger: target shareholders vote on transaction
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In a stock deal of more than 20% of the acquirer‟s outstanding stock, an acquirer shareholder approval is also required From signing of definitive agreement to closing can take as little as six weeks (or as long as 3-4 months) Two-step merger: negotiated or unsolicited basis Provide offer to shareholders directly If a sufficient proportion of shareholders are tendered (50%+), a subsequent approval is made as under the one-step merger (this step can be circumvented if a threshold portion of shares are captured - usually in excess of 90%) Financing and closing o Acquirer may bridge financing to complete the deal until permanent debt or equity can be secured
Negotiated Sale Particularly compelling for companies with natural and obvious synergies Often buyer initiated o May be done to pre-empt a full auction process o Seller reserves the right to launch an auction process if an agreement cannot be reached
Acing the Finance/IB Interview - Wall Street Prep Discounted Cash Flow Analysis Controversies exist predominantly over the cost of equity Extremely sensitive to operating, discount and exit assumptions Cash flows are typically projected for between 5-10 years Enterprise value - net debt = equity value o Equity value / diluted shares outstanding = equity value per share DCF advantages o Not influenced by temperamental market conditions o Can value synergies separately from the business DCF disadvantages o Terminal value represents a significant component of enterprise value o Realistic cash flow projections are needed for at least one business cycle EBIT (1-t) + depreciation and amortization - capital expenditures - change in working capital + increase in future tax liability - increase in future tax assets = Unlevered free cash flow Net income + depreciation and amortization - capital expenditures - change in working capital + increase in future tax liability - increase in future tax assets + (-) net borrowings (repayments) = Levered free cash flow
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Financial institutions: should be valued with after-interest FCF because interest is a cost of doing business
Methods of calculating terminal value: o 1) growth in perpetuity method Use the long-run average industry growth rate o 2) exit multiple method Ensure an enterprise multiple is matched to UFCF A steady-state industry multiple should be used (rather than the current industry multiple) Generally derived from comparable / precedent transaction analysis
Enterprise value = equity value + net debt (gross debt - non-operating assets) o Non-operating assets include: Cash Investments o These assets are excluded from enterprise value because UFCF excludes interest income o Gross debt: short-term debt current portion of long-term debt minority interest preferred stock Capital leases
The cost of capital is the opportunity cost of investing in a business compared to another business with comparable risk o As a result, cost of capital is typically estimated by analyzing similar businesses with similar risks The WACC should be calculated using: o The target capital structure o If this is unavailable: The current capital structure Comparable companies‟ capital structure WACC elements o The cost of debt Best approximated with the YTM on the company‟s long-term debt If this is unavailable: Calculate the YTM on comparable companies‟ debt By adding a yield spread to the treasury yield in proportion to credit quality o If a credit quality rating is unavailable (i.e., moody‟s, S&P), a synthetic rating can be constructed using liquidity, coverage and leverage ratios Because the cost of debt rises in proportion to the leverage level, if the current capital structure does not align to the target weightings, the YTM may be inappropriate o The cost of equity Difficulty to estimate because cash flows are unknown (unlike bond pricing) The range of FCF available to equity holders is wider (and therefore the required return on equity is higher) Equity return models: CAPM o Accounts for only systematic risk
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Unsystematic risk can be diversified away and therefore rational investors will not consider (nor include in the price of equity) Fama-French three-factor model Arbitrage pricing model elements The risk free rate o Theoretically, the yield should match duration of each cash flow o In practice, the 10-year Treasury bond yield serves as a proxy The risk premium o Typically use the historical excess return spread (market over risk-free rate) Beta o Private company betas are estimated from a set of comparables o It is important to properly lever and unlever betas to remove the impact of financial structure decisions on beta o
CAPM
Trading Comparables Challenges: o Selecting truly comparable companies o Selecting the right multiple o Selecting the right time-frame o “Scrubbing” the multiple; removing the effects of non-recurring items, including: Restructuring charges One-time write-offs Gains/losses on sale of assets Anything below the operating income line of the income statement o Market is emotional Strengths: o Facilitates valuation of private companies o Provides a market-based sanity check on intrinsic valuation Selecting comparables: o Financial characteristics: Size Leverage Margins Growth prospects Ownership dispersion o Operating characteristics: Industry Industry position (leader/middle/bottom) Products Markets Distribution channels Customers Seasonality/Cyclicality Types: o P/E Accounting profit can be misleading because it includes: Non-cash items (expenses and incomes) 80
One-time charges Manipulation o Historical v. market value o Depreciation policies o Revenue recognition policies Not relevant for growth firms P/B ratio Book value can be negative (making this ratio meaningless) Useful for asset-intensive businesses EV / EBIT Includes depreciation and amortization (non-cash and subject to policy choice) More conservative than EBITDA because D&A approximately equals capex for mature firms EV / EBITDA EV / EBITDAR (rent) Lease v. buy decision can skew profitability picture Useful for lease-intensive businesses (ex: retail) EV / Revenue Useful for early stage, high growth companies
o o
o o o
Transaction Comparables Offer value = offer price per share • fully diluted number of shares outstanding o Offer price = trading price + premium o Fully diluted shares = shares outstanding + options + convertibles Offer value is equivalent to equity value Transaction value is equivalent to enterprise value Advantages: o Realistic since previous transactions were completed at these multiples o Trends may become clear in analysis (consolidation, foreign acquisitions, etc.) Disadvantages: o Vary widely o Premiums and appropriate multiples change over time o All deals are different Mergers & Acquisitions When a buyer / seller consider an acquisition, they usually: o Form a special committee to assess the deal o Retain an investment banker to advise them Roles of an M&A advisor: o Buy-side engagement o Sell-side engagement o Divestitures o Fairness opinion o Hostile defenses Accretion / Dilution o Accretion - pro forma earnings exceed original earnings (dilution is the opposite) o Analysts and investors may tolerate dilution in the short-run o Accretion / dilution serves as a proxy for the value created / destroyed Purchase price accounting / Goodwill o The purchase price is allocated to assets to increase their values to fair market value o The excess of purchase price over fair market value is goodwill o Goodwill is not amortized but is tested for impairment 81
Assets typically written-up PP&E Intangible assets Inventory *Note that liabilities are also written up upon acquisition o
Pro Forma Balance Sheet
Acquirer
Target
Target adjustment
Target Pro Forma
Cash
100
20
20
PP&E
20
5
+10
15
Goodwill
0
0
0
0
Debt
50
15
Equity
70
10
Pro Forma
-70
50
15 +10
20
-20
Cash deals: o Borrowing increases the interest expense on the income statement o Refinancing debt of the target may increase/decrease interest expense o Excess cash usage for the purchase will reduce cash available to generate interest Underwriting fees: o Underwriting fees are capitalized and amortized over time o Advisory fees are expensed immediately Incremental D&A - D&A will change as assets are written-up to FMV Therefore, considerations in accretion / dilution: o Consideration form: Cash Interest expense of borrowing Interest associated with cash Stock Relative P/Es Premium offered o Synergies o Additional interest expense (lost income) o Incremental amortization resulting from write-up effect o Amortization of transaction fees o Expensing of advisory fees
Leveraged Buyouts Exit opportunities (typically within 3-7 years): o IPO o Sale to a strategic/financial buyer o Recapitalization (remove an equity dividend) Characteristics of a strong LBO candidate: o Steady, predictable cash flows with little cyclicality o Minimal capex requirements o Little existing leverage o Business is undervalued 82
o Subsidiary businesses are can be divested (to raise emergency cash) o Strong management team Equity financing: o Financial sponsors, capitalized by: Insurance companies Endowment funds Pension funds o Other financial sponsors (“club” deal) o Management and employee equity Financial sponsors provide equity incentives to management through vesting options Debt financing: o Long-term senior debt o Medium-term debt o Revolving credit o Subordinated (unsecured) debt LBO valuation analysis is useful for setting a floor on a bid price by a strategic bidder LBO analysis is only meaningful for companies which could operate under financial leverage
Investment Banking Overview - UBS Overview of Investment Banking Purposes: o Raise capital through issuance of securities: Debt and equity Specialized securities and derivatives o Advise companies in M&A and restructuring o Provide valuation and strategic advisory
Products groups focus on execution Sector groups focus on marketing and client management There is a high degree of overlap
Interview Preparation Your story should flow with your resume but you should not read off your resume The story should answer why banking? 83
Things to mention: o Who you have spoken to at the bank o Who else you have final rounds with / have received offers from o Tell your story of why banking o Mention the names of prominent deals the bank has advised on o Show that you have done your homework and know which groups are strong
Technical Reference Valuation techniques: o Comparables Analyze valuation as well as operating and leverage characteristics Pros: Reliable indicator of price for minority investments Useful technique for assessing vulnerability Cons: Thinly traded companies may not provide reasonable valuations Stocks markets are emotional Does not include a control premium or synergy values o Precedent transactions Pros: Recent transactions indicate supply and demand for corporate assets Cons: Interpretation of the transactions requires industry expertise Analysis is based upon historical data (not forward looking data) Important to understand the terms of the deal o i.e., unsolicited deals will offer a higher premium o Discounted cash flow Comparables Analysis Equity value and enterprise value o The latest shares outstanding should be taken from the cover page of the latest Form 10-K or Form 10-Q Be sure to check for additional stock offerings / consolidations since the last report date o Offer value = latest shares outstanding • offer price + shares of options / warrants / SARs • (offer price - average exercise price) + shares for convertible debt • offer price + shares for convertible preferred stock • offer price The last two items are relevant only if the offer price exceeds the conversion price o Enterprise value = Equity value + Short-term and long-term debt + Capital lease obligations + Out-of-the-money convertible debt + Out-of-the-money convertible preferred stock + Minority interest + (cash and cash equivalents and investments)
Net income - taken before extraordinary items and before non-operating gains/losses (these items should be net of tax) 84
EBIT o o
Before net interest expense (i.e., before both interest income and interest expense) Items below the operating line should be included if: They are recurring They are non-financial in nature
EBITDA o o
EBIT + Depreciation and amortization Take the depreciation and amortization figure from the cash flow statement because there may be amortization buried in cost of goods sold (ex: depletion charges)
Equity value multiples o Net income (i.e., P/E) - ensure net income is to common equity holders (i.e., remove preferred dividends) o Book value o Levered free cash flow
Enterprise o o o o
A control premium must be introduced to align comparables and transaction multiples Steps: o 1) identify peer group Identify pure plays for application to divisions Sources: SIC code run FactSet o 2) refine peer group read business descriptions to ensure alignment o 3) calculate an industry median Means are selectively included, depending on skewness of data 4) select the appropriate multiples o Each industry differs: Manufacturing industry: EV / EBITDA Financial institutions: Price / book Other notes o Footnote all assumptions o Leave an audit trail Comparable inputs o Dividend annualize the most recent quarterly dividend perform a news run o Common shares front page of latest 10-Q or 10-K o Net interest expense Interest income Interest expense o Depreciation and amortization
value multiples Sales EBITDA EBIT Industry specific Mineral production Retail sales R&D
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o
EPS
Found in the cash flow statement
Calculation of shares differs because there is a difference between: Weighted-average shares outstanding Most recent shares outstanding
Precedent Transactions Precedent transaction analysis o Allows for the imputing of control premium o Often suggest a wide valuation range (because of deal-specific factors) o Many transactions occur at the division level, where no trading multiples exist Equity value = offer value o Fully-diluted shares must be used because the following typically come in-themoney after an offer: Options Management options typically vest in change of control transactions Convertible: Preferred shares Bonds Enterprise value o If a deal is completed at the division level, and no debt is assumed, assume that enterprise value = equity value Note that the number of shares is always calculated on a diluted-basis: o All in-the-money options and convertibles are considered shares o Dilution is calculated using the treasury stock method: 1) EPS is calculated assuming warrants and options were exercised at the beginning of the period 2) the funds obtained were used to repurchase common stock at the market price o Calculations: Fully diluted shares outstanding = shares outstanding + incremental shares Incremental shares = number of options in-the-money - number of retired shares Number of retired shares = (number of options in-the-money • exercise price) / market price of stock The market price of the stock is the closing price, used for: Determination of in-the-money Calculation of retirement of shares Discounted Cash Flow (DCF) If the terminal value accounts for more than 50-60% of the DCF‟s value, the DCF is rendered meaningless Match inflation forecasts o Nominal cash flows must be matched with a nominal discount rate o Real cash flows must be matched with a real discount rate EBIT (1-t) + depreciation - capex - change in working capital* + increase in deferred taxes (i.e., deferred tax liabilities - deferred tax asset) = UFCF 86
Net income - capex + depreciation - change in working capital* = LFCF * working capital: Current assets - excludes cash and equivalents Current liabilities - excludes short-term debt
Other cash flow calculation notes o Interest expense should be calculated based upon the average debt outstanding in a period: (ending debt + beginning debt) / 2 PP&E for depreciation purposes: o Excludes leased property because this is not depreciable o Deferred taxes: Assumed to be some % of depreciation based upon a historical relationship o CapEx Expenditures necessary to maintain required capital intensity Solve: Beginning PP&E (known) Less: depreciation (known) Plus: CapEx (unknown) Equals: ending PP&E (known) o Working capital Excludes short-term debt Excludes cash and cash equivalents Primary components Receivables o modelled with days A/R = (avg. A/R / net credit sales) • 365 Inventory o modelled with days inventory = (avg. inventory / COGS) • 365 Payables o modelled with days payable = (avg. payables / COGS) • 365 Other current assets o modelled as % of sales Other current liabilities o modelled as a % of COGS o Debt Assume short-term debt as a % of long-term debt going forward Calculated as a % of equity (to maintain target weights) May require the repayment of debt (use FCF) o Be sure to impute a growth rate when a terminal multiple is employed to perform a reality check Cost of equity o Adjusted beta is often used to project beta Adjusted beta = (2/3) historical beta + (1/3)(1) Based upon the notion that all betas approach 1 over time Equity risk-premiums vary across markets o 87
Note that it is more technically correct to unlever based upon historical market weights; in practice, the most recent values are typically employed Relevering is performed with target weights
Accretion / Dilution: o Stock deal: If P/E of acquirer > P/E of target, accretive o Cash deal: If P/E cash of acquirer > P/E target, accretive
M&A Valuation Overview - JP Morgan Introduction Valuation uses: o Research o Hostile defense o Debt offerings o Equity offerings o Fairness opinions o Divestitures
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Leveraged buyout - sets a floor on value based upon maximum leverage capacity of target Trading Comparables Remember that different accounting standards can skew the multiples analysis Note that net debt is calculated on a market basis (like equity value) Rule of thumb: if the numerator has debt (i.e., enterprise value) the denominator must be before interest Forecasting performed on: o “LTM” basis - last twelve months o Projected basis, derived from: IBES - Bloomberg Analyst reports Non-financial measures: o Growth Analysis Sales growth Operating income growth Net income growth Margins & Profitability o Gross margin EBITDA margin EBIT margin Net income margin Operating margin Return on equity (for financial institutions) o Capitalization / Credit Leverage ratios Liquidity ratios Coverage ratios Off-balance sheet debt / operating leases analysis
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Treasury stock method
Note: accounting convention for diluted EPS in financial statements uses average stock price over the prior year - this is incorrect for calculating current shares outstanding
All comparables items must be before: o Income from discontinued operations o Valuation changes resulting from disposal of discontinued operation o Effect of changes in accounting principles o Restructuring charges o Gains/losses on sale of assets o One-time write-offs Common mistakes in preparing comparables: o Stock splits, dividends, repurchases o Differences in fiscal year end (Use LTM) o Cash (long-term investments) o Recent acquisitions and divestitures o Changes in earnings estimates o Non-recurring items o Recent debt or equity offerings o Take-over activity o Re-statements o Conversion of convertible securities since last reporting period o Differences in international accounting treatment
Discounted Cash Flow Analysis DCF analysis is particularly useful if: o There are no (or limited) comparable pure-play companies 90
o There are no (or limited) precedent transactions Remember to adjust the resulting valuation for all assets and liabilities not accounted for in cash flow projections Mid-year convention: Some investment banks (like JP Morgan) discount FCF by a power of one-half year less (i.e., the first year is discounted by a half-year‟s discount factor) to reflect the fact that cash is received in a uniform fashion throughout the year A terminal multiple assumes the business will be sold at the end of the projection period o If the terminal multiple is based upon a terminal statistic (i.e., LTM EBITDA), apply a historical terminal multiple o If the terminal multiple is based upon an addition project year‟s statistic, apply a forward looking terminal multiple A growing perpetuity assumes the business will be held after the projection period o Typically assume depreciation and capex are equal (i.e., the replacement ratio is 1) Sanity check: Test a multiple for the implied growth rate
Sensitivity analysis structure
91
Larger firms typically have lower costs of debt (and hence WACC falls for larger companies with equivalent target weights - all else constant) LBO Analysis
92
Remember that cash received by the sponsor prior to exit (i.e., excess cash) must be involved in the calculation of IRR Drivers of IRR: o Level of leverage o Operating improvements o Multiple expansion Transaction structure viability assessed with: o Leverage ratios Total debt / EBITDA Senior debt / EBITDA o Coverage ratios EBITDA / Total interest (EBITDA - capex) / Total interest o These ratios must be maintained as a component of the covenants governing loan agreements **Sources of funds = uses of fund o Sources: Senior debt Subordinated debt Mezzaine debt Management equity (rolled-over) Sponsor equity o Uses: Equity purchase price (market value + control premium) Debt refinancing Fees
Building Technical Understanding - ACQUIRE
Purposes of valuation:
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IPOs Debt offerings Research M&A Buy-side transactions Sell-side transactions Merger-of-equals o Asset acquisitions & divestitures o Restructuring Spin-offs Share-repurchases Trust conversion o Recapitalization and leveraged buyouts o Minority buy-in / going-private transaction o Defense analysis o Fairness opinions Key valuation considerations o Who is the seller? Dual class ownership structure Insider ownership or sizable public float Public company or privately held o Who are the potential buyers? Strategic (industry trends) Financial (leverage capacity) o What is the context of the transaction Privately negotiated Public auction Hostile or friendly transaction o What are the market conditions? Availability of acquisition currency Cash o Excess cash o Debt raising ability Stock o Valuation of stock Precedent of premiums State of the industry Timing of the offer Vulnerability of the target What is the value of control? o Access to cash flow o Ability to generate synergy o Decision-making authority o o o o
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Notice that an LBO analysis and merger consequences analysis are additional valuation methodologies Comparables analysis - public market value Precedent transaction analysis - private market value DCF analysis - objective neutral value Merger consequence analysis - determines ability-to-pay o Based upon an earnings-neutral base case o Used to determine WTP from a strategic buyer LBO analysis - determines WTP from a financial buyer
Comparables Analysis Structuring a comparables valuation should employ the following multiples from the peer group: o Low o Median 95
o
High
Precedent Transactions Includes the value of control and therefore the value of synergies Apply the same technique as above for valuation (low, median, high) LBO Analysis
Relationship between exit net debt and entry net debt is determined by the debt repayment schedule Discount the exit equity value at the hurdle IRR to determine the current equity value (amount a sponsor + management roll-over would be willing to contribute) o Add: required additional net debt in LBO o Subtract: existing net debt o Equals: LBO equity value (i.e., equity value with premium)
Merger Consequence Analysis Acquisitions: 96
Types of consequence analysis: Accretion / dilution (of EPS, CFPS, EBITDA, etc.) Answers the question: how much can a company pay for a target, after considering synergies, and still allow the acquisition to be accretive? (willingness-to-pay analysis) Larger synergies yield a greater ability to pay Leverage ratios and credit rating Share price o This is not a valuation tool - it is a tool for price negotiation Merger of equals - contribution analysis: o Measures the contribution of each merger partner to various statistics: Market capitalization EBITDA Earnings Production Etc. o
Other Valuation Techniques Income fund conversion o Measures how the impact of shares / units from the adoption of a new business structure Sum-of-the parts analysis / break-up analysis o Evaluates the independent value of divisions o Eliminates the holding company discount (i.e., loss of value from poor corporate focus) Net-asset-value analysis o Measures the present value of revenue generating properties o Particularly useful for: Mining sector Energy sector Real-estate sector Discounted Cash Flow Analysis
97
One key weakness of the DCF technique is that its sophistication can yield a false sense of security about the model‟s validity Comparables
98
Goldman Sachs eLearning Modules Corporate Valuation – An Overview Use the market value of debt (book value is a useful proxy for companies that are not in financial distress) Include short-term marketable securities in “cash and cash equivalents” Remember to normalize EBIT and EBITDA (remove the effect of non-recurring items) Corporate Valuation – Public Comparables Analysis Peer group determination: o Operational aspects Markets Products / services Industry Distribution channels Seasonality Cyclicality Customers o Financial aspects Leverage Size Liquidity Margins Growth prospects Proxy statement is a useful place to find a peer group S-4: merger proxy statement / securities offering statement Calculating the LTM of a financial statement item removes the effect of seasonality Calendarization: standardize firms‟ financial statements for common fiscal year end (December 31) Multiple drivers: o Size o Risk Credit profile Operational efficiency ROIC 99
o
Growth in: Operating CF EBITDA EPS Sales
Corporate Valuation – Acquisition Comparables Analysis Remember to consider special circumstances when creating a transaction list (ex: hostile takeover, industry conditions) Information sources: o Thomson Financial Securities Data o Dealogic o Mergerstat o Capital IQ o Merger documents S-4 / merger proxy (for shareholder vote on takeover) 8-K – material change event Schedule TO – announces the launch of a tender offer 14D-9 – target company‟s response to tender offer (BoD recommendation) o Regular press releases o Research reports Offer value complications: o 1) gross up offer value (only part of the company is purchased o 2) offer price is in stock (multiply exchange ratio by acquirer share price) Unaffected share price: share price before acquisition announcement or “exploration of strategic alternatives” announcement Consider integration risk when assessing a multiple / premium Synergies adjustment can make multiples comparable Corporate Valuation – Discounted Cash Flow Analysis DCF analysis does not rely on the existence of a strong peer group Practitioners use a market risk premium between 4.5-7.2% Cost of debt sources: o Public sources (if debt is publicly traded) o DCM desk o 10-K notes o Comparable company spread Book value is used as a proxy for the market value of debt (caution required because market / firm-specific changes may make this assumption unfounded)
100
Corporate Valuation – Merger Consequences Analysis Three considerations in M&A transaction: o Business combination adjustments Allocation of purchase price Impact of potential synergies o Tax considerations Tax free or taxable event to seller Tax benefits to buyer o Financing considerations Offering cash v. stock Impact on EPS Impact on credit statistics Post-transaction ownership structure Affordability analysis based upon: o 1) income statement adjustment (accretion / dilution) o 2) balance sheet impact (credit statistics)
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There is typically an increase in the amortization expense when assets are written up; asset write-ups usually include: o PP&E o Land o Intangible assets (brand names, patents, customer lists) Goodwill = offer value – write-up effect – net tangible assets o Net tangible assets = assets – existing goodwill – liabilities Goodwill is not amortized; it is tested for impairment Break-even synergies: o Dilution per share x FDSO = after-tax synergies required o After-tax synergies / (1 – tax rate) = before-tax synergies required Interest-expense adjustment is important in cash deals o Pro-forma debt = acquirer debt + target debt + new debt issue o Calculate: Debt / EBITDA EBITDA / Interest Remember to use offer value per share when comparing relative PEs (for accretion / dilution analysis) Transaction types: o Asset sale – taxable event for target o Stock deal – usually can be structured to avoid a taxable gain for the seller
Corporate Valuation – Leveraged Buyout Analysis The improvement in the balance sheet of the target company in an LBO is called deleveraging Sellers of the LBO target may desire a particular resulting capital structure because there is roll-over equity Capital structure: o Senior debt: 30-50% of total capital structure Commercial and investment banks, hedge funds Maturity between 5-8 years Collateralized debt o Subordinated debt: High yield funds, merchant banks, hedge funds Unsecured 8-10 years “bullet” structures (no principal amortization) 15-35% of capital structure 102
Debt capacity measurement: o Leverage ratios Senior debt / EBITDA Debt / EBITDA o Coverage ratios EBITDA / interest (EBITDA - capital expenditures) / interest o Equity investment / total capital ratio
Other Notes Sources of Synergies Revenue Enhancements Marketing gains; improvements to: o Ineffective media programming and advertising efforts o Weak distribution network o Unbalanced product mix Strategic benefits o Beachhead - entering a new industry Market or monopoly power o Increase market share and pricing power Cost Reductions Economies of scale (horizontal integration) o Spreading overhead - sharing of facilities Economies of vertical integration o Coordination of closely related operating activities Complementary resources o Provide missing ingredients or better use of existing resources Elimination of inefficient management o Incumbent managers do not understand changing conditions Negative side of takeovers o Layoffs resulting from rationalizations can cause employees to distrust management Tax Gains Net Operating Loss o Firms generating a pre-tax loss will not pay taxes; since they have negative net incomes, they will not use this tax exclusion 103
o The combined firm therefore has a lower tax bill than the two firms separately o Canadian tax law has a provision for tax carry-forwards and carry-backs Unused Debt Capacity o Diversification reduces the cost of financial distress; this increases debt capacity (and therefore firm value) Surplus funds o Instead of paying dividends (which is a taxable event) the firm can acquire another firm
Cost of Capital Generate economies of scale in capital raising (IPO costs are smaller on a relative basis as deal sizes rise) Why IPOs are Underpriced
Greater risks associated with uncertainty of a new issue require lower price Underpricing generates social proofing of issue (information cascades and herding) Winner‟s curse o Average investor can only get shares in an issue that is unpopular (because the smart money will not demand the issue) o Hence, „winning‟ by getting these shares is actually losing o Investment bankers therefore eliminate the „winner‟s curse‟ by underpricing Prospect theory / mental accounting o People focus on the change in their wealth rather than their level of wealth o Issuers fail to be upset about money left on the table because the their aggregate change in wealth from the issue is large relative to the amount left on the table Spinning o Allocate hot IPOs to best clients (often managers of client firms) o This redistributes wealth to the decision makers o „Money left on the table‟ goes to decision makers, who will therefore remain loyal to the investment bank Marketing event o Generates brand awareness by having share price jump
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II. Introduction to Recruiting Introduction
The enclosed manual is a guide for summer and full-time finance recruiting. Its contents are a compilation of the varied and extensive interview experiences of the senior members and alumni of the Queen‟s University Investment Club. This guide also includes material from the following sources: ACQUIRE (August Course for Queen‟s University Investment Banking and Related Industry Education) McCombs School of Business M&A Valuation Primer McCombs School of Business Investment Banking Recruitment Guide Tuck School of Business Note on Leveraged Buyouts McKinsey Note on Valuation Multiples Wall Street Prep Investment Banking and Valuation Seminars Training The Street Investment Banking and Valuation Seminars Wall Street Oasis Investment Banking and Valuation Seminars Vault Guide to Finance Interviews IBankingFAQ (www.ibankingfaq.com)
The Banks The investment banks that recruit at Queen‟s fall into three categories: (1) international banks, (2) Canadian banks, and (3) boutiques / independents. International banks: • Goldman Sachs (GS) • JP Morgan (JPM) • Morgan Stanley (MS) • Credit Suisse (CS) • UBS • Bank of American Merrill Lynch (BAML) • Barclays • Citigroup • Macquarie Canadian banks: • Royal Bank of Canada (RBC) • Toronto Dominion Bank (TD) • Bank of Montreal (BMO) • Canadian Imperial Bank of Commerce (CIBC) • Scotia Capital (SC) • National Bank Financial (NBF) Boutiques / Independents: • Greenhill • Lazard • Genuity Capital Markets • Blackmont Capital • Canaccord Adams • Jennings Capital • Cormark Securities 105
• Blair Franklin Capital Partners The international banks who come to campus usually only recruit for positions in their local satellite offices. These jobs are usually in Toronto, but positions are also sometimes available in Montreal or Calgary. Satellite offices typically hire 1 – 2 analysts during both summer and full-time recruiting. Most international banks conduct their satellite office recruitment process separately from their headquarters recruitment process (for jobs in New York or London), so it is difficult to land jobs outside the country. Goldman Sachs‟ process is the exception – GS‟ Toronto office recruits from Canadian campuses for jobs at all offices across North America, and candidates who wish to work outside the country are sent to their destination of choice for final round interviews if they pass the first round. Another alternative available to Canadian candidates for jobs overseas is to submit an application online through banks‟ online application portals. The chances of success through this channel are typically lower than with on-campus recruiting. The Canadian banks are composed of the big six Schedule I banks that dominate the banking industry in Canada. Their postings are usually for jobs in Toronto, and they typically hire 5 – 6 analysts during both summer and full-time recruiting. Boutiques are smaller competitors that are usually regionally focused or do not offer the full array of investment banking services. Most boutiques tend to hire the same number of analysts as the satellite offices of international banks.
About Investment Banking Interviews Interviews are usually composed of two rounds. The first round takes place on campus and is usually composed of one or two interviews, each of which can be with one or two interviewers. Candidates who pass the first round are invited to attend the second (final) round, which usually takes place at the employer‟s office. The final round is usually composed of 4 – 8 interviews, most of which are one-on-one. Interview questions typically fall into the following categories:
Technical Questions –designed to assess your knowledge and comfort level with the finance-based technicalities of the job Personal / Qualitative Questions –designed to assess the quality of your interpersonal skills, level of personal reflection, and potential “fit” with the firm Market-Based Questions –designed to assess how actively you follow markets, your general knowledge level, and your ability to generate and defend an opinion Firm-Specific Questions – designed to assess your knowledge of and interest in the recruiting firm Brain Teasers / Mental Math – designed to assess your analytical ability, math skills, and overall intelligence
Recruiters are known to “role play” in their interviews. Some will intentionally adopt a laidback approach in order to create a casual atmosphere – these interviewers tend to focus more heavily on the personal questions and market-based questions. Other interviewers will intentionally adopt a more rigid, critical approach – these interviewers tend to focus more heavily on the technical questions, firm-specific questions, mental math, and brain teasers. Some interviewers will adopt a very unforgiving attitude, which is meant to assess how you react under pressure / stress. Typical “stressors” include avoiding eye-contact (making no human connection with the candidate), rapid-fire questions, repeating the same question over and over (to test how many different plausible answers you can come up with), asking mental math questions even before introducing oneself, etc. Regardless of the interviewer‟s approach, 106
the name of the game is poise. Poise is a function of your level of comfort, and comfort is a function of your level of preparation. Hope for the best, but prepare for the worst.
The Intangibles That Make the Difference Show, don‟t tell Have examples prepared for your strengths, weaknesses, and interests. If you state that “maturity” is one of your strengths, the next logical question is to ask to elaborate by providing an example. If you state that one of your interests is film, the next logical question is to ask for your top [x] all-time favourite movies, along with explanations about why you like them. Be prepared to demonstrate the attributes that you declare. Try to work the interview There are things you can do to shape the interview in your favour, but it is important not to be too forceful. Steer your answers toward topics that you‟d like the interviewers to be aware of or investigate further (this applies mainly to the qualitative questions). When asked an openended question, play to your strengths – don‟t bring up things that you can‟t discuss in detail. Everything that you mention in an interview is fair game for further questioning. Don‟t get flustered, maintain your composure Investment banking is a stressful job. Between the long hours and fast-approaching deadlines, bankers don‟t want to have to work with people who can‟t cope with the stress. Part of their job as interviewers is to gauge how well you respond to new scenarios. The best you can ask of yourself is to be composed, so that you can rely on your instincts and lifetime‟s experience to pull you through. The required composure, in turn, is something that can be developed – it‟s the product of the right frame of mind. You need to prepare yourself psychologically for the unexpected and walk into your interviews with confidence and an open mind. Dress like a pro Investment banking is the most conservative business in the world. Ultimately, the job of investment bankers is to advise CEO‟s and CFO‟s on the strategic financial management of their firms. No executive will take advice about their own business from an outsider who doesn‟t look the part. Every banker will tell you that a pitchbook is only as effective as how good it looks; indeed, it‟s difficult to sell something that isn‟t visually appealing. Shirt pressed, shoes polished, hair cut, face shaven, nails clipped, breath freshened. No detail is too small. Body language is very important Stand tall, sit upright in your seat, look your interviewers in the eye, give a firm hand shake, and smile. Remember that the interviewers are just people – they‟re subject to the same prejudices about first appearances as everyone else. Be as presentable as you can be, and carry yourself with confidence. If you don‟t know, don‟t try to B.S. You‟re still only a student. You‟ve never done an investment banker‟s job, and the only exposure you‟ve had to finance is through your finance classes at school, QUIC, and whatever other relevant extracurricular activities you‟ve become involved in. Recruiters don‟t expect you to know everything, but they will try to find out how much you know, so don‟t expect to know the answer to every question they‟ll ask. The worst thing you can do is being caught in a lie. Be honest – you‟re far better off saying that you‟re not familiar with the topic in question and postulating how you might approach the problem given your limited experience than pretending to know everything inside and out. Knowing your limits and seeking help is a sign of maturity, which is something that the recruiters are looking for in their candidates anyway.
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Understand the job of an analyst and the commitment Read about investment banking and become familiar with the job. Talk to senior members of QUIC and QUIC alumni about their summer and full-time experiences. The more familiar you are with the rigours of the job, the better able you‟ll be to demonstrate that you can handle them. Practice, practice, practice Even though you might understand a concept, the true test of whether you can demonstrate your knowledge convincingly is to say it out loud. Practice out loud by yourself or with a friend. Rehearse everything as much as possible. Know the firm and the deals they‟ve worked on Highly qualified candidates have been refused offers or second round interviews because the recruiters weren‟t convinced that they were interested in working for their firm. Do research on every company you interview with – the more you know, the greatest the level of interest you demonstrate in each firm.
Practical Tips That Will Make Your Life Easier Bring a pen and pocket-folder to every interview It‟s always a good idea to bring your own folder into the interview. It‟s a good place for keeping two copies of your resume, transcript, and cover letter (make sure you only bring the cover letter for the right bank!) in case the interviewers forget to bring them or haven‟t had a chance to read them yet. Some blank sheets of paper and a pen can also come in handy when taking down telephone numbers or addresses. If you‟re asked a brain teaser that would be easier to solve on paper, you can ask permission to use a pen and paper. Bringing your own insures that you‟ll have it handy even if they don‟t have any available. Ask for business cards Ask for your interviewers‟ business cards at the end of every interview. That way you‟ll always have their contact information, and you can always refer to them if you‟ve forgotten the interviewers‟ names or don‟t know how to spell them. Always keep your phone on Keep your cell phone on at all times and make sure your voicemail message is professional. Try to avoid places with no cell phone reception. If you know that an incoming call is coming from a recruiter but you don‟t feel comfortable taking the call at that moment, feel free to let it go to voicemail. However, you must be sure to return the call promptly (ideally within the hour). Notify your professors beforehand of classes you‟ll miss due to interviews Not every professor will be happy to dismiss you from class so you can attend an interview. Send your professors an email (this provides a written record, which is better than word of mouth) ahead of time to let them know that you‟ll be missing class because of an interview. Keep a record of all of your interview times and dates in case there is ever any confusion down the road.
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II. Interview Questions Technicals General Valuation How do you value a company? o From lowest to highest valuation Public market analysis Market valuation (i.e., market capitalization) Comparable companies analysis Financial modelling Discounted cash flow modelling Leveraged buyout analysis (floor price) o This technique is meaningless for companies which cannot support debt Private market analysis Precedent transactions analysis o Key concept - all of these methods work in tandem to produce a valuation range o Variation: Of the three main valuation methodologies, which ones are likely to result in higher/lower value? What are some other possible valuation methodologies in addition to the main three? o Above o Merger consequences analysis - determine the maximum willingness-to-pay from a strategic buyer based upon an earnings-neutral assumption (i.e., no accretion / dilution) Premised upon: Consideration (cash or stock) Multiple of earnings paid Cost of debt / interest rate earned Synergies Write-up effect o Merger consequence analysis (2) - contribution analysis in a merger of equals o Leveraged buyout o Break-up analysis / liquidation analysis / sum-of-the-parts o Replacement analysis o Dividend discount model o Net asset value Why might there be multiple valuations for a single company? o Public market - lowest valuation but still influenced by market aberrations o Private market - premiums for control and synergies o Financial modelling LBO analysis - debt assumptions DCF analysis - operating assumptions How do you determine which of the valuation methodologies to use? o Depends on the needs of the client: Acquisition: precedent transactions may make the most sense; adjust the transaction table depending on the deal conditions: 109
Hostile v. friendly Cash v. stock Financially distressed Bolt-on acquisition Financial v. Strategic buyer Merger of equals Horizontal, vertical, conglomerate Speed: public comparables can be calculated quickly and efficiently because the information is readily available Financial modelling: Strategic -allows for synergy adjustments Financial - allows for leverage adjustments Why do you subtract cash in the enterprise value formula? o DCF reason: interest revenue is not included in FCF (because EBIT is employed) and therefore the asset generating interest revenue cannot be included in enterprise value (i.e., cash) o Transaction intuition: purchasing the company entitles the acquirer to the cash (and hence including it in enterprise value is unnecessary) Removing cash yields a net cost of acquiring the business What are some common valuation metrics? o Multiples Enterprise multiples Generic (moving down the income statement) o EV / revenue (EBITDA - negative businesses; young businesses) o EV / EBITDA o EV / EBIT (high capex businesses) Inclusions in EBIT or EBITDA must be: Recurring Not related to financing decisions (ex: lease expense) Industry specific o Renewable energy: EV / MW o Telecommunications: EV / subscriber o Mining and Energy: EV / production capacity Equity multiples Generic: o P/E Poor metric because of differences in : Depreciation policies Non-recurring items Tax regimes Capital structure Industry specific: o Financial institutions: P/B o Mining: P/NAV o Operating metrics Size Market metrics (EV, market cap) Financial statistics (revenue, EBITDA) Efficiency / margins (moving down the income statement) Gross margin EBITDA margin EBIT margin 110
Net income margin Growth rates Use CAGR for: o Revenue o EBITDA Return on investment ROE ROA ROIC Industry specific metrics Telecom o ARPU o Subscriber adds (and some media businesses) o Churn factors Renewable energy o Utilization factor o Development pipeline Credit profile Liquidity (quick, current ratio) Coverage (EBITDA / interest) Leverage (debt-to-capitalization, Debt / EBITDA) Why can‟t you use EV/Earnings or Price/EBITDA as valuation metrics? o Mismatching of claimants and flows to claimants EV / earnings Numerator = all claimants Denominator = equity claimants Price / EBITDA Numerator = equity claimants Denominator = all claimants o Variation: What is wrong with the Price/(Revenue/share) ratio?
Valuation Scenarios How much would you pay for a company with $50 million in revenue and $5 million in profit? o Step 1 - which financial statistic? Use revenue because we need to calculate an enterprise value to structure a bid for transaction value Profit will likely not be useful to determine a bid because: Profit figures are rendered less useful may variances in amortization policies, taxes, etc. o Step 2 - which multiple? EV / revenue Find comparables with similar operating efficiency and capital structure (i.e., 10% profit margins) and calculate their EV/ revenue multiples How would you value a company with no revenue? o Discounted cash flow projections: Project FCF as well as possible Employ a long-run projection period because the company will likely be EBITDA-negative for some time Use scenario analysis (weight outcome likelihood) o Real options (theoretical): Apply real option techniques (if asset variances can be determined) o Operating metrics: 111
Employ operating metrics (such as subscribers) to estimate value How do I value a technology company? o Technology subsegments 1) hardware EV / EBITDA applicable Operating metrics: o Gross margin o Average selling price o Volume o Scalability of cost (operating leverage) 2) software EV / revenue more applicable Do NOT use balance sheet items because: o True assets are people o Most of balance sheet is goodwill EV / EBITDAC adjustment (add back stock-based compensation) 3) IT consulting Book-to-bill ratio Recurring revenue stream may stabilize UFCF; therefore, apply a beta which is lower than the rest of the technology industry
Valuation Building Blocks What is EBITDA? o Earnings before interest, tax, depreciation and amortization o This metric removes the effects of: Leverage Tax regime differences Amortization policy differences Non-recurring items o It is a strong proxy for unlevered free cash flow What is Enterprise Value? o The sum of the market value of all claims on the firm (except the government‟s) o It is equal to the sum of: Equity value Short term debt Long term debt Out-of-the-money convertible debt Out-of-the-money convertible preferred debt Capital lease obligations Preferred shares Minority interest Pension obligations (less) cash and cash equivalents Variation: How do you get from Equity Value to Enterprise Value? How do we use the Treasury Stock Method to calculate diluted shares? The treasury stock method is a way to add the dilutive impact of outstanding warrants to the number of shares outstanding Steps: 1) determine the additional shares issued: o Any class of warrants whose weighted-average strike is below the closing share price is included in this calculation
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2) determine the number of shares retired: o Divide the amount of cash raised from the exercise of the warrants (i.e., weighted strikes times the number of warrants) and divide this by the closing price 3) calculate the incremental shares resulting from the warrants (i.e. step 1 minus step 2) is Minority Interest and why do we add it in the Enterprise Value formula? o Minority interest arises when an acquirer buys a target but does not acquire all of the outstanding stock In this case, the extra claim not captured is represented by minority interest o Minority interest is included in enterprise value because it is an additional claim on the firm (not unlike debt or equity) is the difference between shares outstanding and fully-diluted shares? Shares outstanding - net shares issued by company Fully-diluted shares outstanding - assumes all in-the-money options are exercised
What
What
Comparable Company Analysis Why are the P/E multiples for a company in London different than that of the same company in the States? o Numerator Differences in market sentiment (should kept relatively interchangeable by arbitrage, but this process is imperfect) Liquidity o Denominator Tax regime differences Depreciation convention Recurring items Calculation of fully-diluted shares outstanding o Variation: 20 P/E in Spain for Starbucks, 15 P/E in Canada, how come? Stock prices have different values in two countries, dollar at par, why? Which industries are you interested in? What are the multiples that you use for those industries? o Retailing EV / EBITDAR EV / sq. ft. Sales / sq. ft. (operating metric) EBITDA / sq. ft (operating metric) o Metals & Mining / Oil & Natural Gas EV / EBITDAX EV / Production capacity (units) EV / Reserves P / NAV o Telecommunications EV / (EBITDA - capex) or EV / EBIT (because of maintenance capex required) EV / access lines EV / subscriber ARPU (operating metric) o Financial Institutions P / NAV Tier 1 capital ratio (operating metric) Income trusts o 113
Price / FFO (funds from operations) Is 10 a high P/E ratio? o External analysis - compare to peer average Consider the effect of non-recurring items o Internal analysis P = LFCF / (r-g) if LFCF = (about) = EPS, then E/P = r - g Determine whether the spread between cost of equity and growth rate should be higher or lower than the implied value from the multiple Also consider historical analysis Which is a better measure of performance P/E or EV/EBITDA? Why? o EV / EBITDA because this metric neutralizes the influence of: Different tax regimes Different depreciation policies Different mark-to-market procedures Non-recurring items such as: Restructuring events Gain / loss on sale of assets Extraordinary items Sale of division / operation Changes in accounting principles Inventory write-offs Goodwill impairment Extinguishment of debt Losses from litigation settlement Capital structure differences Note that EV / EBITDA will be influenced when excessive leverage leads to: o Restrictions on growth (via covenants) o Anticipation of the costs of financial distress o Variation: What are some of the flaws of the P/E ratio? What would affect your P/E ratio? o Market sentiment Bull / bear market conditions? o Deal activity Pre-deal: Speculation that company is a target Post-deal: affect of an acquisition on operating value of a company (also consider accretive/dilutive effects of a completed deal) o Earnings manipulation Taxes Depreciation Non-recurring items Dilution o Expectations Dilution: does the market expect the company will issue stock to raise capital? Analysts: companies trade on a forward basis Why use market prices of comparable companies or industry beta? Objective does not require analyst assumptions (as a DCF model does) Market efficiency - reflects the combined wisdom of the market Speed - relatively simple to calculate because information is publicly available Consideration set - provides alternatives to an acquirer Why would you not use the EV/EBITDA ratio for bank holding companies? 114
Because interest is an operating cost for a bank The interest it pays on its deposits is a cost of doing business Since EBITDA is an operating metric, interest expense must be included Furthermore, interest revenue is a bank‟s primary source of revenue; so excluding it from EBITDA is also nonsensical What is NAV? Why do analysts look at P/NAV specifically for mining companies? NAV = net asset value Analogous to price-to-book Depends on the intrinsic value of individual mines What happens to EV/EBITDA when you pay down debt with cash? Nothing EV = equity + debt - cash EV = equity + debt (down) - cash (down) = original EV If you know a company‟s P/E, what is its ROE? P = DIV / (r - g) P = EPS(1-b) / (r- ROE • b) Therefore, P/E = (1-b) / (r - ROE • b) Plug in r and b to solve for ROE When would a business use a P/B ratio? Financial institutions and capital intensive businesses (where the assets of a business have considerable market value) What happens to P/E if the company issues debt to buy back stock? No signalling - EPS will rise and hence P/E will fall Signalling - price may rise and it is therefore impossible to determine the effect on P/E
Precedent Transaction Valuation Name the advantages/disadvantages of using past transactions to value a company o Disadvantages: Many factors affect the transaction value, hence making truly comparable transactions difficult to identify: Bolt-on acquisition: Potential for synergistic integration with existing portfolio of companies (financial sponsor) Hostile situation: typically garner a higher premium Financial distress: typically garner a lower premium Consideration employed: stock deals tend to provide a lower premium because the synergy up-side potential is provided to target shareholders To be truly comparable, synergies should be included in the financial statistic (ex: EV / (EBITDA + synergy) but synergies are notoriously difficult to estimate Why are transaction multiples generally higher than trading multiples? o A premium is paid for: 1) Control premium 2) (if strategic buyer) synergies 3) (if financial sponsor) application of leverage o This drives offer value and hence transaction value higher How do you calculate offer value? o Offer value = offer price per share • fully diluted number of shares outstanding Offer price = trading price + premium Fully diluted shares = shares outstanding + options + convertibles How do you calculate transaction value? Transaction value = offer value + net debt Why might one company sell at a higher multiple than another? 115
What
Synergies Hostile takeover Landmark deal Strategic significance Auction process typically makes comparable acquisition analysis more challenging than trading comps? o Access to information Acquirer is not public Target was public but was rolled into a private company Target was never public
Discounted Cash Flow Modelling Walk me through a DCF. 1) Project FCF (see below) If a balance sheet is also projected, ensure the capital structure remains constant 2) Estimate terminal value (see below) 3) Calculate WACC (see below) 4) Apply WACC to FCF 5) Sensitize model What is the formula for the Capital Asset Pricing Model? cost of equity = rf + B (rm - rf) How do you calculate the terminal value of a company? 1) apply exit multiple to terminal year‟s financial statistic 2) perpetuity growth method Variation: What are the two ways to calculate the terminal value of a company? Which would you use if the company was the acquirer? Which would you use if the company was an LBO candidate? 1) strategic buyer - use the growing perpetuity method because the company is likely to the hold the company into the foreseeable future 2) financial buyer - use the exit multiple method because the sponsor will sell the investment after the investment time horizon (usually about 5 years) How do you get the discount rate for an all-equity firm? Take the beta unlever and apply CAPM Can I apply CAPM in Latin American markets? Yes - define the “market” portfolio to be Latin American stock indices What is the difference between the APV and WACC? WACC Assumes a consistent capital structure Represents the value of the tax shield in the discount rate APV Separates the operating and financing values of a project Useful in LBO or other scenarios where capital structure changes over time What is Beta? What are its limitations? Examples: Beta < 1 Consumer staples Healthcare Utilities Tobacco Beta >1 116
Biotechnology Computer software/services/hardware Entertainment technology Beta = covar (I,m) / var(i) Measure sensitivity to the market portfolio Projected beta = historical beta (2/3) + (1/3) - based upon the notion that beta tends toward 1 in the long-run How do you unlever a company‟s Beta? Beta unlevered = (B levered) / (1 + (D/E)(1-t) + (preferred equity value / E)) Use market values for the ratios Useful when the target‟s beta is not directly observable but comparable companies‟ betas are available What kind of an investment would have a negative beta? Gold - decrease in gold price indicates a reduction in risk aversion and hence (likely) an increase in demand for risky securities (i.e., stocks) Bankruptcy advisors - revenue and earnings are inversely related to the rest of the economy‟s movements Risk-free assets - very small negative beta (since variance on these securities will be nominal) How do I value an airport? Two lines of business: 1) landing fees # Landing strips • through-put rate • landing fees Key variable is through-put rate - project the traffic based upon macro-trends: o Consumer confidence o Business confidence o Etc. 2) retail space Lease payments (fixed) Share of retail products sold (variable) o Forecast number of patrons (which will be related to the number planes via the utilization factor) Also consider the impact of government subsidies and protection What kind of risk does Beta measure? How do you measure the other kind of risk? Beta measures systematic risk - i.e., all the risk which is not diversify-able and results from movements in the market portfolio The other type of risk in unsystematic or firm-specific risk Measuring unsystematic risk: 1) calculate the firm variance 2) calculate the beta 3) calculate the market variance 4) firm variance = beta squared • market variance + unsystematic variance; solve for unsystematic variance If the B/S ratio of a firm goes up, why does the cost of capital decrease? Does it decrease indefinitely? What factors cause it to increase after a certain point? The cost of capital declines because additional leverages enhances the value of the firm by creating a tax shield It does not decrease indefinitely because eventually the costs related to financial distress outweigh the benefits of the tax shield The optimal capital structure occurs where the marginal benefit of the tax shield equals the marginal cost associated with financial distress Two firms, one in area prone flooding and one not, will betas be different?
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No because the market portfolio will be defined in each area and since beta only measures movements relative to the market portfolio, the company in the flood-prone area will not appear risky What drives / changes WACC? o Operations (above the EBIT line) Changes in the operating performance of the company alter the cost of capital If a company becomes riskier, its cost of capital will rise Measurement tools: Growth Margins Coverage / leverage ratios (relative to EBITDA) Working capital efficiency o Capital structure Addition of debt lowers WACC until a point of diminishing returns is reached, at which point the marginal benefits of the tax shield are outweighed by the costs of financial distress What would happen to a company‟s enterprise value if its Account Receivable turnover increases from 60 to 90 days? o The value of the firm will decrease because: 1) working capital efficiency has decreased 2) this will result in a greater change in working capital Mathematically, days A/R = (avg. A/R / net credit sales) •365 For the quantity in brackets to increase, average A/R must increase, hence driving greater increases in working capital 3) this will reduce the value of UFCF Variation: Xeron Software Corporation‟s days sales outstanding have gone from 58 days to 42 days. Does this make you more or less likely to issue a Buy rating on the stock? Describe how to value a privately held company o Privately held companies are difficult to value because of the availability of information o This lack of information is most relevant to the cost of capital: 1) target weights because “market values” are unavailable for equity and debt these must be approximated use comparable companies to estimate the optimal capital structure or ask management directly 2) cost of equity no beta is available unlever the beta of comparable companies and relever this beta based upon the determined optimal capital structure 3) cost of debt use a comparable companies‟ YTM Or: apply a spread to the yield curve based upon the credit rating of the company (which can also be estimated with liquidity, leverage and coverage ratios) 4) add a risk premium to account for the asymmetry of information Variation: If you had to do a valuation for a company like Mars (private held), what problem(s) do you run into? how would you need to modify the DCF methodology? How can we find the cost of debt? 118
Calculate the YTM on outstanding debt instruments if the company is at its optimal capital structure How can we find the cost of equity? If a company‟s current taxes include a future income tax asset, how does this affect FCF? What about if it‟s a future tax liability? o A future tax asset inclusion will reduce FCF Intuitively: paying high taxes and accruing an asset as a result in a cash outflow Mathematically: an increase in any asset is a deduction from FCF This is why an increase in current assets (like inventory) reduces FCF o The inclusion of a future tax liability will increase FCF What is the resulting DCF value using levered FCF? If FCF is discounted at the levered cost of equity, the result is the intrinsic equity value of the company This is logical because the cash available to equity claimants, discounted at the equity claimants‟ required rate of return, must yield the value of the equity claim If I give you the DCF value of levered FCF what can you add/subtract to it to get Enterprise Value? o Add: Net debt Preferred shares Pension obligations Capital lease obligations Minority interest Out-of-the money convertible debt If you discount Levered FCF by WACC and divide the final value by net income will this be an over or under approximation of the P/E ratio. This will overestimate the P/E ratio because the equity value is inflated The equity value will be overestimated because the discount factor applied to LFCF will be less than then levered cost of equity (WACC is always less than the levered cost of equity) This approximation will be correct if the firm is all equity Start with FCFF and get FCFE FCFF Less: interest (1-t) plus / less: debt issuances (repayments) less: preferred dividends less: claim of minority interest holders = FCFE How do you calculate FCF? EBIT (1-t) Less: capex Plus: depreciation Less: change in working capital Less: change in net deferred tax assets = UFCF How do you project out free cash flows for the DCF model? o EBIT Project sales Assume various margins for line items between sales and EBIT o Capex 1) simple approach - % sales method 2) complex approach - capex schedule
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Depreciation 1) simple approach - ratio to capex (replacement ratio) 2) built into capex schedule o Changes in WC 1) current assets A/R - days A/R Inventory - days inventory Other - % of sales 2) current liabilities A / P - days A/P Other - % of sales o Changes in net deferred tax assets 1) simple approach - assume a % of taxes are deferred 2) complex approach - calculate from capex schedule If you have 2 identical companies, one has variable assets, one has fixed, which one has a higher valuation? o Interpretation 1 - asset variability refers to variability in the assets‟ value Firm value will not change Equity value will be higher, all else constant, in a firm with higher asset variability because equity holders own a call option on firm value o Interpretation 2 - asset variability refers to the variability of the cash flows generated by the asset The firm with a fixed cash flow pattern will be more valuable because it will be able to support more debt and hence generate a greater tax shield How do you go from NI to cash flow? FCF to FCFE? Net income Plus: depreciation and amortization Less: capex Less: changes in working capital Plus / Less: borrowing / lending Less: changes in net deferred tax assets = FCFE Plus: Interest(1-t) Plus: Preferred dividends Plus: Minority interest claims Plus: Capital lease payments Less / Plus: borrowing / lending = FCFF Variation: Say you knew a company‟s net income. How would you calculate its free cash flow? Starting with Net Income, calculate Levered Free Cash Flow If you have a P/E of 10x and you initially had 500 shares outstanding, if you issue 500 new shares, by how much will your P/E increase (or decrease)? Assumption: price per share does not change P/E will double (because EPS will fall be 50%) In all likelihood, this will not be the case because equity issuances are usually followed by a decline in share price (signalling theory) o
Leveraged Buyout Modelling What is a leveraged buyout? How is it different than a merger? A leveraged buyout is a transaction in which the acquirer is a “financial sponsor”, typically a private equity company, and in which leverage is used to finance the purchase
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Differences:
The buyer: a financial buyer purchases the company instead of a strategic buyer I.e., the acquirer is not: o A competitor o A supply chain partner o A conglomerate The target: LBO targets have a number of required characteristics: A strong asset base Stable, recurring FCF Defensible market position Opportunities for efficiency enhancements Minimal capex requirements The objective: LBOs have a different objective than strategic acquisitions Strategy acquisition - realize a synergy LBO acquisition - realize tax shield of interest The premium: LBOs have a lower transaction multiple than strategic acquisitions because the marginal benefit of debt is lower than the addition of synergies Why does infrastructure make sense as an LBO target? Strong FCF generation o Product or service is often government secured Stable business model Not subject to cyclicality Ex: electricity sale prices are government-secured o Asset base Infrastructure companies generate their cash with their tangible asset base o Defensible market position Often government protected industries Very difficult to enter the infrastructure market because of the high set-up costs o Low capex requirements Relatively small maintenance costs relative to the up-front set-up costs o Other considerations: Efficiency opportunities Management team Business elements can be divested (to raise emergency cash) Business is undervalued Business has a low level of existing leverage Variation: o What makes a company an attractive target for an LBO? What are some characteristics of a company that is a good LBO candidate? Why would a Company want to go through an LBO? o Stakeholder analysis: Management - incentivized via equity offering; management shares in the benefits of the high IRR in an LBO Shareholders - receive a premium on the market value of their shares Existing creditors - receive their principal and the call premiums on their debt New creditors - receive reasonable interest on their investment, so long as the company is well-managed
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Suppliers - may benefit from operating improvements as the company rationalizes its operations Employees - may also benefit from greater productivity as the company attempts to improve efficiency How could a firm increase the returns on an LBO acquisition? Entry multiple - higher = lower IRR o A higher up-front cost requires IRR to fall to equate the present value of future cash flows o Exit multiple - higher = higher IRR A higher terminal cash flow improves IRR o Equity contribution - higher = lower IRR A lower amount of equity injected increases leverage and hence the tax shield benefits o Operating efficiency - higher = higher IRR Higher operating efficiency yields strong FCF and hence more debt paid down Timing of Sale - longer = lower IRR o The longer an LBO is stretched out, the less debt their is to repay to increase the equity stake in the business o Variation: Let‟s say you run an LBO analysis and the private equity firm‟s return is too low. What drivers to the model will increase the return? In an LBO, what would be the ideal amount of leverage to put on a company? o Balance: Net benefits of leverage The marginal tax benefit of tax = the marginal cost of financial distress Stress test the LBO model to determine this optimal point Flexibility and growth Balance the financial benefits of leverage against the opportunity cost of: o Limits on strategic flexibility o Inorganic growth via bolt-on acquisitions Walk me through an LBO analysis… o Step 1 - gather information o Step 2 - build the pre-LBO model Income statement Build out only until EBIT Balance sheet Leave line items blank under the liabilities section Cash flow statement Leave line items blank under the financing section o Step 3 - determine the financing structure Determine the purchase price (multiple) Determine the financing for the purchase Level of debts Types of debt Determine the starting balance sheet (pro forma) after the transaction o Step 4 - complete the model Debt schedule Apply forward LIBOR curve Determine cash and gross interest expense Apply debt schedule to: Income statement
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Balance sheet Cash flow statement o Step 5 - LBO analysis Determine if target can support debt level Stress test Apply leverage and coverage ratios Sensitize returns to: Exit multiple Entrance multiple Operating scenarios Timing of sale Equity contribution Why do private equity firms use leverage when buying a company? 1) to generate a tax shield 2) to improve the IRR on the equity investment What is the maximum leverage in an LBO typically based upon? A multiple of EBITDA Debt to capitalization ratios Interest coverage ratios Credit ratings Consider off-balance sheet financing arrangements (EBITDAR) Stress-testing the LBO model What restrictions does management face after an LBO? Cannot afford to have a bad year Forces cost consciousness on management Conservative capital spending Cannot undertake acquisitions Maintenance of covenants Why is an LBO often referred to as a “floor” on valuation? Determines a financial value that a strategic bidder must exceed What is a “PIK” security? Stands for payment-in-kind Issue additional debt/preferred shares in place of interest payment Where do financial sponsors typically get their money? Insurance companies Public pension funds Corporate pension funds Foundations Sovereign wealth funds Endowments High net-worth individuals
Mergers and Acquisitions Are most mergers stock swaps or cash transactions and why? Strong markets - stock because of elevated valuations Weak markets - cash because stock offers can be dilutive Market volatility - in a volatile market, target shareholders will prefer cash What is a hostile tender offer? A tender offer is usually a hostile takeover technique. It occurs when the acquiring company offers to purchase the stock of the target company for a price over the current market price in an attempt to take control of the company without management approval.
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The CEO of a $500 million company has called you, her investment banker. She wants to sell the company. She wants to know how much she can expect for the company today. o Apply valuation techniques: Public market Outstanding enterprise value Public comparables Financial model DCF analysis LBO analysis Private market Precedent transactions In an M&A transaction, will a strategic or financial buyer pay a higher premium? What analysis would you run to determine the affordable premium? o Strategic buyer: Accretion / dilution analysis DFC with synergies incorporated Financial buyer: o LBO model Apply the hurdle IRR to calculate the maximum offer value o Variation: What is the difference between a strategic buyer and a financial buyer? Which will pay a higher price? Strategic buyer - corporation acquirers another for strategic and synergistic reasons Financial buyer - a sponsor looking to acquire a company to improve operations and exploit the gains from leverage Strategic buyers will be willing to pay more because of o 1) the potential synergies associated with a deal o 2) capital budgeting divisions of strategic buyers have a lower IRR o 3) lower cost of capital o 4) management ego Consider market conditions: Technology bubble - stock consideration more o valuable, allowing strategic buyers to offer higher premiums o Credit bubble - cheap and abundant debt financing allow financial sponsors to make comparable bids to strategic buyers Your client is a privately held human resources software company. You are advising the company in the potential sale of the company. Who would you expect to pay more for the company: Oracle Software (a competitor) or Kohlberg Kravis Roberts (a Private Equity firm)? Oracle Software because this acquisition will generate significant synergies and hence increase willingness-to-pay If you have a P/E of 10x, and a cost of debt of 10%, what consideration would you use to finance a transaction? What assumption are you making here and why does it make sense? o Use the acquisition currency which has a higher P/E because this will result in higher accretion “P/E of cash” = 1 / 0.1 = 10x Therefore, management should be indifferent between these two alternatives o Assumptions There is no tax (if there was, the P/E of cash would be higher) Accretion / dilution analysis is paramount 124
Debt is being issued to finance the transaction (as opposed to existing cash) There are no restrictive covenants in place The target shareholders are indifferent between the two offers
What are synergies? o Synergies are the incremental benefits of a merger o They represent the value generated when two companies cooperate o Types: Revenue Greater pricing power Cross-selling Wider distribution network Strategic value - entering a new industry Cost Economies of scale Economies of vertical integration Reduction of management inefficiency Complementary resources Tax Unused debt capacity Tax loss assets Excess funds - not paid as dividends because this is a taxable event Financing Financing economies of scale o Variation: Explain the concept of synergies and provide some examples. Why might one company want to acquire another company? Also consider: o Meet Wall Street growth expectations o Satisfy management ego o Because the target is under-valued o The company would be worth more if it was sold off piecemeal What is a cash offer? o Offer cash in exchange for target‟s shares o Finance cash with: Reserve cash Issuance of debt Often temporarily financed with a bridge loan Would I be able to purchase a company at its current stock price? No because of the associated control premium of acquiring a company Why pay in stock versus cash? o Stock deal: Allows participation in company integration Can reduce volatility via collar offering Does not consume cash (and there is therefore no foregone interest revenue or additional interest expense) Does not precipitate a taxable event What are the three types of mergers and what are the benefits of each? o Horizontal Bargaining power with buyers Bargaining power with suppliers Cross selling 125
Vertical Rationalizing the supply chain o Conglomerate Economies of scope Sharing of distribution channels Walk me through an accretion/dilution analysis… o 1) Combine the income statements of the two companies o 2) Adjust for incremental revenue / expenses: Synergies Amortization of financing fees Expensing of advisory fees Incremental amortization of assets from write-up effect o 3) Adjust for the deal: Cash deal: Balance sheet cash - remove the foregone interest revenue Debt cash - add an interest expense Stock deal: Increase the number of fully diluted shares outstanding o Variation: What factors can lead to the dilution of EPS in an acquisition? If a company with a low P/E acquires a company with a high P/E in an all stock deal, will the deal likely be accretive or dilutive? o If all stock, dilutive because the acquirer paid per dollar of earnings for the target than its own market valuation o Other considerations: Purchase price of target Synergies Amortization of financing fees Expensing of advisory fees Incremental amortization of assets from write-up effect Integration expenses Effect of refinancing the target‟s debt What are some reasons two companies would not want to merge? Management ego Investment banking fees Diversification Media attention For an investment banker, why is a sell-side process typically shorter than a buy-side assignment? There is a willing seller, whereas in a buy-side mandate a potential target must be identified first and then the process is initiated If Company A pays a premium of 20% for Company B and of this 15% represents a backward calculated value of the realizable synergies, what does the 5% represent? o The additional 5% represents the control premium o Premium offered = synergy payment + control premium o Follow-on questions: How would you account for the 5% and on what financial statements? Capitalize on the balance sheet as goodwill If the 5% increased to 20%, how would cash flow be affected going forward on a relative basis? Cash flow will decrease because the depreciation tax shield will fall (there is no amortization of goodwill) The above example had a composition of 15%-5% for the synergies and the other item which you identified in part a. What industry is more o
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likely to have a higher ratio of the other item than synergies (i.e. 1%19%)? Start-up technology firms (no synergies - paying for control of intellectual property and intellectual capital) What is a dilutive merger? Decreases EPS (or some other financial statistic) What is an accretive merger? Increases EPS (or some other financial statistic) Company A is considering acquiring Company B. Company A‟s P/E ratio is 55x earnings, whereas Company B‟s P/E is 30x earnings. After Company A acquires Company B, will Company A‟s earnings per share rise, fall or stay the same? o It depends: o Stock deal: So long as the differential in the acquisition currency is not offset by the below factors, the deal will be accretive Effect of write-up on depreciation Amortization of financing charges Advisory fees Integration expenses Purchase premium o Cash deal: It depends on the cost of debt and the subsequent “P/E of cash” as well as the above factors What are some common income statement adjustments related to a transaction? Synergies Capital financing fees Incremental D&A Additional interest expense Lost interest income Integration expenses
Financial Statement Analysis What is the difference between the Income Statement and the Statement of Cash Flows? o Causality Statement of cash flows depends upon the income statement o Effects on the balance sheet The income statement is linked to the balance sheet via retained earnings The cash flow statement is linked to the balance sheet via cash o Items Income statement shows all revenue and expenses, irrespective of the associated cash flows Hence, it is prepared using accrual accounting Cash flow statement shows only cash items: Operating section: o Add back non-cash deductions to net income o Deduct non-cash additions from net income Financing and investing section are concerned only with the cash flows resulting transactions o Organization The income statement flows from large to small (revenue to net income) The cash flow statement is divided into three, relatively autonomous components and resulting in a change in cash YoY 127
Final thought - a firm can go bankrupt while still having a positive net income because its operating cash flow are insufficient to service debt obligations What is the link between the Balance Sheet and the Income Statement? o The balance sheet and income statement are linked via: Retained earnings - net income flows into retained earnings (after dividends have been deducted) Depreciation and amortization - charges against the NBV of PP&E and intangible assets are displayed on the income statement and accrue on the balance sheet Write-downs - the impairment of goodwill or other assets relates the two statements What is the link between the Balance and the Statement of Cash Flows The cash flow statement ultimately produces a change in cash, which is used to calculate the most recent cash balance on the balance sheet Operating section: working capital changes drawn from balance sheet Investing section: long-term asset changes drawn from balance sheet Financing section: long-term financing changes drawn from balance sheet If Company A buys Company B, what will the Balance Sheet of the combined company look like? Without minority interest: simply add the line items of each company‟s balance sheet together to construct a consolidated balance sheet With minority interest: the same procedure as above except an additional claim is generated on the financing side of the balance sheet to represent the assets which are not wholly owned by the acquirer If a company incurs $10 (pretax) of depreciation expense, how does that affect the three financial statements (assume a 40% tax rate)? How does it affect the value of the company if this change occurs in year 4? Income statement: EBIT down $10 Net income down $6 Taxes down $4 Cash flow statement: Net income down $6 Depreciation up $10 Cash from operations up $4 (represents tax savings) Balance sheet: Cash up $4 PP&E down $10 Retained earnings down $6 (represents reduction in net income) DCF value: present value of $4 tax shield @ WACC A company makes a $100 cash purchase of equipment on Dec. 31. How does this impact the three statements this year and next year? This year: DR: PP&E (balance sheet) CR: cash (balance sheet) Next year: DR: depreciation expense (income statement) CR: accumulated depreciation (balance sheet) Same question as the previous but the company finances the purchase of equipment by issuing debt rather than paying cash. This year: DR: PP&E (balance sheet) CR: long-term debt (balance sheet) Next year: Depreciation: o
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DR: depreciation expense (income statement) CR: accumulated depreciation (balance sheet) Interest expense: DR: interest expense (income statement) DR: cash / interest payable (balance sheet) Continuing with the last question, on Jan. 1 of Year 3 the equipment breaks and is deemed worthless. The bank calls in the loan. What happens in Year 3? Equipment write-down: DR: loss on disposal of equipment (income statement - non-operating) DR: accumulated depreciation CR: equipment Repayment of the loan: DR: long-term debt CR: cash / another liability account (ex: revolving credit facility) Walk me through the major lines on a Cash Flow Statement. o Operating section Net income Plus: depreciation and amortization Plus: other non-cash expenses Loss on sale of equipment Stock-based compensation Less: changes in working capital Less: other non-cash additions (gain on sale of equipment) Less: changes in net deferred tax assets o Investing section Securities Short-term sale / investment Long-term sale / investment Acquisitions Purchase of business Divestiture of business Asset additions Purchase / sale of PP&E Purchase / sale of intangible assets o Financing section Stock issue/retirement Debt issue/retirement Common / preferred dividends o Variation: Walk me through a cash flow statement How do you get Cash Flow from Operations? What are the three components of the Statement of Cash Flows? Walk me through the major items of an Income Statement Revenue o Gross sales Less: sales returns and allowances Less: sales discounts o COGS Opening inventory Plus: net purchases Less: ending inventory o Operating expenses SG&A Selling Non-operating gains / losses o 129
Interest income / expense Gain / loss on sale / disposal of equipment o Net income Apply net income to the above Calculate EPS (normal and fully diluted) o Non-recurring items: Discontinued operations (net of tax) Disposal of business line Income associated with discontinued operation Extraordinary items (net of tax) Both unusual and infrequent o Other comprehensive income Related to unrealized gains / losses on AFS securities Derivative positions Donations What happens to each of the three primary financial statements when you change: a) gross margin b) capital expenditure c) any other changes? o A) gross margin Income statement Net income up Cash flow statement Cash from operations up Balance sheet Retained earnings up Cash up o B) capital expenditure Income statement No effect Cash flow statement Cash outflow in investing section Balance sheet PP&E up How do you calculate a company‟s Days Sales Outstanding? Days sales outstanding = (avg. A/R / net credit sales) • 365 How do you calculate a company‟s current ratio? Current ratio = current assets / current liabilities If I was to give you 2 of the 3 Accounting Statements, which would you want to be able to create the third? 1) Balance sheet 2) Income statement Create the cash flow statement So what‟s the accounting term for when you overpay for an asset? Goodwill How does deprecation affect three financial statements? o Income statement - deduction from revenue to arrive at net income o Balance sheet - reduces the net book value of the outstanding assets on the balance sheet o Cash flow statement Added back to net income to arrive at cash flow from operations May be used to drive capital expenditures (in a financial model) through the replacement ratio If a company buys a 35% interest in another company, how would you account for such a purchase? Reflect this on the relevant financial statements?
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Significant but non-controlling interest; therefore, do not consolidate line items o Balance sheet Capitalize as an investment Income statement o Income from the subsidiary company is investment income How do you amortize Goodwill for large Canadian Corporations and how does this affect FCF? o Goodwill is not amortized; it is tested for impairments o Goodwill write-downs do not impact FCF because they are a non-cash expense They only affect FCF by reducing taxable income What is operating leverage? Relationship between fixed and variable costs; a higher proportion of fixed costs yields a higher degree of operating leverage Effect: higher operating leverage yields greater earnings volatility (and hence a higher beta) Measurement: % change in EBIT / % change in revenue (higher = more operating leverage) What is goodwill and how does it affect net income? o Goodwill: is the excess of purchase price paid for an asset/company over the fair market value of the target When a company is acquired, the target‟s assets are first increased to their fair market value This impacts the financial statements by increasing the depreciation tax shield It also decreases net income because the depreciation expense will increase The excess of the purchase price over the fair market value of the target is goodwill It is capitalized as an asset representing intangible benefits of an acquisition: Brand name Good customer relationships Synergies Goodwill remains on the balance sheet and is not amortized; it may be impaired if the circumstances of the acquired asset change negatively o Affect on financial statements: Balance sheet: increase goodwill account Income statement & cash flow statement: No impact initially In the case of an impairment: o Net income will be depressed o Cash will increase from the tax shield impact of the impairment What is working capital? o Working capital = current assets - current liabilities o Net working capital = Current assets excluding: Cash Cash equivalents Short-term investments Less: current liabilities excluding: Short-term debt Current portion of long-term debt Discuss the different accounting treatment for different securities (e.g., AFS, HTM, HFT) o
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HTM Measurement acquisition
at
Measurement acquisition
after
Transaction costs Unrealized holding gains / losses Impairment losses
HFT
AFS
Fair value
Fair value
Fair value
Amortized cost
Fair value
Fair value if active market
Choice
Expense
Choice
NA
Net income
OCI
Net income
NA
Net income - transfer out of AOCI
Discuss how minority active, passive and majority active are handled. o Minority active - equity accounting method Capitalize Increase value resulting from net income (record as investment income) Decrease value resulting from dividends o Minority passive - held-for-trading investment o Majority active - consolidation accounting Treat for minority interest What are some liquidity/leverage ratios? o Liquidity: Current ratio Quick ratio o Leverage: Debt-to-capitalization Debt / EBITDA EBITDA / Interest (coverage) What are the two largest ways companies can play with their earnings? 1) Depreciation policies and estimates 2) Revenue recognition policies 3) Capitalization of expenses 4) Impairment charges 5) Debt issuance / retirement (change interest expense) 6) Off-balance sheet structures (SIVs) Why do capital expenditures increase assets (PP&E) while other cash flows, like paying salaries, do not create an asset and instead instantly create an expense? If an asset is expected to provide economic benefits for longer than one period, it is capitalized; else it is expensed This is consistent with the matching principle Is it possible for a company to show positive cash flows but be in grave trouble? Unsustainable improvements in working capital (sale of inventory, A/R) Divesture of core businesses / assets Lack of projects in pipeline to generate revenue in the future How is it possible for a company to show positive net income but go bankrupt? Deterioration of working capital (excessive A/R from credit extension and low A/P) Accounting information manipulation Breach of covenants Why are increases in accounts receivable a cash reduction on the cash flow statement?
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Because it represents a non-cash addition An increase in A/R implies that some revenue was recorded without the receipt of cash is goodwill? An asset that captures the excess of purchase price over fair market value Bankers typically assume that the book value is the FMV in acquisition analysis is a deferred tax liability? o A deferred tax liability results from the excess of shareholder depreciation over tax depreciation If depreciation > CCA, a tax liability is generated because the tax expense on the income statement will exceed the cash taxes paid The accounting entry will be: DR income tax expense (calculated based upon shareholder depreciation) CR taxes payable (calculated based upon CCA) CR deferred tax liability o Variation: Where do Deferred Tax Liabilities come from? What is a deferred tax asset? A deferred tax asset can result from: 1) shareholder depreciation falling short of CCA (opposite of the above) 2) tax-loss carry-forward which results a company recording an operating loss, which can be used to off-set taxable income in the future Who determines the value of fair market write-ups in a transaction? Independent appraisers, accountants and other valuation experts What are some balance sheet items commonly adjusted to fair market value in a transaction? A/R Inventories PP&E Which fees in an M&A transaction are capitalized on the balance sheet and which are amortized on the income statement? Transaction fees are amortized Deal fees are not Walk me through how you would proceed to show the transaction of the sale of an equipment that was bought at $1.4M three years back and is deprecated at a steady rate over 10 years and had a salvage value of $100,000 and was sold at a break even price. o Depreciation base = 1.3M o Depreciation per year = 130,000 o Accumulated depreciation = 390,000 o Break-even sale price = 1,010,000 o Transaction: DR cash 1,010,000 DR accumulated depreciation 390,000 CR equipment 1,400,000 If you have a company which operates at a 25% gross margin (pre-tax income) with a 50% tax rate, if the company had a net income of 500, what was its revenue? $4,000
What What
Capital Structure, Capital Raising and Cost of Capital Describe a typical company‟s capital structure o Senior debt (bank debt) Characteristics Highest claim on asset More restrictive covenants Cost based upon LIBOR + spread 133
Types
Revolving credit facility Term loans o Class A - some amortization o Class B - no amortization o Subordinated debt (high-yield debt) Characteristics: Fixed coupon Bullet repayment High yield Types: Senior subordinated Senior unsecured o Mezzaine financing (mixed equity/debt) Preferred equity Convertible debt Equity (straight equity) o Would you invest equity or debt in a technology company? o Use equity because technology companies have : Nominal asset bases with which to collateralize debt Unstable FCF A need for flexibility I‟m a private company, I want to raise money…what are ways? o Left-side of balance sheet Divest non-core assets o Right-side of balance sheet Bank debt Revolving credit facility Asset-based lending Term loans High-yield bonds Insurance companies Pension funds Hedge funds Preferred shares - highly tailored solution Common equity Consider dual share-class to preserve existing shareholders‟ control Go public! EV question: if I had 100 MIL, raise 50 MIL in equity offering, what‟s EV? Nothing - cash will increase by $50m, off-setting the increase in the equity value When calculating WACC, if you convert your capital structure from 50% straight debt, to 20% convertible debt, and 30% straight debt, what happens to your WACC? o Reduction in WACC because convertible debt has two components: 1) straight debt - lower cost of capital 2) warrants - not included in the WACC calculation If you have two identical businesses, would you invest in the company that has 100% equity or 100% debt? The 100% debt business (assuming no financial distress) because it maximizes the value of the tax shield Alternatively, debt is associated with a lower cost of capital and hence the firm is more valuable under debt financing (because WACC is lower) What is cheaper – debt or equity? Why? o Debt is cheaper because: 134
1) debt is associated with fixed claims (interest and principal) and as a result the required rate of return (or YTM) is lower 2) the cost of debt is taken after-tax (because interest is tax deductible) 3) debt holders have firm claim on the value of the firm in the case of bankruptcy Where do you find the risk-free rate? The YTM on a long-term government bond (usually 10 years) Sources: bloomberg terminal or bloomberg website What is the market risk premium? Represents the additional return holders of the market portfolio earn above the risk-free rate Mathematically, the risk premium is the difference between the expected return on the market and the risk-free rate It can be calculated by averaging historical risk premiums Estimates usually range between 4-8% When should a company issue stock rather than debt to fund its operations? Stock valuation: inflated stock value Debt capacity: in ability to support additional debt Optimal capital structure: movement toward optimal capital structure Why do some stocks rise so much on the first day of trading after their IPO and others don‟t? o It depends on how bankers price the issue (if it is priced at a discount to intrinsic value, the shares will rise as the efficient market removes the valuation discount) o How is that “money left on the table”? This is “money left on the table” because, had the issue price been higher, more funds can have been earned by the investment banks and the issuing corporation Reasons for “leaving money on the table”: Spinning - offering rising stop to best clients in exchange for future fees Marketing event Social proof / cascading theory Underwriting risk reduction What is the order of creditor preference in the event of a company‟s bankruptcy? 1) bank debt 2) senior unsecured / senior subordinated 3) mezzaine financiers 4) common equity What is CAPM? What are its assumptions? o CAPM is an cost of equity pricing technique o CAPM: cost of equity = rf + B (E(rm) - rf) o Assumptions All investors hold the market portfolio Hence, systematic risk is the only relevant risk Homogenous expectations Market equilibrium No transaction costs No taxes Write the formula for WACC Rwacc = (target weight of equity)(cost of equity) + (target weight of debt)(cost of debt)(1-t) Define the sharpe ratio Sharpe ratio = (E(r) - rf) / standard deviation
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Expected excess return over the standard deviation of the investment Variation: Define the reward to risk ratio. How would you describe the cost of capital to a non-finance person? 1) investors demand a return which is proportional to the risk of the investment; this required rate of return becomes the cost of capital for a business 2) it is determined by assessing similar investments and the returns they have yielded; in this respect, the cost of capital is the opportunity cost of not investing in a different, similar business Why would a company issue equity v. debt? o Equity pros No required prepayments Management flexibility o Equity cons Dilutes ownership More expensive cost of capital o Debt pros Tax deductible No ownership dilution o Debt cons Increases the cost of debt (through increasing the probability of default) Reduces management flexibility (through covenants) If a company was typically financed by 50% debt and 50% equity, if it increases it debt financing to 75%, ceteris paribus, what happens to its ROE? What consequentially happens to its Share Price? ROE will increase because the amount of common equity will decrease by more than net income will decrease (assuming the cost of debt is reasonable) This is how PE firms earn high IRRs - by recapitalizing firms with more debt Share price will also rise as a result because shareholders benefit from the higher rate of return (and also benefit from the tax shield)
Portfolio Management If you add a risky stock into a portfolio that is already risky, how is the overall portfolio risk affected? it becomes riskier it becomes less risky overall risk is unaffected it depends on the stocks risk relative to that of the portfolio (correct answer) Put the following portfolios consisting of 2 stocks in order from the least risky to the most risky and explain why. A) A portfolio of cable television company stock and an oil company stock B) A portfolio of an airline company stock and a cruise ship company stock C) A portfolio of an airline company stock and an oil company stock C then A then B If the CAPM model only shows systematic risk, how do you incorporate unsystematic? Measure the variance or standard deviation of the target If I give you the expected returns, and probabilities for two stocks, explain the steps that you would take to find the minimum variance portfolio. (would only be asked in S&T/Hedge Fund interviews) 1) Calculate the variance of each stock 2) Calculate the covariance of the two stocks 3) Calculate the variance of the portfolio under different weights 4) Repeat step 3 until the minimum variance portfolio is revealed 136
What is correlation? A standardized way of measuring the relationship between securities‟ returns Mathematically, correlation = COV (1,2) / (SD(1) • SD(2)) Correlation = 1 implies perfect correlation Correlation = -1 implies perfectly inverse relationship What is diversification? The risk benefit achieved by combining securities which are not perfectly correlated Diversification occurs through the elimination of unsystematic risk factors If you add a risky stock to a portfolio, what happens to the overall risk of your portfolio? It depends upon the risk level of the security relative to the portfolio, as well as the covariance between the security and the portfolio What is the difference between technical and fundamental analysis? Technical analysis - attempts to analyze historical price and volume data to predict future patterns Fundamental analysis - analyzes the company-specific, industry and macro-economic circumstances of an investment opportunity and attempts to the determine the investment‟s intrinsic value
Fixed Income Securities What is the relationship between a bond‟s price and its yield? Inverse - higher yields produce a lower price How are bonds priced? o Discount the coupons and principal at the appropriate YTM o YTM is determined by adding a spread to the YTM of a corresponding treasury instrument The spread is proportional to the risk level of the company How would you value a perpetual bond that pays you $1,000 a year in coupon? Divide 1,000 by the YTM on the bond When should a company issue debt instead of issuing equity? Equity is undervalued Sufficient cash-flow generating capacity Lower cost of capital Capacity to utilize tax shields Shift to optimal capital structure What major factors affect the yield on a corporate bond? o Base - movements in the treasury yield curve influence the base YTM; driven by: Inflationary expectations Federal reserve manipulation o Spread company specific credit circumstances alter the spread; a deterioration in credit quality will widen the spread The degree of risk aversion will also influence corporate spreads more broadly If you believe interest rates will fall, which should you buy: a 10-year coupon bond or a 10-year zero-coupon bond? Zero-coupon because it is has a higher duration Which is riskier: a 30-year coupon bond or a 30-year zero coupon bond? Zero-coupon because it is has a higher duration If the price of the 10-year Treasury note rises, does the note‟s yield rise, fall, or stay the same. Fall (inverse relationship) If you believe the interest rate will fall, should you buy bonds or sell bonds? Buy (inverse relationship) 137
How many basis points equals .5 percent? 50 basis points Why can inflation hurt creditors? It reduces the real rate of return earned How should the following scenario affect the interest rate: the President is impeached and convicted. To calm markets, the federal reserve may lower the discount rate; this will increase the price of bonds An additional factor supporting the bond prices will be a growing risk aversion in the face of uncertainty What does the government do when there is a fear of hyperinflation? Raise taxes Slash fiscal stimulus Increase in the interest rate (through the Federal Reserve) How would you value a perpetual zero coupon bond? o Trick question - this instrument has no value because it has no: Interim cash flows Bullet repayment Let‟s say a report released today showed that inflation last month was very low. However, bond prices closed lower. Why might this happen? Bonds are priced based upon expected future inflation If the stock market falls, what would you expect to happen to bond prices, and interest rates. Bonds appreciate in value because investors are becoming more risk-averse Interest rates will fall (signals cooling economic activity) If unemployment is low, what happens to inflation, interest rates and bond prices? Low unemployment = high inflation = high interest rates = low bond prices What is a bond‟s yield to maturity? The discount rate required to equate the PV of coupons and principal to the price of the bond It is the IRR on a bond investment If the price of a 10 year, 10% annual convertible bond is $102, and the price of a 10 year, 10% annual straight bond is 99, what is the reason for this discrepancy? The convertible debt is more valuable because it is the up-side potential associated with an equity investment Explain liquidity preference theory and the expectations hypothesis with respects to how bonds are priced. Expectations - assumes the yield curve is a projection of future spot rates (i.e., expected spot rates = forward rates) Liquidity preference - assumes the yield curve includes a liquidity premium to compensate long-term investors (i.e., forward rates exceed the expected future spot rates) What is default risk? o Refers to the risk associated with a company‟s inability to: Meet interest or principal repayments Remain solvent (assets exceed liabilities) Fulfill covenants (coverage, leverage, etc.) o Default risk is compensated with the spread above the treasury yield What is the difference between an investment grade bond and a “junk” bond o Investment grade bonds receive high credit ratings Institutional investors (such as pension funds) can often only hold investment grade securities o Junk bonds have low credit ratings They compensate investors with a higher YTM What is the difference between a bond and a loan? 138
Bond Traded on the public market Fixed coupon rate Fixed repayment (bullet repayment) Loan o Private market mechanism Fixed payment Varying principal repayments (change over time) What would cause the price of a treasury note to rise? Flight to quality - investors degree of risk aversion rises and demand for risk-free securities subsequently rises Why could two bonds with the same maturity, same coupon, from the same issuer be trading at difference prices? Call feature (or call protection) Retractable feature Convertible feature What will happen to the price of a bond if the fed raises interest rates? Decrease (inverse relationship) What is a Eurodollar bond? A US-dominated bond issued by a foreign company What is a callable bond? A bond which can be retired early by the corporation, usually at a premium (i.e., call protection) What is a put bond? Providers the holder the right to force the company to repurchase the bond at a given price What is a convertible bond? A bond which can be converted to equity (essentially swaps equity for debt) What are some ways to determine if a company poses a credit risk? o 1) Ratings agency o 2) Liquidity ratios Quick ratio Current ratio 3) Interest coverage ratios o o 4) Leverage ratios What steps can the Fed take to influence the economy? o 1) Open market operations Buying / selling government securities to manipulate the money supply o 2) Raise or lower interest rates Discount rate - Fed-to-bank lending rate Federal funds rate - inter-bank lending rate o 3) Manipulate reserve requirements What does X-economic event effect inflation/interest rates/bond prices? o
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What is duration? o Sensitivity measure - higher duration equals higher sensitivity of bond price to interest rate movements o Intuitively - represents the effective maturity of the bond after coupons are taken into considerations o Mathematically Timing of each coupon is weighted by the % of the bond price that coupon‟s present value accounts for It is the derivative of the bond pricing function with respect to the market rate of interest Draw the yield curve Show how convexity impacts a bond‟s price to yield relationship? o The higher a bond‟s convexity, the better its relationship with yield: A decrease in the yield will increase a bond‟s price by more for a higher convexity bond An increase in the yield will decrease a bond‟s price by less for a higher convexity bond Explain the meaning of interest rate risk and duration.
Derivatives When would you write a call option on Disney stock? o When you believe Disney‟s stock will either: Decrease Remain the same Increase by less than the option premium Explain how a swap works. A swap is an exchange of future cash flows Ex: swap fixed-for-floating rate coupon obligations Say I hold a put option on Microsoft stock with an exercise price of $60, the expiration date is today and Microsoft is trading at $50. About how much is my put worth rate now? $10 (intrinsic value) When would a trader seeking a profit from a long-term possession of a future be in the long position? When he believes the commodity will appreciate in value All else being equal, which would be less valuable: a December put option on Amazon.com stock or a December put option on Bell Atlantic stock? Amazon.com (higher volatility) All else being equal, which would be more valuable: a December call option for eBay or a January call option for eBay? January option (longer time to maturity) Why do interest rates matter when figuring the price of options? Because the exercise of a call option is a cash outflow (and hence a higher interest rate reduces the PV of this outflow, improving the value of the option) If the current price of a stock is above the strike price of a call option, is the option holder at the money, in the money or out of the money? In the money When would you buy a put option on General Mills stock? When you expect it‟s price to decline below the strike by more than the option premium What is the main difference between futures contracts and forward contracts? Forward - private contract (traded OTC) Future - public, standardized contract (traded in liquid secondary market) What is hedging? A risk-reduction strategy What factors affect the price of an option? 140
Stock price Strike price Dividends Time to maturity Interest rates Volatility
What is the Black-Scholes model? An option pricing model based upon risk-neutral valuation Write the formula for Black-Scholes.
Currencies What is a spot exchange rate? The spot exchange rate is the rate of a foreign-exchange contract for immediate delivery. Spot rates are the price that a buyer will pay for a foreign currency. What is the forward exchange rate? The forward exchange rate is the price that a foreign currency will cost at some time in the future. A company can enter into a forward contract on exchange rates to help hedge against exchange rate fluctuations in the future. What factors affect foreign exchange rates? Interest rates Inflation rates Demand for imports and exports Capital market equilibrium What is the difference between a “strong” and a “weak” currency? Strong - appreciating in value, relative to other currencies Weak - depreciating in value, relative to other currencies
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If the US dollar weakens, should interest rates generally rise, fall or stay the same? Interest will rise because the price of imports will rise (hence driving inflation) If inflation rates in the Untied States fall relative to Great Britain, what happens to the exchange rate? US dollar increases in value When the currencies in countries like Thailand, Indonesia and Russia fell dramatically in 1998, why were US and European-Based investment banks hurt so badly? The value of their overseas investments declined If US inflation rates fall, what will happen to the relative strength of the dollar? Rise If the interest rate in Brazil increases relative to the interest rate in the US, what will happen to the exchange rate between the Brazilian real and the US Dollar? Real will appreciate relative to the dollar If inflation rates in the US fall relative to the inflation rate in Russia, what will happen to exchange rate between the dollar and the rouble? Dollar will appreciate relative to the rouble What is the difference between currency devaluation and currency depreciation? Devaluation - occurs in a fixed exchange-rate system Depreciation - occurs in a floating exchange-rate system What are some of the main factors that government foreign exchange rates? If the spot exchange rate of dollars to pounds is $1.60/£1, and the one-year forward rate is $1.50/£1, would we say the dollar is forecast to be strong or weak relative to the pound? Strengthen because one pound will be less costly in one-year How does FOREX work and more specifically between US and Canada? The foreign exchange market (forex, FX, or currency market) is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. What 3 thing govern the valuation of various currencies? Capital market equilibrium Inflation rates Interest rates Other: Demand for imports Demand for exports Reserve bank interventions Expectations
Special Situations What is a poison pill? Give an example of when a poison pill was successfully used. Poison pill - collection of methods used to prevent corporate takeovers Types: Shareholders‟ rights plan - provide shareholders with rights to purchase equity if the takeover is successful, hence diluting the acquired shares Employees‟ rights plan Over-leveraging Other promises Ex: Peoplesoft promised clients they would refund fees by 3-5x the original values if they were acquired What is a tender offer? An acquirer circumvents the board of directors and management team and makes a direct offer to shareholders with the objective of acquiring a majority stake (50%+) What are some defensive tactics that a target firm may employ to block a hostile takeover?
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Pre-offer Control block Poison pill Corporate charter Super-majority amendment Staggered BoD elections o Post-offer Pac-mac strategy (counter off) Crown jewel (sell critical assets) White knight White squire Litigation (anti-trust law-suit) What is a carve-out, spin-off and split-off? o Carve-out Firm turns asset into a separate corporation and sells shares Receives cash from this transaction o Spin-off Turn asset into a separate firm through share offering - provide shares to current shareholders Parent receives no cash Shareholders retain control (unlike asset sale, where another firm likely takes control of the asset) Advantages Greater corporate focus Greater financial data = greater ability to value firm Link incentives more closely to asset performance (by remunerating managers with shares) Superior tax consequences (no cash received) o Split-off A type of corporate reorganization whereby the stock of a subsidiary is exchanged for shares in a parent company. o
Other Questions What is the currency risk for a company like Microsoft? What about Ford? o Microsoft - revenue currency risk; if the USD depreciates relative to the currencies of the countries where Microsoft sells its products, its revenue will be bolstered o Ford Revenue risk from foreign markets Cost risk What is the effect on US multinational corporations if the US dollar strengthens? Decline in revenue because the worth of foreign sales declines Why would an electric utility company pay dividends instead of reinvesting in its business? o Because it has a limited number of: Positive NPV projects available Accretive acquisitions available o It has engrained an expectation of continued dividends Two companies identical income statement, why is one valued higher? Because their cash flow statements may be completely different What happens to stock price after issuing dividends? Decline by the amount of the dividend (on the ex-dividend date) What are 3 main reasons a stock‟s price may rise after a share buyback? Market reasons - increase in the demand for any commodity increases its value
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FCF expectation - investors anticipate the stock will generate strong FCF (since it has the financial capability to repurchase stock) Under-valued stock - it signals to investors that management / board of directors believe the shares are underpriced If you have two companies that are exactly the same in terms of revenue, growth, risk, etc. but one is private and one is public, which company‟s shares would be higher priced? o Public company will have a higher price because the following increase the cost of capital for the private company Liquidity premium Information asymmetry What could a company do with excess cash on its balance sheet? o Operating options (growing firms): Invest in additional positive NPV projects Make acquisitions Offer greater compensation to employees to drive performance o Financial options (mature firms): Repurchase shares Pay a dividend Company XYZ released increase quarterly earnings yesterday, but their stock price still dropped. Why? o Other statistics: the earnings increase disguised more fundamental problems: Declining cash Deteriorating customer base Extension of easy credit o Expectations: earnings missed Wall Street estimates If you read that a given mutual fund has achieved 50% returns last year, would you invest in it? o It depends on: The source of the fund‟s gains The performance of the fund‟s peers The investment strategy The consistency of the returns If a company‟s stock has gone up 20% in the last 12 months, is the company‟s stock in fact doing well? o It depends on: The performance of the company‟s peers‟ stock price performance The performance of the market portfolio The risk level of the company How can a company raise its stock price? Share repurchase program Exceed earnings expectations Undertake accretive acquisitions Restructuring Etc. A stock is trading at $5 and a stock is trading at $50, which has greater growth potential? The company with the smaller market capitalization likely has greater growth potential (and hence the $5 is more likely to have high growth potential) When should a company buy back stock? Stock is undervalued Excess cash Send positive signal to market Increase EPS When should an investor buy preferred stock? When they wish to receive a constant stream of dividends
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If you worked in the finance division of a company, how would you decide whether or not to invest in a project? NPV analysis Payback period IRR Accounting rate of return Profitability index *Ensure all calculations are performed on incremental cash flows Company A doubles sales in five years; Company B grows at 20% each year for the next five years. Who is growing faster? A firm is considering acquiring one consumer goods company. They have two possible targets, both with the same earnings, the same distribution network etc. What could you quantify to assess which company our firm should acquire? I‟m giving you an option to take $10.00 now and an option to open two envelopes. One envelope has no money and the other holds $20. Which option will you choose? What questions would you ask the CEO of a company if given five minutes to determine the state of his/her business? How would Quebec separating affect the Income Statements of a gold mining company in B.C.?
Brain Teasers If a population doubles every hour, how big is the population after 6 hours? After n hours? After what hour will the population be at 1024? If you know that 2^13 is 8192. What (approximately) is the square root of 8192? Two people start racing around a circular track from the same point. Person A runs at a constant rate, whilst Person B runs at a rate that is 1.5x as fast as person A for the first lap, and the same as person A for the second lap, then 1.5x as fast as person A for the third lap and so on. If it takes person A 40 seconds to complete one lap, after how many seconds will Person B lap (i.e. catch and overtake) person A? What is 3% of 113? What happens to P/E when you issue dividend? What‟s 17 squared? What‟s 18x22? Two boats are going towards each other at 10 mils per hour. They are 5 miles apart. How long until they hit? How many NYSE companies have 1 letter ticket symbols? A driver is going to drive 100 miles. If they drive the first 50 miles at 50 miles per hour, how fast do they need to drive the second to average 100 miles per house for the entire run? How many gas stations are in the US? If you were going to build a building in a city, and had no physical constraints, no capital restraints, how would you build it? You are late for a pitch with the CEO of a company in the Town of Truth. You are speeding down a road that suddenly forks, and there are no signs. You know that one way leads to the Town of Truth where everyone tells the truth and the other way leads to the Town of Lies where everyone lies. There is a guy standing there at the crossroads and you don‟t know which town he‟s from. You only have time to ask him one question...so what do you ask him? You have a five gallon container and a three gallon container with no markings. You are standing next to a hose. Measure exactly two gallons of water. How many are there between a clock‟s two hands when the clock reads 3:15? A stock is trading at 10 and 1/16. There are a million shares outstanding. What is the stock‟s market cap? What is the sum of the numbers from 1 to 100? What is the angle between the hour-hand and minute-hand of a clock at 3:15? You‟ve got a 10x10x10 cube made up of 1x1x1 smaller cubes. The outside of the larger cube is completely painted red. On how many of the small cubes is there any red paint?
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A car travels a distance of 60 miles at an average speed of 30 mph. How fast would the car have to travel the same 60 mile distance home to average 60 mph over the entire trip? You are given a 3-gallon jug and a 5-gallon jug. How do you use them to get 4 gallons of liquid? You are given 12 balls and a scale. Of the 12 balls, 11 are identical and 1 weighs slightly more. How do you find the heavier ball using the scale only three times? You are given 12 balls and a scale. Of the 12 balls, 11 are identical and 1 weighs EITHER slightly more or less. How do you find the ball that is different using the scale only three times AND tell if it is heavier or lighter than the others? A windowless room has 3 lightbulbs. You are outside the room with 3 switches, each controlling one of the lightbulbs. If you can only enter the room one time, how can you determine which switch controls which lightbulb? Four investment bankers need to cross a bridge at night to get to a meeting. They have only one flashlight and 17 minutes to get there. The bridge must be crossed with the flashlight and can only support two bankers at a time. The Analyst can cross in 1 minute, the Associate can cross in 2 minutes, the VP can cross in 5 minutes and the MD takes 10 minutes to cross. How can they all make it to the meeting in time? Three envelopes are presented in front of you by an interviewer. One contains a job offer, the other two contain rejection letters. You pick one of the envelopes. The interviewer then shows you the contents of one of the other envelopes, which is a rejection letter. The interviewer now gives you the opportunity to switch envelope choices. Should you switch?
Definitions What is a hedge fund? A hedge fund is a loosely regulated investment pool. Generally speaking, they are only open to high net worth individuals or institutional investors since they are limited to 100 or 500 investors. They use many strategies to hedge against risk with the goal of making a profit in any market environment. Oftentimes these funds take on high risk and are highly leveraged to give their clients the potential for higher returns. They have much more latitude in the types of securities they can invest in because they are typically not restricted by most of regulations that other mutual funds must follow. What is an institutional investor? An institutional investor is an organization that pools together large sums of money and puts that money to use in other investments. Some examples of institutional investors are investment banks, insurance companies, retirement funds, pension funds, hedge funds, and mutual funds. They act as specialized investors who invest on behalf of their clients. What is securitization? Securitization is when an issuer bundles together a group of assets and creates a new financial instrument by combining those assets and reselling them in different tiers called tranches. One of the reasons for the recession has been the mortgage-backed securities market which is made up of securitized pools of mortgages. What is arbitrage? Arbitrage occurs when an investor buys and sells an asset or related assets at the same time in order to take advantage of temporary price differences. Because of the technology now employed in the markets today, the only people who can truly take advantage of arbitrage opportunities are traders with sophisticate software since the price inefficiencies often close in a matter of seconds. What is insider trading and why is it illegal? Insider trading is trading activity informed by information that is not publicly available What is an IPO? o An IPO is an initial public offering o It is way companies raise capital initially on public equity markets o IPOs are under-written by investment banks in the following structures: Bought-deal (full under-writing) Best-efforts commitment 146
II. Interview Questions - Fit Marketing Yourself
Walk me through your resume I haven‟t had time to read your resume. Fill me in. What do you want me to know about you and your background? Walk me through your resume explaining why you made the choices you did in the past Coming out of this interview, what are the three things about you that I should take away? What differentiates you from all the other highly qualified candidates we are looking at today? Why should we hire you? What makes you an ideal candidate for this role? Let‟s say I give you this summer job today. Now let‟s move to the future and say that at the end of the summer, you find out that you did not get a full-time offer. Give me three reasons why this could happen, and what you can do to prevent this. What three adjectives would your: 1) peer, 2) superiors, 3) subordinates use to describe you? What is the number one thing I should know about you that I cannot learn from your resume? How would you compare your writing skills to your oral skills?
Banking Commitment
Tell me - why banking? Why do you want to do investment banking? Why do you want to work on Bay/Wall Street? How do you know you will be able to handle the hours required for an investment banker? What have you done to learn about investment banking? What product or industry group are you interest in working with? What qualifications will help you do well at this job?
School and Career Plans
Why did you choose Queen‟s Commerce? What non-finance and accounting electives have you taken? Describe what you learned in class this morning What kinds of grades did you get? Tell me about your college experience Where do you see yourself in 5/10 years? What was your favourite course in school? Your least favourite? Why? What were you grades in each?
Work and Team Experiences
Give me an example of a project that you‟ve done that involved heavy analytical thinking Give me an example of a project that has required you to think quantitatively and analytically Walk me through a sample project from your work Give me an example of a project you enjoyed working on
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Give me an example of a time you worked as part of a team. / Describe a project you have worked on that you enjoyed. Can you tell me about a time when you handled many things at the same time? Give me an example of a time where you have had to multi-task How do you work for someone? Describe a team situation you were in where things did not work out Give me an example of a time you had to deal with a conflict in a team situation Tell me about a time where you were in a group where someone wasn‟t contributing as they should been. What did you do? What was the most important thing you got out of your job last summer? What role do you like to take in a team situation? Do you feel more comfortable working in a group or individually? Give me an example of a time you worked as part of a team Give me an example of a time you took a leadership role in a team situation Describe a situation when you or your group was at risk of missing a deadline. What did you do? Tell me about a time where you had to deal with a very up-set teammate or co-worker. How do you manage to successfully deal with a difficult boss, co-worker or teammate? Tell me about a time where you motivated others Give me an example of a time when you‟re been required to pay close attention to detail Tell me about at time where you anticipated potential problems and took measures to prevent them Tell me about a time where you learned something new in a short amount of time What kind of financial modelling have you done in the past?
Personality and Character Think of a person you feel knows you very well both professionally and socially. If I were to call this person and ask them to describe you, what would he say? What motivates you? What motivates you? What serves are your biggest motivation? Tell me about a time when you were faced with a tough decision and how you dealt with it. If you could spend 15 minutes with anyone, who would they be and why? If you could open one business, what would it be and why? Describe your leadership style Name three traits you would want to have in a friend and show how you have those too Do you consider yourself a risk taker? How well do you function under pressure? Are you a smart person? Who is your best friend? Would you lie for him? Can you handle the grunt work? How hard do you work to achieve you goals? Describe your ideal working environment What is an example of a big risk you have taken in your life? What is the toughest decision you have ever had to make? What would you do for a living if you did not have to worry about money? How do you manage stress in your life? Give me an example of a time you have gone above and beyond what was expected of you Give me an example of a time where you had to make a split second decision Tell me a (clean) joke What are the qualities of a successful leader?
Strengths and Achievements Tell me about an accomplishment that you are proud of. 148
What do you consider to be your greatest accomplishment? Tell me some of your strengths and weaknesses. What are some of your strengths? Tell me about your best and worst mark and why you got them. What is your greatest team and personal achievements? What is your greatest accomplishment outside of school? Tell me about something creative you have done What is the most intellectually challenging thing you have done? What is the biggest obstacle or challenge you have faced and overcome in your life? Give me an example of a time where you set a goal and were able to meet or achieve it
Failures and Weaknesses
Can you give me an example of an experience of failure? When have you made a mistake? What is your biggest weakness? What is the greatest risk we face in hiring you? Tell me about a situation where you disappointed your boss and why
Other Skills and Interests
What types of activities did you pursue while in college? What else do you do in school other than study? Tell me about how you have modeled with equations in the past. If it wasn‟t Investment Banking what else would you be doing? What do you like to do in your free time? What competitive activities have you participated in, and have they been worthwhile?
The Recruiting Process What other investment banks are you interviewing with? If you got offers from all of them, where would you go? How did you go about preparing for interviews? Who else are you interviewing with?
Questions for the Interviewer
How long have you been with the bank and how has your experience been? What do you like best about working here. Worst? How do you compare working here with other banks at which you have worked? How is the deal-flow? On what types of deals are you currently working? What kind of responsibility does the typical Analyst/Associate receive? Can you tell me about your training program? How do Analysts/Associates get staffed? How has the negative publicity received by investment banks affected your job?
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II. Interview Questions Markets Education Here‟s a whiteboard. Stand in front of it and present a chapter from your favourite finance textbook. You have five minutes. Walk me through a Finance concept you learnt in one of your classes
News and Markets
What is your favourite web site? What is the most striking thing you have read recently in the Wall Street Journal? Talk to me about a current event What did the S&P500/DJIA/Nasdaq close at yesterday? Where do you think the stock market will be in 3/6/12 months? What did the markets do last week/this week and why? What was in the Journal today? What business publications do you read? What interesting articles have you read in those publications of late? Do you think the market is efficient? Do you think the Bank of Canada should raise rates? Why? What are the four most important factors that have contributed to volatility in Canadian markets in the last six weeks? What's the safest possible investment in today's markets? What role does the housing market play in the economy?
Macro-economics and Marco-outlooks Where do you think the US economy will go over the next year? What do you think the Fed will do with interest rates over the next two years? Where do you see the Canadian, U.S., worldwide markets heading in the next 6 months, year, 5 years?
Transactions Describe a recent M&A transaction that you‟ve read about What were the reasons behind an M&A transaction you‟ve read about? Does that transaction make sense? Can you name two companies that you think should merge? Can you tell me about a recent IPO you have followed? Name some hostile transactions. Oracle acquiring Peoplesoft Microsoft attempting to buy Yahoo! InBev acquiring Anheuser-Busch Oracle acquiring BEA systems
Companies and Investments Name three companies that are undervalued and tell me why you think they are undervalued. If I was to give you $1 Million, how would you invest it? 150
Discuss a company which you would take a long/short position in. Pitch a stock Who is the CEO of the company? Who are its major competitors? What are the major drivers of its revenue? What are the risks the company faces? What economic factors drive/compress the company‟s earnings? What metrics would you use to value this company? What is a stock that you follow? Give a five-minute presentation on a public company whether to buy or sell. Now support the opposite recommendation. When you look at a company's financials, what do you look at first, second, third and why?
Commodities & Currencies What is the price of Gold and Oil? What are the fundamentals that guide the price of Gold, Oil, Forex currencies? Why is the Canadian dollar in its current situation? Can the government really do anything to improve the situation?
Interest Rates
What is your take on the future direction of interest rates in US and Canada? What is the current yield on the 10-year Treasury note? What is the Fed Funds rate? What is the discount rate? When does the Fed meet next? What is The Long Bond trading at? Where do you think interest rates are going? Does this always depend on the FED? What is libor? What is libor's current level? Draw today's yield curve: 3m, 6m, 2yr, 3yr, 5yr, 10yr, 30yr.
Credit Crisis What do you think is the cause of the current Financial Crisis? First explain the Credit Crisis: its causes, the major players and attempts to resolve it. Then tell me: What companies did it directly affect? What companies has it indirectly affected? What is the bail-out plan? What is liquidity?
Industry Events and News
What do you think is going on with XYZ company/industry? What are some recent trends in investment banking? What are three major news items related to the industry in which you are interested? Here are three sectors (Paper, Defense, Tobacco, Technology, Software, Healthcare, it could be anything). Are you long or short and why?
Other Concepts Are markets efficient? If you say markets are efficient, then explain the dot-com bubble or the real estate bubble. Aren‟t you saying that there is no such thing as a bubble? I still don‟t get it. How can fundamental value change in such a short period of time? 151
Even if markets are efficient then surely a boom or subsequent bust proves that market participants are irrational, right? How can you say that people are rational given all of the research that seems to show otherwise in addition to all of the booms and busts throughout history? Who cares if investors are rational or irrational? Is investing in stocks really investing? What does it mean for a market to be efficient? Does technical analysis work? Does fundamental analysis work? So how do you make money in the “markets?”
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II. Interview Questions - Firm & Industry Industry Understanding What do investment bankers do? What do investment bankers do? What do you expect to be doing as an analyst? Let me give you a situation: it is a Friday afternoon. Tomorrow morning you have to catch a flight to Boston to your best friend‟s marriage, and you are in the wedding. You have informed you deal team well in advance and they know that you will be gone. However, the client wants to meet tomorrow to discuss the deal. What do you do? You don‟t seem like you are a very driven person. How will you be able to handle a job in banking? What is the difference between commercial and investment banking? What do you think is the most important characteristic for thus job? What do you consider to be the biggest negative about this job? What decision criteria will you use in deciding among investment banks?
Bank Understanding
Why are you applying to this firm? Why our firm? If you were the CEO of our bank, what three things would you change? Compare bank XX and bank YY. What is the market cap, current price, 52-week high and low, and expected EPS and next earnings date for bank XX? Name three major news items related to Bank XX in the last 2 months. What is bank XX known for? Who are bank XX‟s competitors? What is the structure of bank XX? What do you know about our firm? Why not firm YY instead of our firm? If you were running this firm, in what direction would you take it? Can ethical requirements in a firm be too high? What are you looking for in this job? Why would you pick our firm over the other firms that you are interviewing with?
People and Relationships Who have you talked to at our bank? Who is the CEO of company XX? What is his background? What would you ask him? Tell me the full names of the people who interviewed you before me
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III. Appendix 1 - Vault Guide The Financial Services Industry Notes There are two types of questions in a finance interview: technical and fit. Stress your ability to work hard and to perform complex, detailed-oriented work. Also demonstrate your mathematical, quantitative, and analytical aptitudes. Understand investment banking and research individual firms before interviews. Be able to elaborate on career trajectory: why you chose business school, why you want to work at the firm you are interviewing with, etc. In greatest weaknesses questions, choose weaknesses that are not deal-breakers. At the interview‟s end, ask intelligent questions which demonstrate that you have researched the firm and industry. Questions 1. Why do you want to do investment banking?
Emphasize you know the position: describe the work and job functions required by the position o Description of analyst functions: Building and implementing models Constructing comparables tables Editing pitch-books Explain your fit: explain that you enjoy performing those tasks and that you have the skills and abilities to do them efficiently
2. What do investment bankers do?
Raise capital for companies or governments by issuing and selling securities on public markets Provide advice on such transactions as mergers, acquisitions and divestitures. Recommendations on the trading of and investing in equity securities, fixed incomes securities, foreign exchange, and commodities. (sell side) Some investment banks have o a buy-side component, which include entities such as asset managers and hedge funds o Merchant banking divisions (private equity) o Structuring
3. Here‘s a whiteboard. Stand in front of it and present a chapter from your favourite finance textbook. You have five minutes. 4. Walk me through your resume 1. Let me give you a situation: it is a Friday afternoon. Tomorrow morning you have to catch a flight to Boston to your best friend‘s marriage, and you are in the wedding. You have
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informed you deal team well in advance and they know that you will be gone. However, the client wants to meet tomorrow to discuss the deal. What do you do? Objective: show that you are willing to sacrifice. Explain you understand the sacrifices involved in investment banking and are not only prepared for such sacrifice, but have experienced it in the past. 2. Why should we hire you? 3. What types of activities did you pursue while in college? Objective: demonstrate that you can handle stressful, demanding environments. 4. Why are you applying to this firm? Objective: demonstrate knowledge of firm-specific attributes and show that these appeal to you. 9. Give me an example of a project that you‘ve done that involved heavy analytical thinking. Objective: demonstrate ability to crunch-numbers. 5. If you were the CEO of our bank, what three things would you change? Objective: demonstrate thorough understanding of the bank 6. What is your favourite web site? 7. Give me an example of a time you worked as part of a team. / Describe a project you have worked on that you enjoyed. Objective: demonstrate strengths as a team member - debate and consensus building, organized, dedicated 8. What is the most striking thing you have read recently in the Wall Street Journal? 9. Let‘s say I give you this summer job today. Now let‘s move to the future and say that at the end of the sumer, you find out that you did not get a full-time offer. Give me three reasons why this could happen, and what you can do to prevent this. 10. Think of a person you feel knows you very well both professionally and socially. If I were to call this person and ask them to describe you, what would he say? 11. What motivates you?
Objective: prove... o HIgh level of motivation o Show that motivational factors align with investment-banking drivers: financial security, problem-solving, deadlines and productivity
12. Can you give me an example of an experience of failure? Objective: demonstrate humility but show that you learned from a setback.
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13. You don‘t seem like you are a very driven person. How will you be able to handle a job in banking? Objective: demonstrate ability to remain driven despite fatiguing circumstances. 14. Tell me about an accomplishment that you are proud of. Objective: demonstrate that you are team-oriented, analytical, hard-working and dependable 15. What was your favourite course in school? Your least favourite? Why? What were you grades in each? Do not mention unreasonable professors. 16. Tell me about how you have modeled with equations in the past. 17. Who have you talked to at our bank? 18. Can you tell me about a time when you handled many things at the same time? 19. What is a hedge fund? Private, largely unregulated pool of capital. Hedge funds are required by law to have less than 100 investors; minimum hedge fund investments are therefore typically $1 million. Employ more aggressive investing strategies, making use of such financial instruments and techniques as short-selling, swaps, risk arbitrage and derivatives.
Mergers and Acquisitions Notes Why Merge? Due to the synergy generated by the merger, the sum of the values of the two companies together should be greater than the sum if the firms remained autonomous.
Entry medium: firms often merger to gain access to a new market (defined by product, geography, or both) o Ex: JP Morgan Chase‟s acquisition of Bank One gave the bank access to both consumer banking and a new geographic area (the South and Midwest). o Ex: Chrysler (North American Market) and Daimler-Benz (Europe) merged Brand recognition: leverage brand to access market o Ex: 3Com‟s acquisition of US Robotics added brand recognition in the modem industry Economies of scale o Cost savings on volume o Cost savings on reduction of duplication Market power: size is required to compete effectively in some industries o Bank of America‟s acquisition of FleetBoston Financial
Why Not Merge? 20% of mergers fail to achieve the synergies promised. This can result from: o Poor implementation o Poor advisory 156
Investment bankers can be overly enthusiastic about the synergies a merger can produce because M&A activity generates fees Clash of corporate culture
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Types of Buyers Strategic buyers - corporations who purchase businesses for the strategic business advantages Financial buyers - corporations who purchase companies as an investment instrument. o Typically these are LBO funds or Private Equity funds Usually, strategic buyers will pay more for a company than a financial buyer o This results from the fact that strategic buyers believe they can increase the cash flow of the target (through synergy) and therefore valuation is higher (since the cash flows discounted are higher). Valuing the Target Preparing pro forma financial statements for a strategic buyer will involve a faster earnings growth rate than for a financial buyer as a result of synergy. A financial buyer can assume some reasonable growth in FCF increases in pro forma statements due to the tax shield benefits (or some obvious changes the financial buyer can force management to make). Stock Swaps v. Cash Offers The two primary methods of purchase are stock swap or cash. Stock swaps are better suited to strong markets since companies with large market capitalization can use their valuable stock to purchase other companies o Strong markets create purchasing power In a cash deal, shareholders must pay taxes; there is therefore a tax advantage to stock swap deals.
Tenders Offers In a tender offer, the hostile acquiring company renders a tender offer for the public‟s stock at a price higher than market prices in an attempt to gather a controlling interest When a tender offer is made, the share prices jump to a price slightly below the offer price. The discount is inversely proportional to the probability that the deal will close. Sometimes, companies are acquired not to improve management or generate synergies, but because the acquirer believes the company is worth more if it is liquidated (divested) A defensive tactic is to hire an investment bank to make a counter bid Mergers v. Acquisitions When companies of approximately equal size merger, this is referred to as a merger of equals. o Ex: Sears/Kmart o Ex: Sprint/Nextel When one company purchases another, this is an acquisition. o Ex: JPMorgan Chase‟s purchase of Bank One o Ex: Oracle‟s acquisition of Peoplesoft Will that be cash or stock? The choice of cash or stock depends on: o Tax considerations o The desires of the target If the target‟s shareholders believe the created company will be an industry leader, they will push for a stock swap o Market volatility
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The more volatile the market, the more favourable a cash deal
Accretive v. Dilutive Mergers Accretive mergers increase the EPS of the acquirer; dilutive mergers are the opposite. Making a determination between the two can be made with the following techniques: o Combining the earnings of the two firms and dividing by the total shares outstanding (the sum of the original shares and the newly issued ones) o Employing the rule: If the P/E of the target is less than the P/E of the acquirer, the deal is accretive Else, if the deal is dilutive. Questions 1. Describe a recent M&A transaction that you‘ve read about 2. What were the reasons behind an M&A transaction you‘ve read about? Does that transaction make sense? This is a must-prepare for investment banking interviews Analyze the deal with the following at least the following barebones framework: o Structure of the transaction Financing term (stock swap or cash or mixture) Financing sources Inflated market capitalizations Leverage Idle cash o Synergy analysis Revenue synergies Expense synergies o Strategic benefits Market entry Brand benefits o Investment risks Corporate culture conflict Diminishing returns resulting from over complexity Management distraction 3. Your client is a privately held human resources software company. You are advising the company in the potential sale of the company. Who would you expect to pay more for the company: Oracle Software (a competitor) or Kohlberg Kravis Roberts (a Private Equity firm)?
Oracle Software (strategic buyer) should be willing to pay more than KKR (financial buyer). This results from the fact that Oracle would be able generate synergies from the deal, therefore by increasing the FCF from the business; this will increase the per-share price through the DCF valuation methodology. o For instance, Oracle could cut costs by sharing (reducing duplication of) administrative /customer support services or through volume purchasing economies o Further, revenue could be increased through cross-selling and greater market pricing power On the other hand, KKR would not receive these incremental FCF increases; rather, KKR would only be willing to pay more for the NPV of the tax shield.
4. Are most mergers stock swaps or cash transactions and why?
That depends upon when. 158
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In a strong market, most mergers are stock swaps because large market capitalizations are used to finance deals. On the other hand, in weak marks, cash transactions dominate.
5. What is a dilutive merger?
A merger is dilutive if the acquiring company‟s EPS falls as a result of the transaction. o Equivalently, a deal is dilutive if the P/E of the acquirer is lower than the target.
6. What is an accretive merger?
An accretive merger is one in which the EPS of the acquirer increases. o Equivalently, a deal is accretive if the P/E of the target is less than the P/E of the acquirer.
7. Company A is considering acquiring Company B. Company A‘s P/E ratio is 55x earnings, whereas Company B‘s P/E is 30x earnings. After Company A acquires Company B, will Company A‘s earnings per share rise, fall or stay the same? This is an accretive since the P/E of the target is lower than that of the acquirer. Therefore, the EPS of Company A will increase. 8. Can you name two companies that you think should merge?
Answer this question with four arguments o Synergies available between the two o Strategic benefits o Financing available o Acceptable to the FTC (antitrust laws)
9. What is a hostile tender offer?
If company A wishes to acquire company B, but company B refuses, company A can launch a hostile tender offer. A hostile tender offer involves company A offering to purchase a majority shares directly from shareholders through communications mediums such as the Wall Street Journal and other widely read publications. o The offer price is typically much above the market price If company A can acquire more than 50% of the common shares, it will gain control over the company.
10. What is a leveraged buyout? How is it different than a merger? A leveraged buyout occurs when a group, by refinancing a company with debt, is able to increase the valuation of the company. LBOs are typically conducted by financing groups (such as KKR) or company management, whereas mergers are led by companies in the industry. If Company A buys Company B, what will the Balance Sheet of the combined company look like? Add the items on the balance sheet.
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Valuation Techniques Notes
The purchase of a company requires the acquirer to assume the target‟s debt. The market value of debt is equal to the book value of debt There are four techniques used to value equity: o Market valuation o Discounted cash flow (DCF) analysis o Multiples method o Comparable transactions method The value of a firm is equal to the equity value plus the debt value
Market Valuation According to the market valuation method, the value of a company‟s equity is equal to market capitalization plus or minus a premium or discount o The differential (discount or premium) is the difference between the market capitalization and the value of the company if the entire company were placed on the market o Acquisitions (particularly hostile takeovers) typically generate a premium _____________________________ Discounted Cash Flow (DCF)
There are two ways to perform a DCF: o Adjusted Present Value (APV) method o Weighted Average Cost of Capital (WACC) method Both methods involve the discounting of free cash flows
Net Present Value A time value of money exists as a result of o Foregone interest o Inflation‟s dilution of purchasing power A discount rate is equal to the expected rate of return on an investment (adjusted for the investment‟s risk level) The method of calculating the discounted rate varies between the APV method and the WACC method.
Net Present Value (NPV) in year 0 of future cash flows is calculated with the following formula: Capital Asset Pricing Model (CAPM) Use CAPM to determine the correct discount rate This linear model has a single independent variable, Beta, a measure of volatility 160
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If Beta is greater than 1, the investment instrument is more volatile than the market; if Beta is below 1, the inverse is true.
Mathematically, the discount rate is calculated with the following formula: Where: re = Discount rate for an all-equity firm rf = the risk-free rate of return (This is assumed to be the treasury bill rate for a period over which the cash projects are being considered. Ex: 10-year US treasury note). rm = Market return rm - rf = excess return B = equity beta If the Asset Beta is given, solve for Equity Beta:
Free Cash Flow EBIT + Depreciation and Amortization = EBITDA Current Taxes Capital Expenditures Net increase in working capital + Other relevant cash flows for an all equity firm = Unlevered Free Cash Flow Investment bankers construct models which project the variables included in FCF; these models are influenced by both the bankers‟ own projections for FCF drivers as well as company guidance Terminal Year Calculation The terminal year calculation is a perpetuity calculation which determines the present value in year 10 of the company‟s FCF into the future ad infinitum at a constant growth rate.
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Adding it up: the sum of the present values of the company‟s FCF for the first ten year (derived from the analyst‟s predictions) and the PV of the terminal value (perpetuity calculation at year 10) is equal to the equity value of the company.
Calculating discount rates In the WACC method, we calculate the discount rate for leveraged equity
In the APV method, we calculate the discount rate for unleveraged equity (all-equity firm) To convert from leveraged (WACC Method) to unleveraged (APV Method), apply the following formula:
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The discount rate for the APV method is:
However, if a firm has debt, the APV method will not adequately capture the firm‟s value since debt generates a tax shield that has value. The debt tax shield (DTS) for any given year is:
The rate used to discount the DTS is either the unleveraged equity discount rate (if the risks associated with the tax shield are equal to the risk of a disruption in free cash flow) or the average interest rate (if the risks are equal to the risk of inability to repay debt). Summary: Calculate the free cash flows Determine the discount rates o WACC method (leveraged equity, in combination with debt) For leveraged equity, use the unleveraged BETA and convert to the leveraged BETA while using future debt and equity capitalization assumptions o APV method (unleveraged equity - use conversion formula) Determine the terminal value (an add this quantity to the final projection year FCF) Discount and sum (NPV) all of the FCFs Determine the company‟s value o If WACC method was used, it is simply the NPV of the FCFs o For the APV method, add to the NPV the PV of the DTSs for each year
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_____________________________ Comparable (Precedent) Transactions
Involves the application of multiples and metrics of past acquisitions to companies for valuation o For instance, if there is a precedent in the financial industry for large financial institutions paying 10x EBITDA for discount brokerages, this multiple can applied to discount brokerages‟ EBITDAs to determine their values.
Comparable Company Analysis This involves calculating the industry average in various multiples (EV/EBITDA, Debt/EBITDA, EV/S, P/S, P/E, P/CF, etc) and applying these multiples to the company to determine its value. Questions 1. What is the difference between the Income Statement and the Statement of Cash Flows?
An income statement is a record of revenues and expenses; an income statement is prepared upon accrual accounting standards, meaning that revenue and expense items are recorded when they are incurred, not when cash is received or disbursed. A statement of cash flows depicts the flows of cash into and out of the firm. It is divided into the sections operating cash flow, investing cash flow and financing cash flow o In an indirect cash flow statement, non-cash items are added to or subtracted from net income to calculate cash flow from operations o This is a critical link between the income statement and the cash flow statement To illustrate the dichotomy between the income statement and the statement of cash flows, a company can be profitable on its income statement (positive GAAP earnings) but go bankrupt if it is unable to make interest payments (cash flows are not adequate).
2. What is the link between the Balance Sheet and the Income Statement? The main link between the balance sheet and the income statement is that earnings flow from income statement to the retained earnings section of the balance sheet Further, balance sheet debt is used to calculate the interest expense As well, balance sheet assets are depreciated and this expense is placed on the income statement Any write down on the balance sheet (ex: goodwill) flows onto the income statement 3. What is the link between the Balance and the Statement of Cash Flows The beginning cash balance on the statement of cash flows is taken from the balance sheet The increase/decrease in cash (on the CF statement) is used to determine the new cash balance on the balance sheet Numerous components of the Cash Flow from Operations section are derived from changes in working capital items on the balance sheet (accounts receivable, accounts payable, inventory, etc.) Any additions/disposals of fixed assets appear as changes on the balance sheet and items in the Cash Flow from Investing section on the CF statement The issuance/retirement of any debt or equity alters the capitalization structure of the balance sheet and appears in the Cash Flow from Financing section of the CF statement 4. What is EBITDA? 164
EBITDA = Earnings Before Interest, Tax, Depreciation and Amortization It is employed as a proxy for cash flow 5. Say you knew a company‘s net income. How would you calculate its free cash flow? Add to net income deprecation and amortization (since these are non-cash items) Deduct any increase in working capital (since this represents cash drained by balance sheet items) Deduct capital expenditures (since this is cash paid to maintain the asset base of the company) + =
Net Income Depreciation and Amortization Capital Expenditure Increase in working capital Free cash flow
6. Walk me through the major lines on a Cash Flow Statement.
Cash Flow from Operations o Indirect Net Income Add back all non-cash deductions Depreciation and amortization Subtract all non-cash additions Increase in accounts receivable Direct o Manually show cash receipts form customers Cash disbursements for supplies, expenses, etc. Cash Flow from Financing o Cash in/out-flow from issuance of debt or equity o Payment of dividends Cash Flow from Investing o Capital expenditures o Cash flow from sale of assets Beginning cash balance Increase/decrease in cash Ending cash balance
7. What happens to each of the three primary financial statements when you change: a) gross margin b) capital expenditure c) any other changes? a) Gross margin change Gross margin changes will alter gross profit on the income statement (revenue less COGs) This will alter net income (holding all other variables constant) A change in net income will alter cash flow from operations (since the initial item in the indirect cash flow method is net income) Ultimately, this will impact the balance sheet since cash flow will be different (cash balance different) and net income is different (retained earnings different) b) Capital expenditure change A change in capital expenditure will change the cash flows from investing section 165
This will alter cash flow This will ultimately impact the balance sheet in two ways: o Capital expenditure changes will alter assets changes YoY o The cash balance will be affected on the balance sheet In the long term, alterations of the capital expenditure item will affect the number of assets held, which will, in turn, affect the levels of depreciation and amortization o This will influence the income statement
8. How do you value a company?
There are three ways to value a company: o Discounted cash flow method Adjusted present value (APV) Weighted average cost of capital (WACC) o Comparables analysis o Precedent transactions
Discounted cash flow Involves the discounting of future cash flows at a risk-adjusted discount rate Project the company‟s future free cash flows (FCF calculation - see above) Determine an appropriate discount rate o APV method Unlever BETA Use the unlevered BETA in CAPM to determine the unlevered cost of equity (discount rate) o WACC method Lever BETA (under a debt/equity ratio assumption going forward) Calculate the levered cost of equity using CAPM Weigh the cost of equity and the after-tax cost of debt to determine WACC. This is the discount rate. Calculate the terminal value o Apply a perpetuity calculation Assume a constant growth rate Increase the final year FCF by this growth rate Apply the perpetuity calculation o Apply a multiple Multiply the final year FCF (or EBITDA or earnings) by the multiple (ex: P/E) to determine terminal value Add the terminal value to the final year FCF Discount all the FCFs at the determined rate If the APV method was used, calculate the PV of the tax shield for each year and had these PVs to the final figure The resulting quantity is the enterprise (or firm) value. Comparables analysis Apply an industry average multiple (ex: EV/EBITDA) to a company metric (ex: EBITDA) to determine the company‟s value Precedent transactions Apply acquisition or LBO multiples (how much a PE firm or an acquirer paid for a company as a multiple of its EBITDA, for instance) to a company metric to determine the company‟s value. 9. The CEO of a $500 million company has called you, her investment banker. She wants to sell the company. She wants to know how much she can expect for the company today.
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See the above valuation methodologies. 10. What is the formula for the Capital Asset Pricing Model? The CAPM calculates the expected rate of return on an asset BETA measures the volatility of an investment instrument
If BETA is greater than 1, the investment is more volatile than the market 11. Why might there be multiple valuations for a single company? Each valuation methodology will produce a different value DCF APV WACC Comparables analysis Precedent transactions 12. How do you calculate the terminal value of a company? Terminal year value is calculated by taking a given year in the future at which a company is stable (usually year 10), assuming perpetually stable growth after that year, using a perpetuity
formula to come with the value in that year based on future cash flows and discounting that value back to the present The terminal value of a company can also be calculated through the application of a multiple to the terminal year cash flow, and discounting it to the present.
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13. Why are the P/E multiples for a company in London different than that of the same company in the States? The way earnings are recorded in different countries Growth rates in different countries Market sentiments in different countries 14. What are the different multiples that can be used to value a company? P/E (trailing or forward looking), P/CF, P/S EV/EBITDA, EV/Revenue, EV/EBIT P/NAVPS, P/B
The relevant multiple depends on the industry o Internet companies apply revenue multiples (because earnings are typically low or negative) o Metals and mining companies typically focus on EBITDA multiples Be cautious of the time horizon for the multiples (actual or going-forward estimates)
15. How do you get the discount rate for an all-equity firm? Apply the CAPM framework to the all-equity BETA 16. Can I apply CAPM in Latin American markets? Although the CAPM framework was originally developed for US markets, it the best tool for determining discount rates. Therefore, adjusting for risk-free rate and market returns, this tool can be applied outside the US borders. 17. How much would you pay for a company with $50 million in revenue and $5 million in profit? Assuming this is the only information available, this company can be valued in two ways: o Comparables analysis Apply industry average multiples o Precedent transactions Apply multiples used in previous acquisitions or LBOs 18. What is the difference between the APV and WACC
WACC incorporates the effects of the tax shield into the discount rate used to calculate the PV of the cash flows o WACC is typically calculated using actual data and numbers from balance sheets for companies or industries APV adds the present value of the financing effects (mainly the tax shield) to the NPV of the company‟s cash flows o The APV approach is particularly useful in cases where subsidized costs of financing are more complex, such as a leveraged buyout.
19. How would you value a company with no revenue? Make reasonable assumptions about the company‟s future revenues and (given various margins, like EBITDA) free cash flows discount these cash flows back to the present (using WACC or APV method of a DCF)
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Do NOT use comparables or precedent transactions, as these methodologies rely on positive revenues, earnings, EBITDA and other profitability and performance metrics. 20. What is Beta? Beta is a metric which compares a company‟s share price volatility to the market‟s volatility If beta is greater than one, the shares are more volatile than the market; if beta i less than 1, the opposite is true. 21. How do you unlever a company‘s Beta? To unlever a company‟s beta, divide the levered Beta figure (the Beta found in popular press) by the debt to equity ratio times one minus the tax rate, plus one.
As a check, the levered Beta should always be greater than or equal to (in the case of a zero debt-to-equity ratio) the unlevered Beta. 22. Name three companies that are undervalued and tell me why you think they are undervalued.
Apply the three methodologies (DCF, comparables, precedent transactions) Demonstrate catalysts that have driven the share prices down and therefore lead to undervaluation o Market trends o Negative press o Catalysts that will increase forward performance and therefore justify a higher present-day price
23. Walk me through the major items of an Income Statement
Revenue o Business units Less: cost of goods sold Gross profit o consider gross margin to assess pricing power Less: Operating expenses o Selling, General and Administrative o Depreciation and Amortization o Other Operating profit/income (EBIT) o Add depreciation/amortization back to this to determine cash proxy - EBITDA Less: taxes and interest o Consider size of interest expense (liquidity risk) Net income
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24. Which industries are you interested in? What are the multiples that you use for those industries?
Telecommunications o APRU o Churn rate Technology o Emphasis on revenue multiples Media o Subscriber emphasis Energy Mining and Metals Financials o Tier 1 capital ratio o Tier 2 capital ratio
25. Is 10 a high P/E ratio?
The correct answer is it depends. P/E ratios are a relative metric. In order to use a P/E ratio for valuation it is important to know: o The P/E ratios of similar (comparable) companies o The historical P/E of the company The P/E ratio is influenced by such factors as: o General market sentiment o The growth rate of the company Higher expected growth rates generated higher P/E The inverse is also true
26. Describe a typical company‘s capital structure
Capital structure refers to the relative weight of different financing elements These financing elements include: o Debt Senior Subordinated o Preferred/Hybrid shares o Common stock These items are ordered in terms of priority on assets in the case of the company‟s liquidation A highly leveraged capital structure has a heavier weight of debt relative to equity The sound-byte metric for capturing capital structure is the debt-to-equity ratio
27. Re-read this question in vault guide for DCF example.
Equity Analysis and Portfolio Management Notes The goal of every portfolio manager is the same: to achieve the highest rate of return possible (given the asset class) while minimizing risk. Risk Risk is defined as the standard deviation of the portfolio‟s expected returns. 170
Standard deviation is a measure of volatility. Hence, the more predictable the returns, the lower the risk. Ultimately, greater returns demand a greater risk level. Portfolio Risk v. Single Security Risk It is important separate the risks of these two entities: the risk of a portfolio is less than the sums of the risks of the individual securities. When asked whether the addition of a security to a portfolio is attractive, consider how the addition of this security alters the risk level of the entire portfolio. o Correlation is a useful tool for performing this analysis Strong positive correlations do not lower risk levels as much as strong negative correlations Correlation coefficients can be used to measure correlation (perfect positive = +1; perfect negative = -1). Diversification: o Across asset classes (ex: stocks and bonds) o Within asset classes (ex: stocks driven by different variables) A portfolio with strong correlations between its securities is not well diversified. Technical Analysis v. Fundamental Analysis Technical analysis involves identifying patterns and trends in charts for the purpose of predicting future price movement. Fundamental analysis involves using financial analysis to assess the company‟s underlying business. o One fundamental analysis tool is ratios. o Ratios must be analyzed in the context of previous ratio values or industry averages
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Questions 1. If you add a risky stock into a portfolio that is already risky, how is the overall portfolio risk affected? A) it becomes riskier B) it becomes less risky C) overall risk is unaffected D) it depends on the stocks risk relative to that of the portfolio D - it depends. Modern portfolio theory suggests that the change in a portfolio‟s risk with the addition of a new security depends not only on the individual risk of the security but also on the correlation of the security with the portfolio‟s existing assets. 2. Put the following portfolios consisting of 2 stocks in order from the least risky to the most risky and explain why. A) A portfolio of cable television company stock and an oil company stock B) A portfolio of an airline company stock and a cruise ship company stock C) A portfolio of an airline company stock and an oil company stock C than A than B. C is the least risky since there is likely a negative correlation between these two securities - as the price of oil rises, profits (and therefore share prices) rise at the oil company but fall at the airline company. A is moderately risky since the correlations between a television company and an oil company is likely to be low (a small positive number). There is little overlap in the businesses of these companies, but both are still subject to the broader market trend.
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B is the most risky since both airline and cruise ship companies depend upon a common variable - the demand for holidays. As a result, the correlation between these shares is likely high. 3. How do you calculate a company‟s Days Sales Outstanding? Average Accounts Receivable / Sales • 365 = days sales outstanding *average accounts receivable = (beginning AR + ending AR) / 2 4. How do you calculate a company‟s current ratio? Current assets (cash and cash equivalents, inventory, AR, etc.) / current liabilities (AP, shortterm debt, etc.) A high current ratio indicates that a company has enough liquid assets to cover its short-term liabilities. 5. Xeron Software Corporation‘s days sales outstanding have gone from 58 days to 42 days. Does this make you more or less likely to issue a Buy rating on the stock?
More likely. A smaller DSOs indicates that the company can collect cash from its customers more quickly One caveat to this is that the reduction in DSOs was not achieved through tighter credit standards (as this will tend to depress revenue growth) o If revenue still grew at a reasonable pace at DSOs fell, the signal is positive
Bonds and Interest Rates Notes Bond terminology review: o Par value or face value: amount bond issuer will repay upon maturity (bond expiration) o Coupon payments: interest payments made to the bond holder by the issuer Coupon rate = interest payment / principal o Bond price: the price the bondholder pays the bond issuer to hold the bond o Default risk: the risk that company issuing the bond will go bankrupt and default on its loans o Default premium: the spread on the yields of a corporate bond and an equivalent government bond o Credit rating: bond ratings by credit agencies (underwriters). Companies guard their credit ratings closely because the higher the rating, the lower the interest rate. o Investment grade bonds: high credit ratings and low interest payments o Junk bonds: (also known as high yield bonds), these bonds have poor credit ratings and pay high interest o US Treasury bills, notes and bonds Bills mature in one year or less Notes mature in two to ten years Bonds in 30 years Pricing Bonds
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Since the discount rate is in the denominator, the higher the discount rate, the lower the bond value. Yield to Maturity (YTM) Yield to Maturity is the measure of the average rate of return that will be earned on a bond if it is bought now and held until maturity. o To calculate the yield to maturity, insert the bond value, coupon and par value into the above equation and solve for the discount rate. This discount rate equals the yield to maturity. Holding Period Return (HPR) Income earned over a period as a % of the bond price. Simply add the coupon payment to any capital gain from the bond and divide by the bond price Other Bond Types/Terms Callable bonds: can be retired by the company before their expiration (typically if interest rates rise). The callable feature of a bond affects the discount rate Zero-coupon bonds (strip bonds): no coupon or interest is offered on this type of bond; instead, the bond issued at a discount and the face value is received by the holder at maturity. Forward rates: these are agreed upon interest rates for a bond to be issued in the future. o These forward rates change daily The Fed and Interest Rates
The Fed sets margin requirements on stocks and options and regulates bank lending to securities market participants (ie, it regulates leverage). The Fed also controls the country‟s monetary policy The Fed has three tools with which to conduct monetary policy o check writing capabilities through open market operations purchase of securities expands the money supply sale of securities causes the money supply to contract raise or lower the interest rates. The interest rate can be manipulated via: o altering the discount rate (bank rate) - the rate banks pay for shortterm loans Federal Funds rate - the rate banks charge each other for short-term loans o manipulate the reserve requirements for various banks to control the money flow and thereby the interest rate
The Fed and Inflation
Using floating rates, lenders are protected from inflation risk. Some level of inflation signals a healthy economy When inflation increases, interest rates must increase (since this maintains the real ROR); hence, when inflation rises, bond prices must fall o Therefore, broadly speaking, positive macroeconomic news pushes bond prices down (since positive economic news tends to imply a higher level of inflation). See below.
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Questions 1. What is the relationship between a bond‘s price and its yield? Inverse relationship. As a bond‟s price rises, its yield falls. This results from the definition of yield, which is mathematically the interest payment divided by the bond price. As the denominator (bond price) increases, the yield falls. 2. How are bonds priced? Bonds are priced on the net present value of all future cash flows expected from the bond. The cash flows are discounted at a rate which is proportional to the level of risk associated with the cash flow (and repayment of the principal) 3. How would you value a perpetual bond that pays you $1,000 a year in coupon? Divide the $1,000 coupon by the applicable discount rate. 4. When should a company issue debt instead of issuing equity?
A company will prefer to issue debt over equity when: o The company exhibits a strong free cash flow (required to meet interest payments). o The expected return on equity is higher than the return on debt. o The company wishes to make use of the tax shield generated by interest payments. o The company does not wish to raise questions about its cash situation (since debt offerings are less publicized than equity offerings).
5. What major factors affect the yield on a corporate bond? The level of market interest rates (rates of comparable US Treasury bonds) The company‟s credit risk 175
To tie these variables together, the corporate yield trades at a spread above the comparable US Treasury Bond. The size of the spread is proportional to the company‟s credit risk. 6. If you believe interest rates will fall, which should you buy: a 10-year coupon bond or a 10year zero-coupon bond? The 10-year zero coupon bond. A zero-coupon bond is more sensitive to changes in the interest rate. Since a decrease in the interest rate pushes bond prices higher, it will be more profitable to hold a more sensitive bond. 7. Which is riskier: a 30-year coupon bond or a 30-year zero coupon bond? A 30-year zero coupon bond. With a coupon bond, some cash is returned before maturity (through the semi-annual coupon payments); with a zero-coupon bond, no cash is returned until maturity. Further, the zero-coupon bond is more interest-rate sensitive. 8. What is The Long Bond trading at? The Long Bond is the US Treasury‟s 30-year bond. This is particularly relevant for corporate finance and sales and trading jobs. 9. If the price of the 10-year Treasury note rises, does the note‘s yield rise, fall, or stay the same. Fall. Bond prices and yields are inversely related. 10. If you believe the interest rate will fall, should you buy bonds or sell bonds? Buy bonds, since an interest rate decline will increase bond prices (inverse relationship). 11. How many basis points equals .5 percent? 50 basis points equals .5%. (remember that 1% = 100 basis points). 12. Why can inflation hurt creditors? Because the higher the rate of the inflation, holding the nominal interest rate constant, the lower the real rate of return (inflation-adjusted rate of return). Remember the equation: real return = nominal return - inflation rate 13. How should the following scenario affect the interest rate: the President is impeached and convicted. These kind of events will lead to fears that the economy will go into recession. To combat these fears, the Fed may lower the interest rate. 14. What does the government do when there is a fear of hyperinflation? The government, through fiscal policy, will likely increase the taxation rate and decrease the level of government spending. 15. Where do you think the US economy will go over the next year? 16. How would you value a perpetual zero coupon bond?
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This bond has zero value. Since a zero-coupon bond has no interest payments, and since a perpetual bond never repays the principal, this bond yields no cash flow and therefore is valueless. 17. Let‘s say a report released today showed that inflation last month was very low. However, bond prices closed lower. Why might this happen? Bond prices trade on the expectations of future inflation (and therefore interest) rates. Past inflation data is only useful in so far as it predicts future inflation data. 18. If the stock market falls, what would you expect to happen to bond prices, and interest rates. The stock market is positively correlated with the level of inflation; therefore, a downturn in the stock market will push the level of inflation downward. This will lower interest rates (since IR and inflation are positively correlated) and this will increase bond prices. 19. If unemployment is low, what happens to inflation, interest rates and bond prices? If unemployment is low, inflation will tend to be high (since jobs and income will be abundant and this will drive demand for goods). This will drive up the interest rate and down bond prices. 20. What is a bond‘s yield to maturity? A bond‟s yield to maturity is the yield that would be realized through coupon and principal payments if the bond were to be held to the maturity date. If the YTM > current yield, the bond is selling at a discount. Else, it it selling at a premium. 21. What do you think the Fed will do with interest rates over the next two years?
Currencies Notes Currency terminology review: o Spot exchange rate: the price of one currency relative to another. o Forward exchange rate: the price of currencies at which they can be bought and sold for future delivery. o Strong/weak currencies: when a currency is strong (or appreciating) it is rising relative to other currencies; a weak currency is the opposite. Exchange Rates In a free market, the exchange rate is determined by two variables: the interest rate and the inflation rate. However, artificial controls exist (such as a foreign currency reserve) which manipulate this free market condition Influence of Interest Rates on Foreign Exchange The larger the spread of the real interest rate (as opposed to the nominal rate) of Country A over Country B, the greater the value of Country A‟s currency.
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This results from the fact that investments flow toward countries with higher rates of return (which drives up the value of the currency). Influence of Inflation on Foreign Exchange The larger the inflation spread of Country A over Country B, the lower the value of Country A‟s currency. This results from the inflation differential creating an arbitrage opportunity which, in turn,
modifies the currency‟s value.
Capital Market Equilibrium This is the concept that all currencies are priced such that no arbitrage opportunity exists amongst currencies (ie, no profit can be made by buying and selling various currencies). The forces of interest rates, inflation and capital market equilibrium govern exchange rates. Exchange Rate Effects on Earnings For exporting businesses, a weakening in the domestic currency increases profits; conversely, for importing business a weakening currency decreases profits (since expenses in domestic terms). Effect of Exchange Rates on Interest Rates and Inflation A weak dollar increases the cost of imports, which drives up the rate of inflation; a strong dollar has the opposite effect. Questions 1. What is the currency risk for a company like Microsoft? What about Ford? Microsoft: has a foreign currency risk in the export dimension - its software sales revenue abroad will be influenced by currency fluctuations. Ford: Ford has currency risks in both the import and the export dimension. On the export dimension, its sales revenue from foreign countries will be influenced by exchange rates. As well, it has currency risks from importing (or outsourcing in this case).
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2. When the currencies in countries like Thailand, Indonesia and Russia fell dramatically in 1998, why were US and European-Based investment banks hurt so badly? Because the value of investments (currencies, bonds, stocks) in this collection of countries became worthless. 3. If the US dollar weakens, should interest rates generally rise, fall or stay the same? Rise. A falling US Dollar increases the price of imports, which drives inflation and therefore interest rates higher. 4. If US inflation rates fall, what will happen to the relative strength of the dollar? It will strengthen. 5. If the interest rate in Brazil increases relative to the interest rate in the US, what will happen to the exchange rate between the Brazilian real and the US Dollar? The real will strength relative to the dollar. 6. If inflation rates in the US fall relative to the inflation rate in Russia, what will happen to exchange rate between the dollar and the rouble? The dollar will strengthen relative to the rouble. 7. What is the difference between currency devaluation and currency depreciation? Devaluation occurs as a result government action (on a fixed exchange rate currency); depreciation occurs as a result of market forces (on a flexible exchange system). 8. What is the effect on US multinational corporations if the US dollar strengthens? US multinationals see their earnings decrease when the dollar strengthens. Essentially, sales in foreign currencies don‟t amount to as many US dollars when the dollar strengthens. 9. What are some of the main factors that government foreign exchange rates? There are three: inflation rates, interest rates and capital market equilibrium. 10. If the spot exchange rate of dollars to pounds is $1.60/£1, and the one-year forward rate is $1.50/£1, would we say the dollar is forecast to be strong or weak relative to the pound? Currency traders believe that the dollar will strengthen against the point in the coming year. Derivatives Notes Derivatives are financial instruments whose value is contingent upon an underlying asset such as a stock, bond, commodity of market index. Derivatives can be used to hedge risk or to speculate. Options An option gives its holder the right, but not the obligation, to buy or a sell a security at a given price.
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There are two types of options: calls (which give the owner the right to buy) and puts (which give the owner the right to sell). There are two expiration forms: American (which give the owner the right to convert the option at any time) and European (which can only be converted on the expiration date). The specified price is called the strike price.
Call Option
Put Option
In the money
Out of the money
At the money
At the money
Out of the money
In the money
share price > strike price
share price = strike price
share price < strike price
Writing Options Anyone who owns the underlying asset can write an option Option markets are a zero-sum game in that if the option holder earns, the option writer must lose.
Action to Take Stock will go up
Buy a call
Write a put
Stock will go down
Buy a put
Write a call
Option Pricing There are six variables that influence the price of an option: o the stock price; o the exercise price; o the volatility of the stock price; o the time to expiration; o the interest rate; and o the dividend rate on the stock.
Consider these variables in the context of a call option: Stock price: the greater the share price, the greater the value of the option Exercise price: the lower the exercise price (holding the share price constant), the higher the options‟ value Volatility of the underlying security: the option value increases if the volatility of the underlying stock increases. o A higher volatility implies a higher potential value for a call option with a limited downside (fixed option fee) 180
Time to expiration: the greater the time period, the more valuable the option. o First, a longer time-horizon implies a lower exercise price present value (which increases the value of the option); and o Second, a longer time-horizon makes the probability of an extreme event moving a share more likely. Interest rates: if interest rates are higher, the exercise price has a lower present value. This also increases the value of a call option. Dividends: a higher dividend rate policy implies a larger portion of the return on a security is composed of dividends (and reciprocally, a smaller portion is based on capital gains). This lowers the value of the call option.
Forwards A forward contract is an agreement that calls for future delivery of an asset at an agreed-upon price. A forward contract is simply a deferred delivery sale of some asset with an agreed-upon sales price. The contract is designed to protect each party from fluctuations in the underlying asset. Futures The futures contract is a type of forward that calls for the delivery of an asset or its cash flow at a specified delivery or maturity date for an agreed upon price. The price is called the futures price and is said to be paid when the contract matures. The trader who commits to purchasing the commodity is said to be long; the supplier of the commodity is said to be short. Futures differ from other forwards in the fact that they are liquid, standardized, traded on an exchange, and their prices are settled at the end of each trading day (that is, futures traders collect/pay their day‟s gains and losses at the end of each day). Swaps A swap is a simple exchange of futures cash flows. Two types of swaps are foreign exchange swaps and interest rate swaps. Foreign exchange swaps are agreements between companies to exchange currencies at fixed rates, thus circumventing exchange rate risk. Interest rate swaps are similar agreements. They allow two companies to exchange two different types of interest rates - floating and fixed. o For instance, if company A has debt of $1,000 and fixed semi-annual interest charges of $5 and company B has $1,000 in debt but a floating rate proportional to LIBOR, then a interest rate swap would entail the following: Company B would pay company A $5 each six months Company A would pay company B $1,000 times LIBOR times the constant of proportionality Questions 1. When would you write a call option on Disney stock? When you expect the price of the Disney stock to fall or remain the same. Assuming this outcome occurs, the value captured is equal to the premium received for writing the call. 2. Explain how a swap works.
A swap is an exchange of future cash flows. The two most popular swaps are interest rate swaps and currency swaps.
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In an interest rate swap, companies agree to trade the type of interest payment each is obligated to (floating or fixed) by exchanging cash flows. o In a currency swap, companies agree to exchange currencies in the future at a particular exchange rate. Swaps are used to hedge currency exchange rates or interest rate risks o
3. Say I hold a put option on Microsoft stock with an exercise price of $60, the expiration date is today and Microsoft is trading at $50. ABout how much is my put worth rate now? About $10. 4. When would a trader seeking a profit from a long-term possession of a future be in the long position? When he believes the underlying commodity price will increase. 5. All else being equal, which would be less valuable: a December put option on Amazon.com stock or a December put option on Bell Atlantic stock? The put on Amazon.com will be more valuable become it is a more volatile stock. 6. All else being equal, which would be more valuable: a December call option for eBay or a January call option for eBay?
January call on eBay since: o More time exists for an event to generate volatility for the stock o The present value of the strike price is lower
7. Why do interest rates matter when figuring the price of options? The interest rate influences the present value of the exercise price, which influences the option‟s value; the higher the interest rate, the higher the value of the call option since the present value of the strike price is inversely related to the interest rate. 8. If the current price of a stock is above the strike price of a call option, is the option holder at the money, in the money or out of the money? In the money. 9. When would you buy a put option on General Mills stock? When you believe the price of General Mills will decrease. 10. What is the main difference between futures contracts and forward contracts?
The main difference is that futures contracts are traded on auction markets (large exchanges) and forward contracts are traded on over-the-counter markets. o Forward contracts are privately negotiated and constructed o Futures contracts are standardized and inflexible
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III. Appendix 2 - Other Terms & Concepts The Finance Industry Buy-side: set of financial institutions which make large purchases of securities (such as mutual funds, hedge funds, insurance companies, pension funds, etc.). Sell-side: set of financial institutions which provide recommendations for security purchases (upgrades, downgrades, target prices, etc.) and sell securities (ie, brokers, investment bankers, etc.) Corporate finance: is an area of finance dealing with the financial decisions corporations make and the tools and analysis used to make these decisions. The primary goal is to maximize corporate value while reducing the firms‟ financial risks. ______________________________ Capital Requirement Capital requirement is a bank regulation which sets a framework for how banks must handle their capital o The categorization of assets and capital is highly standardized so that it can be risk weighted. The capital ratio is the percentage of a bank‟s capital to its risk-weighted assets. o Weights are defined by risk-sensitivity ratios o Capital adequacy is based primarily on the perceived credit risk associated with balance sheet assets, as well as certain off-balance sheet exposures such as unfunded loan commitments, letters of credit, and derivatives and foreign exchange contracts. To be well-capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 6%, a combined Tier 1 and Tier 2 capital ratio of at least 10% and a leverage ratio of at least 5%. o Tier 1 capital: consists largely of shareholders‟ equity o Tier 2 capital: supplementary capital Undisclosed reserves - profits not retained in normal retained earnings account Revaluation reserves - a reserve is revalued and an increase in value is brought to the account General provisions: a provision for a loss that has not yet been incurred (count this loss as capital) Hybrid instruments: preferred shares Subordinated debt: non-redeemable for a set (usually long) term and ranks lower than depositors of the bank Tier 1 capital ratio = tier 1 capital / RWA Total capital ratio = (tier 1 + tier 2 capital) / RWA Leverage ratio = tier 1 capital / average total consolidated assets ______________________________ ______________________________ Monetary Policy
Monetary policy is the set of decisions which control the supply of money There are four tools central bankers use to control the money supply: o Open market operations 183
Reserve requirements Discount window lending Interest rates The discount rate is the rate a central bank charges depository institutions that borrow reserves from it The overnight rate is the rate that large banks use to borrow and lend from one another in the interbank market In Canada, the overnight rate may be the rate targeted by the central bank to influence monetary policy (through SPRAs special purchase and sale agreements - and through SRAs - sale and repurchase agreements) ______________________________ ______________________________ Prime Brokerage o o o
Prime brokerage is the generic name for a bundled package of services offered by investment banks and securities firms to hedge funds and other professional investors needing the ability to borrow securities and cash to be able to invest on a netted basis and achieve an absolute return. ______________________________ ______________________________ Quantitative Easing The term quantitative easing describes an extreme form of monetary policy used to stimulate an economy where interest rates are either at, or close to, zero. Normally, a central bank stimulates the economy indirectly by lowering interest rates but when it cannot lower them any further it can attempt to seed the financial system with new money through quantitative easing. In practical terms, the central bank purchases financial assets (mostly short-term), including government paper and corporate bonds, from financial institutions (such as banks) using money it has created ex nihilo (out of nothing). This process is called open market operations. The creation of this new money is supposed to seed the increase in the overall money supply through deposit multiplication by encouraging lending by these institutions and reducing the cost of borrowing, thereby stimulating the economy.[1] However, there is a risk that banks will still refuse to lend despite the increase in their deposits, or that the policy will be too effective, leading in a worst case scenario to hyperinflation.[1] ______________________________ ______________________________ Savings and Loan Associations For decades, savings and loan associations, also known as S&L's or thrifts, had been staples of the American economic landscape -- solid if unexciting institutions whose major business was making mortgage loans within their community. But in what became known as the S&L crisis of the late 1980's, hundreds of thrifts made a torrent of bad loans, ending in a government takeover and bailout that ultimately cost taxpayers over $120 billion. In the 1960's, the government capped the interest rates that thrifts could offer on their federally guaranteed accounts. When interest rates soared in the early 1980's, the thrifts faced such difficulty in attracting money that the caps were removed. At the same time, some states relaxed the limits on the kinds of investments thrifts could make. A new breed of aggressive S&L's emerged, that attracted large pools of deposits by offering higher returns, and then used this cash to move into new lines of business, including junk bonds and real estate development.
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By 1984, federal bank board examiners detected signs of strain among S&L's, but budget cuts hampered their ability to detect or restrain problems. As the real estate boom came to an end, first in Texas and later elsewhere, losses started to pile up and by 1988 were estimated at $60 billion, overwhelming the funds available to the agency responsible for the federal deposit guarantee. In 1989, Congress created the Resolution Trust Corporation to take over the assets of shaky thrifts and dispose of them at fire-sale prices. Resolution Trust closed or reorganized 747 institutions holding assets of nearly $400 billion. It did so by seizing the assets of troubled savings and loans and then reselling them to bargainseeking investors. At the peak in early 1990 there were 350 failed savings and loan institutions under the agency's control. By 1995, the S.& L. crisis abated and the agency was folded into the Federal Deposit Insurance Corporation, which Congress created during the Great Depression to regulate banks and protect the accounts of customers when they fail. The total cost to taxpayers was later estimated at $124 billion. ______________________________
Investment Banking Pitchbook: There are two main types of pitchbooks. There is the main pitchbook, which contains all of the main attributes of the firm - such as the number of analysts it has, its prior IPO success and the number of deals it completes per year - which the sales team should focus on when selling the benefits of the firm to potential clients. The second type of pitchbook contains details about a specific deal, such as a company's IPO. This form of pitchbook focuses on all of the benefits of the issue, helping brokers and investment bankers demonstrate how the firm can service the specific needs of their potential clients. ______________________________ Investment Bank Structure Investment banking Capital raising M&A advisory Sales and trading Sales refers to the sales force of an investment bank, whose primary goal is to sell securities to high net-worth and institutional clients Research Strategy Investment management Merchant banking Private equity activity of investment banks Structuring ______________________________ ______________________________ Underwriting
There are two meanings of the word „underwriting‟: o In banking, underwriting is the detailed credit analysis preceding the granting of a loan, based on credit information furnished by the borrower. 185
o
In capital raising, underwriting is the purchase of corporate bonds, commercial paper, government securities, municipal general obligation bonds by a commercial bank or dealer bank for its own account, or for resale to investors.
Securities underwriting A process of placing a newly issued security, such as stocks or bonds, with investors. A syndicate of banks underwrite the transaction, meaning they have taken on the risk of distributing the securities. If they cannot find enough investors, they end up holding some of the securities themselves. Underwriters make their income from the price (underwriting spread) between the price they pay the issuer and what they collect from investors (or from broker-dealers who buy portions of the offering). Insurance underwriting Insurance underwriters evaluate the risk and exposures of potential clients. They then decide how much coverage the client should receive, and the premiums they should pay for the coverage. ______________________________
Private Equity
Management buyouts (MBOs): a company‟s management buys or acquires a large part of the company o Creates an incentive for management to depress share prices and then conduct an MBO at bargain prices.
______________________________ Leveraged Buyouts
A leveraged buyout occurs when a financial sponsor acquires a controlling interest in a company‟s equity where a significant portion of the transaction cost is financed by debt (leverage or borrowing) The target company is required to repay the debt obligations; as a result of this, some qualities which make a firm an attractive LBO target are: o Strong free cash flow o Low existing debt levels o Temporarily depressed stock prices o Potential for new management to make operational improvements Typically debt accounts for between 50%-85% of the transaction price Since the financial sponsor pays only a small fraction of the cost of equity, returns are enhanced; further, if the company is resold later, because the sponsor pay so little for the target, a large profit can be turned.
Rationale Use of leverage increases returns to the financial sponsor The tax shield generated by the increase debt proportion enhances the value of the firm Most leveraged buyout firms look for an internal rate of return in excess of 20%. ______________________________ ______________________________ Private Equity Firm
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A private equity firm is an investment manager that makes investments in operating companies through a set of loosely affiliated investment strategies called private equity. Private equity firms are often called financial sponsors. A private equity firm will manage a set of private equity funds. These funds raise capital from wealthy investors or institutions. Private equity firms earn money through management fees and a share in the profits earned from each private equity fund. Private equity firms, with their investors, will acquire a controlling or substantial minority interest in a company and seek to maximize the value of this investment. Private equity firms, upon enhancing the value of the firm, will use one of the following tools to liquidate the holding and capture profits: o IPO (sold to the public) o M&A (sold to another company) o Recapitalization (replacement of equity with additional debt) o Incremental divestiture ______________________________ ______________________________ PIK Bond Payment-in-kind (PIK) bond A bond in which coupon payments come in the form of more bonds, rather than cash. At times, the investor has the option of choosing whether to accept cash or payment-in-kind, but more often this option resides with the issuer. A problem with PIK bonds for the issuer is the fact that it becomes tempting to pay coupons with more debt rather than cash when the company has a liquidity problem. Of course, doing this often only adds to the issuer's liquidity problems. This type of bond was not unusual during the private equity boom in the mid-2000s, but became rare during the credit crunch at the end of the decade. ______________________________
Fixed Income Securities The Long Bond: the US Treasury‟s 30-year bond. ______________________________ The Yield Curve The yield curve is a relationship between the interest rate and the term to maturity; this is often called the term structure of interest rates. The yield (Y) is a function of time (Y(t)) Only a few of the yields at specific times are known; the remainder of the curve is determined through interpolation
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Yield Curve Shape The yield curve is traditionally asymptotically upward sloping, with diminishing marginal growth. This is called the normal yield curve. The are two explanations for this shape: o The market may be anticipating an increase in the risk-free rate. If the risk-free rate is going to rise, then investors who lock-in to longer terms must be compensated (and hence higher yields are required) o Longer maturities entail greater risk (since more dangers face the economy over a longer time horizon) and therefore require greater yields. This effect is called liquidity spread. The yield curve can be inverted, where long-term yields are lower than short-term yields. This occurs in an environment where investors are anticipating a decline in interest rates. o If investors anticipate a interest-rate decline, this is bullish for bond prices. Since longer-term bonds have greater sensitivity to interest rate changes, investors are more bullish on long-term bonds. This drives long-term bond prices higher and yields down by more than short-term bonds. o This is called a negative liquidity premium o Strongly inverted yield curves have historically preceded economic depressions. o An inverted yield curve has indicated a worsening economic situation in the future 5 out of 6 times since 1970 A movement of the interest rate up or down tends to shift the yield curve in the same direction. In a steep yield curve (where the 20-year Treasury Bond yield exceeds the three-month yield by more than 200 basis points) environment, the economy is expected to grow quickly. Theory Market expectations: yield curve shape is determined by interest rate anticipation Liquidity preference: investors have a preference for shorter-term instruments (since these are more liquid); therefore, higher yields are required to compensate investors for less liquidity Market segmentation: posits that financial instruments of different terms are not substitutable; therefore, supply and demand for short and long-term instruments are determined independently (and therefore their prices and yields are independent). ______________________________ ______________________________ Collateralized Debt Obligation
Collateralized debt obligations (CDOS) are a type of asset-backed security and structured credit product. CDOs are constructed from a portfolio of fixed-income assets. These assets are divided into different tranches: o Senior tranches (AAA) o Mezzaine tranches (AA to BB) o Equity tranches (unrated) CDOs serve as an important funding vehicle for fixed-income assets Since CDOs are valued on a mark-to-market basis, the paralysis in the credit markets lead to substantial write-downs in 2007. o In 2001, David X. Li introduced the Gaussian Copula Models, which allowed the rapid pricing of CDOs.
Investors: CDOs are purchased by insurance companies, mutual fund companies, unit trusts, investment trusts, commercial banks, investment banks, pension fund managers, private banking organizations and other CDOs and structured investment vehicles. Concept 188
CDOs vary in structure and underlying assets, but the basic principle is the same: a CDO is a corporation constructed to hold assets as collateral and sell cash flows to investors. It is assembled as follows: o A special purpose entity (SPV) acquires a portfolio of credits. Common assets include mortgage-backed securities (MBSs), Commercial Real Estate (CRE) debt and high-yield corporate loans. o The SPV issues senior debt, junior debt and equity notes (listed in priority sequence), the holders of which are entitled to receipt of the cash flows from the portfolio of credits CDO tranches are typically issued by investment bankers, who earn a commission at the time of sale and earns a management fee throughout the life of the CDO. An CDO is therefore an investment in cash flows and the promises of the mathematical models of this intermediary. The loss to investor‟s principal is applied in reverse cash-flow-priority sequence ______________________________ ______________________________ Securitization
Securitization is a structured finance process, which involves pooling and repackaging of cash-flow producing financial assets into securities are then sold to investors. All assets can be securitized so long as they are associated with cash flow; as a result the securities that result are called asset-backed securities (ABS). Securitization often utilizes a special purpose vehicle (or a special purpose entity) in order to reduce the risk of bankruptcy and thereby obtain lower interest rates from potential lenders. Unlike conventional corporate bonds which are unsecured, securities generated in a securitization deal are credit enhanced, meaning their credit quality is increased above that of the originator‟s unsecured debt or underlying asset pool. o Credit derivatives are used to change the credit quality of the underlying portfolio. Securitized instruments can have either a fixed interest rate or a floating rate. Individual securities are often split into tranches or categorized into varying degrees of subordination. o Senior classes have a superior claim on the SPV‟s assets o This is called a cash flow waterfall Most securitizations are amortized, meaning that the principal amount is paid back gradually over the specified term of the loan, rather than in one lump sum at the maturity of the loan.
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Fully amortizing securitizations are generally collateralized by fully amortizing assets such as home equity loans, auto loans and student loans.
Motives for Securitization Advantages to issuer Funding costs: through securitization, companies can borrow at lower rates Transfer risks: securitization makes it possible to transfer risks from an entity that does not want to bear it, to one that does. Disadvantages to issuer Costs: securitizations are expensive due to management and systems costs, legal fees, underwriting fees, rating fees and ongoing administration. Size limitations: securitizations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions. Advantages to investors Higher rate of return: greater risk-adjusted return Specific pool of high quality credit-enhanced assets: securitizations allow for the creation of large quantities of AAA, AA or A rated bonds (which are required by some institutional investors) Portfolio diversification: securitizations may be uncorrelated to other bonds and securities Isolation of credit risk from the parent entity: since the assets that are securitized are isolated from the assets of the originating entity, under securitization it may be possible for securitization to receive a higher credit rating than the parent. Risks to investors: Credit/default risk Prepayment/early amortization Interest rate fluctuations Mortgage Backed Securities Pools of mortgages purchased by investors and underwritten by banks Often rated AAA because of the perceived diversification benefit o Ignored the systematic risk factor of the housing market driving MBS value Collateralized Debt Obligation (CDO) A CDO is a broad asset class in which a number of interest paying securities are packaged together and sold in the form of bonds o A MBS is a type of CDO ______________________________ ______________________________ Credit Default Swap
A credit default swap (CDS) is a credit derivative contract between two counterparties o One party (buyer) makes periodic payments to the other and receives the promise of a payoff if a third party defaults o The other party (seller) guarantees the principal on a bond issued by a third party known as the reference entity In the event of default, the protection seller either takes delivery of the defaulted bond for par value or pays the protection buyer the difference between the par value and the recovery amount (the cash settlement) o Default risk is transferred from the buyer to the seller.
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CDSs trade on a bps (basis points) system - if a CDS costs x bps, then the cost of the CDS is x bps times the principal on the bond CDSs can be used for: o Hedging o Speculation CDSs are the most widely traded credit derivative product. The typical term of a CDS is five years The most important variable influencing the price of a CDS is the reference entity‟s credit quality (with credit ratings serving as a proxy for this).
Credit Default Swaps CDS sellers included: o Banks o Hedge funds o Insurance companies (ex: AIG) CDS buyers included: o Speculators o Hedgers ______________________________ ______________________________ Syndicated Loan A syndicated loan is a large loan in which a group of banks work together to provide funds for a borrower. There is usually one lead bank (the „arranger‟ or „agent‟) that takes a percentage of the loan and syndicates the rest to other banks. A syndicated loan is the opposite of a bilateral loan, which only involves one borrower and one lender (often a bank or financial institution). ______________________________ ______________________________ Mezzaine Capital Mezzaine capital is an investment instrument which ranks senior only to common equity. These are typically structured as either debt (unsecured or subordinated note) or preferred stock. ______________________________ ______________________________ Commercial Paper Commercial paper is an unsecured promissory note with a fixed maturity of one to 270 days. Commercial Paper is a money-market security issued (sold) by large banks and corporations to get money to meet short term debt obligations (such as payroll) and is only backed by an issuing bank or corporation‟s promise to pay the face amount on the maturity date specified on the note. ______________________________ The Credit Crisis ______________________________ Subprime Mortgage (Credit) Crisis Summary Economic problem manifesting itself in liquidity issues in the global banking system owing to foreclosures which accelerated in the US starting in late 2006.
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The crisis began with the bursting of the US housing bubble and the high default rates on subprime and other adjustable rate mortgages (ARM) made to higher-risk borrowers with lower income or lesser credit histories. o Loan incentives and rising housing prices encouraged borrowers to assume mortgages, believing they would be able to refinance at more favorable terms. o With the drop in housing prices, refinancing became more difficult o Defaults and foreclosure activity increases dramatically as ARM interest rates reset higher
Mortgage brokers were the first to be hit Major financial institutions have written down approximately $379 billion as of May 21, 2008 Owing to a form of financial engineering, many mortgage lenders passed mortgage payments and credit risk to third-party investors. o Mortgage-back securities o Collateralized debt obligations Individuals and institutions holding these securities suffered significantly Because of the lack of loans, housing demand declined and inventories ballooned. This pushed housing prices down and halted new home construction. Subprime lending refers to the practice of making loans to borrowers who do not qualify for market interest rates, owning to various factors like income level, credit history, employment status, etc.
Causes Inability of homeowners to make mortgage payments Poor judgement by the borrower and/or lender Mortgage incentives such as „teaser‟ rates that later rise significantly Declining home prices which made refinancing more difficult Innovations in securitization which spread risk more broadly Risk Type Credit risk (risk of default) - though traditionally accepted by the bank extending the loan, securitization innovation spread risk to third-party investors (through MBSs and CDOs) Asset price risk - valuation of CDOs and MBSs for „mark-to-market‟ accounting is difficult because of the complexity of the instruments o Valuation is derived from both the collectibility of subprime mortgage payments and the price on a liquid market (the two of which are interrelated). As collectibility falls, trading of such instruments falls, thereby reducing the liquidity of the market o Investors have faced large losses as a result of the write-downs in these securities Liquidity risk - companies rely on short-term funding markets for cash to operate; they access these markets through commercial paper instruments and structured investment vehicles o However, MBSs and CDOs are often used as collateral to back lending in these markets o Because of the decline in the value of these securities, investors have become unwilling to invest in these markets Counter-party risk - major investment banks and other financial institutions have taken significant counter-party positions in credit derivative transactions, some of which serve as a form of credit default insurance.
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Effects on Corporations and Investors Bank corporations: banks must write down mortgages which become uncollectible. This may lead banks to o seek additional funds to maintain capitalization requirements o Reduce lending Mortgage lenders and REITs: these entities face risks similar to the banks. Additionally, they require new financing through o CDOs o Commercial paper backed by mortgages Special purpose entities (SPE): Structured Investment Vehicles issue commercial paper to purchase securitized assets such as CDOs. The Causes in Finer Detail Housing: Subprime lending generated housing demand and therefore fueled housing price increases (and hence consumer spending). o Some homeowners refinanced their homes with lower interest rates or took out a second mortgage against the value added and used the funds for consumer spending o US household debt as a percentage of income rose to 130% in 2007, up from 100% a decade earlier. Borrowers: easy credit and the assumption that housing market would continue to appreciate lead borrowers to obtain ARMs they could not afford past the incentive period. o Once home prices fell marginally, refinancing became more difficult and many defaulted on their mortgages as rates reset o Many borrowers were also fraudulent in loan and mortgage applications Financial institutions: o The subprime credit spread (risk premium) actually declined between 2001 to 2006. o ARM mortgages often allowed the borrower to pay only the interest during the initial period o Payment option loans allowed unpaid interest to be added to the premium 193
Securitization: process of offering investment instruments as collateral to third-party investors o MBSs are a product of securitization o Rating agencies improperly assigned investment-grade ratings to MBSs Mortgage Brokers: act as an intermediary who sourced mortgage loans on behalf on individuals or businesses o They have big financial incentives to sell complex, ARMs because they earn higher commissions. Mortgage underwriters: underwriters determine if the risk of lending is acceptable under certain parameters. o Underwriters made heavy use of automated risk analysis systems Government: some economists blame the subprime debacle on regulators who failed to curb subprime lending Credit Rating Agencies: under scrutiny for giving investment-grade ratings to securitization transactions (CDOs and MBSs) based on subprime mortgage loans. o High ratings were justified by credit enhancements such as Overcollateralization Credit default insurance o Critics argue that a conflict of interest exists since crediting rating agencies are paid by the firms that organize and sell debt to investors (ie, investment banks) Central banks: o The intervention of the Federal Reserve Bank of New York on behalf of LTCM (Long Term Capital Management) encouraged large financial institutions to assume more risk under the assumption that the Federal Reserve would intervene on their behalves o The low interest rates set by the Fed encouraged the run-up in housing prices ______________________________ ______________________________ Bear Stearns
Two Bear Stearns hedge funds were heavily invested in CDOs; the fund‟s assets were worth far less than their mark-to-model value. o Merrill Lynch seized $100 million of the collateral in the funds, but could only sell $10 million of it. o During the week of July 17, 2008, Bear Stearns disclosed that the two funds had lost nearly all their value amid the rapidly declining market for subprime mortgages o Investors took legal action against Bear Stearns, arguing that the company had mislead them o Matthew Tannin and Ralph Cioffi were arrested and charged with misleading investors as to the risks involved in subprime mortgages on June 19, 2008 On March 18, 2008, JPMorgan Chase along with the Federal Reserve Bank of New York, provided a 28-day emergency loan to Bear Stearns to prevent the market collapse that would result from Bear Stearns becoming insolvent. o Two days later, Bear Stearns signed a merger agreement with JPMorgan in a stock swap worth $2 per share. o The Federal Reserve agreed to issue a non-recourse loan to JPMorgan, thereby assuming the risk of Bear Stearn‟s less liquid assets o On March 24, 2008, Bear Stearns shareholders filed a class action lawsuit disputing the initial $2 offer. The deal was revised to $10 per share. ______________________________ ______________________________ Monoline Insurance
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Monoline insurers guarantee the timely repayment of bond principal and interest when an issuer defaults. o This insurance is called „monoline‟ because it provides services to only one industry - capital markets The economic value of bond insurance to the government unit, agency, or company offering bonds is a yield spread between an uninsured bond and an insured bond. Insured securities range from municipal bonds and structured finance bonds to CDOs.
Credit Crisis Monoline insurers suffered losses from insurance of structured finance products back by residential mortgages(like CDOs). Monoline insurers were downgraded by rating agencies; this simultaneously triggered the downgrading of the insured bonds of corporations and municipalities. ______________________________ ______________________________ Freddie Mac (Federal Home Loan Mortgage Corporation) Freddie Mac is a government-sponsored enterprise (GSE) of the US Federal Government. It is a stockholder-owned corporation authorized to make loans and loan guarantees. It was created in the 1970 to expand the secondary market for mortgages. Freddie Mac buy mortgages on the secondary market, pool them and sells them as mortgagebacked securities to investor on the open market. This increases the supply of money available for home purchases. Freddie‟s primary means of generating revenue is charging a guarantee fee on the MBSs they sell; in return of the fee, Freddie guarantees the principal and interest on the underlying loan. On Sunday, July 13 The Secretary of the Treasury announced that the US government would buy some of Freddie Mac‟s stock and extend to it the full lending power of the Federal Reserve bank of NY. Private banks currently have access to this resource. On February 27, 2007, Freddie Mac announced that it will buy a subprime adjustable rate mortgagae only if the borrower qualifies for the maximum rate of the loan, rather than merely a low introductory (so-called teaser) rate. Officially, Freddie Mac is not given any backing, insurance, or statutory support by the US government. Unofficially, it has long been assumed that the corporation, along with its sister GSE, Fannie Mae, were „too big too fail‟. Both companies often benefited from an implied guarantee of fitness equivalent to truly federally-backed financial groups. ______________________________ ______________________________ The TED Spread - a leading indicator
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______________________________ The Mortgage Crisis January 2009: 20% of the homes in the US are “underwater” o The value of the house is less than the value of the mortgage, implying negative equity o This encouraged home owners to walk away from their mortgage obligations As bank‟s capital bases eroded (from losses on MBSs), they were required to restrict lending, hence slowing economic activity further (contracting the monetary base)
Mergers and Acquisitions ______________________________ Mergers and Acquisitions Overview One defensive tactic is called a poison pill (shareholder rights plan) Corporate mergers are aimed at: o Reducing market competition o Cutting costs o Reducing taxes o Removing management o „Empire building‟ Acquisition (Takeover)
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Acquisitions can be either consensual/friendly (management of the target company assists the purchaser in generating value) or hostile (the purchaser goes directly to the market with a tender offer). Reverse takeovers refer to the acquisition of a larger firm by a smaller firm, where the name of the larger firm is retained for the entire firm There are two types of acquisitions o Purchase of controlling interest in shares o Purchase of the assets of the target company The proceeds from the assets are distributed to shareholders This creates an „empty shell‟ company This technique allows „cherry-picking‟ of only the assets desired by the acquiring company, and no retention of unwanted liability (particularly, liabilities which could arise in the future from defective products, litigation, etc.)
Merger Merger: combination of two firms into one larger firm Commonly involve stock swap or cash payment o Stock swap allows the shareholders of the two companies to share the risk involved in the deal together Mergers often resemble takeover. o They can involve rebranding, which typically is not the case for takeovers o Sometimes takeovers are called mergers purely for political reasons
Merger classifications: o Horizontal mergers: between two companies producing a similar product in the same industry o Vertical mergers: between two companies at different levels along the supply chain o Congeneric mergers: between two companies in the same industry but sharing no mutual customers or supplier relationships Ex: bank and leasing companies o Conglomerate mergers: two firms operating in different industries
Mergers which violate antitrust legislation can be blocked by such regulatory bodies as the European Commission, the United States Department of Justice and the US Federal Trade Commission
Accretive mergers are those in which the acquiring company‟s EPS increases. If the P/E of the target firm is below that of the acquiring company, the merger is accretive. Conversely, in a dilutive merger, the EPS of the acquirer falls. This occurs when the P/E of the target is above that of the acquirer.
Devoting resources to solving incompatibility problems can drain value: o Technology o Equipment o Corporate culture o Overlapping operations o Redundant staff
A successful merger generates value faster than the two firms could independently
Distinction between Mergers and Acquisitions Acquisition - a company purchases another and declares itself the owner Merger 197
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In a technical sense, two firms of approximately equal size are combined into a new firm Shares of both companies are cancelled and a new company is created This is referred to as a merger of equals In practice, mergers of equals are uncommon. Instead, friendly acquisitions are euphemistically referred to as mergers. Hostile takeovers (acquisitions) are never referred to as mergers
Business Valuation The five most common ways to value a business are: o Asset valuation o Historical earnings valuation o Future maintainable earnings valuation o Relative valuation Comparables tables o Discounted cash flow (DCF) valuation Financing M&A Cash o Typically employed in acquisitions since the shareholders of the target are removed from management control o Cash deals are typically employed in low-interest business environments (since this reduces financing costs) o Cash deals tend to have a lower chance of diluting EPS of the acquiring company o Using cash (if it is debt-financed) can reduce free cash flow Stock o Stock in the acquiring company can be offered as a consideration Hybrid o A combination of cash and stock Motives behind M&A The ultimate objective of M&A is the generation of shareholder value Synergy - generating value by increasing earnings o Expense synergy: Economies of Scale Holding revenue constant, the two companies can reduce duplicate operations and therefore expenses Managerial economies - greater opportunity for managerial specialization Purchasing economies - volume discounts Taxes Purchase of a loss-maker to use the target‟s loss as a tax shield o Revenue synergy Market power In horizontal merger, the market concentrates and therefore pricing power rises Cross selling Accessing the clientele of the partner companies can generate additional sales o Ex: retailing banker and discount brokerage share customers Marketing and Distribution Access to shared distribution channels
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Access to marketing knowledge (segmentation variables, for instance) Diversification - generating value by reducing risk o Geographic diversity o Market diversity (in the case of conglomerate mergers) ______________________________ ______________________________ Poison Pill
A poison pill refers to a collection of methods used to avoid takeover bids. Takeovers include both: o Proxy fights - to get elected to the board; or o The acquisition of a controlling block of shares to get elected to the board. Once in control of the board, the controller can determine management. Poison pills harm both the bidder and the target (or its shareholders) The most common poison pill is the shareholder rights plan. o In a shareholder rights plan, existing shareholders are given rights to purchase a large number of new securities, usually common stock or preferred stock, if an acquirer obtains more than a set amount of the target‟s stock (usually 20%30%). o This dilutes the position of the acquirer.
Other poison pill tactics include: o The target takes on large debt in an effort to make the debt load too high to be attractive o The company buys a large number of smaller companies through stock swap, diluting the value of the target‟s stock. o Issuance of stock options to employees which are valid after a takeover occurs; employees will often cash-in their stock options and exit the company. o Offer to clients/customers unreasonable benefits if the acquisition is permitted. For instance, Peoplesoft guaranteed its customers (if it were acquired within two years, presumably by Oracle) they would receive a refund of between two and five times the fees they paid for their Peoplesoft software licenses. o Staggered elections for the Board of Directors (ex: three directors per year, with nine directors in total). ______________________________ ______________________________ White Knight
A white knight is the friendly acquirer of a target firm in a hostile takeover attempt by another firm. The intention of the acquisition is to circumvent the takeover of the object of interest by a third, unfriendly entity, which is perceived to be less favorable. The knight might defeat the undesirable entity by: o Offering a higher and more enticing price; or o Strike a favourable deal with management
Alternatively, a white knight may be the acquirer of a struggling firm (struggling from, for instance, huge debts). In such a case, the knight acquires the firm that is in crisis at great risk. After the firm is acquired, the knight rebuilds it or integrates it into itself. For instance, the purchase of Bear Stearns by JPMorgan. ______________________________ ______________________________ 199
Competition Law
Competition law, known in the US as antitrust law, has three main elements: o prohibiting agreements or practices that restrict free trading and competition ex: repression of cartels o banning abusive market behaviour by a dominant firm Predatory pricing Tying (is the practice of making the sale of one good (the tying good) to the de facto customer conditional on the purchase of a second distinctive good (the tied good). Price gouging Refusal to deal o supervising the M&A of large corporations. transactions that are considered to threaten the competitive process can be prohibited altogether, or approved subject to remedies such as obligation to divest part of the merged business or to offer licenses or access to facilities to enable businesses to continue to compete The goals of competition law are: o The protection of consumer welfare o The opportunity for entrepreneurs to compete The regulation of M&A activity is an attempt to combat the problem of market concentration (and the resulting anti-competitive practices it engenders) ex-ante (before it occurs). ______________________________
Hedge Funds
Delta neutral: in finance, a portfolio containing options is delta neutral when it consists of positions with offsetting positive and negative deltas (exposure to changes in the value of the underlying instrument) and these balance out to bring the net delta of the portfolio to zero. o Delta hedging is the process of setting or keeping delta of a portfolio as close to zero as possible. o Mathematically, delta is the partial derivative of the instrument or portfolio‟s fair value with respect to the price of the underlying security. o A portfolio that is delta neutral is effectively hedged. ______________________________ Hedge Fund
A hedge fund is a private, largely unregulated pool of capital whose managers can buy or sell any assets, bet on falling as well as rising assets and participate substantially in profits from money invested. Hedge funds charge: o Performance fees o Management fees Open only to qualified investors Hedge funds dominate certain speciality markets such as trading within derivatives with high-yields ratings and distressed debt In the US, an investment fund must be open to a limited number of accredited investors in order to exempt from direct regulation. o There is no formal definition of a hedge fund o However, on the street, these are simply funds that circumvent regulation usually applicable to mutual funds, brokerage firms and financial advisors, thereby allowing them to invest in more complex, risky instruments.
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Hedge funds make heavy use of short selling, entering futures, swaps and other derivatives contracts and leverage. Hedge funds have acquired a reputation for secrecy due to the protection of proprietary investment strategies. o Informational regulations are lighter on hedge funds The assets under management of a hedge fund can run into many billions of dollars, and this can usually be enhanced by leverage.
Size Some estimates place the value of hedge funds upwards of $2.68 trillion dollars. Fees Hedge fund managers will typically receive both a management fee and a performance fee (incentive fee). Managers can typically charge „2 an 20‟ - 2% of net asset value and 20% of profit (increase in NAV). Performance fees give managers an incentive to take greater risks o Some funds attempt to combat this with „claw-back‟ fees, where a manager may be required to return performance fees if the fund performs poorly. o High water mark (carry-forward provision): manager only receives performance fees on the value of the fund that exceeds the highest net asset value it has previously achieved. o Hurdle rates: some managers set a hurdle rate, requiring that they exceed some minimum benchmark before they will charge a performance fee. Soft hurdle: charge fees on entire return if hurdle rate is made Hard hurdle: charge fees on return above the hurdle rate Withdrawal fees: fees for removing funds early.
Strategies Style: global macro, directional, event-driven, relative value (arbitrage), managed futures Market: equity, fixed-income, commodity, currency, derivative Exposure: directional, market neutral Sector: emerging market, technology, healthcare, etc. Method: discretionary/qualitative (investments selected by manager), systematic/quantitative (investments selected according to numerical systems) ______________________________ ______________________________ Arbitrage
Arbitrage is the practice of taking advantage of a price differential between two or more markets: striking a combination of matching deals that capitalize upon the imbalance between the market prices. Arbitrage is often referred to as a risk-free profit. If market prices do not allow for profitable arbitrage, the prices are said to be in arbitrage equilibrium. Statistical arbitrage is an imbalance in expected nominal values. A casino has a statistical arbitrage in almost every game of chance that it offers - referred to as house edge or house advantage. Conditions One of three conditions must exist for an arbitrage opportunity to exist: o Two assets are priced differently on different markets (related to the law of one price). o Two assets with identical cash flows do not trade at the same price.
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o An asset with a known price does not trade at its discounted price. True arbitrage requires that there is no market risk involved. o True arbitrage involves buying on one market and selling on another simultaneously.
Examples Carry trade: borrowing at lower short-term rates and investing in higher long-term rates. Price of a stock and the its corresponding derivative are out of sync. Global labour arbitrage: the flow of manufacturing jobs to the lowest wage per output unit. ETF arbitrage: long discount ETFs (trading below NAV) and short premium ETFs. Other: hedge funds may use modified arbitrage strategies by exploiting price differences in non-identical assets and using derivatives (credit default swaps, currency swaps) to hedge the remaining risk.
Price Convergence Arbitrage causes prices of assets on different markets to converge. The speed of convergence is a measure of market efficiency. Arbitrage moves different currencies toward purchasing power parity. Risks Counter-party risk - in derivative transactions Minor price movement risk - small movements in prices (since deals do not closely at identical times) are a source of risk Types of Arbitrage Merger (risk) arbitrage: long an acquisition target, short the acquirer. The spread on the offer price and the market price is a function of the interest rate and the probability of the deal closing. Municipal bond arbitrage: simultaneously long and short municipal bonds with a durationneutral book (sensitivity to interest rates are equal). o Managers aim to capture the inefficiencies arising from the heavy participation of non-economic investors Convertible bond arbitrage: an arbitrageur would first buy a convertible bond, then sell fixed-income securities or interest rate futures (to hedge the interest rate exposure) and buy some credit protection (to hedge the risk of credit deterioration). Eventually, what he‟d be left with is something similar to a call option on the underlying stock, acquired at a very low price. He could then make money either selling some of the more expensive options that are openly traded in the market or delta hedge his exposure to the underlying shares. ______________________________ ______________________________ Convertible Arbitrage Convertible arbitrage is a market neutral investment strategy. It involves the simultaneous purchase of a convertible security and the short sale of the issuer‟s common stock. The ratio of the number of shares sold short to the number shares the convertible can secure typically reflects a delta neutral or market neutral position. ______________________________ Risk Arbitrage
There are two types of risk (or merger) arbitrage: o Cash merger: long the target‟s stock until the deal closes.
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Stock swap merger: long the target‟s stock and short the acquirer‟s stock until the spread between the target stock (times the exchange ratio) price equals the acquirer‟s stock price. This process is called setting a spread. Spreads exist (in both cash and stock swap deals) because a risk exists that the deal will not be consummated. This gives rise to the term risk arbitrage. ______________________________ ______________________________ Statistical Arbitrage o
Statistical arbitrage has two meanings: o In academic literature, statistical arbitrage refers to the process of buying (or short selling) investment instruments which trade below (or above) their expected value. For instance, in a coin flip where heads has a pay-out of $1 and tails has a loss of $0.50, the price of the instrument should be $0.25 ($1•50% + $0.50•50%). Any mis-pricing of this instrument can be rectified through statistical arbitrage. o In hedge funds, statistical arbitrage refers to a particular category of hedge funds which employ „highly technical short-term mean-reversion strategies involving large numbers of securities (hundreds to thousands), very short holding periods (days to seconds) and substantial computational, trading and IT infrastructure‟.
The Trading Strategy Statistical arbitrage refers to purchasing a portfolio of stocks (often hundreds) and matching long/short positions by market and industry to eliminate systematic and some non-systematic risk. Portfolio construction is a two-step process: Scoring process: each share is assigned a numeric score that reflects its desirability. The formulae used to assign these scores are based upon a mean reversion principle, meaning that stocks that have outperformed are likely to return to the norm (and should therefore be shorted) and vice versa. Matching and portfolio construction: individual shares are matched in precise proportions to eliminate (or greatly reduce) market and industry risk. Risks The risks involved in statistical arbitrage only theoretically cease when the number of securities held approaches infinity and the time horizon approaches infinity. Therefore, the strategy will always be subject to some risk. For instance, stock-specific risk (resulting, for example, M&A activity or default) will always exist. ______________________________ ______________________________ Volatility Arbitrage Volatility arbitrage is a type of statistical arbitrage that is implemented by trading a delta neutral portfolio of an option and its underlier. The objective is to take advantage of differences between the implied volatility of the option and a forecast of the future realized volatility of the option‟s underlier. The purchase of a options (calls or puts), so long as the portfolio is delta-neutral, is referred to as long volatility; the inverse is called short volatility. To conduct a volatility arbitrage, the trader must forecast the underlier‟s future realized volatility. The can be achieved by analyzing historical volatility and adjusting for upcoming events. ______________________________
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Derivatives ______________________________ Black-Scholes Model
The fundamental insight of Black-Scholes is that he option is implicitly priced if the stock is traded. The parameters of the model include the time to maturity, the strike, the risk-free rate and the current underlying price and the volatility. o All other things being equal, an option‟s theoretical value is a monotonic increasing function of implied volatility. The Black-Scholes model allows the construction of a volatility surface (volatility as a function of strike and maturity) by solving for volatility under differing prices. ______________________________ ______________________________ Put-Call Parity Put-call parity defines a relationship between the price of a call option and the price of a put option - both with identical strike price and expiry. Consider the following example to understand put-call parity: K represents the call‟s and put‟s strike price. S represents the value of the underlying share Portfolio 1 (P1) : 1 put option + 1 share If S > K, value of P1 = S If S < K, value of P1 = S + (K-S) = K Portfolio 2 (P2): 1 call option + K bonds (each with a value of 1) If S > K, value of P2 = S - K + K = S If S < K, value of P2 = K Therefore, regardless of S, both portfolios have the same value upon maturity. So, each portfolio must be priced equivalently (if they were not, arbitrageurs would close the spread). Hence, the put-call parity equation is: C(t) + K • B(t,T) = P(t) + S(t), C(t) is the value of the call at time t P(t) is the value of the put at time t S(t) is the value of the stock at time t K is the strike price B(t,T) is the value of a bond that matures at T. Implications Equivalence of calls and puts: parity implies that a call and a put can be used interchangeably in any delta-neutral portfolio. If d is the call‟s delta, then buying a call, and selling d shares of stock si the same as buying a put and buying 1-d shares of the stock. Parity of implied volatility: the implied volatility of calls and puts must be identical. Put-Call Parity and American Options
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c + PV(x) = p + s ______________________________ ______________________________ VIX VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options. A high value corresponds to a more volatile market and therefore more costly options, which can be used to defray risk from this volatility by selling options. Often referred to as the fear index, it represents one measure of the market's expectation of volatility over the next 30 day period. ______________________________
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III. Appendix 3 - Websites General News and Markets http://www.financialpost.com http://www.theglobeandmail.com/globe-investor http://www.theglobeandmail.com/report-on-business/ http://www.bloomberg.com http://online.wsj.com http://www.reuters.com/ http://www.google.com/finance Sector News http://www.smartmoney.com/map-of-the-market/ http://news.moneycentral.msn.com/category/industries.aspx http://www.baystreet.ca/quotedata/sector_indices.cfm Blogs http://ftalphaville.ft.com/ http://dealbook.blogs.nytimes.com/ http://abnormalreturns.com/ http://network.nationalpost.com/np/blogs/tradingdesk/default.aspx http://www.cliffkule.com/ http://www.psyfitec.com/ http://krugman.blogs.nytimes.com/ http://www.realclearmarkets.com/ http://www.leveragedsellout.com/ http://www.thedeal.com/ Economics http://www.td.com/economics/ http://www.bmonesbittburns.com/economics/ http://www.ny.frb.org/research/global_economy/globalindicators.html http://www.economist.com/markets/indicators/ http://www.scotiabank.com/cda/content/0,1608,CID8339_LIDen,00.html http://www.nbc.ca/bnc/cda/content/0,2662,divId-2_langId-1_navCode-9012,00.html https://www.cia.gov/library/publications/the-world-factbook/index.html Investment Ideas http://canadianinsider.com/ http://seekingalpha.com/ Market Commentary http://www.annaly.com/commentary.html http://www.hussmanfunds.com/weeklyMarketComment.html Other http://www.bankstocks.com/ http://knowledge.wharton.upenn.edu/ http://www.pimco.com/TopNav/Home/Default.htm
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III. Appendix 4 - Finance I&II Summary
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