Their Goals and Their Strategies

The landscape of potential buyers in M&A is multifaceted and diverse, but most buyers tend to fall into four separate categories. Identifying these general groups is helpful to the seller and its agents because it provides guidance to the overall intention and motivation of the buyer, their timing, and their way to negotiate and transact. Although with overlaps and uncertain boundaries, invariably most organizations who are interested in acquisitions fall into one of the following categories:

·         Strategic Buyers

·         Financial Buyers

·         Value Investors

·         Lookie Loos

Strategic Buyers

Strategic buyers come in different flavors, but normally they are corporations, private or public, in search of vertical or horizontal acquisitions.^[1] When faced with the option of returning profits to shareholders in the form of dividends or share buy backs, strategic buyers can be interested in diversifying from their core business. These acquisitions are said to be part of their “corporate strategy.” Johnson & Johnson pursued this strategy quite successfully during the 90’s in its early acquisitions of medical-device businesses such as Cordis and DePuy. Another example is the success story of a small company with 60 employees and approximately $3 million in revenue that was acquired by Best Buy in 2002: Geek Squad. Since then, Geek Squad has become the largest tech-support operation in the world with annual revenues in excess of $1 billion.

When strategic buyers are just seeking to gain additional market share or expand existing services or product lines within the same industry, they pursue acquisitions as part of their “business strategy.” The advantage is that the buyer can use its own valuation assessment in terms of the price of the target because it is familiar with the specific sector and its industry metrics. This makes it easier to justify the acquisition to its internal audience (i.e. board of directors) and / or its external one (i.e. investors and Wall Street analysts). Other advantages include less effort in the due diligence process and smaller integration risk because the buyer and the seller speak the same lingo in terms of technology, target markets and operations.

Ultimately, the typical strategic buyer is interested in buying out the competition to eliminate it from the market (and reduce pressure on prices), take advantage of new distribution channels / geographic markets or leverage fixed costs such as marketing and advertising expenses. Due to the synergistic potential between a strategic buyer and its target, valuations typically tend to be more generous than from other types of buyers. However, strategic buyers aren’t always available. When certain industries, for whatever reason, fall out of favor (i.e. the industry is consolidated or growth opportunities are lacking), strategic buyers may be reluctant to entertain acquisitions.^[2] This puts potential sellers at a disadvantage and they may have a hard time matching up with the “logical buyer.” If strategic buyers are not willing to transact, the seller may become target of either financial buyers or value investors.

If large enough, strategic buyers may have the ability to finance their acquisitions internally without needing financial institutions. Regardless of the financing, it’s worth noting that the strategic-buyer process can be lengthy because of internal procedures and bureaucracies, or even inexperience in the M&A arena.

Financial Buyers

Typically these buyers comprise private equity firms or conglomerates that look for acquisitions that can be highly leveraged and require only small portions of equity investments. These takeovers are commonly referred to as LBOs (leveraged buyouts). The returns to the equity investors increase as the value of the investment grows and target ROIs^[3] typically range between 20 percent and 35 percent. Companies with steady cash flows and / or that are capital intensive are the ideal candidate because the acquisition can be easily financed with borrowed funds.^[4] This strategy is favored during periods of rapid growth, which allows for painless repayment of the borrowed funds and easy availability of credit. Starting in 2004 and through the heights of late 2007, these investors were particularly active and accounted for approximately 32% of the total middle-market M&A activity in the U.S.^[5] It was not unusual during this period for a financial sponsors to contribute only 10 percent of the acquisition cost, while the remaining 90 percent was financed through commercial banks at relatively cheap interest rates.

Since 2008, due to the economic downturn and widespread bankruptcies among many lenders of choice, financial buyers are less active and their equity investments normally account for a larger portion of the purchase price (e.g. 30% to 60%).^[6] The reliance and eventual abuse of over-leveraging was behind the 2009 bankruptcy of CIT Group, a former major lender to mid-market private equity firms.

Financial buyers and value investors may overlap. However, if a financial buyer is seeking “bolt-on” acquisitions for its existing “platform investment,” it is likely to behave like a strategic buyer and offer more enticing valuations to potential sellers. Normally, the investment horizon for financial buyers is between three to seven years; however, exceptions are increasingly more common. At the end of the investment period, which coincides with the repayment of the outstanding debt, the company is sold to new investors or goes through an IPO. Overall, debt brings discipline and requires attentive managerial action and sobriety in business decisions. The incentive of high returns, the absence of a clunky bureaucracies that are typical of public corporations and the freedom to focus on long term results rather than short term goals, have transformed some of these ventures into very successful money making opportunities. One recent example is Fleetgistics, a company created by Atlantic Street Capital though a series of acquisitions to build an expanded same-day logistics company. In 2010, Atlantic Street Capital sold Fleetgistics, and received an internal rate of return on the equity investment of more than 150 percent.

The financial buyer is generally well suited for a seller who is interested in staying with the company for the investment horizon and retain some equity (rollover equity). Furthermore, this type of buyer tends to act quickly when it identifies a suitable target, but has the challenge of having to persuade a lender to contribute a large portion of the purchase price.

Value Investors

Value investors, also sometimes referred to as “bottom feeders” (and often dismissed as such by intermediaries), scout the M&A landscape constantly in search of cheap acquisition opportunities. Companies in distress or operating at a loss attract their interest easily. In their relentless quest to locate turn-around assets, the value investor justifies low EBIT or EBITDA multiples based on real or “alleged” problems with the business or issues related with the transition of the business to new ownership. These buyers are more likely to lower their offers during the due diligence process when the initial assumptions are not fully corroborated by their further investigations. 

Value investors are willing to take on more operating risk only if they can lower their financial risk. This is accomplished through active management, with the goal of streamlining operations and cost cutting to increase the bottom line and cash flow generation. Examples of ‘hands on’ value-investor management tactics include employee reduction, austerity policies that lead to cost saving opportunities, and disposal of non-critical/core assets. Because of uncertainty about the turnaround outcome and the high level of management involvement, public corporations are normally not involved since they prefer predictable, steady earnings.

The value investor might have a preference for significant debt financing to partially transfer risk to the lender, however, depending on market conditions, debt financing might not be available and this can limit the activity. Value investing is more commonly practiced by private companies and financial sponsors that have a specific taste for distressed situations and operating risk.

Lookie Loos

Lookie loos - also known as window shoppers - can be found in each of the previous categories; however traditionally their motives and modus operandi are very specific and they deserve a separate category. As the name suggests, lookie loos like to look, but have no intention of buying. In M&A, these types of buyers often are eager to receive details about an acquisition opportunity, but rarely engage in active discussions and are even less likely actually purchase a business.

Lookie loos review dozens of acquisition opportunities throughout the year. Although they do not use the information directly (they are forbidden to do so by singing a non-disclosure agreement), they study companies’ financial performance and can use the data “indirectly” in their own corporate strategic planning. Having information about margins, for example, can be used for their own pricing and marketing strategies.

Although available in all sizes, lookie loos are often large corporations with respected brands. They often have no difficulty convincing sellers of their genuine interest in a specific M&A opportunity. It is not unusual that one or two junior in-house corporate finance professionals spend a significant amount of time with intermediaries to obtain detailed information about targets. Every once in a while, when there is a perfect opportunity that is too good to pass up; and only then, these buyers might take action. From the seller point of view, it is a good idea to have an agent that can prequalify potential buyers and screen out window shoppers early on the in the process.

The foregoing categories demonstrate that different buyers have their own motives, value drivers, negotiation styles and, inevitably, see the M&A arena through specific lenses. Although, many market participants cannot always be so easily grouped, this generalization can prove itself useful during the marketing process and provide the seller and its intermediaries with clues about buyers intentions and potential outcomes. Even when market conditions are rapidly evolving, it is always helpful to refer to the archetypal types of buyers as it facilitates to understand how market participants might adapt dynamically to different situations and external shocks.

Plutus 

[1] See our article “Buyers Acquisition Strategies, What Buyers Want and How They Pursue it.”

[2] Sectors that have recently faced these challenges include automotive, IT and pulp and paper among others. As these industries have become more mature, growth prospects have softened and they have undergone several waves of consolidation.

[3] Return on investment.

[4] Fixed assets can be used as collateral. The leverage potential changes based on the specifics of a business and depending on market conditions, but according to a general rule of thumb, it is possible to borrow 80% of the value of inventory and accounts receivable and 50% of the value of properties and machinery & equipment.

[5] Robert W. Baird & Co.: M&A Market Analysis, November 2010.

[6] In 2010, approximately 25% of the total middle market transactions in the U.S. were consummated by financial sponsors.

[1] See our article “Buyers Acquisition Strategies, What Buyers Want and How They Pursue it.”

[2] Sectors that have recently faced these challenges include automotive, IT and pulp and paper among others. As these industries have become more mature, growth prospects have softened and they have undergone several waves of consolidation.

[3] Return on investment.

[4] Fixed assets can be used as collateral. The leverage potential changes based on the specifics of a business and depending on market conditions, but according to a general rule of thumb, it is possible to borrow 80% of the value of inventory and accounts receivable and 50% of the value of properties and machinery & equipment.

[5] Robert W. Baird & Co.: M&A Market Analysis, November 2010.

[6] In 2010, approximately 25% of the total middle market transactions in the U.S. were consummated by financial sponsors.

The recent news from Europe is rather dismal. Maybe too much. Is this a concerted attack to Italy, to the Eurozone? Are things being lost in translation? Bad faith? That the Brits do not like the Eurozone is well renown, after all they are not part of it; in the U.S. in the Obama administration is desperately trying to divert the attention from the catastrophic failure of its fiscal and monetary policy, and its inability to put the economy in motion again. This is understandable. And yet the hatful insistence with which Anglo-American media are reporting the alleged peril represented by the Italian economy to the survival of the Eurozone is striking for those who have a firsthand understanding of what is actually happening in Italy. Rumors are being spread with disregard of the truth to a level we have seen only rarely and in special occasions during the last one hundred years.

Surprised? Not really; we do abide by the notion that human beings will use all the rationality at their disposal to maximize their utility, and they will do so even by jumping on the bandwagon of platitudes, rumors, anecdotes and lies. This is even more tempting when there is a fertile soil where those half-truths can live and prosper. What’s new and disturbing then? New is the fact that markets believe it! New is that the ‘wisdom of crowds’ has stopped working in that enchanting way that characterizes only capital markets which always prevail over the democratic processes at any point in history; because something more important, more precious, more sacred is at stake: money. This is what’s new, utterly shocking and unreservedly disturbing. Markets should know better.

We wonder whether this is the result of informational inefficiencies of some sort. Lost in translation? After all, markets have to get the news from somewhere. Especially in the case of Italy, we notice news coming out of major newspapers published in English or heard on the radio where evidently the reporters don’t fully understand the dynamics of the Italian political system, the role of the “President del Consiglio” or how a parliamentary system actually works. If the coalition of central-right cannot push the reforms needed by the country to bolster its economy, will the coalition of central left that could potentially replace Mr. Berlusocni implement them? Most certainly not, as the private sector would have very little to rejoice once socialists and even neo-communists will have a saying on economic matters.

In the end, we acknowledge that despite the underlying economics, a crisis created ad hoc could unravel because of intellectual dishonesty and ignorance of the Italian language and culture. Nonetheless, we have to bow in front of the predictive power of behavioral finance: no matter how strong the fundamentals of the Italian economy are (compared at least to those of other European and North American economies) the crises in Italy / Eurozone could materialize simply because of ‘heuristics’ - a more polite term than what we truly had in mind. Adios rational markets? It is hard to accept. Indeed, we are a bit old fashion because we believe that if it is true that “the love of money is the root of all evil,” it is also true that lack of money typically leads to an even worse state of affairs. Time to buy that Italian debt then.

Plutus

What Buyers Want and How they Pursue It

It is well understood that knowing your customers is the key to a successful product or service. Selling a business is no different. In fact, the first step in maximizing value is understanding what the buyer wants and needs, and how your company fits into the value chain of the buyer’s operations. But how do you get inside the buyer’s head? It’s helpful to remember that most of the time, long before a buyer approaches a potential target, there is a goal and a strategy about how to achieve that goal. While it may be next to impossible to get a buyer to fully disclose its ultimate objectives, an understanding of the focal strategies used in M&A can provide precious guidance. Used by corporations so well as by private equity firms, these strategies can be summarized as follows:

·         Horizontal integration;

·         Vertical integration;

·         Conglomerate integration (also called diagonal integration).

Historically, these strategies, often applied in their pure form, have contributed to the formation of major corporations and reshaped entire sectors of the U.S. economy. Today, these fundamental strategies are more likely implemented in various combinations both by strategic acquirers or financial sponsors and result in the acquisition of big and small organizations alike. A good understanding of their underpinning can prove instrumental in interpreting the economic inventive and value drivers sought by the buyer.

Horizontal Integration

A horizontal integration strategy seeks to combine businesses that operate in the same sector, in the same type of business or in the same stage of production. Some of the big name companies that successfully used horizontal integration in the past are Kodak, Standard Oil and DuPont. This type of integration helps organizations gain a larger share of the market and also eliminates competitors. However, the real advantage often lies in the ability to control prices and have access to new geographic markets. Other benefits include economies of scale and economies of scope. Economies of scale decrease the average cost per unit due to a larger scale of production of a single product so that the fixed costs can now be spread out to a larger number of units. For economies of scope, the average unit cost is lowered by sharing certain resources in the production, marketing or distribution of similar or complementary products. For instance, it is possible to sell different products by using the same sales force through the same distribution channels. The same know-how and technology used, for example, to produce PC monitors can also be used to make televisions. A good example of a company that more recently used this strategy to gain market share and build critical mass is Protection One, Inc. a leading home security companies in the U.S.  During the 1990’s, Protection One, grew rapidly through bolt-on acquisitions of small privately held companies and even the purchase of customer accounts.[1]

Vertical Integration

Vertical integration entails the combination of companies that operate in different stages of production. A typical example is offered by the oil and gas industry where exploration, production, refining and retail can be performed in principle by separate organizations that are not under a single, controlling ownership structure. Interestingly, most of the large public utility companies in the U.S. were created during the vertical integration wave between 1925 and 1929. The benefit to the buyers in this case may vary, but usually it centers on the advantage of having control over the target company. Some of the value-creation opportunities include:

-          Tighter quality control;

-          Elimination of transportation costs, since different stages of production can be combined in the same location;

-          More efficient information flow and coordination of product planning, research and development or inventory management;

-          Lower monitoring and transaction costs throughout the production process. These may include lower contracting, “haggling,” collection and negotiation costs;

-          Lower business to business advertising costs, since the intermediary stages can be eliminated.

Typically, owning a supplier or a customer is considered to be a great way to add flexibility for the firm. This can prevent pressure on margins in the presence of challenging market conditions and even avoid distress during major economic downturns. Overall, the primary driver of vertical integration stems from the elimination of costly market exchanges and contracting activities among participants in the network of the supply chain. A good example of recent wave of vertical consolidation in North America is provided by the farming and food packaged industry. Today most food is produced not by family farmers but by a few of giant agribusinesses that have little resemblance to the traditional family farm. Consolidation was achieved through the acquisition of many small farms / companies that originally focused on a variety of different activities from breeding hens and hatcheries to operating feed mills and processing plants, and packaging and distribution.

Conglomerate Integration

Conglomerate acquisitions bring together various companies engaged in different and unrelated business activities. Typically, a conglomerate controls operations in different sectors, which require completely different skills in very specific functions (i.e. engineering, production, marketing, etc.). At first glance, no immediate synergistic advantages or other benefits to the acquirer would surface from such strategy, but a closer look reveals the opposite. Conglomerate integrations fall into two primary sub-categories and each can be extremely successful: 

-          Managerial conglomerates - For these types of companies, the idea is that the managerial functions performed at the top of the organization are general enough that they can be transferred and applied to a variety of companies in different industries. General Electric Corporation, with its diversified business units and its ability to apply value-enhancing management techniques to newly acquired companies, is perhaps the typical example of a managerial conglomerate.[2] It is usually more challenging to identify the potential economic advantages of a specific transaction when dealing with managerial conglomerates because much of that benefit is related to the talent of the buyer’s management team and the level of indivisibility of the managerial effort.[3] In these types of transactions, the value of control, rather than the value of synergies, most likely represents the premium paid by the buyer.[4]

-          Financial Conglomerates – This term is used rather loosely, but essentially, financial conglomerates derive their appeal from their ability to establish discipline in the financial aspects of the corporation. Management engages in financial planning and analysis with the goal of lowering the cost of capital[5] and increasing the cash flow of the companies under its control. Normally, actions to achieve such objectives include, among others, asset redeployment,[6] tax burden reduction through relocation of certain operations in lower-tax jurisdictions, reduction of working capital, financial leverage[7] and the optimization of operating leverage.[8]  

The traditional targets of conglomerates used to be larger and more diversified. Today, that the creativity of hundreds if not thousands of financial sponsors that acquire companies through Leveraged Buy-Outs have proven that also low middle market companies could become part of this acquisition strategy. Most financial sponsors often operate a very diverse portfolio of companies which allows them to extract financial efficiencies and leverage the expertise of the management team among different types of operations.

While the main strategies are quite straightforward and can be easy to identify, a live transaction is often characterized by various motives with the possibility of virtually infinite combinations. The primary goal of diversification, or financial synergies, might have secondary objectives such as achieving faster growth, tax savings, cost reduction, “cash slack” opportunities, etc.

Also, and maybe quite surprisingly, buyers often get caught up in M&A trends that influence their preference and behavior. Economic climates, market conditions and paradigm shifts created by a few large transactions in the market can change how buyers view M&A opportunities and strategy implementation. For example, easy access to credit can encourage financial buyers to pursue new transactions despite the low level of attractiveness of targets, while tight access to loans favors leading corporations with strong balance sheets and cash on hand, who then act as consolidators in their respective industries.

All in all, identifying the buyer’s strategy, even in its primary form, gives crucial insight and negotiating advantage. In particular, and as it transpires from the foregoing list of objectives, it becomes clear that certain inherent weaknesses of a target company have the potential to represent an alluring opportunity for the appetite of a particular buyer. This “low hanging fruit” can be transformed by the attentive seller and its advisors into concrete opportunities to maximize value.

Plutus

[1] In the M&A lingo, bolt-on acquisitions are companies, products, assets or customer accounts that fit naturally within the buyer’s existing business lines.

[2] In the 1990’s, GE became well known for implementing Total Quality Management, a management tool created by W. Edwards Deming, to improve quality and performance across all of its divisions.

[3] At some point, we can expect that as the management team is spread too thin among different activities, efficiencies will start to decline.

[4] The value of control resides in the benefit derived from changing the way a company is run. Note that the value of control is different from the value of synergy in that it is not predicated on the combination of two separate businesses, but only on replacing the target’s incumbent management team.

[5] The cost of capital represents the cost of financing the assets of the business (both tangible and intangible).

[6] The divestiture of assets that are not considered to be optimally utilized by the target or not necessary to its core operations represent another way to extract economic benefits from acquisitions.

[7] Larger corporations and conglomerates typically enjoy higher debt ratings and therefore easier access to debt capital at a lower cost.

[8] Operating leverage refers to the proportion of fixed costs in a business versus variable costs. The lower the fixed costs, the less volatile earnings are.

Tracking the contentious and, as of yet, unsuccessful legislative path of the DREAM Act, we realize that a route recommended by economists can encounter many obstacles in its real world application, no matter how desirable those outcomes may appear. It is natural to wonder why, given that these are supposedly the rational suggestions of experts in search of the greater good: mobility of labor, free trade, economic growth and regional stability. However, if we dig a bit deeper into the economists’ methodology, tracing back to the theories where from some of those recommendations stem, we can unveil inadequate models cloaked by unrealistic assumptions and mathematical elegance.   This leads us to the discussion of the role of economists in public policies and some the idiosyncrasies of economists when they deal with normative economics and public policies. Below we attempt to answer three questions that are critical to the progress of political economy and the ability of economists to understand and explain the market for public goods: why economists are so bad at explaining these issues, why politics gets in the way of good economic policy and why are economists loathe discussing politics in general.

Economists Assumes One Decision Maker

In the attempt to make generalizations and capture the essentials, economists personify the role of the Leviathan, an autocratic ruler who can make decisions in the name of efficient wealth creation. Even when presented as positive statements, economists’ findings very rarely lack normative potentials, instead always relying on this construct of themselves as the benign dictator. Of course, this approach has proven very effective in microeconomics, where the decision making within the firm does not impair the effectiveness of the discourse or the soundness of the theory. In this case, it is a reasonable simplification to assume that the entrepreneur is essentially the sole decision maker with the ability to arbitrarily allocate resources in his quest for efficiency and wealth maximization.  Conversely, the complex nature of the public goods market and the democratic or even dictatorial process, with its many players (politicians, pressure groups, voters, bureaucracies, religious authority, etc.), and its formal rules, policies and cultural norms are much less suitable for the economists’ traditional simplifying assumptions.

The Principle of Parsimony vs. a “Principle of Generosity”

The mathematical manipulation so often used by economists requires an oversimplification of human interaction, not always appropriate for the complexities of the political exchange, in search of the elegance afforded through the principle of parsimony. Quite the opposite, the real-world political arena is froth with uncertainty and attritive processes whose cumulative effect can be hardly ignored. And despite recent trends in political economy to incorporate anthropological and sociological aspects of society into their models, many mainstream economists still operate in a world without institutions, where the actors are empowered with free access to information, unlimited computational capabilities and rapid fire decision making abilities. To give a more concrete example, one question to which economists have provided little convincing explanation is why some countries are poor and other are rich; or similarly, why certain countries grow faster than others. These models, despite their analytical depth, suffer from an inherent inability to explain causality and use credible assumptions. We learned from the Solow growth model for example (Solow 1956) that countries with higher saving rates will tend to be richer. However, it is intuitively easier to save when there is abundance than when there is scarcity, a causal point that the theory does not address satisfactorily. Also, in later developments of the Solow growth model (Arrow, Romer and Lucas 1992) we accept the fact that human capital facilitates growth; in this respect, empirical evidence suggests that even when knowledge can be freely exchanged or transferred among countries, outcomes may differ greatly and often do not validate what predicted by growth economists. This is not surprising. A country is an imaginary construction that exists only in human minds, a construct that can hardly accommodate the assumptions of restraining mathematical models. Even in countries that have homogeneous institutions (e.g. western countries), different economic realities are unevenly dispersed within their territories and the formal rules emanated by their institutions are applied and enforced in ways that differ greatly depending on customs, weltanschauung and historical ”path dependence” dynamics^[1] (North 1990).

The Gain of Many May Still Represent the Loss of a Few

Actors on the political stage pursue, as predicted by economists, their own interest in order to maximize returns. This is often accomplished at the expense of somebody else. Economists may predict, for example, that due to free trade two countries will both benefit from abolishing tariffs. But even if both countries have to gain, even in different proportions, somebody within those countries will certainly have something to lose. In substance, Pareto moves are more rare in politics than economic theory would like to predict, as the gain of someone is more prone to signifies the loss of somebody else. To make this worse, it is not uncommon that a political exchange  is often not a zero sum game and who has more to lose, but greater resources, is likely to fiercely defend their position to the detriment of the very “greater good” so cared for by economists.

Conclusions

The approach traditionally used by economists works well when the model allows for major simplifications of reality; when decision can be made by one main actor with rationality or at least bounded rationality and great computational power. Politics is the realm of transactions costs which represent one of the last frontiers for economists. The political exchange is always more costly than what economists would like or predict and this creates a certain level of uneasiness.  Notwithstanding the reluctance of many main stream economists, it transpires that at this stage of development of economic theory, a socioeconomic and historical approach can have a much more profound impact in our ability to understand economic growth and economic development.  In other words, and paraphrasing Joseph Schumpeter, if economics outgrew its baby shoes over a century ago, it looks like at times economists are trying to were shoes that are a bit too big.

Plutus

[1] We can think of Eastern Germany vs. western Germany or southern Italy vs., northern Italy for example.

A case study on the investment banking sector

As Coase (1937) first observed, and others later reiterated (Demsetz and Alchian among others), transactions costs are the primary catalyst that concentrates power around an authoritative hierarchical systems known, quite simply, as the firm. As transactions costs diminish, due for example to the availability of better and faster information, we should reasonably expect that companies will increasingly focus on core competencies and outsource other aspects of the business. This focus is likely, in turn, to spur the atomization of the firm into a loosely arranged network of suppliers, contractors, strategic allies and partners. In substance, as transaction costs decrease, the need to vertically integrate and consolidate disappears in favor of more market-oriented types of exchanges.

Given the extraordinary events of the recent financial meltdown, we have decided to examine the investment banking industry as the information revolution undoubtedly has made an indelible impact on this sector. Within it, armies of technologically-savvy early adopters continually endeavor to create information advantages as those have the potential to translate immediately into quasi rents. This effort requires continuous research and ingenuity, which becomes a “permanent revolution.” It is the quick adoption of communication and information innovation that allows investment banks to generate profits in highly competitive markets.

However, despite having speed, low cost and wide-spread availability of information, the investment banking industry has not evolved as we would expect. In fact, during the last two decades, investment banks have become larger, not smaller; more consolidated; more influential and powerful in the financial landscape. They have done so to the point that their size not only affects the market, but the economy itself. In other words, not only the market has not displaced the firm, but the firm “too big to fail” has even established its supremacy over the market.

In order to help explain what appears to be prima facie an inconsistency with main stream economic theory, we have identified three key elements[1] that combine economic, institutional and sociological factors:

• The importance of the institutional framework ;
• The importance of reputation; and
• The increase in the complexity of exchanges.

Institutional framework

Transaction costs are optimized by companies based on specific institutional frameworks that determine a particular industry structure and rivalry. As this state of nature is altered by institutional intervention, a new equilibrium is reached when the cost of an internal transaction equals the benefit at the margin of the transaction performed in the market. In investment banking, the demolition of barriers between commercial and investment banking created new opportunities to decrease risk and uncertainty through consolidation.[2] After a decline in relevance and enforcement, the Glass-Steagall act was repealed in 1999, allowing commercial banks to operate in investment banking and vice versa.[3]

In this consolidation that followed, the investment banking sector acted no differently that others sectors, such as automotive or semiconductors. Although the manufacturing of automobile components can be outsourced, and they have been increasingly outsourced during the last thirty years, the assembly line has physical characteristics that require certain investment of capital and ownership structure. Similarly, an investment bank in the absence of institutional constraints seeks critical mass in order to efficiently offer specific services,[4] and continually add new exchanges within the firm until the marginal cost of doing so equals that of the market.

Reputation

Reputation signals how the firm will respond under certain contingencies and can replace a formal contract, as it serves a similar purpose. Reputation plays a major role in investment banking and it can be considered a primary asset by organizations in its sector. More reputable brands have the ability to charge higher fees, which translates into higher margins. Because of the implied guarantees offered by a strong reputation,[5] the more activities that fall under the umbrella of a specific brand, the greater is the ability of investment banks to extract superior profits from those activities. In substance, due to its characteristic of transferability and indivisibility, reputation turns out to be incredibly advantageous as it allows organizations to save on contracting costs. When uncertainties about future contingencies are high (as they are in investment banking), we can expect reputation to be a central factor which favors firms over market exchanges.

The complexity of the transactions

Information technology certainly has revolutionized the way everyone, including investment bankers, communicate; it has dramatically diminished transaction costs related to obtaining and processing information. Nonetheless, concurrently, the world and in particular the financial world, has become increasingly more complex.[6] As the incentive of the banker to chisel and appropriate personal gains remains high, so is the complexity and costs of monitoring those individuals. It follows that policing, monitoring and enforcement are activities that are still required, even when information is fully and cheaply available. In other words, metering, monitoring and enforcement costs have been swelling virtually at the same speed or even faster than the speed at which information circulates due to the recent staggering technological advances.[7] From this, the central employer with supervision over “the efficient organization of the team production” is still better suited to minimize such costs than free markets.[8]

In light of the recent global financial and economic crisis, it’s clear that capital markets through the information technology revolution were not able to displace investment banks. Quite the opposite, and perhaps surprisingly, the firm maintained its supremacy and tight grip on the allocation of resources in a fashion that subdued even the functioning of capital markets in the U.S. and around the world. Institutional framework, risk and contingency abatement and complexity of transactions continue to be the drivers for these organizations to maintain their structure, defying the expected firm behavior models that emphasize the role of information technology and information costs.

Plutus

[1] Although more factors can be identified, in observance of the principle of parsimony, the selected elements appear to have to most explanatory power. These factors can also help explain the crisis of several investment banks, which in 2008 faced challenges and ultimately collapsed. This is the subject of a different paper.

[2] Just as unequal quantities of fluid in two separate vessels, at rest in stable equilibrium, rapidly seek a new equilibrium when suddenly in communication, organizations quickly adapt to external conditions, achieving new equilibria when artificial barriers among industry are dissolved.

[3] The immediate result was a series of megadeals, including the acquisition of Alex Brown by Banker Trust for $2.1 billion and the acquisition of DLJ by CSFB for $14 billion. The implication of these “supermarket banks” is that size and balance sheet become more important than the trusted relationship and quality of service.

[4] For example, an initial public offering

[5] Reputation is difficult to build and replicate, and requires inter-temporal allocation of resources (sacrificing resources today in order to build a strong brand tomorrow).

[6] As Alchian and Demsets (1972) put it, “sometimes a technological development will lower the cost of market transactions while, at the same time, it expands the role of the firm.”

[7] We can reasonably expect that if the complexity of transactions remained constant during the last 100 years, in light of the information technology revolution, investment banks would have been (to large extent at least) supplanted by market exchanges.

[8] Alchian and Demsetz, 1972.

I watched John Boehner’s “emotional moment” and I was less struck by the whole crying thing than I was by his seemingly perfect “bootstrap” narrative that the media lauded ad nauseum the day after. How much do we love the bootstrap narrative? It’s as American as apple pie (not to be confused with apfle schnitzel or torta di mele).

The funny thing about the bootstrap narrative is that everybody’s got one and if it isn’t a “bootstrap,” it’s sure smells like one. Just take a look at Obama’s raised-by-his-grandmother story or George W. Bush’s folksy, simple ways. So while I don’t have more details than a Google search, I’m not buying the Boehner bootstrap as its being sold to me. To me, it’s just another myth that beefs up the rhetoric about poor people being lazy and, as one example, is used to justify why it’s okay that so many American’s don’t have access to decent, affordable health insurance. The bootstrap story is a convenient safety blanket for all of us red-blooded, employed-with-benefits, Americans to wrap ourselves in whenever we feel somebody of a lower status, tax bracket or different racial or national origin wants something that we feel we are entitled to.

When universal healthcare was in the news (and will be again, as Boehner repeals any remnants of expanded health insurance), there were so many blatant comments about how those without health insurance coulda/shoulda done better in school because then they would have access through their jobs. Apparently, being without health insurance is a verified sign that you didn’t even try to pull yourself up, you lazy bum. You can also see the same thinking when discussing prison overcrowding, the Dream Act, 99ers and, of course, immigration.

So, let’s look at the Boehner bootstrap story. He worked in his dad’s bar, held a bunch of jobs through college, and worked his way up. What was that? … he worked in his dad’s bar? That’s not really a bad gig. I mean, how many poor kid’s have parents who own their own bar? I assume the bar made a profit, although I don’t have the details of course. There were probably ups and downs, but, for goodness sake… his dad OWNED A BAR!!! Since when does owning a bar put you in a disadvantaged economic status and endanger the future success of your kids? 

And as far as working a bunch of jobs through college, go to any campus and you’ll find TONS of white, middle and even higher income bracket kids who work odd jobs. My roommate, whose parents owned the land underneath a very large luxury mall in SoCal, used to stack books in the library and closed out the coffee shop (including dumping the grinds). She did it for “recreational” money, if you know what I mean. In fact, do yourself a little experiment. Ask around and see what your colleagues and friend’s bootstrap stories are. Trust me, none of them think they didn’t have to work their way though tough times just to get where they are today. Everybody’s got a story. You’ve got one of your own and so do I.

But, imagine if John Boehner’s dad didn’t own a bar. Let’s say he was worked for minimum wage as a landscaper and his mom was worked for minimum wage plus tips as cleaning staff at a hotel. Maybe sometimes, little John Boehner had to help get his brothers and/or sisters out the door for school because both parents had to be at their employers at the break of dawn. Let’s say his middle school was, like most schools where people who make minimum wage live, a failing school, staffed with overwhelmed, but well-pensioned teachers that could hold their jobs for life – regardless of whether or not the kids learned anything. Let’s say at the age of 16, when the real John Boehner was mopping floors for his dad, this John Boehner’s uncle pulls some favors to get him some work at the bar down the street to make minimum wage mopping floors and doing the stocking. So, being a rational, self-motivated youngster, he makes the decision that $7.25 an hour, some of which can go towards the family grocery bill, is better than sitting in a glorified kindercare called the local high school.

Where are this John Boehner’s bootstraps? Didn’t he already pull on them? Wasn’t yanking on them from the get go – just to get out of bed every damn day and face the world, keeping enough distance from easy crime and making the right decision to get out of a system that was failing him to go to the wage job that was both a help to his family in a service sector that won’t get shipped overseas? What a crying shame that he wasn’t born with the right bootstraps, because this John Boehner probably doesn’t have health insurance today, which, of course, is his own damn fault.

Fortuna

Underestimated risk, unrealistic rates of return, never-ending paychecks with lavish benefits, betting against tax payers who ultimately have to bail you out when it all comes tumbling down… sounds like another vilification of Wall Street? It’s not. This go-around it is the unholy alliance of civil servants and elected officials. They’ve gambled away the nation’s future ability to provide basic education, public safety and infrastructure and stuck the rest of us with the bill.

Our national obsession with the federal deficit allows the state and local government’s fiscal house of horrors hides in the shadows, but here and there, the truth is coming out.   

 This fiscal year, 48 states are in the red, with a combined gap of $192 billion. We’re jaded, so that number doesn’t faze us, until you remember that states are not allowed to run a deficit and have to have a balanced budget. But if that still doesn’t make you pause, there is a three trillion dollar shortage in pension and other benefits. Three trillion dollars – makes TARP look like chump change.

The way forward will require more than a few service cuts here and there, more than some accounting slight of hand. Neither states nor the majority of municipalities can declare bankruptcy (and even those that can have to do everything else possible first).  And let’s get some things straight – you can’t undo the current pensions. Of course, the pension costs are nothing compared to the health care costs – yeah for aging populations and the amazing array of expensive medical treatments that keep everyone alive well past the number of years they contributed to the fund.

Just to try to keep afloat, we need drastic measures. This means  difficult things like creating economies of scale among the 91,000 local government agencies (for Pete’s sake, Pennsylvania alone has more than 3,100 local government pension plans, some with only one or two people in them), changing the antiquated goods-based taxation system to reflect the current service-sector one, bringing in new civil servants with defined contribution plans and risk-sharing retirement plans, creating some actual standards in public sector accounting, renegotiating with bond holders and probably getting some help from the federal piggy bank.

If those measures get your blood boiling, here’s my question – where the heck have you been all this time? The unfunded liabilities have been growing since 2000 and you certainly didn’t get off your ass to do anything about it. In fact, you probably have someone in your family that benefits from that system and I doubt you had a Thanksgiving dinner discussion it. Oh, but that’s because it takes “special kind of person to be a teacher,” doesn’t it? Everybody loves a firefighter. And even the annoying clerks at the DMV, well that life sucks – and they are giving up all of that private sector pay, so they need a little help in their benefits. Bullshit. What they’ve managed to amass in their defined benefits negotiations (including job security, pensions for themselves and surviving family members and other post-retirement benefits) doesn’t make up for the wage gap, it mocks it. Laughs in its face and leaves the tax payer drenched in vile spittle.

These “pillars of our community” and civil servants are really zombie cows, fat with benefits, meandering in well-protected pastures. They’ve been feeding off the brains of the public for years, making us dumber and dumber with every bond measure and election cycle controlled by powerful union forces on the left and short-sighted tax policy defenders on the right.

So as you head off to the ballot box this fall, try to remember that this crisis needs a two-pronged cattle prod – one that raises revenues and one that cuts spending. One prong is just not enough to get rid of the demon beasts. If you’re the kind of person that can’t handle both, do us all a favor and just stay home. Because it means that they’ve already eaten half your brain and you’ll just vote to let them suck out what’s left.

Fortuna

I really don’t care – and I mean that in the nicest way to Ms. Lohan – about what she does. But it seems like a lot of people do care. People in the grocery checkout line, people in my carefully-culled Twitter stream, even people who listen to NPR. Well, care is not the right word. People love to pat themselves on the back for their own tempered ways when they see yet another tabloid story in the grocery line, “When will she ever learn?,” and smugly reply, “She never will.”

But this post isn’t about America’s obsession with celebrity calamities; it’s about looking at the latest mug shot splashed on the cover of the gossip rag and seeing a national self portrait. Because it’s become painfully apparent that America is really just riding out the Great Recession like a petulant starlet in a Malibu rehab center: going through the motions, day to day, biding time until the mandatory court order expires and it’s back to the party.

Of course, when I say “party” I mean real estate prices go back up, consumers are back in the stores and then, you know, there are all those jobs we used to have. It’s like all the economists, pundits and politicians are in the break room while the counselor steps out and all they talk about is how we miss the parties, the friends, the blow, the awesome dizzy buzz from the Perón and just how damn great it was before all this shit happened to us – which totally isn’t our fault. Because partying is what makes us who we are, right? I mean, every American deserves a house. Everybody needs a big screen TV. But, of course, next time we just won’t go over that edge, because, well, we’re not stupid. Oh yeah baby, once we get out of this hell hole and back to that  – it’ll be sweet, again. 

Obviously, the counselor has left the building and forgot to book the next session. No one ever points out that if the value of our houses go back up to where it was three years ago, we are back in a housing bubble. For housing starts to go back up and all those construction jobs to come back, we’re going to have to approve a whole bunch of zero-down, risky mortgages to fill those homes – and we’re going to have to find some fancy financial products to keep that money flowing. If we, as consumers, are going to spend, spend, spend, we’re going to have to pull out those credit cards again and go back to racking up higher and higher levels of household debt.

Don’t you remember? That party? It’s over; and it wasn’t even a really good one to start with. Back in the day, all those economists, pundits and politicians used to go on Sunday morning snooze-fests and give dire warnings about ridiculous home prices, scary levels of consumer debt, even scarier non-existent levels of savings and a good smattering of the real threats to the environment due to the buy-and-bin consumer culture. Remember? Those things were bad, unsustainable and ultimately going to bring us down. Oops, they did.

Regrettably, there is an absolutely no discussion of what America would look like without the party. The only thing that has been put out there is PIMCO’s El-Erian’s “New Normal,” which isn’t even a different story. It’s the same party, just a really slow taxi ride to get there. There actually is no vision for an America that isn’t tied to outrageous housing prices and easy store credit. There isn’t any sort of future out there at all, just a reshuffle of the past.

So, at the very least, we should admit it. We’re jonesing for a powder-fine myth with a very bitter underside – and we’ll bitch and complain non-stop, along every one of the other faked eleven steps – until we can be back in that party again. When will we ever learn?

Fortuna

Have you seen the comments regarding the great Obama Traffic Jam this week? They sure are heated. Lots of expected “socialist” vitriol from the right and actually, there are lots of very unhappy folks of all political persuasions. But the comments are also peppered with the comments from those who think Los Angelenos deserve it or that we are just whining. Well, I can tell you – we sure weren’t wining as in ‘wining and dining’ on the West Side – and that’s not trivial. And rather than suffer in silence, I’m going for the numbers.

Let’s keep things simple. Lots of people travel back and forth on the main arteries that were closed, but I immediately thought of the service workers who keep the restaurants and bars in the area humming and happening. Evening shift starts at 4:00pm. Traffic closures started at 3:00pm. The streets were closed/blocked for four hours. What does that mean? Well it means that wait staff, bar servers, kitchen and crew showed up FOUR HOURS LATE. It also means they didn’t get paid for those hours. Of course, diners didn’t show up either. Heck, the news anchor on KFWB even told his listeners to cancel their dinner reservations on the West Side. So let’s throw some numbers against that, shall we?

I went to Yelp! to get an idea of how many restaurants were in the affected area. I used zip codes 90036 and 90210. (This is just a portion of the affected area, but I’m going to be pretty conservative throughout my little project here.) Yelp! has 1553 establishments in 90210 and 889 in 90036, for a total of 2442. Some of those are outside the affected area and there may be some overlap – so I’m going to look at 40 percent of those restaurants as being affected that evening – that’s 976. Give me a break and let me round up to 1000.

Tuesday night isn’t a BIG night out, but it’s a heck of a lot better than Monday for the restaurant industry. Size differs – but with four hours impacted, looking at a dining party per hour and say, and if only three parties of two canceled/didn’t show – that’s 24 customers that didn’t come in per restaurant. If I say that they were being cheap on a Tuesday night and only would have run up a $30 per person bill, that’s an average of $720 per establishment or $720,000 for total income lost to those establishments.

Now let’s look at the other end. Some are large places, some are small. Staffing could range from about 6 to 25 that night. So let’s say, on average that four employees per shift got significantly delayed. And they missed four hours. California has a minimum wage of $8.00, so if you figure in some wage variance plus tips, its conservative to look at $12 an hour lost. Doing the math, its $192,000 in lost wages.

But I’m a wonk, so let’s not stop there. Those wages that were lost, guess what? That’s money that now won’t spent on groceries, gas, manicures, InStyle magazines… you know, economic multiplier stuff. The multiplier for dinning establishment wages in Los Angeles (yes, I am that kind of wonk) is 1.95. Forgive me for rounding up to two, will you? That means that the total wage impact comes to $384,000.

Yes, this is just a stab in the dark, or me goofing around on an excel sheet. And I’m not including parking fees, parking attendants (and LA has the BEST parking attendants – love you guys), or the hourly wage earners at Cedar Sinai. It doesn’t include movie tickets receipts or shopping at The Grove, on Rodeo, etc. It’s just a little sketch of the wining and dining. And the conservative grand total is $1,104,000, which, coincidently, is more than what was raised at the fundraiser. That’s worth whining about.

Fortuna

Economists don’t know much, but they do know something.

It’s August 2010 and the economy is still sluggish. Consumer spending is down, the market struggles, the dollar plunges against the unpopular Euro. Is this the new normal? Is it a double dip? What lies ahead? So many uncertainties, so much volatility; desolation and fear emanate from the headlines of major newspapers around the world: nobody really knows.

During time of great uncertainties- and not just in economic downturns-, we all become very emotional and even bipolar. Good news and we start thinking about that sports car we saw at the auto dealer the other day. Bad news and we become wrapped up in desperation and wonder whether we will be able to pay rent next month.

But wait, economists should know. Why don’t we ask them?  What do they have to say about the current situation? After all, economists are well respected professionals and economics, with all that math and charts, is a science. Or is it? Economics is a science, but a social one; like anthropology, sociology, demography, archaeology, geography, history, linguistics, political studies, international studies, business studies, etc. Would we ask anthropologists about the end of the recession?

The reality is that economists don’t really know much. Not that they don’t try hard or that they aren’t prolific enough. Most economists live by the cruel imperative of publish or perish. They are in fact quite industrious, but they just don’t seem to get it right all the time. And  economists disagree among themselves a great deal and much more publically in a way that is certainly unheard of in physics or mathematics. This is not very comforting for us mortals who are looking for their sage advice.

So what do economists really know?

Well, for one thing, economists do know and understand quite well the power of “regression toward the mean.”  This power comes from two critical notions, the first that the mean is a good estimator and that regression is a process.  When Carl Gauss (1777–1855) was trying to calculate the orbit of the asteroid Ceres, he developed the least squares method (when he was still a teenager!). Although, far from trivial, this technique shows that the mean of a sample is the best possible estimator. In simpler words, the average of several observations of whatever occurrence that can be measured with numbers provides the best possible indication of value.

Sir Francis Galton (1822-1911), another illustrious and dead social scientist very much liked by economists, developed what we today call regression analysis. In substance, regression analysis started from Galton’s very simple observation that the children of tall parents tend to be shorter than mom and dad; while children of short parents tend to be become taller. This would suggest that in the long term any phenomenon on earth regresses to its average.[1]

So what? Well, we know that for example since the historical P/E[2] average of the MSCI index is about 14.5 and that today that multiple is approximately 11.5, economists can tell us with confidence that if we invest in the market today, eventually we will make some money as in the midterm the index will revert to its mean.

Riiiiiiight, that’s not much. But it is something. And that something is what economics is good at. Because economics, like most of the world’s religions, is a path that requires faith and the immediate, short term answers are not always readily available. And it just may be that those demanding immediate answers are new members of the congregation and they, um, never read “the book.”

Plutus

[1] This would entail also that in the long-term humans should be all the same height, which is not really true (“Galton’s fallacy”).

[2] Price to earnings ratio. This ratio indicates how much an investor is willing to pay for each dollar earned by a company.