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Tuesday, August 14, 2007

Citizen Murdoch

fragmentationIt is hard to look at the hard fought (and hard won) battle for Dow Jones with through the lens of any emotion other than shock and awe.  It is both a measure of how occupied I have been with all thing "work" lately and my psyche's need to process the news that the Bancrofts have finally been brought to bended knee in the face of News Corp's onslaught.  Most financial journalists I paid any attention to looked at the story as an "end of an era," piece, and focused on the storied history of the Bancroft family.  Few, I fear, looked deeper and beyond what passes for "human interest" pieces in financial journalism (dynastic worship) into the strategic messages for dealmakers.

I think any analysis of the long battle requires the tacit admission that the close of the transaction signaled the utter failure of dual class structuring in the traditional media business, one of few corporate finance environments where the arguments for rigid dual class structures in publicly held firms are even remotely valid.

If there ever was a nightmare that Dow Jones' elaborate dual class structure was designed to avert, it was certainly Murdoch's News Corp.  Many things can be said about Murdoch's reputation, except, perhaps, that he is well known in any large measure as a purveyor of high quality journalism.

Murdoch is exactly the sort of threat that elaborate control provisions were designed to frustrate.  A scale driven media strategy can only, of necessity, deliver content with a low news:entertainment ratio as it aims farther and farther to the left on the bell curve in search of consumers.  By extension, a scale driven media baron must seek to dumb down content, or, perhaps as will be the case with the Wall Street Journal, distill from the quality content of the Wall Street Journal highly filtered streams of "more accessible" content for wider distribution.  Unfortunately, the Wall Street Journal will have to endure the indignity of attribution when this content filters down through the weeds and moss before settling into the swamp of what has become "financial journalism."

Still, one cannot help but look askance at the Bancrofts and marvel that they somehow managed, despite their indomitable apathy as managers, to preserve a jewel of some luster over these many years.  The fact that the journalists of the Journal are among the lowest paid and still bear the weight of some of the highest expectations in the industry tends to color the discussion, however.  This highlights what I think is the first lesson in dual class structures:  They almost certainly promote managerial apathy to one degree or another.  One cannot decouple the pressures of financial accountability from the management oversight process (the very explicit and stated purposes of most media dual class structures, including that of Dow Jones) and expect no long-term governance effect.  To wit: on the eve of deadlines, Crawford Hill, one of the Bancroft cousins and an evolutionary biologist by education, penned a letter to the disparate clan which mused in part:

I spent a good amount of time at The Oaks during college summers and thereafter and Suzie and I spent 3 lovely spring breaks with her down in Sarasota before she passed away. Aunt Jane graciously invited us down the following three spring breaks and we had wonderful times with Gay's sister then. Furthermore, it was I who jumped into the back seat of the limo that we grabbed to rush Gay to Lenox Hill Hospital after her renowned collapse at the family dinner at "21" [Manhattan's 21 Club] in April of 1982. In that back seat, next to Uncle Bill, I attempted CPR on her, but sadly, it was too late and she had taken her last breath.

Nearly half of the 3900 word letter could fairly be characterized as of this general tenor.  Step back for a moment and consider this in the context of a governance dialog among controlling shareholders.  What is even more remarkable, perhaps, is the fact that Crawford himself recognizes the deficiency even as he drones on about the last family reunion.  Specifically, where he continues:

There is nothing new about having to be responsible, active and engaged owners. We, despite the attempts of a few, have not until very, very recently acted as successful owners do. We are actually now paying the price for our passivity over the past 25 years. This is not something that happened overnight and in the context of history and circumstances it is very understandable if sad that the company that we own is now in the position that it is in. We have, as Buffett himself pointed out, not acted like we owned the company. Well, we had no legacy as to what in fact that meant. And in the absence of that legacy it certainly did not evolve independently by those in a position to make that happen.

Of course, Dow Jones, and by extension the Wall Street Journal (or is it the reverse?) is a huge "vanity capital" buy for Murdoch.  As close students of vanity capital, well versed Going Private readers will naturally be interested to see what lessons the Chicago Cubs have to teach us about the sorts of premiums that one can expect for vanity capital investments.  It would be interesting to examine the price elasticity of vanity brands in relation to capital markets performance in the several quarters before a purchase.  Is it possible that what I will now coin as the "vanity spread" (the spread between intrinsic value + reasonable control premium and actual purchase price) widens after extensive bull markets?

Though Murdoch paid a 67% control premium, it is still interesting to speculate that a good measure of his success was a consequence of the intense and extensive fragmentation of the Bancroft family.  From this perspective, it actually wasn't much of a fight.  Murdoch saved himself a lot of time, expense and headache by merely jumping to a borderline absurd premium and allowing the complete lack of cohesiveness of the Bancroft clan, its branches and cousins pull the resistance apart with the brute centrifugal force of its chaos.

While dual class structures have reliably preserved the artificial power of families in the media business for generations, each generation along with the many skip-generation trusts, bequeaths and distributions causes the wide proliferation of the economic and governance interests in the underlying asset to a population experiencing non-linear growth.  Doubtless, the rule against perpetuities, among other nuances of tax and estate planning law, contributes to the power dilution.  Before too long the population of even the super-voting class begins to look like a public market.  It would be interesting to speculate what a control premium in similar economic circumstances but .5 of a Bancroft generation half-life later would look like.

Take note of generational effects in closely held acquisitions, dear LBO demand generation folk.  They matter.

I have seen the effect even in closely held acquisitions by Sub Rosa.  Patriarch builds the business up over 30 years, keeping 85% of the shares in the family but his two sons, for whom he has been saving the shares, are far more interested in becoming, respectively, a world class poker player and a jazz musician than taking over the family business.  The control premium for such an acquisition is held in orbit by the centripetal force of shareholder entropy.

I suppose this leaves us with:

"On a long enough timeline the survival rate for everyone drops to zero."

- Chuck Palahniuk, "Fight Club," 1996.

"On a long enough timeline all science becomes falsehood."

- Robert Falnear, c. 2003.

"On a long enough timeline the effectiveness of any dynastic control mechanism drops to zero."

- Equity Private's Law of Dynastic Deterioration

Friday, August 31, 2007

Liquid Reflections

liquid dreams Much has been made of the value of liquidity in the marketplace and its role in preventing the kind of melt-downs that, hitherto, have caused anything from fifteen-standard deviation volatility to recessions to the election of William Jefferson Clinton (depending on who you ask).  Dot-comesque analogies ("it's different this time," "the market dynamic is changed," "new paradigms," "the old rules don't apply") are, however, the first symptom of overreaching by the more optimistic among us and the one that causes astute Going Private readers to start looking for clever and leverageable shorting opportunities.  The simplistic view is easy enough to articulate that you can use a single operator sign.  Liquidity = Good.  Rationally skeptical Going Private readers (a redundant description) recoil at such simplistic formulae.  Could there not, they might ask, be a dark side to liquidity?

I think, as we overlay the question of liquidity on top of the current credit landscape (and for selfish reasons I have a particular interest in the corporate debt/commercial paper side), it might be helpful to trace the impact of liquidity and other structural issues on debt instruments in each step down (and up) stream from demand to supply to securitization.

In this connection, a series of articles have come to my attention that shed some light.  One of the things that frustrates me about "financial journalism" is that these kinds of structural analysis are few and far between.  They require deeper and more fundamental thought, and a certain disciplined approach that, even if a member of the press mustered the motivation, is possessed of a vanishingly small audience.  (c.f. Vipal Monga over at The Deal who should be on every Going Private reader's "must read" list).  Accordingly, such inquiries often require the assimilation of a number of disparate sources into a larger whole.  In this case, the result will initially resemble a large linkfest, a style of posting I generally have an aversion to (c.f. Abnormal Returns).  Patience, dear readers.  Patience.

I trust that a discussion outlining the basic demand and the structural incentives for the first layer of debt (be it a home mortgage or corporate debt to finance an LBO) need not occupy much space in these pages.  Going Private readers will be intimately familiar with the effect of cheap cash and debt on these demand curves.  They should also recognize that liquidity in such quantities necessarily has the effect of reducing the returns (quality) required of a transaction in order to trigger a decision to invest.  Lower costs of capital result in pulling the trigger on deals with lower returns.

A flood of liquidity into such deals removes the "low hanging fruit" and reduces the universe of profitable opportunities.  Further, the delay in return reporting (reports of LBO returns significantly lag the last investment cycle due to the "J curve" effect of LBO investment) may cause liquidity in LBO spaces (or elsewhere) to surge just when opportunities are becoming scarce.  The result may be an imbalance between liquidity (the willing supply of cheap debt, pressed into service by the demand for the debt returns by issuers) and the actual availability of quality deals.  Going Private readers will recognize that the pressure to "place debt" on the part of LBO sponsors will drive more and more creative (foolish) investment theories as firms struggle to deploy cheap credit into dwindling opportunity pools.

What might bear examining more closely is the next level, the incentives for banks to shift that debt off their own books.  For this. The Wall Street Journal's David Wessel points out:

One culprit, however, has gone unnoticed: A sweeping change in international rules governing the capital banks must hold. By requiring banks to boost the capital held in reserve against the loans carried on their books, the rules encouraged banks to get rid of those loans by turning them into securities to be sold to investors. Banks took the hint.

Via the always yummy Abnormal Returns last week, we were pointed to this piece from The Big Picture, outlining a reader's take on the irrational (or insidiously rational) behavior by CDOs.  Specifically:

I was talking to CDO managers in mid-'05 that were saying how rich sub-prime MBS was and how wrong everyone was for buying that stuff at the spreads they were. To a man, they all agreed they were paying too much for the risk, they all believed that [home price appreciation] was going negative soon. But, sadly, they had to buy the stuff because they needed to accumulate collateral for their CDO issuance. Fuck, we all knew we were overpaying, even back in 2005. We knew it was essentially a bet that home price appreciation was going to continue at levels that couldn't be sustained. No way that could keep going on.

So what was the prime motivating factor?

The answer is quite simple: DEAL FEES. I gotta keep buying collateral, in order to keep issuing these transactions as a CDO manager. Its my job: I gotta keep accumulating collateral, and I gotta issue the liability against that collateral.

This is an interesting "down-stream" bit of color from a moral hazard issue in loan origination that I reflected on back in March.  Specifically:

The Going Private reader, being well versed in such matters, will recognize this as a "moral hazard" problem.  As a Vice President, why not write the big loan today that will likely blow up in 48 months? Bonus time is only 9 months away, after all.  Absent a claw-back provision for such bonuses, why worry?  And, taking it a step further, if you are the managing director of a bank filled with Vice Presidents writing loans that may well blow up in 48 months, why not sell them to a CLO?  (A nicely done, albeit slightly old, primer on CLOs of exactly the sort that will intrigue the Going Private reader and written by Andreas Jobst can be found here and is recommended).

I will bore long-time Going Private readers via redundancy by pointing out that the essence of moral hazard problems is a disconnect between information and compensation or incentive structures, of the kind that will cause Going Private readers to cringe when non-risked based insurance premiums are proposed.  (For this reason, Going Private readers have a particular distaste for FDIC-like programs, which were not effectively risk based- i.e. were willfully on the wrong side of asymmetric information imbalances- until recently).  A particularly relevant problem for our purposes is directly related to moral hazard: the "principal-agent" problem, also related to information asymmetry.  In this case, the agent is acting on behalf of the principal, but the principal lacks information about the agent's intentions or interests.  In the absence of careful monitoring or a mechanism to align the agent's incentives (or disincentives) with the principal's interests, trouble brews.

The Alea blog then delivers two interesting, and seemingly unrelated, articles pointing to academic papers that round off the discussion.  First, they tackle the question "Why Are Securitizations Issues Tranched?" resulting in this, interesting conclusion:

Finally, we investigate the effect of tranching on the pricing of issues at launch. We find evidence that tranching might be successful in remedying problems of market segmentation. For those issues where our model predicts a higher optimal number of tranches, we find that additional uniquely-rated tranches are associated with higher prices for the issue as a whole. This suggests that structuring is allowing issuers to exploit market factors – such as greater investor sophistication and heterogeneous screening skills related to asymmetric information – to their advantage via tranching.

Not to be left behind in the liquidity discussion, they then provide us with "Asset Pricing in Markets with Illiquid Assets," presenting a conclusion that both will and won't surprise Going Private readers:

Illiquidity has a dramatic effect on optimal portfolio decisions. Agents abandon diversification as a strategy and choose highly polarized portfolios instead. The value of liquidity can represent a large portion of the equilibrium price of an asset.  We present examples in which a liquid asset can be worth up to 25 percent more than an illiquid asset even though both have identical cash flow dynamics. We also show that the expected return and volatility of an asset can change significantly as the asset becomes relatively more liquid.

Then, today, Abnormal Returns points us to Accrued Interest (a sometime Going Private favorite) which observes:

Every bond portfolio is marked to model. Every mutual fund. Every UIT. Every brokerage account. Every portfolio manager. Every pension. Every hedge fund. Every bond portfolio in the whole damn world is marked to model.

The article goes on to say:

  • There are 152,732 different US dollar denominated corporate bonds outstanding as of today, according to Bloomberg.
  • Between Fannie Mae, Freddie Mac, Federal Farm Credit Bank, and Federal Home Loan Bank, there are 21,989 different issues outstanding.
  • There are 1,269,428 different municipal bond issues outstanding.

How many of those trade on a given day? A very small percentage. According to TRACE, which is a system for tracking corporate bond trading, about 4,300 TRACE eligible corporate issues trade each day. That's less than 3% of the total corporate universe. I note that trading activity in non-TRACE eligible bonds is not publicly reported. According to the MSRB, about 14,900 municipal bonds trade each day, or just over 1% of the universe.

Completing the Abnormal Returns link trifecta, the same, and still yummy, Abnormal Returns piece suggests we might find a piece by TheStreet.com on the annoying and more recent tendency of gold to be correlated to stocks, and therefore to also be more and more useless as a diversification tool or a safety net.  Says TheStreet:

After all, the more people there are who believe gold will rise when stocks fall, the more the price of gold is likely to be bid up ahead of a selloff in stocks.

I think this attributes a bit more predictive skill to the general market than it historically exhibits, (perhaps I err in using TheStreet as a reference given the oft poor analysis) but the observational data holds (whatever the analysis in front of it).

What does this mean for the structure of the credit markets?  Extremely low credit spreads make a "debt-equity" arbitrage opportunity compelling.  Using cheap cash / debt to finance the purchase of equity (particularly the highly liquid equity in publicly traded firms) should be a no-brainer given the spreads.  There is also the effect of differing attitudes towards debt in the public and private markets.  I discussed this subject back in June.  Add to this an illiquidity arbitrage opportunity and demand for LBO debt (indeed any debt) soars.  What, you might ask, is illiquidity arbitrage?  For this we turn back to
Asset Pricing in Markets with Illiquid Assets:

Finally, these results illustrate that differences in patience across investors can have major asset-pricing effects. Thus, heterogeneity in patience may provide an important (but underresearched) channel for understanding financial markets and resolving asset-pricing puzzles. Furthermore, differences in patience may map well into the familiar notions of short-horizon financial institutions and longer-horizon investors often found in the literature.

We can also see from this paper that:

As might be expected, illiquidity generally has the effect of making the liquid asset more valuable, and the illiquid asset less valuable, relative to what prices would be in the fully-liquid case. Surprisingly, however, the opposite can be true. This situation occurs primarily when the impatient agent’s incentive to hold the liquid asset conflicts with his incentive to hold the riskier asset.

If it is true that the public markets are short-term thinkers, it is also true that they seem happy to be such.  Liquidity, it seems, may be overpriced.  Patient agents are taking advantage.  The impatient agent's incentive to hold a liquid asset may conflict with an incentive to hold the riskier asset, no?

And so, seeing a demand to fill, banks issue debt.  Quite a lot.  But, dear friends, this presents them with David Wessel's quandary.  They must hold larger reserves as they take debt on their books.  Fortunately, they have a mechanism to shift the liabilities off their books effectively.  No, no, not special purpose entities, that's so last year.  Securitization.

Moreover, avoiding reserve requirements, while one piece of the puzzle, is not the only one.  Moving what could be termed "regulatory overcharged" assets (those assets that count, for instance, towards capital reserve requirements, or have other impacts on the bank's regulatory risk profile- as distinguished from the market's view of the riskiness of the assets) into tradeable securities permits institutions to arbitrage the difference between regulatory risk measures (which tend to be more conservative) with market risk measures of the same securities.  Consider also that to the extent banks can reduce the debt on their books, they can reduce their provisions for bad debt and thereby reduce quite directly their cost of capital.

Cdo Collateralized Debt Obligations are one of several "asset backed securities" that, as the Going Private reader is surely aware, have seen tremendous growth in the last many years.  In essence, a separate entity acquires various debt pieces, bundles them and then issues tradeable securities in various tranches to investors.  Astute Going Private readers will recognize this passage from Jobst:

The issued securities are structured in so-called senioritized credit tranches....  The tranching can be done by means of various structural provisions governing the participation of investors in the proceeds and losses stemming from the collateral.  Subparticipation is one of the most convenient vehicles for attaching different levels of seniority to categories of issued securities, so that the losses are allocated to the lowest subordinated tranches before the mezzanine and the senior tranches are considered.  This process of filling up the tranches with periodic losses bottom-up results in a cascading effect, which conversely applies in the distribution of payments from collateral by the issuer.  Both interest and losses are allotted according to investor seniority.  Thus, the prioritization of claims and losses from the reference portfolio guarantee that senior tranches carry a high investment-grade rating (triple-A or double-A rating), provided sufficient volume of junior tranches have been issued to shield more senior tranches from credit losses.

To guard against the potential for ex ante moral hazard (i.e. that the CDO issuer would attempt to avoid monitoring costs, etc.) CDO issuers generally hold the riskiest tranch, the equity layer.

A critical part of understanding CDO structures, and the incentives that motivate the selection of assets in the reference portfolio that defines the assets base of the collateral, is the need to blend debt instruments with varied risk/return profiles.  Going Private readers will recognize in this the advantage of blending low-risk assets with risky assets to develop a portfolio that sits near the most advantageous part of a risk/return frontier.  The importance here?  The acquisition of risky debt instruments is essential to CDO portfolio and therefore CDO issuance.  AAA rated debt must be mixed in with riskier instruments.  The larger the demand for CDO instruments in general the larger the demand for the riskier (but higher return) debt- irrespective of the quality of the debt.  A large amount of liquidity pouring into the CDO space can "artificially" press up the prices of this debt as portfolio models force CDO managers to buy more and more collateral at this level.  As the prices of the lower rated debt rise due to the increase in demand, CDO managers have to bring aboard even riskier debt to continue to enjoy the returns demanded by their investors.  The net result?  A slow but certain increase in risk of the collateral underlying CDO instruments.

Turning back upstream for a moment, demand for risky debt necessarily places incentives on originators to create more of it.  Hence our Big Picture CDO insider's comment:

To a man, they all agreed they were paying too much for the risk, they all believed that [home price appreciation] was going negative soon. But, sadly, they had to buy the stuff because they needed to accumulate collateral for their CDO issuance.

And let us delve deeper into the internal structure of CDO firms.  It seems clear that with this kind of liquidity, incentives for CDO firms quickly become to transform themselves into "placement agents."  They are more in the business of minting CDO instruments to collect fees rather than acting as investment managers.  Compensation schemes reinforce this basic goal (placement).  Bonuses are typically tied to overall fees or the ability to place/issue more instruments (regardless of quality).  As with many incentive structures in more "liquid" investment management roles (hedge funds, CDO managers, etc.) these are poorly aligned with the long-term performance of the portfolios.  The incentive for the CDO manager is divorced from the interests of the CDO's investors.

Attach to this the reversal of the usual preference for liquidity (in the face of the need to hold the risky asset for portfolio purposes) and you have an artificially inflated market for illiquid assets.  This brings full-circle the observation in the Illiquid Asset paper, that liquidity, in excess, can create a flight to what are typically illiquid assets and that the price (value) of assets can be divorced entirely from their cash-flow properties.

There is a third order effect here as well.  The prices of these illiquid assets are inflated, they look more liquid than they are and they have the effect of boosting the value of collateral portfolios that "mark-to-market" as the traded prices (or their acquisition costs) are integrated into the books of CDO portfolios.  And when the liquidity of these instruments dries up?  Their "value" on the books is frozen at the high point by the lack of active trading in the instruments.  As our Accrued Interest author hints at, almost none of these instruments are liquid except by "accident," and how do you "mark-to-market" an asset that hasn't traded in months, or at all since you acquired it?

Worse, the liquidity that pours universally into these instruments (both the risky and less risky debt instruments) from the same sources for the same purpose has the effect of correlating them "artificially."  The effect on portfolio diversification (even within a given CDO reference portfolio) is predictable.  This looks very much like the recent effect on gold.  If enough people seek diversification and efficient frontier advantages via investment in the same risky/non-risky asset baskets, the diversification (and efficient frontier) effect is lost as the assets become more and more correlated.  This effect, unfortunately, only reveals itself when the correlation is most needed.  Clever that.

What are the lessons for the Going Private reader?  The combination of unaligned incentives (both on the intra-institutional and inter-institutional level), overheated first order liquidity (cheap cash), fickle second order liquidity (as distinguished from true liquidity), and a time lag between liquidity supply and performance feedback for that liquidity, should present strong, structural arguments that, when carefully examined, result in legions of smug looking Going Private readers sunning themselves while floating on liquid(ity) in their new yachts.

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