An outlaw story

We all like a good outlaw story, whether a western bandit, a gangster or a spy.  Fortunately, in finance, we also have outlaws.  One guise of them is insider traders.

Unfortunately, most of them are neither very likeable, neither very flashy.  The exception being Ivan Boesky who did it in a big way in the 80’s and, through his association with junk-bond king Michael Milken, brought down the mighty Drexel Burnham Lambert (Read the story in  The Predator’s Ball in the History of Finance section of my bookstore).

The Business Insider website has now published an entertaining summary of the eleven most shocking insider trading scandals of the last 25 years (Read on at : and Stéphane Wuille, journalist and blogger at L’Echo has added a Belgian version of it (Read on at :élits-dinitiés-les-plus-choquants-de-belgique.html ).

But insider trading, which is trading on the basis of non-public information, is a victimless offense, isn’t it ?  It should even contribute to market efficiency by incorporating non-public information in the price formation. So why is it punishable ?

Insider trading regulation is a rather recent worry as shown in the graph below :

BD_The_world price of insider trading_044

Source : “The World Price of Insider Trading” by Utpal Bhattacharya and Hazem Daouk in the Journal of Finance, Vol. LVII, No. 1 (Feb. 2002)

Actually, insider trading is not victimless.  It penalizes all the other market participants.  How would you feel trading in the stock market if you knew (or suspected) that your counterparties have (or may have) inside information ?  You would fear to be the patsy, you would partly withdraw from the market, you would have less confidence : in other words, you would increase your required risk premium.  So, here is the victim : the cost of capital. By undermining the confidence of market participants, insider trading decreases the liquidity, increases the risk premium and the cost of capital and therefore decreases the value of assets.  By increasing the cost of capital, it could even deter investment and decrease the growth rate of the economy.  Enough to make it punishable, it sounds !

Posted in Asymetry of information, Corporate governance, Market operation | Leave a comment

What’s in a name ?

You probably all know EasyJet, the British low-cost airline.  What you probably don’t know, is that it doesn’t own its brand name.  Its founder, the young Greek-Cypriot businessman Stelios Haji-Ioannou (in the meantime Sir Stelios), has kept the name for himself when he floated the airline on the London Stock Exchange back in 2000.

That wasn’t an issue as Sir Stelios generously awarded the use of the name to the airline for £ 1 a year.   As he was also developing other EasySomething businesses, he restricted however the use of the name to airline operations with a maximum of 25% for ancillary services.

And here is the snag ! As anybody who has ever flown with a budget-airline can testify, ancillary services make up a growing part of the bill.  Therefore, Sir Stelios sued his company for breach of the license agreement and now a new deal has been reached that should provide Sir Stelios with some £ 100m in fees over the 10 next years.

I don’t know about you but, if I were an EasyJet shareholder, I would feel a bit cheated even if Sir Stelios stated that “It’s a fair deal” and that I am sure the original agreement was explained in the listing prospectus.

So a few lessons (beyond “always read the small print”, which you already knew),

–          Beware of investing in companies with unusual corporate governance practices and potentially large conflict of interests,

–          Costs (or revenues if you take Sir Stelios’s position) potential shouldn’t be judged by numbers alone, have a look at conditions, restrictions, terms …

–          Brands are worth a fortune, certainly in consumer markets

Posted in Corporate governance, Intangibles | Leave a comment

What do you do with $ 30 bn cash ?

On October 10th, it was revealed that Google is developing a self-driving car and that it had already tested it over 140,000 miles of public roads. I also learned, reading  that article, that Google is sponsoring a prize for landing a robot on the moon.

On October 11th, Hal Varian, Google’s chief economist, unveiled the existence of the Google Price Index, a daily measure of price fluctuations based on e-commerce offers that could one day be an alternative to official statistics.

On October 12th, Google announced that it will finance, together with the specialist family office Good Energies and with the Japanese trading house Marubeni, the Atlantic Wind Connection, a giant project of underwater cables to link off-shore Atlantic wind farms to US consumers.  The project is rumoured to cost $ 5bn and Google has 37.5% of it (though probably part of it will be financed with project debt).

By that time, like many others, I suspect, I was wondering what is going here ?  Is the “do no evil” company attempting to take over the world ? Have the geniuses of Mountain View found so many new ways of making billions ?  Is there a strategic link, that escapes me, between all these highly original initiatives ? Is it purely a public relations exercise ? Or is this another bureaucracy trying to spend a surfeit of cash in projects that sound fun but will prove to be dubious investments ?

To be sure, the CFO of Google is overseeing the world from the top of $ 30bn cash mountain.  This is the ultimate problem of riches : what do you do with $ 30bn cash ?

Actually Google isn’t alone in this situation : from their latest bank statements, Apple has $ 25bn of cash and Microsoft $ 40bn.  Also, Google is not paying any dividend (or buying back any shares) and Apple stopped paying dividends back in 1995.  Microsoft only started paying dividends in 2003 after having sat on its cash for years.

As a finance professor, I am a bit puzzled.  Financial theory tells me 1. that there is a tax advantage to debt financing and that a mature company’s value is probably optimized with some leverage, 2. that a cash cushion is a recipe for agency conflicts between shareholders and managers investing in pet projects (like a self-driving car ?) or building empires and 3. that, in efficient markets, investors are in a better position than companies to diversify.

So why keep so much cash?

The cynical part of me explains that this is indeed a traditional agency conflict between managers and shareholders.  But, as these companies are extremely successful and have charismatic and forceful leaders, nobody dares challenging them.  And why would executives want to dilute the value of their stock options and remove the management comfort of immediately available cash?  Also, young upstarts don’t pay dividends, they reinvest.  Only mature companies with not enough positive-NPV projects pay dividends.  And maybe Apple and Google’s CEO’s don’t accept that their companies have grown up, that they have become older, that they can’t reinvest all their cash in new projects.

But the more strategic-thinking part of me wonders if it is pure chance that Google, Apple and Microsoft all have about the same cash reserves.  All three of them are aggressively competing against the other ones.  The stakes are high and the environment is changing fast: battle moved from the web to the mobile, will television be next ?  So what would happen if one of the three wouldn’t have its huge stock of fire powder anymore?  Wouldn’t the other two encircle him in his bastion, either PC software, search engine or consumer electronics, and prevent him from moving out by snapping every opportunity in new fields, even if it means overpaying for acquisitions. So each of them thinks it needs as much cash as the other ones to be able to move and purchase fast in order to take the number one position in future markets.  It makes a lot of strategic sense.  Whether it is in the shareholders’ best interest is another matter altogether.

PS: Brilliant work on the link between cash reserves and strategic flexibility has been recently published by Laurent Frésard, Financial Strength and Product Market Behavior: The Real Effects of Corporate Cash Holdings, Journal of Finance, June 2010, volume 65, n° 3.

(See the Google articles in the FT :,dwp_uuid=9a36c1aa-3016-11da-ba9f-00000e2511c8.html#axzz1987PqbKt, and ).

Posted in Choice Debt Equity, Corporate governance | Leave a comment

And another great graph on the pre-history of the financial crisis

As always, we are so much wiser after the event.

The Economist(Oct 2nd, 2010 edition)  has again published a great graph on the impressive deviation from historical norms that preceded the financial crisis.  This time it’s about the Spanish banks and shows the ratio of loans to deposits.



If you want the comment that goes with it :

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The limits of covenants

On October 5th 2010, the Flemish business paper De Tijd published a short article entitled “Banken blijven noodlijdend technologiebedrijf Option steunen” (Banks are obliged to go on supporting the technology company Option).

Option is a Belgian company manufacturing mobile modems.  Founded in 1986, still headed by its founder and overall a success story, it has nevertheless been marred by extremely violent ups and downs over the years. Presently, it is suffering from aggressive Chinese competition and is clearly in a down with an EBIT margin of minus 68% of revenues !

Due to the losses, the equity has fallen below the threshold fixed in a covenant by its two banks (Dexia and ING) and the banks have the right to call in their loans.  What do you think they did ? They waived the covenant of course (but insisted on receiving a bi-monthly financial report and are reported to be pushing for a sale of assets).

This is not surprising.  If they had insisted on the immediate reimbursement of their loans, they would have pushed their debtor into insolvency.  As the value of a technology company resides in its IP (short for Intellectual Property) and its know-how, it is extremely doubtful that the winding down of such a company  would have provided the banks with enough cash for their reimbursement.  Then, they have no choice than accepting what they had said initially they wouldn’t !  They are prisoner of their credit.

Does that mean that covenants are useless, because banks are obliged to waive them if they want their debtor to survive and reimburse them ?  Not really, because that waiver is a carrot with which they force a company to restructure and generate cash.

And if the debtor had been flushed with generic tangible assets (like real estate or power plants or listed shares), they would maybe have decided to call in the receivers.

Posted in Choice Debt Equity, Debt structure | Leave a comment

Conflict between shareholders and lenders: the perfect example

For years, I have been explaining to my students that there is a potential conflict of interest between the owners of a company and the people that lend money to it.  Indeed, shareholders have the chance to get an upside on their investment, while the lenders “only” get the interest but nevertheless suffer the risk of losing (part of) their money if  the company can’t reimburse them in the end.  Therefore, shareholders have a definite interest in taking risk while the lenders have absolutely none!  As long as everything goes well, all those considerations are not at the forefront and there is no actual conflict.

When the situation gets tougher and the risk of not being repaid becomes a possibility that can’t be ignored, the conflict appears.  At a certain point, the shareholders have lost so much that they could be prepared to gamble the company, i.e. to take very large risk and even to make investments with negative NPV.  Why is that?  Because they have a limited liability (unless they commit a fraud obviously), they are only committed to the funds they have provided to the company, not to further capital increases.  The NPV of a project is always an estimate of its average value, meaning averaged over the various possible future outcomes.  So a risky project with negative NPV has some chances of turning positive, even largely positive, but, on average, will be negative.  The point is that shareholders, who are left with a very small financial stake in the company, are not interested in the average: if the gamble turns out to be profitable, they will be the beneficiaries but if the investment is loss-making, they will lose the small amount their stake was still worth but the lenders will bear the bulk of the loss. The typical: heads I win, tails you lose.

And, for all those years, I had trouble coming up with actual examples of these extreme situations, that are nevertheless important to understand the debt-equity ratio. Now, thanks to the financial crisis, we have a surfeit of cases.

The best one is probably the Swiss bank UBS. UBS, one of the world largest and most respected banks, had lost not less than $ 50 bn during the crisis, largely thanks to its underestimated and unreported exposure to the infamous US mortgage market. And between the top of the market in the spring 2007, just before the crisis exploded, and two years later, the stock price had dropped by 85%.  The scene was set for my conflict of interest : the bank regulator, representing and defending the depositors, wanted UBS to be managed as conservatively as possible, but with a really conservative investment policy shareholders had no chance of recovering part of their losses for ages.

That this conflict actually took place was reported in 2009 in a fantastic article of The Economist appropriately entitled “Rebuilding UBS: Ossie’s casino” (Ossie being the CEO’s nickname): “I’d like to see us put more risk on the table and actually trade a bit harder.” In these times, such words from any banker might be enough to cause a little concern. Coming from the chief financial officer of a bank that is still clawing its way out of a $50 billion hole of accumulated losses and write-downs, they ought to set the fire alarms ringing. In fact, the gambling-for-redemption strategy outlined by UBS, Switzerland’s biggest bank, is winning the support of shareholders. … Taking a big bet may make perfect sense for shareholders. Yet the thought of UBS doing so again terrifies its regulators

Posted in Choice Debt Equity, Equity | Leave a comment

Oops ! Michelin decides to launch a rights issue

On Tuesday Sept 28 2010, Michelin announced a surprise capital increase of € 1.2 bn … and the stock price immediately dropped by 10%, wiping out about the same amount from the pre-money market capitalization! What’s going on here?

At first sight, such market reaction seems absurd.  The company is recovering nicely from the crisis and the stated use of the proceeds is investment in emerging countries where Michelin has not enough production capacity to fulfil the expected market demand.  Doesn’t that sound like a juicy positive NPV business case to you?

The explanation is bad communication, in other words surprising the market.  It is Michelin’s first cash call in 30 years, so this move is certainly a bit exceptional.  And, back in June, the CEO had sounded very cautious on growth and new investment.  So, investors are justified at wondering: why that sudden change? Are they under pressure from their banks to increase the equity? Are they planning a (potentially value destructive) hostile take-over bid?  The CEO’s explanation were not concrete enough to dispel the doubts that future profits will not be high (or secure) enough to compensate for the extra number of shares.

This effect is different from a technical adjustment that happened two days later when the rights to participate in the capital increase were split from the shares.  It’s an issue of 2-for-11 (2 new shares for every 11 existing shares) at a 27% discount to the pre-announcement stock price, i.e. at € 45 per share vs € 63.1 per share.  After the announcement, the price had dropped to € 55.7. Obviously the right to subscribe at € 45 a share priced at € 55.7 is worth something.  How much? If you buy 11 old shares at € 55.7 and then subscribe to 2 new shares at € 45, you will have spent € 702.7 for 13 shares or € 54.05 per share.  That will be the ex-right price of a Michelin share.  A single right is then worth € 1.65 (i.e € 55.7 minus € 54.05).  And indeed if you buy 11/2 rights at € 1.65 to subscribe a new share at € 45, you will have spent € 54.05 per share. Or if you buy an old share at € 55.7 and sell the right at € 1.65, you will have also spent € 54.05 per share. Q.E.D.

More comments on the operation at: and

and the prospectus at

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