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

Why “Best” Doesn’t Mean Anything

One thing I fixate on is finding “the best” something.  In finance, however, I have to radically adjust my thinking. “Best” is meaningless–albeit for unintuitive reasons. I always thought that to put together the “best” trading desk, one only needs to go out and get the “best” traders. Well, along what dimensions does one judge a trader? Risk management? Percentage of trades that are profitable? Overall P&L? Ability as a manager?

Let me give two examples that show why “best” is a meaningless term. First, consider a trader who is senior and runs a trading desk. This trader still has a trading book, though, and is given a lot of balance sheet to use and take risk with. This trader has many trades on at once and, in general, they go in his favor (say 60-75%). He/she has demonstrated a consistent ability to generate positive P&L, and with more resources generally generates more P&L.  He/she is a very hands-off manager, however, and his/her subordinates go to him/her only with specific issues. This trader goes home earlier than the rest of the desk and pushes off as many outside obligations as possible to others. He/she knows most major players in the business and will have some email or IM conversations frequently and shares information with others on his/her desk.

Second, consider another senior trader who runs a trading desk. This trader is involved with a trading book, but has a subordinate to take over the day-to-day trading responsibilities. He/she is very focused on being a good manager and making his subordinates feel like their voices are heard. This trader has been around for a long while and dictates the overall risk positions of the desk, but not necessarily specific trades. He/she will take a view on, for example, the shape of the yield curve, risk/reward in the marketplace, and where supply and demand are headed and then recommend his/her desk to position themselves accordingly.  This trader commits sizable amounts of capital to trades, but has been working in an environment where balance sheet is constrained. He/she is very focused on maintaining good relations with major market participants and is pro-active about setting up and attending events outside the office with important accounts. This trader, due to the focus on relationships, is able to source very large “franchise trades” that allow the desk to control billions of dollars in supply and/or demand in various securities–these lead to large positive P&L for the desk.

Now, which is better? See? Completely different people. Completely different styles. The first probably is a great person to have at a shop that takes a lot of proprietary risk. The second is most likely a terrific fit for a business that focuses on secondary trading and being in the flow of big customers. But, which is better to build a trading business from scratch? Which is a better fit to take over a desk that has just lost a lot of money and had several traders fired? Which of the two traders described above is better for a nascent hedge fund? These questions are much more complex and multi-faceted than I would have believed just a short time ago.

Perhaps I’ve just taken 653 words to say something obvious, but it’s always been counter-intuitive to me that one can’t just take a list of traders, sort them by the revenue they generated, or some other number,  and interview them from top to bottom to find the best trader for the job.

My Thoughts on the Cycle (From LBO’s to sub-prime)

Wall Street is a funny place. Your friends are almost worse for you than enemies. At the top of the market every deal worked. You would enter into a commitment that might have been aggressive for the market, but the truth of the matter was that in an environment where spreads are tightening (essentially rising prices) the market was subsidizing your poor choices. For those that don’t know how the process works, I’ll go through a sample time-line and try to keep it as generic as possible.

1. A deal is brought to an investment bank, by a sponsor of some kind or a corporation.
2. The investment bank bids on some aspect of the deal. For an acquisition or L.B.O. it’s usually a role in the debt.
3. Banks go out to the market and solicit “color” (information). This is used to figure out what economic terms they should quote for a role in the deal. For example, they might offer to arrange a set of loans at an interest rate of 400 basis points above some benchmark (LIBOR, treasuries, swap rates, etc.) based on the information they received.
4. A process is run to determine who has offered the most attractive terms.
5. The firms are offered roles. Some might lead portions of the deal and some might just earn fees. The nuances of the various roles and how they work varies based on the product in question (loans, bonds, equity, etc.).
6. The terms that banks will be agreeing to if they take a role are given to them–these terms are derived from the terms proposed by the banks themselves (see #3). From what I have seen a role is rarely turned down. Not only that, but any given term offered on the deal might be incrementally worse than the worst proposal drawn up by the banks (an aggressive sponsor, for example, will take conditions or covenants and make them more lax, and then present that set of terms–any bank that doesn’t have access to all proposals will be none the wiser until much later).
7. Banks accept roles and begin the process to close the deal, due diligence the various points that were represented to them, and documenting everything that has been agreed to already. Banks will also, later in the process, begin their process of distributing whatever risk they have taken on (once again, bonds, loans, etc.) where applicable.

Now take into account the fact that P.E. firms have been paying billions in fees, that the leaders of these P.E. firms have very senior relationships, and investment banks have league table pressures. The fact that investment banks trip over each other to bid for a place in deals, sometimes through the market (and, if you read the prescient piece by Steven Rattner you would know banks even rushed to reprice loans as the market moved in their favor, giving P.E. firms back some of the upside despite the fact that the P.E. firms took no risk). Now you see P.E. firms sticking it back to the banks again. While banks were rushing to give back money and while the secular direction of the market was bailing banks out of bad decisions everyone was making money but P.E. firms were making more than their fair share. Now that the market has stalled and banks are stuck holding lots of inventory and sitting on the losing side of underwater commitments there is nearly no movement o the part of P.E. firms.

Now you see investment banks putting some protection for themselves where they should have had them before (the same way P.E. firms have protected themsevles), but there are still these pressures. You still have banks swallowing their pills for P.E. firms–all while these P.E. firms are doing deals that only work because of the banks. This isn’t a relationship or a partnership. And the question is, how will this affect business going forward? I would imagine there would be more outs built into the legal agreements between banks and sponsors (P.E. firms are often called financial sponsors) now. One would also hope that there would be a very senior understanding that economic flexibility works two ways.

Now, one thing I see all over is how, much like a fractal the same tricks are employed by Wall Street over and over again.  The situation described above is essentially EXACTLY the same way the sub-prime situation occurred. Banks bid on loans that they could profit from during a tightening spread environment because the market would bail them out. I remember when sub-prime loan packages were being bought from originators at 103% of their face value (100 million on loans would sell for 103 million dollars).  And now, just like with L.B.O. debt, the day of reckoning has come. Except here, banks can’t really rely on relationship or even a central entity to bargain with to try to get themselves out of their predicament–their own short-term profit motivation has created the same long-term pain.