Tuesday, April 27, 2010

Why value value?--defending against crises

Companies, investors, and governments must relearn the guiding principles of value creation if they are to defend against future economic crises.

McKinsey Quarterly - Corporate Finance – Valuation

APRIL 2010 • Timothy M. Koller

Corporate Finance, Valuation article, Why value value? defending against crises

In response to the economic crisis that began in 2007, several serious thinkers have argued that our ideas about market economies must change fundamentally if we are to avoid similar crises in the future. Questioning previously accepted financial theory, they promote a new model, with more explicit regulation governing what companies and investors do, as well as new economic theories.

My view, however, is that neither regulation nor new theories will prevent future bubbles or crises. This is because past ones have occurred largely when companies, investors, and governments have forgotten how investments create value, how to measure value properly, or both. The result has been a misunderstanding about which investments are creating real value—a misunderstanding that persists until value-destroying investments have triggered a crisis.

Accordingly, I believe that relearning how to create and measure value in the tried-and-true fashion is an essential step toward creating more secure economies and defending ourselves against future crises. The guiding principle of value creation is that companies create value by using capital they raise from investors to generate future cash flows at rates of return exceeding the cost of capital (the rate investors require as payment). …The combination of growth and return on invested capital (ROIC) relative to its cost is what drives value. Companies can sustain strong growth and high returns on invested capital only if they have a well-defined competitive advantage. …

The corollary of this guiding principle, known as the conservation of value, says anything that doesn’t increase cash flows doesn’t create value.1 For example, when a company substitutes debt for equity or issues debt to repurchase shares, it changes the ownership of claims to its cash flows. However, it doesn’t change the total available cash flows,2 so in this case value is conserved, not created. …

These principles have stood the test of time. Economist Alfred Marshall spoke about the return on capital relative to the cost of capital in 1890.3 … Using them to create value requires an understanding of both the economics of value creation (for instance, how competitive advantage enables some companies to earn higher ROIC than others) and the process of measuring value (for example, how to calculate ROIC from a company’s accounting statements). With this knowledge, companies can make wiser strategic and operating decisions, such as what businesses to own and how to make trade-offs between growth and returns on invested capital—and investors can more confidently calculate the risks and returns of their investments.

Market bubbles

During the dot-com bubble, managers and investors lost sight of what drove ROIC …When Netscape Communications went public in 1995, the company saw its market capitalization soar to $6 billion on an annual revenue base of just $85 million, an astonishing valuation. This phenomenon convinced the financial world that the Internet could change the way business was done and how value was created in every sector, setting off a race to create Internet-related companies and take them public. …

Many of the companies born in this era, including, eBay, and Yahoo!, have created and are likely to continue creating substantial profits and value. But for every solid, innovative, new business idea, there were dozens of companies that turned out to have virtually no ability to generate revenue or value in either the short or the long term. …

Many executives and investors either forgot or threw out fundamental rules of economics … Consider the concept of increasing returns to scale—also known as “network effects” or “demand-side economies of scale”—an idea that enjoyed great popularity during the 1990s in the wake of Carl Shapiro and Hal Varian’s book Information Rules: A Strategic Guide to the Network Economy.4 The basic idea is this: in certain situations, as companies get bigger, they can earn higher margins and returns on capital because their product becomes more valuable with each new customer. In most industries, competition forces returns back to reasonable levels. But in industries with increasing returns, competition is kept at bay by the low and decreasing unit costs incurred by the market leader (hence the “winner takes all” tag given to this kind of industry).

Take Microsoft’s Office software, a product that provides word processing, spreadsheets, and graphics. As the installed base of Office users expanded, it became ever more attractive for new customers to use Office as well, because they could share their documents, calculations, and images with so many others. Potential customers became increasingly unwilling to purchase and use competing products. Because of this advantage, in 2009 Microsoft made profit margins of more than 60 percent and earned operating profits of approximately $12 billion on Office software—making it one of the most profitable products of all time.

As Microsoft’s experience illustrates, the concept of increasing returns to scale is sound economics. What was unsound during the Internet era was its misapplication to almost every product and service related to the Internet. …To illustrate, some analysts applied the idea to mobile-phone service providers, even though mobile customers can and do easily switch providers, forcing the providers to compete largely on price. With no sustainable competitive advantage, mobile-phone service providers were unlikely ever to earn the 45 percent ROIC that was projected for them. …

The history of innovation shows how difficult it is to earn monopoly-sized returns on capital for any length of time except in very special circumstances. …

When the laws of economics prevailed, as they always do, it was clear that many Internet businesses, … did not have the unassailable competitive advantages required to earn even modest ROIC. The Internet has revolutionized the economy, … but it did not and could not render obsolete the rules of economics, competition, and value creation.

Financial crises

Behind the more recent financial and economic crises beginning in 2007 lies the fact that banks and investors forgot the principle of the conservation of value. … First, individuals and speculators bought homes—illiquid assets, meaning they take a while to sell. They took out mortgages on which the interest was set at artificially low teaser rates for the first few years but then rose substantially when the teaser rates expired and the required principal payments kicked in. In these transactions, the lender and buyer knew the buyer couldn’t afford the mortgage payments after the teaser period ended. But both assumed either that the buyer’s income would grow by enough that he or she could make the new payments or that the house’s value would increase enough to induce a new lender to refinance the mortgage at similar, low teaser rates.

Banks packaged these high-risk debts into long-term securities and sold them to investors. The securities too were not very liquid, but the investors who bought them—typically hedge funds and other banks—used short-term debt to finance the purchase, thus creating a long-term risk for whoever lent them the money.

When the interest rate on the home buyers’ adjustable-rate debt increased, many could no longer afford the payments. Reflecting their distress, the real-estate market crashed, pushing the values of many homes below the values of the loans taken out to buy them. At that point, homeowners could neither make the required payments nor sell their houses. Seeing this, the banks that had issued short-term loans to investors in securities backed by mortgages became unwilling to roll over the loans, prompting the investors to sell all such securities at once. The value of the securities plummeted. Finally, many of the large banks themselves owned these securities, which they, of course, had also financed with short-term debt that they could no longer roll over.

This story reveals two fundamental flaws in the decisions made by participants in the securitized mortgage market. They assumed that securitizing risky home loans made the loans more valuable because it reduced the risk of the assets. This violates the conservation-of-value rule. Securitization did not increase the aggregated cash flows of the home loans, so no value was created and the initial risks remained. Securitizing the assets simply enabled their risks to be passed on to other owners: some investors, somewhere, had to be holding them. Yet the complexity of the chain of securities made it impossible to know who was holding precisely which risks. After the housing market turned, financial-services companies feared that any of their counterparties could be holding massive risks and almost ceased to do business with one another. This was the start of the credit crunch that triggered a recession in the real economy.

The second flaw was to believe that using leverage to make an investment in itself creates value. It does not, because … it does not increase the cash flows from an investment. Many banks used large amounts of short-term debt to fund their illiquid long-term assets. This debt … increased the risks of holding their equity.

Excessive leverage

As many economic historians have described, aggressive use of leverage is the theme that links most major financial crises. …

In the past 30 years, the world has seen at least six financial crises that arose largely because companies and banks were financing illiquid assets with short-term debt. …

Market bubbles and crashes are painfully disruptive, but we don’t need to rewrite the rules of competition and finance to understand and avoid them. Certainly the Internet … has not created a “New Economy,” as the 1990s catchphrase went. On the contrary, it has made information, especially about prices, transparent in a way that intensifies old-style market competition in many real markets. … [The] key to avoiding the next crisis is to reassert the fundamental economic rules, not to revise them. If investors and lenders value their investments and loans according to the guiding principle of value creation and its corollary, prices for both kinds of assets will reflect the real risks underlying the transactions.

Equity markets

Contrary to popular opinion, stock markets generally continue to reflect a company’s intrinsic value during financial crises. For instance, after the 2007 crisis had started in the credit markets, equity markets too came under criticism. In October 2008, a New York Times editorial thundered, “… In the last month or so, shares in Bank of America plunged to $26, bounced to $37, slid to $30, rebounded to $38, plummeted to $20, sprung above $26 and skidded back to almost $24. Evidently, people don’t have a clue what Bank of America is worth.”5 … [This] example points out the fundamental difference between the equity markets and the credit markets. The critical difference is that investors could easily trade shares of Bank of America on the equity markets, whereas credit markets (with the possible exception of the government bond market) are not nearly as liquid. This is why economic crises typically stem from excesses in credit rather than equity markets.

The two types of markets operate very differently. Equities are highly liquid because they trade on organized exchanges with many buyers and sellers for a relatively small number of securities. In contrast, there are many more debt securities than equities … and even more derivatives, many of which are not standardized. The result is a proliferation of small, illiquid credit markets. Furthermore, much debt doesn’t trade at all. … Illiquidity leads to frozen markets where no one will trade or where prices fall to levels far below that which reflect a reasonable economic value. Simply put, illiquid markets cease to function as markets at all.

During the credit crisis that began in 2007, prices on the equity markets became volatile, … The volatility reflected the uncertainty hanging over the real economy. The S&P 500 index traded between 1,200 and 1,400 from January 2008 to September 2008. In October, … the index began its slide to a trading range of 800 to 900. But that drop of about 30 percent was not surprising given the uncertainty about the financial system, the availability of credit, and its impact on the real economy. Moreover, the 30 percent drop in the index was equivalent to an increase in the cost of equity of only about 1 percent,6 reflecting investors’ sense of the scale of increase in the risk of investing in equities generally.

… Many investors were apparently sitting on the market sidelines, waiting until the market hit bottom. The moment the index dropped below 700 seemed to trigger their return. From there, the market began a steady increase—reaching about 1,100 in December 2009. Our research suggests that a long-term trend value for the S&P 500 index would have been in the 1,100 to 1,300 range at that time, a reasonable reflection of the real value of equities.

In hindsight, the behavior of the equity market has not been unreasonable. It actually functioned quite well in the sense that trading continued and price changes were not out of line with what was going on in the economy. … [Equity] markets rarely predict inflection points in the economy.7

About the Author

Tim Koller is a partner in McKinsey’s New York office. This article is excerpted from Tim Koller, Marc Goedhart, and David Wessels, Valuation: Measuring and Managing the Value of Companies (fifth edition, Hoboken, NJ: John Wiley & Sons, August 2010). Tim Koller is also coauthor, with Richard Dobbs and Bill Huyett, of a forthcoming managers’ guide to value creation, titled Value: The Four Cornerstones of Corporate Finance (Hoboken, NJ: John Wiley & Sons, October 2010).


1 Assuming there are no changes in the company’s risk profile.

2 Indeed, the tax savings from debt may increase the company’s cash flows.

3 Alfred Marshall, Principles of Economics, Volume 1, New York: Macmillan, 1920, p. 142.

4 Carl Shapiro and Hal R. Varian, Information Rules: A Strategic Guide to the Network Economy, Boston: Harvard Business School Press, 1998.

5 Eduardo Porter, “The lion, the bull and the bears,” New York Times, October 17, 2008.

6 Richard Dobbs, Bin Jiang, and Timothy M. Koller, “Why the crisis hasn’t shaken the cost of capital,”, December 2008.

7Richard Dobbs and Timothy M. Koller, “The crisis: Timing strategic moves,”, April 2009.

Thursday, April 22, 2010

Saving the world with behavioural economics

Anthill Magazine

April 7, 2010 By Matt Leeburn


A recent study revealed that adding personalised smiley or unhappy face icons on people’s energy bills had a dramatic effect on their future consumption. …

We all know that climate change is happening. … We all know these things, yet we do not act. …

…If humans were the rational beings most economists think we are, we would have done something about climate change by now, right?

In a recent study, researchers found that people will put in long hours into shopping for a mobile phone or a new TV, but when trying to decide on a new superannuation fund, a decision that has a much greater impact on their life, most people spent less than an hour choosing one.

If we can’t find more than an hour to spend on preparing for our retirement, how the hell can we save the planet from its devastating fate?

We need help.

Benjamin Ho, an affiliated researcher at the Cornell Centre for a Sustainable Future, believes that the key to saving the world from climate change is not just in technological advancement, it requires a more subtle approach; behavioural economics.

In a presentation titled “Using Behavioural Economics to Save the World”, Ho spoke of a study to try and reduce energy use by simply adding a smiley face or a frown to an energy bill.

The original study was conducted by Robert Cialdini, a social psychologist at Arizona State University in conjunction with the Sacramento Municipal Utility District. Thirty-five thousand statements were sent to randomly selected homes in the area. Each statement rated consumers on their energy use by comparing it to that of their neighbours.

Consumers would receive two smiley faces for great energy use, one smiley for good and frowns for below average.

The results of the study were astonishing. After a six month period, Cialdini found that the customers who received the personalised statement reduced their energy use by two percent more than those who received the standard statements.

Two percent doesn’t sound like much of a reduction, but in energy speak its huge. It’s like taking 700 homes off the grid. …

There are sceptics out there that would say no. But if a simple smiley face on a statement in California can reduce energy use by two percent, shouldn’t we at least try?

Matt Leeburn is co-founder and Managing Director of Interaction Dynamics and Click Logic. He has extensive experience in new business development, marketing and digital strategy. Follow him on Twitter @intdynamics.

Survey Finds Companies Adding Green Jobs

April 21, 2010 ( – One-in-ten employers say they have added environmentally-focused positions in the last 12 months and nearly 10% plan to add more in 2010.

A CareerBuilder news announcement said employers in the Northeast (14%) added the most "green" jobs over the last year, followed by 11% in the South, 10% in the West, and 9% in the Midwest. Retail led the industries surveyed with 24% indicating they have added the "green" jobs over the last 12 months, followed by 18% of transportation and utilities, 15% of sales, 14% of IT and manufacturing, and 10% of financial services.

…Nearly 70% of companies say they added programs to be more environmentally conscious in the last year.

The most popular green programs include:

  • Recycling (47%)
  • Using less paper (43%)
  • Controlling lighting (40%)
  • Powering down computers at the end of the day (29%)
  • Purchasing office supplies made from recycled materials (25%).

"Green opportunities continue to grow as companies take advantage of increased government programs designed to spur job growth and reduce the country’s carbon footprint," said Rosemary Haefner, vice president of human resources for CareerBuilder, in the announcement. "The green category has expanded over the past few years and job seekers are finding environmentally friendly positions in virtually every industry and at every job level."

The survey was conducted online within the U.S. by Harris Interactive on behalf of among 2,778 U.S. Hiring Managers and HR professionals (employed full-time; not self-employed; non government); ages 18 and over between February 10 and March 2, 2010.

Fred Schneyer

Monday, April 19, 2010

Climate Change - Building a Green Economy

Photograph by Yoshikazu Nema; Artwork by Yuken Teruya


Published: April 5, 2010

If you listen to climate scientists — and despite the relentless campaign to discredit their work, you should — it is long past time to do something about emissions of carbon dioxide and other greenhouse gases. If we continue with business as usual, they say, we are facing a rise in global temperatures that will be little short of apocalyptic. And to avoid that apocalypse, we have to wean our economy from the use of fossil fuels, coal above all.

But is it possible to make drastic cuts in greenhouse-gas emissions without destroying our economy?

Like the debate over climate change itself, the debate over climate economics looks very different from the inside than it often does in popular media. …[There] is widespread agreement among environmental economists that a market-based program to deal with the threat of climate change — one that limits carbon emissions by putting a price on them — can achieve large results at modest, though not trivial, cost. There is, however, much less agreement on how fast we should move, whether major conservation efforts should start almost immediately or be gradually increased over the course of many decades. …

Environmental Econ 101 If there’s a single central insight in economics, it’s this: There are mutual gains from transactions between consenting adults. … More than that, some careful analysis shows that if there is effective competition in the … market, so that the price ends up matching the number of widgets people want to buy to the number of widgets other people want to sell, the outcome is to maximize the total gains to producers and consumers. Free markets are “efficient” — which, … means that nobody can be made better off without making someone else worse off.

Now, efficiency isn’t everything. …[There] is no reason to assume that free markets will deliver an outcome that we consider fair or just. … But the logic of basic economics says that we should try to achieve social goals through “aftermarket” interventions. That is, we should let markets … [make] efficient use of the nation’s resources, then utilize taxes and transfers to help those whom the market passes by.

But what if a deal between consenting adults imposes costs on people who are not part of the exchange? … When there are “negative externalities” — costs that economic actors impose on others without paying a price for their actions — any presumption that the market economy, … will do the right thing goes out the window. So what should we do? Environmental economics is all about answering that question.

One way to deal with negative externalities is to make rules that prohibit or at least limit behavior that imposes especially high costs on others. That’s what we did in the first major wave of environmental legislation in the early 1970s: cars were required to meet emission standards for the chemicals that cause smog, factories were required to limit the volume of effluent they dumped into waterways and so on. And this approach yielded results; America’s air and water became a lot cleaner in the decades that followed.

But while the direct regulation of activities that cause pollution makes sense in some cases, it is seriously defective in others, because it does not offer any scope for flexibility and creativity. …

Enter Arthur Cecil Pigou, an early-20th-century British don, whose 1920 book, “The Economics of Welfare,” is generally regarded as the ur-text of environmental economics.

… What Pigou enunciated was a principle: economic activities that impose unrequited costs on other people should not always be banned, but they should be discouraged. And the right way to curb an activity, in most cases, is to put a price on it. So Pigou proposed that people who generate negative externalities should have to pay a fee reflecting the costs they impose on others — what has come to be known as a Pigovian tax. The simplest version of a Pigovian tax is an effluent fee: anyone who dumps pollutants into a river, or emits them into the air, must pay a sum proportional to the amount dumped.

…[With] the rise of environmental regulation, economists dusted off Pigou and began pressing for a “market-based” approach that gives the private sector an incentive, via prices, to limit pollution, as opposed to a “command and control” fix that issues specific instructions in the form of regulations.

The initial reaction by many environmental activists to this idea was hostile, largely on moral grounds. Pollution, they felt, should be treated like a crime rather than something you have the right to do as long as you pay enough money. …[There] was also considerable skepticism about whether market incentives would actually be successful in reducing pollution. Even today, Pigovian taxes as originally envisaged are relatively rare. The most successful example I’ve been able to find is a Dutch tax on discharges of water containing organic materials.

What has caught on instead is a variant that most economists consider more or less equivalent: a system of tradable emissions permits, a k a cap and trade. In this model, a limited number of licenses to emit a specified pollutant, like sulfur dioxide, are issued. A business that wants to create more pollution than it is licensed for can go out and buy additional licenses from other parties; a firm that has more licenses than it intends to use can sell its surplus. This gives everyone an incentive to reduce pollution, because buyers would not have to acquire as many licenses if they can cut back on their emissions, and sellers can unload more licenses if they do the same. …[Economically], a cap-and-trade system produces the same incentives to reduce pollution as a Pigovian tax, with the price of licenses effectively serving as a tax on pollution.

In practice there are a couple of important differences between cap and trade and a pollution tax. One is that the two systems produce different types of uncertainty. If the government imposes a pollution tax, polluters know what price they will have to pay, but the government does not know how much pollution they will generate. If the government imposes a cap, it knows the amount of pollution, but polluters do not know what the price of emissions will be. Another important difference has to do with government revenue. A pollution tax … imposes costs on the private sector while generating revenue for the government. Cap and trade is a bit more complicated. If the government simply auctions off licenses and collects the revenue, then it is just like a tax. Cap and trade, however, often involves handing out licenses to existing players, so the potential revenue goes to industry instead of the government.

Politically speaking, doling out licenses to industry … offers a way to partly compensate some of the groups whose interests would suffer if a serious climate-change policy were adopted. This can make passing legislation more feasible.

…[The] Waxman-Markey bill, a cap-and-trade setup for greenhouse gases that starts by giving out many licenses to industry but puts up a growing number for auction in later years, was actually passed by the House of Representatives last year; it’s hard to imagine a broad-based emissions tax doing the same for many years. …

In any case, experience suggests that market-based emission controls work. Our recent history with acid rain shows as much. The Clean Air Act of 1990 introduced a cap-and-trade system in which power plants could buy and sell the right to emit sulfur dioxide, leaving it up to individual companies to manage their own business within the new limits. …[Over] time sulfur-dioxide emissions from power plants were cut almost in half, at a much lower cost than even optimists expected; electricity prices fell instead of rising. Acid rain did not disappear as a problem, but it was significantly mitigated. …

…The emission of carbon dioxide and other greenhouse gases is a classic negative externality — … . Textbook economics and real-world experience tell us that we should have policies to discourage activities that generate negative externalities and that it is generally best to rely on a market-based approach.

Climate of Doubt? …[It’s] worth establishing three things about the state of the scientific debate.

The first is that the planet is indeed warming. … [If] you look at the evidence …­— taking averages over periods long enough to smooth out the fluctuations — the upward trend is unmistakable: each successive decade since the 1970s has been warmer than the one before.

Second, climate models predicted this well in advance, even getting the magnitude of the temperature rise roughly right. …So the fact that climate modelers more than 20 years ago successfully predicted the subsequent global warming gives them enormous credibility. …

…[My] third point: models based on this research indicate that if we continue adding greenhouse gases to the atmosphere as we have, we will eventually face drastic changes in the climate. …[We’re] talking about massively disruptive events, like the transformation of the Southwestern United States into a permanent dust bowl over the next few decades.

… Is a cap-and-trade program along the lines of the model used to reduce sulfur dioxide the right way to go?

Serious opposition to cap and trade generally comes in two forms: an argument that more direct action — in particular, a ban on coal-fired power plants — would be more effective and an argument that an emissions tax would be better than emissions trading. … There’s something to each of these positions, just not as much as their proponents think.

When it comes to direct action, you can make the case that economists … are too ready to assume that changing people’s financial incentives fixes every problem. In particular, you can’t put a price on something unless you can measure it accurately, and that can be both difficult and expensive. So sometimes it’s better simply to lay down some basic rules about what people can and cannot do. …

Is there a comparable argument to be made for greenhouse-gas emissions? My initial reaction, which I suspect most economists would share, is that the very scale and complexity of the situation requires a market-based solution, whether cap and trade or an emissions tax. … Reducing emissions of those gases will require getting people to change their behavior in many different ways, some of them impossible to identify until we have a much better grasp of green technology. … Econ 101 tells us … that the only way to get people to change their behavior appropriately is to put a price on emissions so this cost in turn gets incorporated into everything else in a way that reflects ultimate environmental impacts.

… A market-based system would create decentralized incentives to do the right thing, and that’s the only way it can be done.

That said, some specific rules may be required. James Hansen, … has argued forcefully that most of the climate-change problem comes down to …burning coal, and that whatever else we do, we have to shut down coal burning over the next couple decades. …[A] market-based system might turn out to have loopholes — and their consequences could be dire. So I would advocate supplementing market-based disincentives with direct controls on coal burning.

What about the case for an emissions tax rather than cap and trade? There’s no question that a straightforward tax would have many advantages over legislation like Waxman-Markey, which is full of exceptions and special situations. … The question is whether the emissions tax that could actually be put in place is better than cap and trade. There is no reason to believe that … a broad-based emissions tax would make it through Congress.

To be fair, Hansen has made an interesting moral argument against cap and trade, one that’s much more sophisticated than the old view that it’s wrong to let polluters buy the right to pollute. What Hansen draws attention to is the fact that in a cap-and-trade world, acts of individual virtue do not contribute to social goals. If you choose to drive a hybrid car or buy a house with a small carbon footprint, all you are doing is freeing up emissions permits for someone else, which means that you have done nothing to reduce the threat of climate change. … But altruism cannot effectively deal with climate change. Any serious solution must rely mainly on creating a system that gives everyone a self-interested reason to produce fewer emissions. …

The bottom line, then, is that while climate change may be a vastly bigger problem than acid rain, the logic of how to respond to it is much the same. What we need are market incentives for reducing greenhouse-gas emissions — along with some direct controls over coal use — and cap and trade is a reasonable way to create those incentives. …

The Cost of Action Just as there is a rough consensus among climate modelers about the likely trajectory of temperatures if we do not act to cut the emissions of greenhouse gases, there is a rough consensus among economic modelers about the costs of action. That general opinion may be summed up as follows: Restricting emissions would slow economic growth — but not by much. The Congressional Budget Office, relying on a survey of models, has concluded that Waxman-Markey “would reduce the projected average annual rate of growth of gross domestic product between 2010 and 2050 by 0.03 to 0.09 percentage points.” … Over all, the Budget Office concludes, strong climate-change policy would leave the American economy between 1.1 percent and 3.4 percent smaller in 2050 than it would be otherwise.

And what about the world economy? In general, modelers tend to find that climate-change policies would lower global output by a somewhat smaller percentage than the comparable figures for the United States. …

Such figures typically come from a model that combines all sorts of engineering and marketplace estimates. …

There are, … a number of ways this kind of modeling could be wrong. Many of the underlying estimates are necessarily somewhat speculative; … There is also reason to doubt the assumption that people actually make the right choices: many studies have found that consumers fail to take measures to conserve energy, like improving insulation, even when they could save money by doing so.

But while it’s unlikely that these models get everything right, it’s a good bet that they overstate rather than understate the economic costs of climate-change action. That is what the experience from the cap-and-trade program for acid rain suggests: costs came in well below initial predictions. …

… Even if you do not fully trust the models — … history and logic both suggest that the models are overestimating, not underestimating, the costs of climate action. …

The China Syndrome … China, which burns much more coal per dollar of gross domestic product than the United States does, overtook us by that measure around three years ago. Over all, the advanced countries — the rich man’s club comprising Europe, North America and Japan — account for only about half of greenhouse emissions, and that’s a fraction that will fall over time. In short, there can’t be a solution to climate change unless the rest of the world, emerging economies in particular, participates in a major way.

Inevitably those who resist tackling climate change point to the global nature of emissions as a reason not to act. Emissions limits in America won’t accomplish much, they argue, if China and others don’t match our effort. … Indeed, emerging economies feel that they have a right to emit freely without worrying about the consequences — that’s what today’s rich countries got to do for two centuries. It’s just not possible to get global cooperation on climate change, goes the argument, and that means there is no point in taking any action at all.

…Carrots, or positive inducements, are one answer. Imagine setting up cap-and-trade systems in China and the United States — but allow international trading in permits, so Chinese and American companies can trade emission rights. By setting overall caps at levels designed to ensure that China sells us a substantial number of permits, we would in effect be paying China to cut its emissions. Since the evidence suggests that the cost of cutting emissions would be lower in China than in the United States, this could be a good deal for everyone.

But what if the Chinese (or the Indians or the Brazilians, etc.) do not want to participate in such a system? Then you need …carbon tariffs.

A carbon tariff would be a tax levied on imported goods proportional to the carbon emitted in the manufacture of those goods. Suppose that China refuses to reduce emissions, while the United States adopts policies that set a price of $100 per ton of carbon emissions. If the United States were to impose such a carbon tariff, any shipment to America of Chinese goods whose production involved emitting a ton of carbon would result in a $100 tax over and above any other duties. Such tariffs, if levied by major players — …— would give noncooperating countries a strong incentive to reconsider their positions.

…Keeping world markets open is important, but avoiding planetary catastrophe is a lot more important. …[You] can argue that carbon tariffs are well within the rules of normal trade relations. As long as the tariff imposed on the carbon content of imports is comparable to the cost of domestic carbon licenses, the effect is to charge your own consumers a price that reflects the carbon emitted in what they buy, no matter where it is produced. …[The] World Trade Organization, which is charged with policing trade policies, has published a study suggesting that carbon tariffs would pass muster. …

The Costs of Inaction …[Climate] modelers themselves have grown increasingly pessimistic. What were previously worst-case scenarios have become base-line projections, … . Underlying this new pessimism is increased concern about feedback effects — for example, the release of methane, … from seabeds and tundra as the planet warms.

At this point, the projections of climate change, assuming we continue business as usual, cluster around an estimate that average temperatures will be about 9 degrees Fahrenheit higher in 2100 than they were in 2000. That’s a lot — equivalent to the difference in average temperatures between New York and central Mississippi. … And the troubles would not stop there: temperatures would continue to rise.

Furthermore, changes in average temperature will by no means be the whole story. Precipitation patterns will change, with some regions getting much wetter and others much drier. Many modelers also predict more intense storms. Sea levels would rise, with the impact intensified by those storms: coastal flooding, already a major source of natural disasters, would become much more frequent and severe. And there might be drastic changes in the climate of some regions as ocean currents shift. …

While there may be some benefits from a warmer climate, it seems almost certain that upheaval on this scale would make the United States, and the world as a whole, poorer than it would be otherwise. How much poorer? If ours were … [an]agricultural society, extreme climate change would be obviously catastrophic. But we have an advanced economy, the kind that has historically shown great ability to adapt to changed circumstances. …[The] same flexibility that should enable us to deal with a much higher carbon prices should also help us cope with a somewhat higher average temperature.

…[It’s] not just a matter of having warmer weather — many of the costs of climate change are likely to result from droughts, flooding and severe storms. The other is that while modern economies may be highly adaptable, the same may not be true of ecosystems. The last time the earth experienced warming at anything like the pace we now expect was during the Paleocene-Eocene Thermal Maximum, … when temperatures rose by about 11 degrees Fahrenheit over the course of around 20,000 years (which is a much slower rate than the current pace of warming). That increase was associated with mass extinctions, which, to put it mildly, probably would not be good for living standards.

So how can we put a price tag on the effects of global warming? The most widely quoted estimates, like those in the Dynamic Integrated Model of Climate and the Economy, known as DICE, used by Yale’s William Nordhaus and colleagues, depend upon educated guesswork to place a value on the negative effects of global warming in a number of crucial areas, especially agriculture and coastal protection, then try to make some allowance for other possible repercussions. Nordhaus has argued that a global temperature rise of 4.5 degrees Fahrenheit … would reduce gross world product by a bit less than 2 percent. But what would happen if, as a growing number of models suggest, the actual temperature rise is twice as great? Nobody really knows how to make that extrapolation. For what it’s worth, Nordhaus’s model puts losses from a rise of 9 degrees at about 5 percent of gross world product. Many critics have argued, however, that the cost might be much higher.

Despite the uncertainty, it’s tempting to make a direct comparison between the estimated losses and the estimates of what the mitigation policies will cost: climate change will lower gross world product by 5 percent, stopping it will cost 2 percent, so let’s go ahead. Unfortunately the reckoning is not that simple for at least four reasons.

First, substantial global warming is already “baked in,” as a result of past emissions and because even with a strong climate-change policy the amount of carbon dioxide in the atmosphere is most likely to continue rising for many years. So even if the nations of the world do manage to take on climate change, we will still have to pay for earlier inaction. As a result, Nordhaus’s loss estimates may overstate the gains from action.

Second, the economic costs from emissions limits would start as soon as the policy went into effect and under most proposals would become substantial within around 20 years. If we don’t act, meanwhile, the big costs would probably come late this century … So how you compare those costs depends on how much you value costs in the distant future relative to costs that materialize much sooner.

Third, and cutting in the opposite direction, if we don’t take action, global warming won’t stop in 2100: temperatures, and losses, will continue to rise. So if you place a significant weight on the really, really distant future, the case for action is stronger than even the 2100 estimates suggest.

Finally and most important is the matter of uncertainty. …The recent doubling of many modelers’ predictions for 2100 is itself an illustration of the scope of that uncertainty; … Beyond that, nobody really knows how much damage would result from temperature rises of the kind now considered likely.

… As Harvard’s Martin Weitzman has argued in several influential papers, if there is a significant chance of utter catastrophe, that chance — rather than what is most likely to happen — should dominate cost-benefit calculations. …

Still that leaves a big debate about the pace of action.

The Ramp Versus the Big Bang …On one side are economists who have been working for many years on so-called integrated-assessment models, which combine models of climate change with models of both the damage from global warming and the costs of cutting emissions. … Thus Nordhaus’s DICE model says that the price of carbon emissions should eventually rise to more than $200 a ton, effectively more than quadrupling the cost of coal, but that most of that increase should come late this century, with a much more modest initial fee of around $30 a ton. Nordhaus calls this recommendation for a policy that builds gradually over a long period the “climate-policy ramp.”

On the other side are …[those] who work with similar models but come to different conclusions. …Nicholas Stern, an economist at the London School of Economics, argued in 2006 for quick, aggressive action to limit emissions, which would most likely imply much higher carbon prices. This alternative position doesn’t appear to have a standard name, so let me call it the “climate-policy big bang.” …

The policy-ramp advocates argue that the damage done by an additional ton of carbon in the atmosphere is fairly low at current concentrations; the cost will not get really large until there is a lot more carbon dioxide in the air, and that won’t happen until late this century. And they argue that costs that far in the future should not have a large influence on policy today. …

The big-bang advocates argue that government should take a much longer view than private investors. Stern, … argues that policy makers should give the same weight to future generations’ welfare as we give to those now living. Moreover, the proponents of fast action hold that the damage from emissions may be much larger than the policy-ramp analyses suggest, either because global temperatures are more sensitive to greenhouse-gas emissions than previously thought or because the economic damage from a large rise in temperatures is much greater than the guesstimates in the climate-ramp models. …

The Political Atmosphere …[The] House has already passed Waxman-Markey, a fairly strong bill aimed at reducing greenhouse-gas emissions. It’s not as strong as what the big-bang advocates propose, but it appears to move faster than the policy-ramp proposals. But the vote on Waxman-Markey, … revealed a starkly divided Congress. … And the odds are that it would not pass if it were brought up for a vote today.

Prospects in the Senate, where it takes 60 votes to get most legislation through, are even worse. …

So the immediate prospects for climate action do not look promising, despite an ongoing effort by three senators — John Kerry, Joseph Lieberman and Lindsey Graham — to come up with a compromise proposal. (They plan to introduce legislation later this month.) Yet the issue isn’t going away. …

Paul Krugman is a Times columnist and winner of the 2008 Nobel Memorial Prize in Economic Science. His latest book is “The Return of Depression Economics and the Crisis of 2008.”

Tuesday, April 13, 2010

Equity Analysts Still Too Bullish

After almost a decade of stricter regulation, analysts’ earnings forecasts continue to be excessively optimistic.

McKinsey Quarterly

APRIL 2010 • Marc Goedhart, Rishi Raj, and Abhishek Saxena

Corporate Finance, Performance article, Equity analysts Still too bullish

No executive would dispute that analysts’ forecasts serve as an important benchmark of the current and future health of companies. To better understand their accuracy, we undertook research nearly a decade ago … . Analysts, we found, were typically overoptimistic, slow to revise their forecasts to reflect new economic conditions, and prone to making increasingly inaccurate forecasts when economic growth declined.1

…[A] recently completed update of our work …reinforces this view—despite a series of rules and regulations … that were intended to improve the quality of the analysts’ long-term earnings forecasts, restore investor confidence in them, and prevent conflicts of interest.2 For executives, …this is a cautionary tale worth remembering.

Exceptions to the long pattern of excessively optimistic forecasts are rare, as a progression of consensus earnings estimates for the S&P 500 shows (Exhibit 1). Only in years such as 2003 to 2006, when strong economic growth generated actual earnings that caught up with earlier predictions, do forecasts actually hit the mark. This pattern confirms our earlier findings that analysts typically lag behind events in revising their forecasts to reflect new economic conditions. When economic growth accelerates, the size of the forecast error declines; when economic growth slows, it increases.3

Moreover, analysts have been persistently overoptimistic for the past 25 years, with estimates ranging from 10 to 12 percent a year,4 compared with actual earnings growth of 6 percent.5 Over this time frame, actual earnings growth surpassed forecasts in only two instances, both during the earnings recovery following a recession (Exhibit 2). On average, analysts’ forecasts have been almost 100 percent too high.6

Capital markets, on the other hand, are notably less giddy in their predictions. Except during the market bubble of 1999–2001, actual price-to-earnings ratios have been 25 percent lower than implied P/E ratios based on analyst forecasts (Exhibit 3). What’s more, an actual forward P/E ratio7 of the S&P 500 as of November 11, 2009—14—is consistent with long-term earnings growth of 5 percent.8 This assessment is more reasonable, considering that long-term earnings growth for the market as a whole is unlikely to differ significantly from growth in GDP,9 as prior McKinsey research has shown.10 Executives … ought to base their strategic decisions on what they see happening in their industries rather than respond to the pressures of forecasts, since even the market doesn’t expect them to do so.

About the Authors

Marc Goedhart is a consultant in McKinsey’s Amsterdam office; Rishi Raj and Abhishek Saxena are consultants in the Delhi office.


1 Marc H. Goedhart, Brendan Russell, and Zane D. Williams, “Prophets and profits,”, October 2001.

2 US Securities and Exchange Commission (SEC) Regulation Fair Disclosure (FD), passed in 2000, prohibits the selective disclosure of material information to some people but not others. The Sarbanes–Oxley Act of 2002 includes provisions specifically intended to help restore investor confidence in the reporting of securities’ analysts, including a code of conduct for them and a requirement to disclose knowable conflicts of interest. The Global Settlement of 2003 between regulators and ten of the largest US investment firms aimed to prevent conflicts of interest between their analyst and investment businesses.

3 The correlation between the absolute size of the error in forecast earnings growth (S&P 500) and GDP growth is –0.55.

4 Our analysis of the distribution of five-year earnings growth (as of March 2005) suggests that analysts forecast growth of more than 10 percent for 70 percent of S&P 500 companies.

5 Except 1998–2001, when the growth outlook became excessively optimistic.

6 We also analyzed trends for three-year earnings-growth estimates based on year-on-year earnings estimates provided by the analysts, where the sample size of analysts’ coverage is bigger. Our conclusions on the trend and the gap vis-à-vis actual earnings growth does not change.

7 Market-weighted and forward-looking earnings-per-share (EPS) estimate for 2010.

8 Assuming a return on equity (ROE) of 13.5 percent (the long-term historical average) and a cost of equity of 9.5 percent—the long-term real cost of equity (7 percent) and inflation (2.5 percent).

9 Real GDP has averaged 3 to 4 percent over past seven or eight decades, which would indeed be consistent with nominal growth of 5 to 7 percent given current inflation of 2 to 3 percent.

10 Timothy Koller and Zane D. Williams, “What happened to the bull market?”, November 2001.

Friday, April 9, 2010

The Upside of Irrationality

The discoveries by Duke’s Dan Ariely on how investors make decisions may transform your wealth management practice


"We are all far less rational in our decision-making than standard economic theory assumes. Our irrational behaviors are neither random nor senseless: they are systematic and predictable. We all make the same types of mistakes over and over, because of the basic wiring of our brains."

That’s the financial world as Dan Ariely sees it. A professor of psychology and behavioral economics at Duke University, Dr. Ariely has wondered for years why people often don’t act in their own best interest. In 2008 he wrote about his research in Predictably Irrational: The Hidden Forces That Shape Our Decisions, which he updated last year with observations on the financial crisis. …

Other People’s Money Ariely disagrees with the assumption that people who deal with large amounts of money usually make more rational decisions about it. From investment bankers to mortgage brokers, he says, "a big part of the cause of the financial meltdown was conflict of interest."

While Ariely believes that most people are honest, he says that bad things can happen when you place good people into conflict-of-interest situations. "Imagine that I gave you $10 million a year if you were able to view mortgage-backed securities as a good product," he suggests. "Wouldn’t you be able to see them as better than they are? Of course you would."

What’s more, he adds, "when things like complex financial instruments are difficult to evaluate, it’s easier for us to rationalize unethical behavior and the effects of conflicts of interest become larger. Finally, when other people around us behave similarly, conflicts of interest rule even more." … Ariely concludes, "I think it’s inhumane to put people in strong conflict-of-interest situations and expect them to behave well."

… Interestingly, Ariely’s research finds that cheating is a lot more prevalent when it’s a step removed from cash. In Predictably Irrational, he recounts an experiment in which he first placed six cans of Coke in a refrigerator accessible to college students. All six cans were soon pilfered. He then placed six $1 bills on a plate in the same refrigerator. By the time he ended the experiment 72 hours later, none of the cash had been taken.

Ariely concludes, "When we deal with cash, we are primed to think about our actions as if we had just signed an honor code." … "When cash is taken away—and that’s what’s happening to our economic system," Ariely warns, "we will cheat by a factor bigger than we could ever imagine." Talk about a wake-up call.

Escaping Conflict-of-Interest Risks "This is a very hard time to have trust in financial advisors," Ariely says. He elaborates, "There are two kinds of trust: one is real trust, and the other is sticking a camera on someone to make sure they don’t behave badly." Today, we often opt for surveillance rather than trust. …

"Real trust is wonderful," Ariely says. But after this financial crisis, he feels that the time-consuming process of regaining it has to begin with a high degree of transparency. Unfortunately, Ariely told me, our government, legislators, and banks don’t seem to recognize what it will take to regain people’s confidence and trust. He keeps hoping some bank will break away from the herd to eliminate conflicts of interest and model full transparency—not just because it’s the moral thing to do, but because they understand that engendering trust is the best way to solve the liquidity problem. Without such bold actions, he fears we will not escape "this economic mess."

… Moving to fee-only compensation helps reduce conflict-of-interest perceptions, Ariely says, but it doesn’t solve everything. "Even with fee-only, they only get to keep the fee if they keep the client, so even if they really think at the moment that they’re doing the right thing, they’re biased to make the client happy." …

‘Hot States’ and Risk Tolerance In these turbulent times, investing in the stock market is not for the faint of heart. "The real issue for advisors is to protect people against themselves," Ariely says. He believes advisors can do more to help their clients truly understand how a loss would impact their life. "Imagine you come to me as your financial advisor," he suggests. "I ask how much are you willing to lose, and you say 20%. A little later I call you and say, ‘You lost 20%; do you want to change your risk tolerance?’"

Perceptions of any kind of risk can change dramatically when people go from a cold state, where they tend to make sound and rational decisions, to an emotional, hot state where they’re more likely to behave impulsively and irrationally. …

Ariely agrees with me that risk tolerance should be calibrated for a client’s cold state, while taking their hot (more emotional and risk-averse) state into account. In one experiment, he asked male college students whether they would engage in unsafe, kinky, or morally questionable sexual behavior. Most of the men responded negatively. Before questioning them again, he showed them erotic pictures. Thus aroused, the men were about twice as likely to say they would have unsafe sex or try to get an attractive woman drunk to seduce her. In short, they themselves failed to predict how they would feel when aroused. Other passions—rage, hunger, jealousy—may similarly make us strangers to ourselves….

Procrastination and Self-Control When emotions grab hold of us, we view the world from a different perspective. In a cold state, as Ariely calls it, we promise to save money, exercise, diet, and so on. But when we are in a hot state or aroused in some way, we feel that we have to have that new car, designer shoes, e-reader, etc. To help people start saving more money, Ariely came up with a creative idea: a "self-control" credit card that allows users to restrict their own spending behavior. Cardholders would set spending limits for clothes, entertainment, food, whatever. …

When Ariely presented this innovative concept to one of the major banks a few years ago, its executives could relate to everything he said about the terrible human costs of impulsive overspending. But when he went on to describe his idea, they seemed dumbfounded. Ariely argued that if one bank had the courage to offer consumers a card that helped them control debt and accumulate retirement savings, people would cut up their other cards and flock to this bank.

Despite the bankers’ promise to follow up on the idea, nothing ever happened. Ariely wonders if this was due to procrastination or to a conflict of interest: i.e., the potential loss of up to $17 billion in interest charges. …

Ariely comes back to the problem of not saving enough for retirement in Predictably Irrational. He blames "good old procrastination," as well as people’s inability to understand "the real cost of not saving as well as the benefits of saving." Along with the self-control credit card, he favors the Save More Tomorrow plan devised by Richard Thaler and Shlomo Benartzi. In the plan’s first implementation, a company’s new employees were asked to commit in advance to investing a portion of future raises in retirement savings. Since promising to change one’s behavior in the future is relatively painless, 78% of those eligible took part, increasing their average savings rate from 3.5% to 11.6% over the following 28 months. Ariely calls ideas like these "free lunches" that benefit all the parties involved.

Creating Loyalty: Money vs. Mutual Aid Another aspect of our predictable irrationality around money relates to loyalty toward others. In a purely social environment, people often make generous and altruistic choices. But the moment money is introduced, we lose our altruistic impulses and want to get the best possible deal for ourselves. This can become a problem for a business that insists it cares about its customers and/or employees. … A company can’t have it both ways, Ariely says. "If you want a social relationship, go for it, but remember that you have to maintain it under all circumstances."…

… Ariely points out in Predictably Irrational, money is an expensive way to motivate people. … "In a market where employees’ loyalty to their employers is often wilting, social norms are one of the best ways to make workers loyal, as well as motivated," he argues. Treating employees like "family" or members of a team tends to make them more "passionate, hard-working, flexible, and concerned." However, companies that model a social exchange must remember that they can’t expect employees to take on more work, put in longer hours, and travel at the drop of a hat without providing loyalty in return. This means helping them when they’re sick and keeping them employed when a market slump threatens their jobs. …

The Paradox of Big Paychecks After experimenting with different levels of salary and job performance, Ariely concludes that financial rewards can be a double-edged sword: "They motivate people to work well, but when these financial rewards get very large they can become counterproductive and actually hurt performance." When people start making tremendously high compensation, he explains, they are driven by the amount of the bonus, the stress involved in attaining it, and the fear of not getting it, instead of doing the best job they can. …

Asking the Right Question Sometimes we’re so intent on acting rationally that we don’t realize we’ve veered off into irrationality. For example, Ariely points out that during the mortgage market bubble, home buyers accepted that the key question was "How much house can I afford?" Many who believed the answer (and borrowed the maximum) have ended up defaulting. No one asked the right question: "Given our financial situation, how much should we spend on a house?" or its corollary: "How much should we borrow on a 30-year mortgage?"

Ariely says this is a lesson in human decision-making. When we can’t determine the right answer to the question facing us, we often figure out the answer to a slightly different question and apply this to the original problem. …

Why Can’t We Plan Better? "Rational economics is useful, but it offers just one type of input into our understanding of human behavior," Ariely writes in Predictably Irrational. "Relying on it alone is unlikely to help us maximize our long-term welfare." He cites several ways our emotions can hinder us from doing what’s in our best interest:

1. Relativity Error.

We often think we’re making enough money until we hear of someone in a similar job who earns more. …The only cure for this vicious cycle of "the more we have, the more we want," Ariely says, is to stop comparing oneself to others. …

2. The "Free" Fancy. Ariely’s research shows that once something is offered for free, people will stampede to get it, even if it winds up costing them money at a later date. …

3. Ownership Bias.

Simply put, we think what we own is worth more than it really is. Ariely finds that decisions to sell something (a car, a house) and buy a replacement are influenced by three human quirks: we fall in love with what we already have, focus on what we may lose instead of what we may gain, and assume other people will see things from our perspective. He counsels himself (and us) to "try to view all transactions (particularly large ones) as if I were a non-owner, putting some distance between myself and the item of interest." …

4. The "Price Equals Value" Perception. Ariely phrases this as "why a 50-cent aspirin can do what a penny aspirin can’t." …If you’ve been afraid to raise your rates even a little, you might try testing this irrational belief that more expensive goods and services are better.

5. The Planning Fallacy.

… Ariely adds that we often can’t plan well because we underestimate how long it will take to complete a task. This trips us up in deciding what we can and can’t afford, and what we should and shouldn’t buy. As a result, many of us don’t have a cushion when the unexpected happens.

Using Predictable Irrationality for Good As predictably irrational beings, Ariely says, "we are pawns in a game whose forces we largely fail to comprehend." We think of ourselves as sitting in the driver’s seat, but in reality our decisions are limited by the tools nature has given us. …

On a personal level, it’s good to be vigilant about a tendency to act emotionally. "Trust your intuition only after you have evidence that it’s useful," Ariely counsels. "Intuition is based on emotions, which are all about the short term; investment decisions are not."

… Ariely suggests that when you’re facing a hiring decision or deciding who to date, try testing your intuition by doing the opposite and seeing if it works out. Otherwise, you’ll never know whether or not your instinct is right. Don’t be discouraged by mistakes; they’re very educational. …

He also advises combining "immediate, powerful, and positive reinforcements with the not-so-pleasant steps we have to take toward our long-term objectives." An example might be watching a favorite TV show while exercising on a treadmill.

On a larger scale, businesses and policymakers could develop products and procedures that help us overcome our inability to act in our best interests, so we can make better decisions and improve our lives. In Predictably Irrational, Ariely quotes a Duke University colleague, Ralph Keeney, as saying that "our inability to make smart choices and overcome our own self-destructive behaviors" leads nearly half of us to early graves.

But we are not helpless. Ariely, who is already at work on a new book titled The Upside of Irrationality, urges us to "learn to embrace the Homer Simpson within us, with all our flaws and inabilities." By taking our predictable irrationality into account when we design schools, health plans, and other strategies, tools, and systems, we can create a better world. "This," he says, "is the real promise of behavioral economics."

SIDEBARS Stuck in the Status Quo? Why Women Should Take the Wheel Ariely on Retirement Planning The Risk of Parental Lassez-Faire Professor Ariely's Insights: In Brief

Olivia Mellan

, a speaker, coach, and business consultant, is the author with Sherry Christie of The Client Connection: How Advisors Can Build Bridges That Last, available through the Investment Advisor Bookstore at She also offers money psychology teleclasses for financial advisors and for the general public. E-mail Olivia at

Smaller And Medium Size Companies Hot Targets For Mergers And Acquisitions

by Suzanne McGee Apr 09 2010


Image: iStockphoto and Sean Driscoll

This is shaping up to become one of the hottest markets for baby boomer owners of family businesses or other entrepreneurs who are interested in selling their companies.

For several months now, massive transactions such as the grueling battle for control of Cadbury PLC (in which Kraft Foods Inc. and its $21.4 billion bid finally triumphed in February) have been stirring a sense of revival in the long-dormant merger and acquisition market. But the real action—and much of longer-term profit for Wall Street—rides on what is happening behind the scenes, in the arena where mid-market M&A is structured.

R.W. Baird, one of the many investment banks specializing in deals involving small to mid-market companies, noted that the number of M&A transactions involving these businesses soared 31.6 percent above year-earlier levels in February alone to 799 transactions. The dollar value of those transactions hit $107 billion, a 544 percent increase.

Confirming the trend, the National Venture Capital Association last week reported that the first quarter of 2010 saw more M&A deals involving venture-backed companies than it has recorded in any quarterly period since it began keeping track way back in 1975. A total of 111 venture capital-financed companies were negotiated in the first three months of the year, …. And the value of those deals? Well, that hit an average of $180.2 million—21 percent than the average value of deals done in all of 2009.

What that means, investment bankers agree, is that this is shaping up to become one of the hottest markets for baby boomer owners of family businesses or other entrepreneurs who are interested in selling their companies. Strategic buyers—larger rivals—are eager to boost their revenues and profits, and an acquisition is the most straightforward way to do that after they have spent the last two or three years cutting costs to the bone.

Mid-market buyout funds, … are heading back into the market and hunting for attractive deals. “For a high-quality company that has run into a glass ceiling—it has operational barriers to growth or can’t go global on its own or is struggling to find capital for further expansion—the M&A environment couldn’t be better right now,” says Parker Weil, a mid-market banker and managing director at Bank of America.

While everyone is peering over the shoulders of giant players like Blackstone and KKR, eager to see what kind of coup they will pull of next, Weil says there are 150 or so buyout shops in the tier just below that, each of which could complete 10 to 20 acquisitions over the next 18 months. Then there are the corporate buyers, who have also emerged from the shadows. “They need to show growth, and they can’t always do that organically,” Weil says….

Parker Weil, who also is involved in a seemingly endless series of conversations with entrepreneurs and owners interested in selling their businesses and eager buyers and investors who are willing to help finance the transactions, … The mid-market is the sweet spot of the M&A universe, he argues, calculating the optimal deal value at around $500 million. …

These days, Wall Street is drawing the ire of critics of its proprietary dealmaking and trading businesses, operations that have been very profitable, but that various reform proposals seek to curb, make less profitable or eliminate altogether. Going forward, the question may be whether Wall Street firms find a new source of more stable earnings to replace that, in the form of fees that can be levied on the assets its brokers and wealth managers manage for those clients who use their M&A teams to sell their businesses.

It will be up to those clients—the entrepreneurs seizing the opportunity to find a buyer for their business in what several bankers described to StreetWise as the beginning of a boom in mid-market M&A—to decide if they want to contribute to Wall Street’s well-being by entrusting them with their liquid wealth. …

Even better, suggests Josh Lerner of the Harvard Business School, if they do decide to respond to those initiatives, “this will be more of a seller’s market as we move forward. If a recession is kind of like the Grim Reaper, causing a lot of companies to fall by the wayside, it also means that those smaller and entrepreneurial businesses that survive are the strongest.” With a bevy of these robust survivors available—at least some of whose owners and CEOs have been reminded that when credit crunches hit, smaller businesses tend to suffer disproportionately—no wonder mid-market dealmaking is the hottest part of the M&A universe.

Read more:

Wednesday, April 7, 2010

Momentum builds for annuities in 401(k) plans

Employee Benefit Adviser

By Lee Barney

April 1, 2010

More retirement think tanks are getting on board with the idea of including annuities in 401(k) plans, but so far, only a handful of large employers have this as an option.

“They are complicated,” explains Alicia H. Munnell, director of the Center for Retirement Research at Boston College. …

Furthermore, investors are afraid an insurance carrier could go out of business, and plan sponsors don’t like the administrative headache of switching annuity investments when workers change jobs, added Robyn Credico, a consultant with Towers Watson.

In addition, the Retirement Security Project at Brookings Institution recently spelled out a number of perceived problems with annuities among investors: “… Consumers find themselves mystified by annuities’ complex provisions and worry that insurance companies are pricing their products unfairly. …”

Nonetheless, the Obama administration recently came out in favor of annuities, and the Department of Labor and Treasury Department are gathering information on the feasibility of including annuities in 401(k)s.

The 401(k), which serves plan sponsors, advocates the creation of a federal insurance fund similar to the FDIC to guarantee annuities.

Meanwhile, The Retirement Security Project recommends either automatic annuitization once workers reach age 45, with the right to opt out, or moving 50% of a worker’s savings into an annuity upon retirement. — By Lee Barney, editor-in-chief, Money Management Executive magazine.

Negotiation the fiduciary delegation minefield

ERISA requires every employee benefit plan to [have] a “named fiduciary.” The named fiduciary—typically a fiduciary committee or board of trustees—is the person or entity that has the ultimate authority to control and manage the operation and administration of the plan.

…ERISA permits named fiduciaries to delegate responsibility for managing plan assets to an investment manager. … Where an investment manager is properly appointed under ERISA, a plan’s named fiduciary will not be liable for the investment manager’s day-to-day management of plan assets, resulting in protection for the named fiduciary. In order to be appointed properly, an investment manager must acknowledge in writing that it is a fiduciary with respect to the plan. The named fiduciary’s only responsibility is to select the investment manager prudently and to monitor the investment manager’s performance periodically to determine whether continuing to retain the investment manager is prudent.

Investment Manager Responsibilities Investment managers have traditionally taken full responsibility for the portfolio of assets they are appointed to manage … . However, as investment managers increasingly have begun to implement more-complex investment strategies, … managers frequently are requesting that named fiduciaries execute ancillary documentation with third-party service providers to facilitate the investment managers’ services.

For example, we recently encountered several instances where an investment manager asked plan fiduciaries to execute a contract with a third-party futures commission merchant to facilitate the investment manager’s use of futures in the portfolio it managed on behalf of the plan. … However, the named fiduciary did not have the expertise to determine whether the terms of the contract were appropriate for the plan or whether the futures commission merchant selected by the investment manager was a good choice … .

When confronted with this kind of situation, named fiduciaries ought to consider whether, by signing ancillary contracts, they potentially are taking on additional liability for the responsibilities they previously delegated to an investment manager. In the previous example, a named fiduciary who signed the contract with the futures commission merchant could later be deemed responsible for the terms of the contract and for the selection of the particular futures commission merchant. …

Strategies for Plan Fiduciaries Several options may be available for named fiduciaries in this situation. Named fiduciaries, … may wish to retain an experienced investment professional to whom they can delegate this authority. In addition, the plan’s directed trustee may have negotiated agreements with providers like futures commission merchants, and may be willing to take direction from the investment manager to execute such agreements on behalf of the plan.

Regardless of the approach selected, named fiduciaries ought to be aware that they may be subjecting themselves to potential liability when they execute ancillary documentation at the request of investment managers.

Stephen M. Saxon is a Partner with the Washington-based Groom Law Group. Groom is one of the preeminent employee ­benefits firms in the country. Steve and his colleagues have worked on virtually every major legislative and regulatory initiative affecting employee benefits since the enactment of ERISA.