John Thain Says the Magic Words

One thing that came up often as Merrill’s recent C.D.O. sale and capital raise were discussed is how one could really say the following two statements, from the Merrill press release, are not conflicting with my statement. Let’s examine the Merrill statements first…

• Merrill Lynch will provide financing to the purchaser for approximately 75% of the purchase price. The recourse on this loan will be limited to the assets of the purchaser.
• The purchaser will not own any assets other than those sold pursuant to this transaction.

Seems obvious, then, that a decline in value will mean they take the assets back. Well, then why did I make the following statement (in the comments)?

• [There] can be provisions that allow Merrill to extract assets from other Lone Star entities or require the SPV to get more money from the Lone Star funds

Simply put, there are a lot of different ways one can structure a trade like this. First, there are the moving parts of the economic terms: the interest rate, the margin amount (think of this exactly the same as buying a stock on margin: essentially a loan) required upfront, the level of margin required to be maintained, etc. The interest rate is easy, I would think the interest rate would be somewhere around L+100bps or so. The terms for margin could be tricky, though. For example, the financing could be structured such that it requires 25% of the market value up front and requires that any time the equity decreases by 5% it is paid back in to ensure the fund always owns 75% of the risk.

Now, regardless of whether these terms are correct or not, we have hit a snag. The second statement, cited above, from the release seems to indicate that this isn’t really possible. Lone Star’s vehicle will only own these mortgage assets, so where does the rest come from? There are a number of ways Merrill can enforce this margin be kept up. First, as is common, they give themselves the power to do so by putting in “cross default” provisions. This allows Merrill to seize assets and other monetizable interests that are in its possession or control through financing arrangements with Lone Star. An example would be if a private equity fund owned a company and also purchased some securities with a repo agreement to finance them. If the private equity fund defaulted and the company had collateral with the firm providing the repo financing, the collateral could be seized. It’s also possible that there is a requirement for Lone Star to fund the margin, although not necessarily keep it in the vehicle.

Let’s see that, immediately, something interesting falls out from these terms. First, Lone Star has to be willing to fund some margin in the short run. If the assets drop in value to drive their equity down by some threshold amount (5% in the above example), they would need to fund that or potentially suffer elsewhere (cross default) or, potentially, face the assets being taken back altogether. This last option is clearly in Merrill’s best interest since it could seize the 25% equity already in the trade and have the upside of the assets as well–assuming Lone Star would never have put in more than the 25% upfront. This seems to defy logic, especially with assets being volatile in the short run and the clear implication that 22% of face value would become the valuation benchmark. One must also admit that Lone Star will be willing to put more money into this trade when the most mundane part of the transaction is considered, namely the interest owed on the 75% being borrowed. Consider this: if there was truly no way for Lone Star to put money into these assets then Merill would own them again ~30 days after the transaction closed. Why? Monthly interest payments on the financing. Lone Star will owe around 1/12th of 1 month L.I.B.O.R. + 100bps every month. That isn’t coming out of the margin, I would bet.

So what have I shown? There are enough degrees of freedom that one can cast scenarios where John Thain is either kicking his feet up and relaxing or where he’s calling down to the C.D.O. trading desk every ten minutes asking for marks on the assets to see if they are coming back to “Mother Merrill.” I will caveat the above by saying that I don’t know what is required to be disclosed in these sorts of arrangements, but it seems like Merrill would have the higher burden to disclose anything adversely affecting their financial status, and the lack of further bad news in the financing should be taken as an indicator.

It is for these reasons that some of the speculation surrounding the C.D.O. portion of the sale were a bit simplistic and probably not accurate in the way they stated what the true economics of the trade were. For example, saying they sold for five and change cents on the dollar is not true. We also cannot say that Merrill has sold it’s upside but retained it’s downside. Nor can we say both at once. All of these gloss over a level of nuance necessary to fully understand the transaction or require a number of assumptions.

Now that you know more than you ever wanted to know about financing, what was the point? Well, let’s examine these two statements from a NYT piece on Thain and the recent Merrill activity:

“We went to a lot of trouble to get this deal done, and we structured it in a way where there is very little chance that we ever get these C.D.O.’s back or take the same risk back,” Mr. Thain said.

Mr. Thain has been accused of misleading investors because as recently as mid-July he said that he felt comfortable with Merrill’s capital levels. He said his statements like the one on the second-quarter earnings call were true when he made them. “We would not have needed to raise more capital unless we completed the C.D.O. sale,” he said.

John Thain pretty much says the structure is well protected in the first statement. We’ve shown above that this transaction only makes sense for Lone Star if they are willing to let it run in the short term (and that makes sense if they truly think these assets are under-valued, otherwise why purchase them en masse). Couple this with all the criticism and negative P.R. John Thain and Merrill are taking for having to do the equity raise, and it’s pretty clear that that magnitude of attention is only worth is if this sale ended this chapter. Since he specifically states the contingency in the above quotation, I’m hard-pressed to think the sale has very little chance of ever being kicked back to Merrill.

In the end, I could be wrong and forced to eat my words. We’ll see, though, and I rather doubt it.

Merrill Cleanses Itself, We Think

Well, there was an announcement from Merrill about some things:

1. Selling CDO Assets
2. Settling monoline issues
3. Selling equity

Now, while all these are important, #2 is better covered elsewhere as I think reliance on insurers was stupid to begin with and #3 is what it is… best left for analyst reports for nuance, but very generally obvious. Let’s go to the release…

Merrill Lynch agreed to sell $30.6 billion gross notional amount of U.S. super senior ABS CDOs to an affiliate of Lone Star Funds for a purchase price of $6.7 billion. At the end of the second quarter of 2008, these CDOs were carried at $11.1 billion, and in connection with this sale Merrill Lynch will record a write-down of $4.4 billion pre-tax in the third quarter of 2008.

… [The] sale will reduce Merrill Lynch’s aggregate U.S. super senior ABS CDO long exposures from $19.9 billion at June 27, 2008, to $8.8 billion, the majority of which comprises older vintage collateral – 2005 and earlier. The pro forma $8.8 billion super senior long exposure is hedged with an aggregate of $7.2 billion of short exposure…

Merrill Lynch will provide financing to the purchaser for approximately 75% of the purchase price. The recourse on this loan will be limited to the assets of the purchaser. The purchaser will not own any assets other than those sold pursuant to this transaction. The transaction is expected to close within 60 days.

(emphasis mine).

Now, this is (via the WSJ via naked capitalism) 22 cents on the dollar. Wow! But, to be honest, this is sticker shock that comes from the massive liquidity being used here. The bid someone shows you on $30 billion versus $30 million is a very different proposition. This sounds like advice I gave before (see item #1 on that post). Now, what questions should the analysts be asking? Note the bold, italicized, underlined parts above. Seems as if the purchaser will be an entity, most likely formed for this transaction, that will only need 25% of the $6.7 billion, or $1.675 billion. Now, since the other 75% is financed, what happens if losses start flowing to these CDOs? The amount of equity decreases. From the Journal …

Many CDOs held by Merrill were viewed as highly likely to default and lose some or most of their principal value. Of around 30 CDOs totaling $32 billion that Merrill underwrote in 2007, 27 have seen their top triple-A ratings downgraded to “junk,” according to data compiled by Janet Tavakoli, a structured-finance consultant in Chicago. Their performance has been “dreadful,” she says.

(emphasis mine).

So now Merrill is in a race. Up to 78% of notional value can be written down, now, with no one taking a loss. Then the next $1.675 billion falls to Lone Star’s equity, and then the rest come out of capital Merrill has put up for the benefit of Lone Star. With the above downgrade statistics such losses aren’t completely out of the question. With this in mind, I would want to know the financing terms. The devil is in the details. Such financings could require only some margin up front in addition to the 25% equity, or none at all. The financing terms could limit Merrill’s ability to claw back more capital as the assets see further writedowns. In general, these terms could mean the risk is only cushioned, not removed. I’m sure these questions will be asked, and that Merrill anticipated such questions. This makes me think that these issues lead to the depressed price–price was the one protection potentially preventing Lone Star from having to have to cough up more money (you can’t owe money if the assets are performing better than their price implies). However, if these terms aren’t very favorable (Merrill was trying to get rid of these assets, after all) one might not ever see the financing terms. It’s also possible that Merrill retains some equity upside in these assets. I guess we’ll wait and see…

Dear John Thain: Think Outside the Box with T.P.G.

Dear John Thain,

I am intrigued to see you talking to T.P.G., although the media seems to only care about discussing capital infusions from the P.E. firm and hedge fund manager. With the recent Clear Channel conflict reverberating throughout the financial system it’s never been more clear the friction points that exist between investment banks and the other firms with which they interact. Building a collaborative relationship with a large private equity firm will give Merrill the ability to innovate their business model and profit where other banks are trying to mitigate losses. Would T.P.G. be in a better position with Merrill seeding their funds? Absolutely. Would Merrill have a better franchise if they were assured to be retained as an adviser for all/most of T.P.G.’s acquisitions (and likewise for portfolio companies)? Absolutely. Would financing large deals be easier if both sides (lender and borrower) have a stake in the transaction being completed and the total P&L of the deal (debt and equity)? Absolutely.

The best part is the model already exists and been proven out: Goldman Sachs. Goldman Sachs Capital Partners is one of the top fee payers amongst private equity funds, showing a clear benefit to Goldman’s advisory business. Goldman has been able to be aggressive in moving loans throughout the recent credit market turmoil–having a large P.E. operation, the fee income from their equity investments provides a positive balance to the negative marks for loans. In good times Goldman’s private equity arm generated profitable loans for itself and other banks (wow, how far those days seem) and added to their total income associated with a transaction. Clearly this dynamic is superior to the situation the Clear Channel financing consortium found themselves in, suing the financial sponsors because the sponsors are making money and the banks aren’t.

Merrill would also have an extremely valuable asset in the T.P.G. brand, proven fund raising ability, and long track record–a benefit that other investment banks have pursued but not had much success in achieving, Goldman being the closest to an exception (or perhaps Morgan Stanley in the form of M.S.R.E.F.). Clearly these considerations are extremely similar to the considerations that drove Merrill’s decision to invest in a top brand in money management (Blackrock). Oh, and let’s not forget the alternative asset management platform Merrill will gain access to with T.P.G.-Axon.

So, Mr. Thain, what is my proposal? Well, I’m hardly an expert on structuring these sorts of transactions, but some specific points worth exploring come to mind:

• Merrill should take an equity stake in T.P.G. to align it’s interests with the performance of T.P.G.’s funds.
• Merrill and T.P.G. could form a J.V. where Merrill’s leveraged loan business would, partially or in its entirety, reside. This unit would be responsible for financing buyouts and servicing T.P.G.’s needs. Leveraged finance professionals, leveraged loan trading, and distribution of loans would occur in this unit.
• Merrill and either T.P.G.-Axon or T.P.G. itself (or both) could create an actively managed debt fund to opportunistically purchase corporate loans, real estate loans, etc. Merrill would provide some amount of leverage with T.P.G. using it’s deep relationships to acquire the rest. Some Merrill loans in inventory would seed this venture.
• Merrill would become an adviser to the various T.P.G. funds. I’m not sure if it’s permissible to “lock up” future advisory business, but certainly there would need to be an understanding for a strong preference for Merrill to be included on all advisory work.
• Merrill’s current private equity business, where allowed and not in violation of any agreement (O.M. terms, perhaps), would sell it’s private equity business to T.P.G.
• Merrill and T.P.G. could institute a program for high net worth brokerage/private wealth clients to invest in T.P.G. funds.

Those are just some of the points that could lead to a productive and profitable relationship. This would turn other firms’ weaknesses and conflicts into an opportunity for Merrill. There are, obviously, tons of places where such an arrangement could break down (valuation of businesses, legal constraints, logistical issues, compliance and conflicts, etc.) but innovating the business model of Wall St. is going to set the stage for the next boom, in much the same way firms have failed this time around by, for example, relying on the same distribution-centric business models for new, unproven products. Just a thought.

Sincerely,

DearJohnThain

The Discord in Similarity

here’s an interesting Alphaville post that ran recently that pointed to an article in the FT. From FT’s Alphaville:

Recently installed chief executives at Merrill Lynch and Citigroup are raiding the ranks of their former employers, Goldman Sachs and Morgan Stanley, as they seek to transform the culture and management of banks shaken by the credit crisis.

The article actually has a bit of a glaring error, Vikram didn’t raid Morgan Stanley for the people they mention (John Havens, Don Callahan, and Brian Leach), but rather they came with Old Lane (except for Callahan, who came over from Credit Suisse). Other than this, there are some differences that should be highlighted.

1. At Citi, the team was brought in and given jobs for which they were ill suited. These people had all run businesses, but none had been focused on or solely in the alternative asset management business. That’s why the Old Lane acquisition has been such a disaster in the context of adding to the alternative asset management platform. One need look no further than the man that was heavily involved in the deal:

But the point, [Lewis] Kaden told Fortune this past March, was not for Citi to secure a hedge fund business but rather to capture the talent of Pandit and his team. That was like acquiring Morgan Stanley’s trading establishment, Kaden said, without paying billions to do it.

So, now what do we find? Pandit running the whole of Citi, including a massive and mediocre consumer bank, a large investment bank, an alternative asset management business, and a huge brokerage firm. John Havens, who only ever ran equities at Morgan Stanley, now also has an investment bank, fixed income division, corporate banking, and alternative asset management business under him. I’m sure it’s all the same… Also, the Citi executives have made it a point to bring in Morgan Stanley people at every possible juncture, mainly through acquiring middling (or completely new and not yet open for business) firms staffed by ex-coworkers (although never promoting these acquired people to positions with more responsibility, making it look like they are merely being made rich with Citi money). I’ve documented a fair amount of them in this post. At Merrill, however, Thain is filling positions with people that held those same positions elsewhere. Thomas Montag is running a sales and trading operation after … wait for it … running a sales and trading operation. Noel Donohoe spent eleven years running risk management at Goldman and will now be … well … running risk management at Merrill. Much more symmetry.

2. At Merrill, John Thain is flattening the organizational structure. This is a point the FT piece makes. Mr. Montag, for example, will report to Mr. Thain–This takes a major business unit and un-layers it. It shortens lines of communications and allows one of the C.E.O.’s trusted deputies direct more authority than if a middle ma were involved. At Citi, Vikram Pandit is creating a more complex structure. Now there are regional reporting lines and product reporting lines, resulting in many senior executives with two bosses. When you have the potential for a very opportunistic but very time sensitive investment, and you have two bosses, how many people do you need to get on the phone to make a decision? How many people are pulled in? How conducive is all of this extra work to getting decisions made and promoting a centralization of authority to make and enforce those decisions? As a matter of fact, it’s acknowledged that regional decisions have to travel to the central authority. From the horse’s mouth:

“It’s going to take some time because we have to be diligent,” Pandit said to a questioner in Turkey who asked when decisions can be made without New York’s stamp of approval. Translation: Don’t hold your breath.

At least they know it’s a problem.

3. Merrill’s talent and past leaders were harvested long before John Thain arrived. John Thain even brought back a popular Merrill figure, Jeffrey Kronthal, to help rebuild after Stan O’Neil churned many senior positions. Citi, on the other hand, had all but the most senior executives intact and has taken almost no one from their internal bench and promoted them during Mr. Pandit’s reign. Michael Klein was moved into a new role after threatening to resign (surprising that the C.E.O. would bend to the will of a subordinate who is known for being hard to deal with, but I’m not making the decision). When Tom Maheras and Randy Barker left, Maheras’ old job was filled (and then later demoted) and no one else was named (instead, they reorganized fixed income and equities entirely). The consumer bank, however? The top people are still there (with Ms. Dial augmenting the lineup). Indeed the only people that seems to have changed in senior management are the ones that were between Vikram and the C.E.O. spot (and his subordinates following him up the chain).

4. John Thain was hand picked for the top spot at Merrill and part of the job is being able to hire your direct reports and other key personnel. Indeed it was well documented in the financial press that there were many suitors for the C.E.O. spot at “Mother Merrill” and Thain was selected out of a field of candidates. Vikram, on the other hand, as I stated just above, fell into a power vacuum. It was even reported that most qualified contenders decided they didn’t want to be considered for the job. Clearly this is much less of a mandate to fill the ranks as one sees. There are the egos of the people that were passed over to consider as well as various internal problems that arise from such a sudden shift in power.

It seems pretty clear that once one looks deeper than the surface, there are some subtle but pervasive differences in how the two executives are choosing to fill the ranks at their new firms. These differences will make a massive difference in things like morale, talent retention, and tearing down internal silos. I guess we’ll have to see how all this plays out…