Finance, Planning, Politics, Public Issues, Strategy

Lessons from Greece for India

By now almost everyone will know the entire Greece story and if you don’t then please do read some economic news on the world. The effect of the controversy on one country (Greece), one region (European Union), one currency (Euro) and million of people is unbelievable. Not really unbelievable … because this has happened to countries before but everytime the nuances are different. The important thing is to get a few lessons from the entire debacle specially for India!greece

  • Taxation System: I read last week that Greece has over 11 million residents but only only a few thousand claim to have an income above 100,000 euros. Is it really possible? Nevertheless if residents can get away without paying taxes then they will. For now India also has a taxation system full of loopholes, where anyone with a big company has to pay taxes but small/big business don’t and black money is prevalent. Government needs taxes and without taxes budget deficit cannot be reduced.
  • Importance of Currency: One of the main issues facing Greece is the issue of currency! Greece comes under European Union and has Euros as its currency. If Greece had an independent currency then it could have taken a hit on its currency, exports become cheaper, imports become expensive, the life in the country changes but it would not be as complex as it is.
  • Market will not always be rational: A lot of people ask that why has the focus on Greece come now? Why didn’t it come last year? The budget deficit was still very large last year. All the existing problems have existed for many years. Thus why now? Its because markets are not always rational and we all should be used to it. The bandwagon effect is most prominent in financial markets and when a run begins it is very .. very .. very difficult to fight it even for nations.
  • Don’t spend more than you earn: This is very difficult to maintain specially for Governments but if you continuously do it for years then what can you do.

This is definitely not an exhaustive list. Would be great to hear your views as well!

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Finance, Planning, Politics

Bash the Bankers ! – Updated 17/1

Until about 1.5 years back, Investment banker was one of the hottest and wealthiest job anyone could ever have. It was the ‘Angelina Jolie’ of all campus placements. But today, if there is one profession you want to bash and kick at and get an applaud – just lash out at any top executive employed with one of the global financial institutes or banks.

And of course our hope president Obama is not going to fall back. So he has lashed out at the bonuses declared by the banking institutions and asked them to pay up first before throwing away all the bonuses and has declared a $ 117Bn levy recovery plan over the next 10 years. In what I think is one of the most logical decisions made by the government, he has rightly decided to bash the big guys with more than 50bn worth and that too as a tax on all ‘wholesale finance’ and not the retail deposits and equity capital. So banks dependent on retail public deposits are relatively better off, but bad news for the likes of Goldman Sachs.

But what puzzles me is, is all this really required? Was the bailout money just thrown away at these people while they were out with the begging bowl without a fixed plan to recover every penny of the taxpayers money back? Or more importantly, are the top financial institutions still so greedy and shameless that they have absolute no moral responsibility of taking things easy for about 2 years until they have paid back what they owe to the world(World because when these guys decide to go down, they don’t go down alone. They take the entire world with them). It is like your house catches a fire, you don’t have money to rebuild it and the local sheriff convinces the neighboring community to help you out. You rebuild the house and in 6 months buy a new porche before paying your neighbors back.

So instead of saying – ok, we messed up, thank you taxpayers for bailing us out & we will not take a bonus and get things back on track, you take a big perk and flaunt it shamelessly. Banking institutions seem to be moving towards a role of milking the economy rather than serving the economy. Does this not expose the cultural degrade due to hard core capitalism.

India has a relatively closed banking and financial system that kept it that much insulated from the global crisis. But the big question is, I don’t know if it will happen, but if we are talking about India becoming a developed super power – do we become an easternized- eastern super power or a westernized eastern super power. So will we be able to keep the advantages that our culture has ingrained in us-  for e.g. the attitude of saving, or will we adopt the mistakes of the west as well while moving ahead. Imagine a bank employee from India and I am sure for most who have visited the bank at times, the image would be an honest and sincere middle aged employee who counts the notes for you and hands them over with a smile. I am not aiming at keeping things primitive, but the important point here is – ‘honest and sincere’, not over smart and sly. I hope we retain that always.

A closed banking system will give rise to more number of alternative finance institutions which would then pressurize the government into securitizing their mortgage products. And though it may seem far off, we know what can happen with our government policy decisions. And a completely open will inflate the bubble again. Hopefully, we can hang on to that golden mid way somewhere.

Lets hope when its our turn to dictate the world, we become a socially, morally and culturally responsible capitalist giant. Fearlessly smart and aggressively good !

Updated : 17/01/10

In conclusion, the entire deregulation in US has enabled the bankers in US to do as they please and left the tax payers to suffer. The US went through one of their worst crisis after the great depression, millions of lives were damaged through cutbacks, job loses and washing away of all savings and all this pain, I feel, was self inflicted. The financial system went to being unstable due to adoption of reckless deregulation right from the financial reforms US congress enacted from 1970.

The “Financial Crisis Inquiry Commission” is drilling top bankers to decipher the cause of the crisis. Do follow the day to day coverage if you wish to know what the bankers are having to say after everything. A glimpse :

Mr Dimon of JP Morgan said that the “happens every five to seven years. We shouldn’t be surprised.”

And Mr. Blankfein of Goldman Sachs -“We should resist a response … that is solely designed around protecting us from the 100-year storm.” – So basically intending that its cool, it had to happen, don’t over react.

Lots of other interesting metaphors to go through out here. No one can summarize things better than Paul Krugman : “It tells us that as Congress and the administration try to reform the financial system, they should ignore advice coming from the supposed wise men of Wall Street, who have no wisdom to offer.”

Image Credits : 1

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Business, Finance, Public Issues, Strategy

The worst company in this world is ….. Governments

Well we all keep cribbing about the Government, and ofcourse this has been going on and will go on for many many years. But since the past one year the world has been looking at all companies in a different light, we are seeing companies restructure, de-leverage themselves (remove their debt), and a lot of strategic rethinking. The Governments across the world have done a lot in terms of financial stimulus, bailouts and many more things.

The important question however is that have we ever tried to evaluate the performance of a Government like a company? A company has a balance sheet and so does a Government. A company has earnings from its products, a Government should collect money from taxes. A company issues debt for extra funding, and so does the Government. A company can sometimes run into losses, but a Government almost invariably runs into losses. But why?? Shouldn’t a Government be able to match its assets and liabilities on its balance sheet? why does this fail?

deficitI know many people will say that the Government spends money on aspects such as building schools, hospitals, city infrastructure, roads and the entire civic life. It also maintains an army, defense systems, foreign policy, embassies and the country’s entity. It also maintains many many other aspects and all these require money! And I completely agree with all this but what I don’t understand is that why aren’t taxes sufficient to cover all these expenses? and if they are not then doesn’t it show inefficiency on the part of the Government?

I believe the Government failure is highlighted by a couple of aspects. Firstly the Governments have not been able to create an efficient taxing system. Indian Government is not able to tax the people correctly and a lot of people don’t pay taxes. Governments around the world have various problems and are basically unable to tax people correctly (If they are taxing them correctly then I applaud them on this aspect). The second aspect is spending! I would assume that in the beginning there was just income tax and corporate tax. Slowly someone must have introduced VAT (Value Added Tax) to ensure Government gets money at every step. Next was council tax, road tax, commercial car tax, and so many taxes that the count has become unbelievable. I believe it will be a very good exercise for all of us to just calculate for 1 year the amount of money we pay in various taxes! The third aspect of Government failure is where they are initially not in deficits and then turn into deficits and unable to come out of it.

The world around us is questioning a lot of aspects today and I would request all of us to also question the Government monopoly across the worlds as well. The deficits and therefore the leveraging that the Governments are running is unsustainable. When a company defaults its only the shareholders who are wiped out, but unfortunately when our Governments will default then it is our currency which will face the brunt.

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What is hindering the popularity of Interest Rate Futures in India?

This is a guest article by Saswata Das. He graduated from IIM Calcutta earlier this year and works in the Financial sector. We thank him for his article and look forward to his future articles!

With trade volumes of IRFs in NSE barely touching the 1000 mark these days, it seems that all the initial excitement has fizzled out. This apparently dismal performance doesn’t bode well for the second edition of Interest Rate Futures introduced after a long hiatus of six years.

It’s really intriguing that in India interest rate derivative constitutes only 5% of the total derivative instruments traded value wise vis-à-vis 70% of that traded worldwide.

So what could be the possible reasons for such a state of the Indian financial market especially in the interest rate futures segment? Despite the fact IRFs have been made accessible to a wider base of 638 participants in NSE including 21 Banks, Primary Dealers, Mutual Funds, Insurance companies, FIIs, NRIs and individuals etc. Besides it’s expected that there shall be some significant changes in the interest rate movements owing to a stricter monetary policy on the horizon. Yet the volume in the IRF space has been waning at a faster pace in the recent past.

IRFs can be considered as one of the first few steps the Government of India has taken towards the fulfillment of multiple objectives. Some of them would be the development of corporate debt market; fuller capital account convertibility; complete deregulation of interest rates; strengthening of risk management; development of term money market and lastly a better risk management device to hedge interest rate exposure owing to volatility in Interest rates.

Improvements over the previous edition of IRFs would be the pricing procedure, settlement norms and restricted participant base, which have been changed for better. Previously banks, who are high volume players in the fixed income markets, weren’t allowed to trade in IRFs other than doing ‘effective’ hedging. This time banks are being encouraged to participate in big way as all the rules previously applicable have been done away with.

In any financial market a market maker is required to absorb and infuse liquidity to foster depth in that market. Who is willing to own up the responsibility of market making in this case?

Yet players who are supposed to pour in significant volume are still dormant although for resurrection of IRF their participation is of prime importance. Mutual funds, financial institutions including Insurance companies who claim to be the users of IRFs, have been loath to provide the much coveted liquidity. Mutual funds still waiting for volumes to pick up and they are waiting for the first round of settlement of contracts to be over. In a way this could be a self fulfilling prophecy since a substantial amount of volume was initially expected of them and now they themselves are testing waters.

As far as Insurance companies are concerned, Insurance Regulatory Development Authority has just given a go ahead to insurance companies only on the IRF front. IRDA should allow all the players to use all derivative instruments and facilitate a wider participation from this set of investors. Insurance companies quite predictably are reluctant to act as liquidity providers and have become mere users of the instruments. Insurance giant LIC is still shy to dabble into the IRF space because of reasons like poor volume and liquidity. Most importantly the fact that IRFs first quarterly settlement is due this December and thus it is still in its nascency, nothing much can be expected of the investors who are still not sure as to how effective IRFs would be in serving their purpose.

Here kicks in the importance of the regulator, SEBI in our case has improvised a lot over the previous avatar of IRF contract terms but has missed out on some crucial issues like working in tandem with regulatory authorities like IRDA governing the participating capacities of the insurance companies.

Another facet of the problem would be the underlying of the IRF which is nothing but a notional 10 year bond bearing a coupon of 7% paid semi annually. The current underlying might create basis risk and cause inconvenience to smaller participants. Individuals who are not educated enough to neutralize the basis risk would incur losses. Effective usage of derivative instrument calls for sufficient amount of knowledge on the various facets of the product and the underlying security. Knowledge on pricing of the instrument, dynamics of both short and long term interest bearing instruments help players act with utmost maturity while trading IRFs and this is also one of several factors hindering IRFs from taking off in a big way. Lack of sufficient Benchmarks in the IRF space could be another reason as in India are available only on long term instruments as underlying and this complete absence of short term instruments as underlying in partially responsible for illiquidity in the segment.

Thus it’s high time the regulators act a little proactively and effect certain changes especially in terms of availability of IRFs on a broader spectrum of securities. For instance International Monetary Market, a part of CME has contracts on discount instruments like US Government T-Bills, Eurodollar futures in its short term interest rate future space apart from US Treasury Bond contract popularly traded as long term financial futures contract.

In economies with financially developed financial markets, Interest rate future prices reflect the reactions of the investors to the anticipated movement in the interest rates just the way government signals on expected interest rate by repo and call money rates to the economy.

It is anticipated that a quicker economic recovery, accelerating inflation rate, implying a higher interest regime will come into existence with a quarterly policy review by RBI due on this Oct 27th, investors will soon feel a greater need to hedge fomenting a surge in the volumes of this most successful financial innovation of 1970’s vintage.

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Entrepreneurship, Finance, Human Resources, Planning, Politics

Losing the ‘Education’ edge

As some of my batch mates went from IITs to MITs and other US Universities around the world, the number of publications in their resumes started to increase at an exponential speed. To me this phenomenon really did not make a lot of sense as how can a student or his research change within a couple of months to take their number of publications from non-existent (in IIT years) to innumerable (in US Universities). The simple answer I got from my friends was funding and resources available. Ofcourse IITs being one of the best institutes in the world in terms of students still lack the resources for producing world class research.

I have always considered US Universities as one of the biggest assets of US Economy. The funding and prestige of these universities brings most of the world’s students pursuing PhDs into states and once they are in US they never leave. In turn these students do research which helps US and also start companies which get US billions in taxes. An example is when a macbook is made in China and sold anywhere in the world, the major portion of the cost is divided by US and China (China for manufacturing and US for designing) and in turn China’s contribution can move to any other country where a factory exists but US contribution is permanent simply because Apple designed this in US and is based out of California.

The research and intellectual properties created by US University graduates can probably be considered the single most important reason for making US the superpower it is today. So when I read this article in NYTimes regarding how the US is cutting funding to University of California at Berkeley, I was kinda astonished. Afterall no one should step on their competitive edge and most of all US should not do this. I guess for countries like India and China it might be a little positive as the much hyped brain drain might get a sudden stop from this. Ofcourse the world, innumerable students and research will face a bad consequence. I hope the problem gets solved but well lets see!

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IPOs – How good they are as investments?

NHPC oversubscribed by about 23 times. Adani Power oversubscribed by about 21 times. And there will be a long queue of public issues to tap risk capital in primary markets. Usually IPOs are the instruments through which new retail investors enter equity markets. Why? Because these are advertised on Televisions, Toll check posts, big banners as part of OOH advertisements. We see IPO application forms being distributed as some product pamphlets. Are IPOs really that great tool for new retail investors or the investors which are around for some time to invest in equity? I think they are not! Let me present my thoughts through following points:

The below points are general observations and thoughts. That does not mean IPOs are always bad and should be avoided. Investor has to analyze it on case by case basis otherwise new companies won’t get risk capital for future growth.

1. IPOs come out when there is greenery in the stock markets.

Typically IPOs are floated when there is ongoing bull market rally in secondary stock markets. It’s the timing well achieved by the issuer companies. This facilitates the companies to sell capital at expensive/stretched valuations. Even now a days government is divesting at steep valuations, NHPC stake sold at 38 multiple. So where is margin of safety? There will be little money left on the table for investors to enjoy the gains in public issue. There will be hardly any companies which will value its stocks t fairly, forget the valuations at discounts. Retail investors are better off investing in the company’s peers already listed in stock markets where price discovery has already taken place in much efficient way. There could be chances of bargain price if the company’s future earnings are computed with too much pessimism. Bidding for shares within a price band decided by company, merchant bankers and interested QIBs may not be covering the fair price for the stock. It limits the extent of price discovery process. I recall the concept of transportation of heavy logs of wood being transported through rivers which are originated due to melting of ice at polar region. Isn’t it similar to what happens in IPOs? It could be easier for fundamentally weaker companies to pass through when there is extra-enthusiasm in the markets.

2. Projects financed by IPO proceeds could be more risky.

Diluting IPOs are typically floated to finance the capital expenditures, new business vertical developments; expansion of retail branches etc. When company ventures out into something new, there is inherently higher level of risk involved in successfully achieving the desired results as compared to company doing what it knows best. Company which finances the capex through internal accruals for new business development i.e these investing activities are financed through retained earnings and positive operating cash flows does not need to dilute its equity. If such company is available at lower earning multiples in secondary market why to invest in IPO and expose capital to higher risks that too at stretched valuations? It’s always better to invest in short operating cycle companies with higher net operating cash flows than companies with long gestation periods like power generation company starting fresh without any history of generation or airport development companies.

3. Best investment never goes to investors. Investors go to Best investments.

Best investments are never advertised and are always hidden. These are always smelled out through extensive research by investors when there is element of distress and opportunity inherently in the investment.

4. IPOs are treated as trading instruments by HNIs and FIs.

Within first 2 weeks after listing of stock, its traders’ target. If you like the business and the project to be finance through IPO, it is better to calculate the fair price of the stock and check if issue price is lower than this price with sufficient margin of safety. If the issue price is higher, investor can put the stock on watch list and wait till the traders’ interests vanish. It becomes a investment target if stock price goes below fair price during true price discovery process.

5. The IPO issuer companies are not well covered in research.

The initial due diligence over company assets and business is done by Investment Bankers which have vested interest in success of the issue. Agreed there is SEBI, the watch dog keeping an eye on proceedings. Still full disclosures on business risks, company assets can not be achieved. So it’s always better to stick to companies which are well researched from different angles by various investors in secondary market valuations. I know you are thinking of Satyam exception now.

6. Opportunistic companies could be hitting markets with no candid intention of capex.

Some companies enter primary market just because it’s easy to raise capital in bull market phase. It’s difficult to find out the true/hidden intensions of the issuer. All though it’s mandatory to furnish the usage of IPO proceeds in offer document, there are several instances wherein IPO proceeds are parked in liquid mutual funds or bank FDs for considerably longer period of time. This obviously reduces the ROE for new as well as existing shareholders of the company.

(The article is written by Avinash Bachalkar, our newest strater. We thank Avinash for his post! Avinash is a Senior Engineer at Nomura and did his engineering from BITS Pilani)

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Business, Finance

Steel – Made in China??

With every passing day I think when the recession will take back its curse. When will the potential candidates get employed without having to behave like beggars on street – those who spent huge amount of money to enhance their skills and knowledge so as to beat the other competitors fighting for the same positions?

A small example of how the clubs of the business schools have been affected by Sub Prime (a sneak into the club discussions in our business school):

Be it the Strategy club where we discuss which are the companies who were recession proof and what strategy they had applied to do the same or the Finance Club where we discuss the Sub-prime crisis, Lehman Bros. case, Great depression, Balance Sheet Reviews of companies etc. etc. Be it directly related to the topic or not finally we derive the Sub-prime effect on the topics.

Leaving apart these trivial issues let’s focus on the impact of the same on Global Economy.

Just a small peak in one of the most hit sectors of the world:

Infrastructure Development has been falling in countries like US and UK since the economic bubble burst in the last year. This in return is affecting the steel industry in an adverse way. The steel manufacturers are thus forced to contract their supply in the current fiscal year. We can see reduced growth prospects for the steel manufacturers all over the world. This in turn is leading to fall in steel price. Steel manufacturers are recording losses in their first quarter results. Let’s see which nation looks most prone to face the hit. In order to have a clear picture of the same let us see the steel production scenario globally in the last fiscal. The following figures are derived from Iron And Steel Statistics Bureau’s monthly reports as published in the month August 2009. The five main steel producing countries of the Far East showed varying production with both China and India showing an increase.

1. China’s June steel production showed an increase of 6% to 49.4 million tonnes which contribute to 49.5% of the world’s total steel production.

2. Crude steel production in Japan declined by a third in June with the year to date total down 40.7% to 36.7 million tonnes.

3. India has now become the third largest steel producing country in the world with June production up 5.7%, bringing the year to date total to 27.6 million tonnes, an increase of 1.3%.

4. South Korean steel production was down 14.4% in June, and by 17.3% in the year to date to 22.8 million tonnes.

5. Taiwanese production decreased by 29.5% in June and by 39% in the six months to 6.6 million tonnes. Australian crude steel production dropped by 52% in the first six months to 1.9 million tonnes.

An overview on the past steel production dips:

The biggest fall in demand over one year for the steel industry since the end of the Second World War was the 8.7 per cent drop in 1982, towards the end of a downturn in global industry. That was the third consecutive year in which steel industry output fell. There have been only three occasions since 1900 when output has declined for three years in a row. Similar slump periods for the industry were 1930-32, 1944-46 and 1990-92. Production of crude steel for the countries reporting to the World Steel Association in June 2009 was estimated to be 99.8 million tonnes, a decrease of 16% over June 2008. China accounted for almost half of the global production of steel in 2009, the year to date total fell by 35%. All regions showed a drop in both June and the year to date totals except for that of Middle East. On the other hand if we compare the steel production contraction we will see a decline in the contraction rate.

China followed by India is seen to be the most sensitive in this sector at this point of time. This can be very well validated by the first news I came through in the newspaper on the morning of 28th August:


The company recorded a consolidated loss of Rs. 2209 Crores in the first quarter of the fiscal. If you carefully see the balance sheet of the Company for the quarter ended June 2009 we will see Raw Material cost contributing 38% of the total expense of Tata Steel Ltd. alone and when we look at the consolidated Balance Sheet it is around 29% of the total expense. The consolidated figure gives us the raw material contribution to the business of both Tata Steel Ltd. and Corus. So if we try to arrive at the percentage that Raw material contributes to only Corus it will be around 20%. This means that the rotation of stock is very low due to fall in demand for the finished product in Tata Steel. Even though you say it might be the distance coverage expense that is high in case of Tata Steel while procuring raw materials I would say it can’t throw up such a high difference.

Mr. Laxmi Narayan Mittal is still optimistic about the growth in steel sector in the current fiscal.

(This article is by our guest-strater, Kaushambi Ghosh. Kaushambi is a student at Praxis Business School. We thank Kaushambi for the article and look forward to further articles.)

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Business, Finance, Public Issues

India should do away with 500 and 1,000 Rupee notes

These days, as soon as one steps out of the house, it is amazing how quickly a 500 or 1,000 Rupee note turns into meager change. Everybody is talking about rising prices, inflation, increased ‘essential’ expenditures etc. I think it is still prudent to talk about lowering the highest denomination notes available in India … and I would try to argue why.

The National Sample Survey says that in 2004-05, ~67 crore people had a per day per capita consumption of less than Rs. 20/- . People earning these amounts can be assumed to be living hand to mouth and as such, savings are a distant dream. The high denomination notes are useless for these people (~60% of the total population) who have to spend everything they earn the same day.

Comparing to other countries,

Country          Per-capita income(I)         Highest currency denomination(D)       Ratio(I/D)

U.S.                       ~47,000 USD                                 100 USD                                      470

U.K.                      ~24,000 GBP                                    50 GBP                                       480

Japan                  ~4,000,000 Yen                            10,000 Yen                                    400

Brazil                   ~16,000 Real                                   100 Real                                     160

China                   ~22,000 CNY                                   100 CNY                                      220

India                   ~47,000 Rupee                              1,000 Rupee                                  47

our per-capita income to highest currency denomination ratio is pretty low. Till the time our per-capita income does not increase to atleast 4-5 times of the current levels, we do not need such high denomination notes.

The recent spurt in fake currency circulation can also be checked in case RBI decides to do away with the two highest denomination notes. Most of these fake notes are of the 500 and 1,000 Rupee denominations. If the RBI asks everyone to surrender the notes and exchange them with lower denomination ones, most fake notes would be seized. It would become very uneconomical and not worth the effort for the people who circulate these fake currencies and route them through their network in different neighbouring countries. Various terrorist activities are also funded through gains from the fake currency racket and that could also be curbed.

The same argument goes for the black money in the country. One would expect all this money (i.e. that available in paper form) would be in these denominations (for the sake of convenience of the handlers). People trying to exchange huge amounts of cash for lower denomination can worry about their assets getting checked for irregularities (the government can undertake these investigations through its various vigilance arms).

The availability of high denomination notes leads to people getting the opportunity to avoid using banks, even for high value transactions. As a result, the government finds it difficult to check for money laundering and tax evasion activities. Discontinuation of the high-end notes would make it almost infeasible to transact with paper-currency for deals worth above a certain amount (say, 50 lakhs). All such deals would have to be handled through financial institutions and can be better tracked.

As Baba Ramdevji says, this would also lead to corruption coming down. Huge bribes, donations etc. that go into lakhs and crores can no longer be handled manually for as he says,  “it would require a vehicle to be filled with notes to total these amounts”.

It all seems like after the initial euphoria – getting notes exchanged, assets irregularities being checked, tax evasions getting caught etc – this would work for the better of the country. The notes would be missed in the upper middle income and high income groups, but that is a small price to pay.

(There would be arguments against the notion and I would look forward to discussing these in the comments section, if anybody brings them up.)

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Business, Finance

IPOs are no longer the same

There are many retail investors in the stock market who do not necessarily understand the market, but still want to participate and profit from it. One of the good avenues that these people had were IPOs (Initial Public Offerings). I know of many who have demat accounts just for the purpose of investing as and when IPOs hit the markets. They subscribe to these, and if they are alloted some shares, they sell those on the day of listing. These investors are not willing to be exposed to the market risk by remaining invested in stocks and are happy with the listing gains (difference in the listing price and the IPO issue price).

Share issues of public sector units (PSUs) were eagerly awaited by these kind of investors. The assumption was that these companies left more on the table for the retail investor, as compared to their private counterparts. Gains of anywhere between 10-20% (and sometimes higher) could be expected and the time period of 2-3 months that took for the whole IPO process (during which time the money was locked) was acceptable to them.

SEBI has introduced a lot of measures that have reduced the procedural time to ~20-40 days. This is good news for the investors. The companies also try to accommodate more and more retail investors during allotment of shares. The investor might not get all the shares it has applied for, but would get some percentage of that.

At the same time, companies have gotten smarter with their pricing (or so I believe). Along with investment bankers, they want to raise the maximum amount of funds from the market. The 10-20% that used to be left for the investors is now too much for even the PSUs.

The latest listings of NHPC (PSU) and Adani Power (private) is a case in point. With the government focusing on the power sector (and infrastructure, in general), many power companies have lined up their IPOs. There was good enthusiasm in the markets for these as it had been a while since the primary markets had been active. The retail part of both these IPOs was subscribed ~3x times. The ratings from the various agencies were good. However, different experts had indicated, before the closing of these issues, that the valuation is a little rich (in terms of not leaving much for the investors).

Both the issues gave a meager 3-5% gain (before taxes) to their investors on listing. Both the stocks were below their offer price within days of listing (NHPC on the second day itself). Neither the company management nor the bankers were apologetic about it. They said that the investors should look at it from a long term perspective and not for flipping shares on the first day. The behaved as if they were unaware of any section of the investors who invest solely for the listing gains.

I would suggest investors to be cautious of all the fund raising that would come along their way very soon. They no longer can assume IPOs as investments that would give good returns quickly. The luck factor (of getting shares allotted) has reduced, but so has the returns. Having said that, I am aware that with so much liquidity sloshing around, some of it would easily find its way to these new issues.

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Business, Finance, Human Resources

Transaction costs and Investment Banking

Transaction Costs, Incentive Structures, Free Markets and the Nature of Investment Banking

Disclaimer: This is not a post about life in an investment bank (The books, Monkey Business and Liar’s Poker have done a great job describing that). It is also not about investment banking bonuses about which lot has been written (My personal take is that much of the criticism is absolutely justified), though some inferences about the culture surrounding bonuses could be derived from it. And finally, it is not about those parts of investment banks that sold worthless, toxic assets to the poor, (well, not really …) unsuspecting buyers and almost ruined the world. This is about the mythical, much glorified advisory business of investment banks.

Over the past year, much has been written about investment banks, their role in causing the subprime crisis, the tax-payer funded bail-outs, the brazen, almost obscene culture of bonuses etc. But lot of these has focused on the derivative structuring / trading and securities side of the business. The advisory business (popularly construed to be M&A / corporate finance advisory) has avoided scrutiny. In this article, I intend to touch upon a few basic economic concepts and use them to examine the structure of the business model for the advisory business.

Transaction Costs

The concept of transaction costs is one of the oldest and most researched concepts in economics. Ronald Coase used this concept in his famous paper, “The Nature of the Firm” to explain the limits of a firm and why we do not have infinitely large firms who never use the market (The paper is a must read for two reasons; first, it’s a lesson that wonderful insights can be generated without using nth-order multiple differential equations; second, it’s a reminder of the kind of elegant language we seem to have left behind somewhere). Theoretically, one does not need firms. For instance, you and I can enter into separate contracts with raw material producers, manufacturers, marketing firms etc. In fact, this is how a lot of business was done in the ancient ages. (However, theoretically, one can also argue that this “contracting agent” is in fact a firm, but let us not get into that argument) But each time, we use the market (through entering into contracts or making spot purchases), there is a cost; costs of procuring information about vendors, cost of ascertaining quality and fair prices and finally costs of enforcing the contracts and ensuring sanctity of transactions. There are transaction costs. And whenever these costs become substantial, it might be beneficial to carry out that activity in-house or within the firm. Conversely, there are costs associated with carrying out activities and when these dominate; you are better off using the market. Transaction costs, therefore, are central to decision making and can be construed to be, in some ways, a necessary evil.

Principal – Agent Problem and Incentive Structures

The construct of the Principal – Agent problem is again, something that would be very familiar to students of economics. In fact, it would be difficult to come up with a concept more intuitive than this. Think of a firm owned by a large number of diverse shareholders who cannot directly run the firm. Therefore, they appoint a management to run it on their behalf. The shareholders (or the Principals) would like the management (the Agents) to maximize value to the shareholder; the management might have other objectives – increase the extent of their empire and authority, diverting earnings as salaries and bonuses instead of paying them as dividends to the shareholder or investing them back in the business. This is an age old problem. To counter this, the shareholders do a number of things such as appoint a Board of Directors who have access to material information, supervise the functioning of the management etc. (One may also think of citizens (principals) electing legislators to monitor the functioning of a government (agents))

Why does the Principal – Agent problem exist? Because the agents inherently have different incentives than the principals; and the agents have access to information which the principals don’t.

Therefore, the principals also devise an appropriate incentive structure to “motivate” the agents to act in their best interest. Think of stock options, variable compensation linked to EVA or other metrics designed to measure shareholder value. (As an aside, you can also think of the cost of designing these incentives and managing a Board as “transaction costs” for owning a firm that you do not directly manage)

The Free Market

The concepts of Free Market and Perfect Competition need no explanation. Even if we don’t know / recollect the definition, each one of us intuitively understands the concepts. There is complete information, a number of willing buyers and sellers (none large enough to influence the price), free entry and exit of players etc. The aspects I want you to focus on are the presence of complete information and free entry of players.

Information is often (almost always) present in an asymmetric manner. Some participant has more information than others and she has an incentive to not disclose it / selectively disclose. This information asymmetry in a way creates costs to using the market, i.e. transaction costs.

Investment Banking (Putting It All Together…)

So, why did I launch into an Economics 101 crash course? (I am assuming there are readers who have taken the pain of reaching this point in the article) Now, I want you to think about all the above concepts as I describe the advisory function of an Investment Bank.

What do Investment Banks do? (I am not sure I can give a convincing answer after a year of doing it) But let me try. Banks in their advisory role advise their clients (actual or would-be) who are either large firms, conglomerates or private equity firms on potential acquisitions / mergers / divestments etc. They help clients figure out suitable targets / buyers, arrive at a right valuation, figure out a neat transaction structure to optimize on regulations and tax incidence and help in financing for a transaction if required. For these services, banks get paid a fee (which is usually a percentage of the transaction size) and the fee is paid only if a transaction is consummated.

Why do clients use bankers? Because bankers help perform activities which the firms cannot perform internally in a cost-effective way. Bankers therefore, are a Transaction Cost. Firms agree to bear this cost as long as the in-house option is either expensive or simply cannot deliver work of the same quality. In some cases this is true. For instance, financing requires relationships with stock exchanges, investors who are hedge funds, large insurance companies, mutual funds etc. Most firms would not possess these relationships. Therefore they rely on bankers. Even for an investor, going through a banker avoids the pain of getting to know the company completely, making basic models etc. Financing requires a lot of diligence, documentation etc. which bankers do. Therefore, the transaction cost is justified. What about M&A advisory? Is the in-house option expensive? Difficult to answer, but a case can be made that the in-house option can be made cost-effective based on a simple comparison of compensation packages for executives vis-à-vis advisory fees. Is the in-house option of an inferior quality? An answer to this requires knowing the nature of expertise that a banker brings to the table. He brings access to information about companies through-out the world, market information, valuation practices, regulations etc. Some of knowledge is proprietary to the bank, mostly it can be replicated. For instance, valuation is no rocket science. Similarly, access to market information is easy due to the presence of data providers like Bloomberg. Regulatory knowledge is more easily obtained through lawyers and internal counsel. This is actually being done in a large number of corporate houses and conglomerates who have extremely talented internal M&A teams which perform most of these functions. Also, private equity firms (who possess the same skills as bankers) hardly ever rely on bankers for valuation advice.

I am not trying to make the point that bankers bring no value. My contention is that banking is a transaction cost and firms are constantly going to try to minimize these.

Assume a firm decides that it is going to hire external advisors. The firm signs a mandate letter authorizing a bank to act on its behalf and agrees on a success-based fee which would be a percentage of the transaction size.

Think about it. The firm is a principal who has appointed the bank as its agent. Does the agent possess information that the principal does not? Of course, he does. (This is why he was appointed in the first place!) Does the agent inherently possess incentives which might lead him to behave in a manner that does not further the interest of the principal? This is a slightly difficult question to answer. The firm (principal) would be benefited only by some transactions, depending upon the presence of synergies and the right valuation. But the agents (bankers) are paid only if the transaction materializes. And guess what, they get paid more if the transaction takes place at a higher value.

Therefore, there clearly exists a principal – agent problem. Are steps taken to minimize it? One assumes that the principal exerts a strong, supervisory influence. There are some firms which pay a fixed fee, therefore mitigating the desire of the banker to peddle a high valuation. However, the fee is still paid only if the transaction gets consummated.  There are a few instances of retainers, but the retainer is such a small amount, that it is almost inconsequential.

Hence, bankers are structurally incentivized to peddle “wrong” transactions at artificially “high” valuations. This problem can be made more complex by arguing that the principal (management of the firm) is in fact an agent itself (that of the shareholder) and therefore is itself subject to the principal – agent problem! (If empire building on the management’s part is a key principal – agent problem, does this explain the presence of success based fees?) So, should bankers act in the interests of their direct “clients” (the management) or the ultimate beneficiary (the shareholder)? This is one of those intricate legal and ethical debates which I’ll leave for a later discussion.

What leads bankers to act in the best interest of their clients? Some would argue that reputation transcends short-term monetary gain. Most investment banks have been in business for a long time and value their reputation more than one-time fees. Therefore, they can be presumed to give the correct advice. It is an interesting argument, which would be believable; if one could empirically make the case that most mergers and acquisitions are successful in value creation. In fact, one can empirically prove the exact opposite. Bankers would say acquisitions fail because of execution issues and the buyer’s inability to realize synergies by integrating operations. But what if those synergies on which the valuation was based were artificial and never achievable? (An extremely readable book called The Synergy Trap makes this point)

Banks would argue that it is after all a free market and therefore the fact they continue to be hired by clients should be evidence that they deliver value. This is a brilliant and extremely convincing argument! But the market might not be such a “free” market. Why is this so? Because most regulators require valuation certifications and stuff by “registered merchant bankers”. This requires a license from the regulator thereby constraining free markets, allowing lesser firms and higher prices. It is ironical that a regulatory quirk facilitates higher prices and therefore higher bonuses which most regulators are opposing. (Having said that, this is not the only reason for higher bonuses, but it certainly is one). Also, large global firms have access to regulators and investors which smaller firms don’t, thereby contradicting the assumption of perfect information as well.

Therefore, structurally, banks might be viewed as agents (performing a transaction cost) in an imperfect market with incentives diverging from those of their principals!

(I am not making the case that all banks (and bankers) do not act in the best interest of their clients. There are a lot of good, solid banks and exceptional bankers who are extremely talented and deliver lasting value to clients. I am only pointing out the structural incentives generated by the context in which investment banking activity takes place)

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