Deutsche Bank Brought in Some Help

(Bloomberg Opinion) -- Investor relations (1).

People who work in high finance tend to develop the belief that they know a lot about business, that in fact they are better at business than regular businesspeople. This is an understandable belief. The financial industry is a sort of meta-business. Successfully investing in or lending to companies requires you to understand their underlying business, and the deeper your understanding the more confident you will probably be in your investment. Separately, getting internal approvals, at a big bank or investment firm, to invest in or lend to a company generally requires you to perform an understanding of their underlying business, and the more glib and confident you are at demonstrating that understanding the further you will probably go in the financial industry. And if you go far enough you will get quite rich, which will further reinforce your self-confidence. The predictable result is that, at the highest levels, the financial industry tends to be full of people who (1) know a lot about other companies’ businesses and (2) think they know even more.

And so there is a long tradition of successful financiers descending from the heights of finance and condescending to tell regular people how to run their regular companies. Hedge fund managers will decide that they’re better at operating businesses than business operators are, and become activists, and get companies to adopt their operational suggestions. Leveraged-buyout kingpins, whose training is in raising lots of junk bonds to restructure companies’ balance sheet, transform into private-equity magnates who talk about their deep bench of operational experts. Banks will become general-purpose consultants to their clients. Probably a lot of this is good; probably finance does provide some useful meta-frameworks for thinking about other industries’ problems. Some of it ends up looking—and being—pretty hubristic. What does a hedge-fund manager know about low-end retail?

Anyway, though, there is a class divide, a sense of professional courtesy: Big-time financiers will storm in and tell software companies or food companies or even regional banks how to do their jobs, but they less frequently do that with each other. This just feels weird:

Deutsche Bank has hired one of its top shareholders, New York private-equity firm Cerberus Capital Management LP, as a paid adviser to help the troubled lender tackle runaway costs and boost lagging profits.

The appointment of Cerberus comes as Chief Executive Christian Sewing tries to revive the German bank’s fortunes after three consecutive full-year losses, market-share declines and strategic upheaval. Cerberus President Matt Zames, the former chief operating officer of JPMorgan Chase & Co., is leading the advisory team working with Deutsche Bank, a Cerberus spokesman said.

As a private-equity investor, Cerberus often provides advice for a fee to its portfolio companies. The arrangement with publicly traded Deutsche Bank, which hasn’t previously been reported, makes Cerberus the only Deutsche Bank shareholder in a paid advisory role, formally bringing a firm with skin in the game inside the bank’s operations, according to people familiar with details of the arrangement.

Does Cerberus know better than Deutsche Bank how to run a bank? Quite possibly! After all “Cerberus” here means “Matt Zames,” who arguably has run a bank more successfully than Deutsche Bank has. But there is something faintly embarrassing about a giant international bank going to one of its shareholders and saying “we don’t know what we’re doing, can we pay you to help?”

Vista.

Speaking of financiers telling businesspeople what to do, here is a pleasing story about a former chemical engineer and investment banker turned software magnate whose business involves acquiring smaller software companies and imposing his management style on them. That management style involves “an unusual mixture of formal and informal,” with three-piece suits but also “a lot of hugging.” It also involves requiring employees to take “a proprietary cognitive assessment” with “questions on logic, pattern recognition, vocabulary, sentence completion and math” in order to identify smart people with modest credentials; optimizing commission structures for salespeople; “revamping the company’s contracts and building in automatic price increases and renewals”; and moving the acquired company from California or New York to somewhere with a lower cost of living. There are “110 acronym-heavy directives known as Vista Best Practices.” It seems to work: His company buys companies with 20 percent operating margins and, “once its ‘best practices’ are implemented, four to five years later, profitability is at 50%.”

Oh and right also he’s not a software magnate exactly, he’s a private equity magnate: Robert Smith of Vista Equity Partners, “the richest African-American in the U.S.” with a $4.4 billion net worth. I suppose the difference is that he is not particularly romantic about software:

“Software companies taste like chicken,” he said at a conference in New York a few years ago. “They’re selling different products, but 80% of what they do is pretty much the same.”

Derek Jones, managing director at longtime Vista investor Grosvenor Capital Management, says “their process is like a factory. A deal comes in and it gets compartmentalized, and they apply experts on each compartment. After it goes off the assembly line, the margins are higher.”

But he is an innovator, a connoisseur, a true believer when it comes to capital structures:

When Vista began, investors were wary of software businesses taking on debt, because they had few hard assets. Vista helped persuade them that companies with subscription-based businesses can tolerate debt.

“Robert, over time, convinced an entire market to see this cash-flow stream of software revenue as a reliable annuity that could be financed with debt,” says Gregg Lemkau, co-head of Goldman’s investment banking division, who worked with Mr. Smith before he founded Vista.

Also he is an occasional user of toeholds to reduce the price of acquisitions, which I always like to see, even though it always ends up with people asking me “isn’t that insider trading?” (no): 

Sometimes a Vista hedge fund buys stock in a publicly traded company before its buyout fund acquires the whole company at a premium. In the process, the hedge fund makes a profit on its stock purchase. Because the buyout fund has a stake in the hedge fund, the process reduces the overall cost of the takeover.

The point of the financial processes is to let Vista profit more from a given software company than that company (or another buyer) can: It can buy it cheaply, optimize the capital structure, add more debt as margins improve, etc. The point of the business processes is the same: It can hire better workers for less with its cognitive tests and low-cost locations, and it can sell products more efficiently with its better sales incentives. If you focus only on the latter then you are a software conglomerate; if you focus only on the former then you are a private-equity investor—but in practice, if you are a private-equity investor, you like to get into both.

Investor relations (2).

If you are a hedge fund manager and you are buying stuff, you may not want anyone to know about it, because if they did they might buy that stuff too and push up its price, making it more expensive for you to buy the rest of your position. Once you have finished buying the stuff, though, you also may not want anyone to know about it, because if they did they might sell the stuff, pushing down its price until you are forced (by margin calls, redemptions, embarrassment, whatever) to sell your stuff too, further pushing down the price and creating a profit for them and a disaster for you. (Alternatively, once you have finished buying the stuff, you might go on TV to tell everyone how good the stuff is and try to convince them to buy it too; there are different approaches.) Ideally you would operate in total secrecy, only disclosing positions when you thought it would help your returns.

But the problem is that you have investors, and the investors feel like they have a right to know what you are doing with their money, and you feel some obligation to tell them. The compromise is that you tell them, but in the most annoying and tedious way possible:

A hedge fund posts a letter on its web portal via a content management system and then emails a link to the letter to a preapproved list of clients. If a client forwards the email to someone who has not been authenticated by the hedge fund firm, that person will be denied access. …

Some managers are taking things a step further, using behavioral-analytics platforms in conjunction with services like BlackBerry Workspaces to allow them to track when people are accessing a document — and then using machine learning techniques to observe patterns and detect unusual trading activity that correlates with that document being leaked.   

Just send me a PDF, man, you know? But it gets even worse:

In addition to using long-standing tools like digital watermarking — the easiest and least expensive technique, which acts more as a deterrent than as an outright roadblock to sharing — some are employing technologies that make it impossible to print or download letters, or even to view them in their entirety. At the extreme, one hedge fund industry veteran says, is the example of John Paulson’s Paulson & Co.: Once clients logged in to see their letters, they could read only three lines of the letter at a time — the rest was covered by black boxes above and below. 

Ahahahaha to be fair, if you had access to Paulson’s trades over the past few years and just did the opposite, you’d have done pretty well. Really the smart move would be to let clients read the whole letter, but black out the part with the returns. 

Mascara Kaboom.

I am going to tell you a story about a random company doing a random trade that is close to my heart, not for any particularly important reason but just because sometimes the world is interesting. Intrexon Corp. is a $1.9 billion market-cap biotech company that issued $200 million of convertible bonds last week. The way convertible bonds work is that they are bonds that can be converted into stock: You sell them for $1,000, and at the end of (in this case) five years investors either get a fixed number of shares of stock (if the stock is up more than a certain amount over those five years) or just get their $1,000 back. They are sold to a mix of investors, many of whom are “convertible arbitrageurs” who buy the bonds and sell short some of the underlying stock. The arbitrageurs aren’t betting on your stock price; they’re hedging out the stock risk and betting, essentially, that your stock will be volatile over the next five years.

But to do this they need to sell their stock short, and to do that they need to borrow it. That is not always easy. If short sellers are already selling a lot of a company’s stock short, then there may not be much stock left to borrow. Something like 34.7 percent of Intrexon’s stock float has been sold short. (By contrast, at Tesla Inc., “one of the most-shorted stocks in America,” shorts represent about 29.4 percent of the float.) Also something like 45.8 percent of its stock, before the convertible offering, was owned by its chief executive officer, Randal Kirk, and traditionally CEOs tend not to lend their stock to short sellers.

There is a simple, yet strange, solution: Intrexon can lend them the shares to short. Intrexon, after all, has a limitless supply of its own shares. The arbitrageurs buy the convertible, borrow shares from the company, and sell them short to hedge the convertible. In five years, if the stock is up, the arbitrageurs will convert their bonds into stock and deliver some of the stock back to Intrexon to close out their borrow. If the stock is down, the arbitrageurs will get back their money, and use some of it to buy back the shares they borrowed and return them to Intrexon. 

And so that’s what Intrexon did, though, securities laws being what they are, it was actually a bit more complicated than that. Technically Intrexon loaned $100 million worth of shares to JPMorgan Chase & Co., the bank underwriting the convertible; JPMorgan sold the shares short in a registered public offering and hedged its short position by offering swaps to the arbitrageurs who invested in the convertible, giving them a synthetic short position. (Intrexon describes the trade here and here.) But the basic idea is that convertible arbitrageurs, with nowhere else to borrow stock to hedge their convertibles, borrowed it (indirectly) from Intrexon.

This is an approach that you see from time to time—it is sometimes called a “registered stock borrow facility”—and I have written about it, and related ideas, occasionally before. (Also, when I was a banker, I structured and pitched deals like this, though I never quite did one.) These deals tend to be a bit controversial. One problem with them is that the registered borrow facility requires a big and confusing public offering of stock: JPMorgan has to go out and find, not only convertible investors to buy $200 million worth of convertibles, but also equity investors to buy $100 million worth of stock. And when it calls up those investors and they say “well why does the company need my money,” JPMorgan has to answer “no no no see the company isn’t selling you this stock, we are, to facilitate convertible arbitrageurs’ short sales.” “We will not receive any proceeds from the sale of the borrowed shares offered hereunder,” says Inrexon’s prospectus; “The share borrower or its affiliates will receive all the proceeds from the sale of the borrowed shares.” It is not the most compelling equity investment thesis. When companies announce deals like this, their stocks tend to plummet. 

But Intrexon had a solution to that too: Randal Kirk, the CEO,  bought all the stock. (In a trust and some holding companies, including one called “Mascara Kaboom LLC,” but let’s just say it was him.) He put up $100 million to buy stock that JPMorgan borrowed from his company and sold short to him. To review:

  1. Intrexon sold $200 million of convertible bonds to investors.
  2. Intrexon loaned JPMorgan $100 million of stock so that it could help those investors short it to hedge the convertible.
  3. JPMorgan sold that stock short to Intrexon’s CEO.

(Oh and one other thing, the CEO had entered into a preferred stock purchase agreement last year to maybe buy $100 million of preferred stock from Intrexon, but tore it up after the convertible offering priced. Presumably, having done the convertible—and having used the CEO’s money to make it possible—the company no longer needs his $100 million.) 

There is some real value being added here. Basically Intrexon was able to take its CEO’s $100 million investment and turn it into $200 million: Instead of just selling the CEO $100 million of stock for $100 million, it used the CEO’s willingness to buy $100 million of stock to create borrow for a $200 million convertible. But there is a lot happening to do that, a lot of moving pieces in order to turn a fund-raising into a somewhat larger and better fund-raising. It feels a little like we are out near the frontiers of finance, applying the enormous accreted knowledge of generations of bankers to move a small object a short distance. Which is … fun?

Things happen.

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