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Thursday, March 31, 2016

New Bank Leaders Face Limited Choices

By Roy C. Smith and Brad Hintz

Though none have announced their results yet, European capital market banks will surely experience a quartus horribilus. Total 1Q investment banking revenues are down 36% from the prior year, the lowest since 2009, led by sharp declines in M&A, high yield and IPO activity.

It also appears that trading revenues will be disappointing. Several US banks have discussed the challenging market conditions that have impacted market making and Jefferies, which serves as a harbinger of FICC performance, announced dismal trading performance in its first quarter.

2015 looked like a year that would signify the end of the post-crisis slump for the banks - mergers, equities, debt and LBOs all were firing away, and the beginning of the long awaited recovery of profits in the banking industry was foreseen. But, it was not to be. The oil glut rattled stock, debt and currency markets and recession fears forced unexpected credit write-downs.

The quarter’s results, however, mask mighty efforts being made by the big European banks to restructure themselves after years of dithering. Only three European banks will be among the top ten firms ranked by investment banking revenues. 

Eight years after the 2008 crisis most of them have become unviable relics drowning in a sea of tightened regulation and costly litigation, with little sense of what to do about it. But, by the end of 2015, all of the four largest Europeans had installed new management with no ties to past legacies and charged them with transitioning to a workable business model that could once again be attractive to investors.

Bailed out by a resentful Swiss government in 2008, UBS was the first to confront the need for major change, though it took four years to do so.  Sergio Ermotti, former Deputy CEO of Unicredit, was appointed CEO in 2011, and decided to reduce the investment banking business (and its related risk-weighted assets) to minimal levels, choosing instead to build a new, lower-growth but less volatile, dividend-paying business centered on wealth management. This was an easy call because its wealth management franchise was so vast, and it has paid off. In 2015 UBS reported ROE of 11.5%, its stock was trading at 1.1 times book value with a dividend yield of 3.6% that will increase further when the bank reaches its near-term goal of a 50% dividend payout. However, there was a high cost to Mr. Ermotti’s strategic move: UBS is no longer ranked among the top ten global investment bankers by revenues.

The three European banks that have clung to their investment banking market shares and revenue steam – Barclays, Deutsche Bank and Credit Suisse (ranking 6th, 7th and 8th, respectively, by global revenues) remain in terrible shape, as they have been for most of the last eight years. ROEs were negative in 2015 for all of them, and today, on average, their stocks trade at a mere 43% of book value.

In July 2015, John Cryan, a former UBS finance chief, was appointed to replace Deutsche Bank’s ineffective co-CEOs. In October he announced a new “Strategy 2020” (that replaces a previous, but unaccomplished, “Plan 2015+”) that would rely on simplification, increased capitalization, less risk and better management. Risk-weighted assets (RWA) will be further reduced by 22% to  310 billion by 2020; capital and leverage ratios will be improved, some extraneous assets will be sold, and expenses and headcount will be cut further.  Eliminating dividends for two years will fund these efforts. Returns on tangible assets will rebound (it is hoped) to 10% by 2018 (about 8% of book value), which, however, is still less than Deutsche’s continuing cost of equity capital.  Deutsche Bank’s stock is down 27% since the new plan was announced – JP Morgan’s is essentially flat since then; UBS’ is down about 10%.

Tidjane Thiam, the former head of Prudential Insurance, became CEO of Credit Suisse in June 2015.  He also announced a plan in October similar to Cryan’s to trim hard and cut back, but stick to the old business model and protect profitable market share positions in investment banking.  Last month, however, Thiam announced a further tightening of the plan after the investment banking division blindsided him by adding assets to trading positions that then lost money.  RWA will be cut a further 20% along with 2,000 more jobs in the global markets unit. Despite bringing his miracle worker reputation to the bank, Thiam now seems to be in over his head. Credit Suisse’s stock price is down 37% since last October.

The most recent of the new CEOs is JP Morgan Chase veteran, Jes Staley, who took over at Barclays Bank in December. He too has announced a simplification, cost cutting and balance sheet trimming plan that would involve selling assets in Africa and shutting some non-essential business. His plan, however, also included halving the dividend for 2016 and 2017, and focuses on preparing Barclays for the ringfenced regime it will face in 2019. This, he demonstrated in a presentation to investors, will involve transitioning Barclays into two separately capitalized (and ultimately separable) businesses – a global investment bank, Barclays Corporate and International, with RWA of £195 billion, and a much smaller Barclays UK, with RWA of £70 billion. Even so, Barclays’ stock is also down 37% since October.

The three new CEOs have now all had early lessons on how hard it is to turn around a large underperforming European bank under present regulatory constraints and unsettled market conditions. It may be that balance sheet “optimization” won’t work any better for them than it did for their predecessors, who tried versions of it too.

Ultimately, there may be only two ways out. One is to convince regulators that important players in the global capital market system (there are some Americans too) will be sidelined indefinitely unless there is some relaxation of the capital adequacy, leverage, liquidity and other rules to allow market pricing to adjust to regulatory shifts. This may happen in time, but not soon. The only other way out is to split off the investment banking units into separate companies, which market conditions may make difficult, but not impossible, to do.

The new guys need to be brutally objective about their situations. If the renewed cut, squeeze and trim approach doesn’t work within a year or so, then the more drastic spin off approach may be all that is left.

 From: EFinancial News, March 31, 2016

Tuesday, March 22, 2016

What Has Changed in Cuba?

by Roy C. Smith  

Mr. Obama’s visit to Havana has refreshed the enthusiasm for a New Cuba that was created when he and Raul Castro announced their intentions to “normalize” relations fifteen months ago.  But while enthusiasm is high, progress in improving economic relations has been slow. The outlook is for it to remain slow.

Since the announcement in December 2014, embassies have reopened, travel restrictions administered by the US Treasury Dept. have been relaxed, and some limited concessions to allow financial transactions have been made. Cuban-Americans have travelled back and forth more freely with many bringing money for investments in new licensed private enterprises that are burgeoning.

However, Congress has done nothing to address the several US laws passed over past decades that prevent US companies from doing business or financial transactions in Cuba (called the “Embargo” by us, and the “Blocade” by the Cubans), without which the major US economic opportunities of a New Cuba will be remain sterile.  Though there are loopholes in these laws, without their repeal the President’s hands are tied and there is little more he can do to speed things up while he remains in office.

However, the Cubans have done very little to open their economy for foreign investment, trade and development of their industrial sectors and public infrastructure since the announcement.  Non US enterprises seeking to engage with Cuba, but unaffected by the Embargo, have been frustrated by Cuba’s slow progress in opening up.

It is true that since Raul Castro became head of state in 2008, a number of economic policy changes have occurred – mainly as a result of laying off about 20% of the work force from government jobs to encourage them to become “self-employed” entrepreneurs.  This was a necessary step to take as Cuba’s failed economy, propped up for years by the USSR and then by Venezuela, slid further towards bankruptcy. Even so, the government still employs about two-thirds of all workers.

Raul has said that economic reforms are necessary to preserve “Cuban Socialism,” the legacy that more than 50 years of Castro rule has left behind.  Without the recognized economic threats facing the country, it seems unlikely that Castro would have agreed to the announcement.

Cuban Socialism (Communism is rarely mentioned) has had some achievements – the population is literate, has access to decent free health care, and enjoys a very high degree of income equality, though only to the extent that everyone is equally poor.  But the economy is very sick. It had about a 2% growth rate for the five years trough 2014, little to no foreign direct investment, and has accumulated government debts equal to 125% of GDP. Cuba must import 80% of its food (20% of which comes from the US under a human needs exception to the Embargo) even though Cuba has vast amounts of uncultivated agricultural land in a tropical climate. It has little to export but sugar, cigars and rented-out Cuban doctors.

Despite all this, Cuba has experienced very little social unrest. Civil authorities are powerful and strict, but so were they in the Ukraine, Egypt, and in the former Eastern European states before these regimes fell to public protest.

Indeed, Raul may feel that the announcement already has been a big success. It has been popular with the people, and attracted lots of attention to the prospects of a New Cuba. Without having to give much of anything, Cuba’s foreign exchange inflows from tourism has greatly increased, and GDP growth jumped to 4% in 2015.

Even so, though the announcement increased applications for foreign direct investment, these have largely been rejected or stalled indefinitely. Of 200 such applications since 2014, only about 35 have been approved, and those were have faced draconian obstacles from the Cuban bureaucracy to being implemented.

Raul’s ideas about economic reform seem only to go as far as the retail sector – more small shops and street markets, but not large corporate engagement in the agricultural, manufacturing or financial sectors through which Cuban economic sovereignty, pride and “values” might be at risk.  Going that far but no farther, however, will make little difference to Cuba’s considerable economic problems.

But, Raul says he will retire in 2018, at 86, and turn the government over to someone else.  Within a few years, however, he and Fidel will join their revolutionary colleagues in Cuban Socialist heaven, and a new team will have to decide how far to go.  

In the meantime, other things are changing, due to Raul’s earlier reforms and the announcement. One is the end of fifty-years of anti-Americanism, and rising expectations for improvement in standards of living and economic opportunity because of the possibilities of interacting with the US.

Another, however, is a rapidly growing differential between those who are making money from all the tourist trade (restaurants, real estate, arts and entertainment) or otherwise from wheeling and dealing or corruption. Already the sort of envy and public concerns about the power of the newly rich has surfaced.

And, Cubans are getting more information about how others live as compared to themselves. As the Internet becomes more available this will spread further and faster.

Cuban-Americans are changing their attitudes. Recent surveys show that most of the Miami Cuban population favors normalization, and many see opportunities in bringing their capital and well developed business skills back home. 

So maybe the most likely near term future for Cuba is continuing rigidity and hostility towards large corporations that will be eroded by expectation sof normalization, drip by drip, until the Castros are gone.  By then, the Embargo (which has little continued support in the US) most likely will be gone too, and a greater flow of capitalist economic activity will result and this, as it did in Eastern Europe, will start to carry away the last of the rigidities.

The Castros greatest fear, I presume, is that after them, Cuba will revert to what it was in Batista’s time. A gold-rush of unrestrained capitalism might just bring that about, but it doesn’t have to.  The best thing for the Cubans to do over the next few years – which some of them are –is to spend time planning for a modern political and economic framework that can survive the transition from socialism to a markets-driven form of mixed economy. There are a number of good examples from the recent past – Poland, Hungary, the Baltic countries, Spain after Franco, and more locally, Chile and Costa Rica.

Friday, March 4, 2016

Crowdfunding -- The Next Disruptive Technology

By Roy C Smith

On August 28, 2015 Elio Motors, a startup manufacturer of a slick looking, $6,800 two-passenger, three-wheeled minicar that gets 84 miles per gallon, filed the first equity Crowdfunding IPO under the SEC’s new rules that were published in June 2015.  It could change startup financing forever.

Elio’s founders invested $5 million in the company at an average price per share of $0.26. Accredited investors purchased an addition $9 million of shares at an average price of $1.48 per share through private placements.  In 2015, the company issued $3 million of subordinated secured notes convertible into common stock at $5.98 per share. It has also raised about $38 million of debt since 2008.

Paul Elio did each out to VCs, but was rejected. Every time he pitched his idea to one of them, he encountered skepticism that there would ever be a mass-market for the tiny, three-wheeled commuter car. No single small-sized vehicle has ever had a material success in the US; even the globally successful small cars such as Daimler Benz’s Smart and Fiat’s 500C.

To demonstrate market demand and raise some startup funds, in January 2013 Elio introduced an on-line vehicle reservation system similar to one used by Tesla. . A potential buyer can reserve future delivery of a vehicle by depositing an amount from $100 to $1,000. Depositors have priority for vehicle delivery and receive a discount. By January 1, 2016, the company had more than 50,000 advance reservations for vehicles worth $340 million, and $21.1 million in deposits.

Elio hoped to raise sufficient funds from its equity Crowdfunding issue to fund prototype building and testing of 25 vehicles to be used to demonstrate various performance and safety features required to obtain a major loan from the US Department of Energy to fund production costs.

Enabled by Startengine, a for-profit Crowdfunding portal approved by the SEC, Elio sought non-binding “indications of interests” for up to $25 million of equity from investors over a three-month period to determine an appropriate price level and number of shares to be sold.

In August 2015, Elio closed its market test with over $42 million of interest in purchasing shares indicated by 11,000 investors with an average order of $3,820.

On August 29, Elio Motors filed a registration statement on the newly approved and abbreviated Form 1-A with the SEC. The proposed offering was to be of a minimum of 1 million and a maximum of 2 million shares. The expected offering price, set by the Company, was $12 per share.

The registration statement disclosed that Elio had not yet sold any vehicles, and in 2014 it lost $25 million and ended the year with a cumulative shareholder deficit of $45 million. Elio Motors obtained approval for the offering from the SEC in late November 2015.

The offering was conducted online via the Startengine website for 74 days from late November 2015 to late February 2016, during a period in which the S&P 500 stock index dropped 6.8% and VCs and other investors in many high visibility technology “unicorns” took substantial write-downs.

In February 2016, the Company announced that it had accepted orders for $17 million of shares (approximately 5% of the company) that capitalized the company in the market at $340 million.

Trading in the shares began on February 19, 2016 on OTCQX, an over-the-counter exchange. One week after the offering, shares were traded at $16.50 and soon thereafter increased to $37 per share. Trading volume was very light, however – only in the hundreds of shares. The tradable “float” in the Company’s shares, even after a tripling of the share price, was still only $52 million, an amount too small to attract interest from large institutional investors.

What’s Different About the Elio Offering?

Elio had been denied venture capital financing; the offering essentially allowed the Company to turn to ordinary investors as an alternative source of startup capital, and to do so at a much lower cost than VC investors would have required had they been willing to invest.

The Company itself, not VCs or underwriters, priced the shares

The IPO involved no Wall Street underwriters or underwriting fees; though legal and other fees associated with the offering, including fees to Startengine and Fund America Securities, a broker-dealer acting as a sales agent, amounted to approximately 10% of the amount raised, approximately the same as the sum of underwriting and other expenses associated with traditional IPOs. The Elio offering, however, was the first of its kind and no doubt involved fees and expenses that could be reduced in the future.

The shares were marketed entirely thorough the Internet using user-friendly StartEngine and Elio’s websites, which enabled thousands of potential investors to reserve shares in the offering on a non-binding basis (as well as reserving the Company’s product when it became available).

The shares are not being listed on NASDAQ or the NYSE. Volume of trading in the shares is limited and in small amounts suited to “ordinary” retail investors, but, even so, in the after-market following the IPO, Elio shares initially rose to a 38% premium over the offering price despite a significant downturn in the stock market indices.

Following Elio’s offering, over 40 companies made Form 1-A filings. Companies in many different industries, including healthcare, banking and even cannabis distributers, now see Crowdfunding as a potentially preferable alternative to traditional early stage funding sources.

Bypassing venture capital and the traditional Wall Street dominated IPO process to access ordinary investors through the Internet could certainly be disruptive if Elio’s success is repeated by other companies. 

However, the traditional methods involve venture capitalists or underwriters vetting companies thoroughly and agreeing to pricing at which they are willing to risk their own money.  It has long been thought that this screening process generates value for investors and that investors are prepared to reject alternative processes that do not include it. 

Crowdfunding now presents this unscreened alternative, and the Elio Motors offering suggests the perceived value of the vetting may have been exaggerated.

Indeed, for many years, “angel” investors (individuals investing directly in startup situations) have grown to become significant players in the venture finance area, with 316,000 investors funding 73,000 companies in deals worth $28 billion in 2015. Angel financing assists more startups than traditional VCs do, and angels do not rely on VCs for screening. Crowdfunding can greatly increase angels’ knowledge of and access to deals well beyond what they might encounter on their own.

Further, ordinary investors have been able to purchase shares in traditional IPOs for years, but rarely get a chance to do so because underwriters allocate shares in the IPOs to hedge funds and favored high-net-worth clients. Crowdfunding certainly removes barriers to entry that prevent ordinary investors from participating in the IPO market. 

Crowdfunding brings the power of the Internet to the startup funding market.  Between the SEC’s new rules and Startengine’s new procedures, a different and simpler way to access investors in startup companies has been created that, after some early learning experience, should provide a viable pathway for many companies to raise capital.