Twitter - valuation

http://aswathdamodaran.blogspot.com/2013/11/valuation-myths-young-companies-cannot.html
http://aswathdamodaran.blogspot.com/2013/10/twitter-ipo-why-good-trade-be-bad.html
http://aswathdamodaran.blogspot.com/2013/09/twitter-announces-ipo-pricing-game.html

http://online.wsj.com/news/articles/SB10001424127887324755104579073562166634226

MBA Mondays: The Differences Between Enterprise Value And Market Value

Last week I mentioned that sometimes I am at a loss for something to post about on MBA Mondays. Andrew Parker, who got his MBA at Union Square Ventures (largely self taught) from 2006 to 2010, suggested in the comments that I post about the differences between Enterprise Value and Market Value. It was a good suggestion and so here goes.
The Equity Market Value (which I will refer to as Market Value for the rest of this post) is the total number of shares outstanding times the current market price for a share of stock. To make this post simple, we will focus only on public companies with one class of stock. The Market Value is the price you are paying for the entire company when you buy a stock.
Let's use Open Table, a recent public company as our real world example in this post. Open Table (ticker OPEN) closed on Friday at $48.19 and has a "market value" of $1.1bn according to this page on Tracked.com. According to Google Finance, Open Table has 22.77 million shares outstanding. So to check the market value calculation on Tracked.com, let's multiply the market price of $48.19 by the shares outstanding of 22.75 million. My desktop calculator tells me that is $1.096 billion.
So if you purchase Open Table stock today, you are effectively paying $1.1bn for the company. But Open Table has $70 million of cash and has $11.6 million of short term debt outstanding. So if you paid $1.1bn for the company (as would be the case if your company purchased Open Table), then you would be getting $70 million of cash and a debt obligation of $11.6 million.
So the Enterprise Value of Open Table, meaning the value of the business without any cash or debt, is a bit less than $1.1bn. To get the Enterprise Value, you calculate the Market Value and then subtract cash and add debt. When we do that, we find that Open Table currently has an Enterprise Value of $1.038bn. Not much difference in percentage, but almost $60mm in difference in dollars.
There are some companies that have a lot of cash or a lot of debt relative to their Market Values and in those cases it is really important to do this calculation to get to Enterprise Value.
We do a lot of valuation analysis on our portfolio companies, particularly the ones with a lot of revenues and profits. We do them mostly for our accountants as part of something called FAS 157 or "mark to market accounting". I am not a fan of FAS 157 and I've blogged about it here before. But regardless of whether or not I think "mark to market" is the right way to value a venture portfolio (I do not), it is the current practice and we need to do it.
When we do valuations, we often use public market comps to get "market revenue and profit multiples" and then we apply them to our portfolio companies. When you do this work, it is critical to use the Enterprise Values to get the multiples. Then when you apply the multiples to the target company, again you need to get an Enterprise Value and then work back to get Market Values.
If you use Market Values to calculate multiples, you may end up with some really screwy numbers for businesses with a lot of cash or a lot of debt. So use Enterprise Values when you are doing valuations and calculating multiples.
Fred Wilson is a partner at Union Square Ventures. He writes the influential A VC, where this post was originally published.

Corporate finance prep

http://www.wallstreetprep.com/blog/common-topics-of-confusion-for-investment-banking-analysts/

Herbalife

Một buổi chiều mùa đông năm 1998 ở Canberra, trên đường về ký túc xá sau một ngày học hành mệt mỏi tôi gặp một người đàn ông gầy gò có vẻ khá thân thiện. Sau khi bắt chuyện ông ta hỏi tôi có muốn vừa học vừa làm thêm kiếm tiền không, nếu muốn đến nhà ông ta dự một buổi seminar về phương thức kiếm tiền. Vài ngày sau, mất gần 2 tiếng đi xe bus, tôi đến nhà của người đàn ông này và gặp 4-5 người khác ở đó. Sau khi đã yên vị chúng tôi được chủ nhà cho xem một đoạn băng video về một sản phẩm sức khoẻ rất hấp dẫn, lần đầu tiên tôi biết đến cái tên Herbalife. Sau khi xem video và được người đàn ông đó giải thích về sản phẩm, cách thức bán hàng, ăn chia commission, và nhất là lợi ích của việc tuyển mộ thêm những người bán hàng dưới mình, lần đầu tiên tôi biết về phương thức bán hàng như vậy. Giấc mơ giàu sang như hình ảnh những sale leaders của Herbalife trong đoạn video được xem trước đó làm tôi quên hết cảm giác đói lạnh trên đường về ký túc xá. Trong đầu tôi lúc đó tràn ngập kế hoạch sẽ bán sản phẩm Herbalife như thế nào, thậm chí còn cố điểm mặt trong số bạn bè mình những ai "cần giảm cân" để tiếp cận trước. Nhưng quãng đường dài về ký túc xá cũng có cái lợi, những cú xóc của xe bus lôi tôi về thực tại với một tập tài liệu của Herbalife trên tay. Xem lại những tài liệu này tôi bỗng nhận ra rằng để được trở thành một sale person của hệ thống bán hàng Herbalife tôi phải bỏ ra gần $600 mua trước hơn chục hộp sản phẩm, số tiền đó hơn 2/3 một tháng học bổng của tôi lúc đó. Càng đọc tôi càng thấy viễn cảnh kiếm tiền của mình xa vời, sản phẩm Herbalife quá đắt ngay cả nếu tác dụng của nó đúng như quảng cáo. Với "khách hàng tiềm năng" của mình chủ yếu là sinh viên tôi nhận thấy khó có thể móc hầu bao của họ $100-200/tháng chỉ cho mục đích giảm cân. Về nhà trấn tĩnh lại rồi đọc kỹ các số liệu tôi lờ mờ hiểu rằng thực ra thu nhập của các sale person chủ yếu là từ con số bán $600 sản phẩm ban đầu cho những người sau mình trong chuỗi bán hàng. Ai cũng sẽ tặc lưỡi bỏ ra $600 để hi vọng sẽ giàu có như những sale leader trong video quảng cáo chứ thực ra không dễ bán được sản phẩm cho người tiêu dùng cuối cùng với mức giá trên trời như vậy. Lên mạng search (lúc đó mới có Yahoo chứ chưa có Google) tôi lần mò ra thuật ngữ "pyramid scheme" và phát hiện ra rằng hình thức bán hàng này đã bị một số nước cấm. Suy đi tính lại tôi quyết định không lao vào con đường kiếm tiền này nữa. Tôi không rõ luật của Úc có cấm pyramid scheme không nhưng Herbalife đã không thể bành trướng thị trường ở đây, tôi không còn nghe nói đến Herbalife nữa cho đến gần 15 năm sau. Đầu tháng 5/2012, David Einhorn, một hedge funder khá nổi tiếng đồng thời là một poker player có hạng (tôi đã có lần đề cập đến trên blog này), bỏ một quả bom tấn trong buổi công bố kết quả kinh doanh qua điện thoại (earning conference call) của Herbalife, lúc này đã niêm yết trên NYSE (HLF). Giữa buổi họp Einhorn yêu cầu ban giám đốc Herbalife công bố số liệu bán hàng phân chia rõ tỷ lệ bán nội bộ cho các sale person của mình so với bán ra ngoài cho người tiêu dùng cuối cùng. Einhorn trước đó rất nổi tiếng qua hai vụ short thành công Lehman Brothers và Green Mountain Coffee nên chỉ vài phút sau khi Einhorn phát biểu HLF rớt gần 20%, giới traders hiểu ngay rằng HLF đã bị Einhorn short trước đó. Tại sao chỉ một câu hỏi (thực ra Einhorn hỏi 3 câu nhưng câu hỏi nói trên quan trọng nhất) mà HLF bị mất 2 tỷ USD market cap chỉ trong mấy phút? Theo luật Mỹ pyramid scheme bị cấm nhưng Herbalife tuyên bố cách thức bán hàng của họ không phải pyramid scheme (PS) mà là multi-level marketing (MLM). Cả hai hình thức này đều cho phép sale person được hưởng phần trăm từ doanh số của những sale person dưới họ, nghĩa là những người mà họ tuyển dụng được. Tuy nhiên trong trường hợp PS, như tôi đã từng nghi ngờ năm 1998, lượng hàng thực sự được bán ra cho người tiêu dùng cuối cùng rất ít, chủ yếu sản phẩm được những sale person ở cấp thấp hơm mua với hi vọng họ sẽ tuyển dụng được một mạng lưới sale bên dưới họ. Với MLM lượng hàng bán ra chủ yếu cho người tiêu dùng cuối cùng, do vậy lực lượng sale dù có phải bỏ tiền ra mua một lượng hàng ban đầu nhưng họ có thể quay vòng vốn của mình chứ không chỉ trông chờ vào hệ thống sale bên dưới tiếp tục phát triển. Câu hỏi của Einhorn về bản chất là buộc HLF phải công bố số liệu chứng minh rằng họ là một MLM chứ không phải PS vì nếu không HLF sẽ phải đóng cửa. Mặc dù quả bom của Einhorn gây tiếng vang vào tháng 5/2012 và hedge funder này chắc đã kiếm được kha khá từ vụ short sell đó, cái tên Herbalife chỉ thực sự bùng nổ sau đó 6 tháng với hàng loạt tên tuổi lớn của giới hedge fund tham chiến. Thực ra không chỉ Einhorn "đánh hơi" thấy điểm yếu của HFL mà trước đó vài tháng một hedge funder khác nổi tiếng không kém là Bill Ackman đã âm thầm short sell gần 1 tỷ USD cổ phiếu HLF. Ackman dốc gần như toàn bộ đội ngũ của mình cùng với hai công ty luật và một số accountant chuyên về điều tra để nghiên cứu mô hình kinh doanh của HLF. Cũng trong năm 2012 Jim Chanos, một chuyên gia short sell lừng danh khác, đã bí mật short sell HLF nhưng không ai biết với số lượng bao nhiêu. Cuối năm 2012 Whitney Tilson, bạn học của Ackman ở HBS và là đồng sáng lập Value Investing Congress - một diễn đàn quan trọng bậc nhất cho giới đầu tư giá trị, công bố cũng đang có short position cổ phiếu của HLF. Tất nhiên bốn hedge funders này không hề nói họ "thông đồng" với nhau nhưng cũng khó tin cả bốn đã "tình cờ" short HLF trong năm 2012. Chiến thuật của giới short sellers rất đơn giản. Sau khi đã âm thầm short sell một công ty nào đó (vay cổ phiếu rồi bán, hoặc mua CDS nếu mục tiêu là công ty lớn) họ lên TV, báo chí, hoặc một diễn đàn, hội thảo công bố những nghi ngờ về số liệu hoặc rủi ro kinh doanh của công ty mục tiêu. Thông tin này càng được phổ biến rộng thì càng có nhiều investor khác lo ngại bán tháo số cổ phiếu mà họ đang nắm giữ, tiếp tục gây sức ép mất giá lên cổ phiếu đó. Einhorn nổ phát pháo đầu tiên vào tháng 5/2012, Ackman tiếp tục vào tháng 12, Tilson công bố vài ngày sau đó. Chanos úp mở mình đã short sell HFL tháng 3/2013, mặc dù tiết lộ rằng mình đã đóng hết position nhưng vẫn nói thòng một câu là HLF có mô hình kinh doanh không bền vững và Ackman phân tích đúng. Không chỉ dừng ở việc công bố thông tin, Ackman còn lên tiếng yêu cầu SEC và FTC vào cuộc thanh tra và xác định HLF có phải là một PS hay không. Với một công ty bình thường có market cap xấp xỉ 8 tỷ thì 4 cú đánh liên hoàn của 4 hedge funder nổi tiếng có tổng tài sản hàng chục tỷ dễ dàng hạ gục. Nhưng Herbalife không/chưa chết. Giới short sellers luôn luôn là kẻ thù của các CEO và không nhận được mấy thiện cảm từ public nói chung. Tuy nhiên có những so sánh short sellers với chó sói trong tự nhiên, tàn bạo, lạnh lùng "làm thịt" những con thú ốm yếu chậm chạp nhất nên gián tiếp giúp "làm sạch" bộ gene của bầy đàn sống sót. Chanos đã lật tẩy Enron, Einhorn chỉ ra cho cả thế giới biết Lehman đã quá rủi ro, Ackman phản đối lại AAA rating của MBIA, những hành động này đều vì mục đích đầu cơ kiếm tiền nhưng đã góp phần làm trong sạch nền kinh tế thị trường chưa bao giờ có đủ độ minh bạch. Nhưng cũng giống như chó sói, ngoài những "chiến công vang dội" lật tẩy những vụ gian dối, lừa đảo từ phía các công ty, giới short sellers đã giết không ít những con cừu non vô tội hoặc những con thú khỏe mạnh nhưng chẳng may lỡ bước. Bởi vậy giới CEO/CFO kinh nghiệm phải có những biện pháp chống lại bị short sell. Một trong những vũ khí hiệu quả nhất là thực hiện share buyback. Khi cổ phiếu của công ty bị "đãnh xuống", buyback có 3 tác dụng quan trọng. Thứ nhất nó làm giảm áp lực bán từ phía short sell, nghĩa là tăng cầu cho cổ phiếu trên thị trường. Thứ hai nó là tín hiệu trấn an các nhà đầu tư khác rằng công ty vẫn còn tiềm lực. Các nhà đầu tư khi thấy công ty thực hiện buyback cũng có thể kết luận rằng giá cổ phiếu lúc này đang "rẻ", bởi vậy bản thân họ có thể cũng tăng mua thêm. Thứ ba, khi công ty thực hiện buyback số cổ phiếu tự do (free float) trên thị trường giảm xuống sẽ gây khó khăn cho phía short sell tìm vay cổ phiếu để tiếp tục tấn công (sẽ nói thêm điểm này bên dưới). Tất nhiên để có thể thực hiện share buyback công ty bị tất công phải có strong cash flow hoặc phải có khả năng vay mượn cash từ một nguồn nào đó (banks, investors). Herbalife là một công ty có strong cash flow. Chắc chắn cả 4 short sellers nói trên đều biết HLF sẽ phản công lại bằng share buyback, đội ngũ analysts của họ không thể không nghiên cứu kỹ cash flow của HLF. Tuy nhiên trong số 4 short seller đó, không kể Tilson có position nhỏ, Einhorn và Chanos đã "ăn non" khi short sell rồi "take profit" ngay trong năm 2012, chỉ mình Ackman kiên quyết giữ short position. Ackman tuyên bố sẽ chiến đấu đến cùng vì Herbalife là PS chứ không phải MLM, do đó regulator sẽ đóng cửa công ty này và share price sẽ về zero (Ackman lập hẳn một website đưa ra các bằng chứng kết án Herbalife là một PS). Mặc dù phân tích của Ackman rất thuyết phục, John Hempton, một short seller nổi tiếng khác cho rằng Ackman đã mắc sai lầm khi hi vọng regulator sẽ đóng của Herbalife. Công ty này đã tồn tại hàng chục năm trước mũi các regulator và đã từng bị kiện nhiều lần nhưng đều thoát. Ngay cả nếu Ackman đúng, SEC hoặc FTC có thể phải mất hàng năm trời điều tra và ra quyết định cuối cùng. Trong thời gian đó Ackman sẽ phải chống trọi với dòng cash flow rất mạnh của HLF, và không chỉ HLF. Trong số các short sellers tiếng tăm, John Hempton có lẽ là người đầu tiên sử dụng blogosphere rất hiệu quả để triển khai các cuộc tấn công short sell của mình, điển hình như vụ Sino Forest và Focus Media, 2 công ty TQ niêm yết trên thị trường chứng khoán Mỹ. Khi Hempton phân tích trên blog và ví von cuộc chiến giữa HLF và Ackman như trận Stalingrad, với hàm ý một bên sẽ bị nghiền nát, Hempton đưa ra 2 lập luật rất mạnh hòng chứng minh kế hoạch short sell của Ackman sẽ thất bại. Thứ nhất, như đã nêu bên trên, Herbalife có cash flow rất mạnh, chắc chắn sẽ thực hiện share buyback chống lại Ackman. Thứ hai, Hempton đi thực địa đến tận một Herbalife nutrition club ở một khu phố nghèo của NYC để chứng minh rằng Herbalife không phải là PS. Một loạt blog posts, trả lời phỏng vấn TV, báo chí của Hempton chẳng phải chỉ để chứng minh sai lầm của Ackman và bênh vực HLF, nhiều khả năng Hempton đã mua cổ phiếu HLF, nghĩa là đối đầu trực diện với Ackman trong cuộc chiến này. Nhưng nếu chỉ mình Hempton đứng về phía HLF thì Ackman không ngại, dẫu sao Bronte Capital của Hempton chỉ là một hedge fund nhỏ ở Sydney, còn xa mới có khả năng dồn Ackman vào chân tường. Tuy nhiên không chỉ một mình Hempton cho rằng Ackman đã phân tích sai....

Groupon: All About Unredeemed Coupons

An analysis of the Groupon S-1 filed last week for their upcoming IPO highlights some interesting trends. A single table illustrates how the Groupon business model is entirely based upon the concept of float. The payments the company owes to merchants are growing at much faster rates than actual revenue rates. In fact, the balance sheet shows that the company owes more to merchants than total current assets, an unusual situation.

The Revenue Curve

There is no question that Groupon's revenue curve is amazing.
From sales of just $30 million in 2009 to sales of $713 million in 2010, Groupon has shown incredible growth rates.
As if that were not enough, sales in the first quarter of 2011 were $644 million.
Assuming trailing twelve-month revenue of approximately $1.2 billion, this would give Groupon a price/sales ratio of about 160. This is an extremely high valuation metric for a company with revenues of over $1 billion. (The S-1 does not provide quarterly revenue data for 2010, so assumptions must be made; we assumed $550 million for the last three quarters of 2010.)
This type of growth rate is astonishing, frankly, but focusing on only the revenue growth is superficial with Groupon's business model.

Groupon's Business Model

Groupon sells coupons to customers on behalf of merchants who sign an agreement with Groupon. To the merchant, Groupon serves as outsourced marketing, with the hope that Groupon's incentive to customers increases business. The merchant sells their services at a steep discount through a Groupon coupon.
Why are merchants willing to sell their services at discounts as much as 50% below the retail cost?
Part of the value offered to the merchant is the potential that coupons will either be unredeemed or not redeemed at all. In the U.S., an unredeemed coupon means that the merchant is effectively paid for nothing.
If the coupon is not redeemed for a long time, the merchant has accrued a future liability, but has increased cash flow. Since many small retail businesses survive on cash flow, rather than accrual-based accounting, any increase in current cash flow is a positive factor.
If the merchant views the unredeemed coupon as cash and views the lower revenue for services from redeemed coupons as marketing costs, the Groupon value proposition can be attractive.
The delay of time between the sale of a coupon and its redemption is where Groupon has built nearly all of its value.

Accrued Merchant Payable

On the balance sheet, amounts that are owed, but as yet unpaid to merchants, is recorded as a current liability called "accrued merchant payable." This metric is in addition to the standard balance sheet lines of "accounts payable" and "accrued expenses."
A very interesting picture emerges when the trend of this metric, the accrued merchant payable line, is measured against revenue, gross profit, and current assets trends.
The following table illustrates the trends in revenue, cost-of-goods sold, and gross profit, as given in the Groupon S-1.

Metric, $K	2009	2010	Q1 2011
Revenue	$30,471	$713,365	$644,728
Cost of Revenue	$19,542	$433,411	$374,728
Gross Profit	$10,929	$279,954	$270,000
Total Current Assets	$14,207	$173,855	$208,688

Source: Groupon S-1 Filing
When the trend of "accrued merchants payable" is compared to the trends in revenue, gross profit, and current assets, a curious development is seen, as illustrated in the table below.

Accrued Merchants Metric, $K	2009	2010	Q1 2011
Accrued Merchants Payable	$4,324	$162,409	$290,700
Percentage of revenue	14.2%	22.8%	45.1%
Percentage of cost of revenue	22.1%	37.5%	77.6%
Percentage of gross profits	39.6%	58.0%	107.7%
Percentage of current assets	30.4%	93.4%	139.3%

Source: Groupon S-1 Filing, Briefing.com calculations
It is the accrued merchants payable line that is astonishing, particularly as a percentage of current assets.  The accrued merchants payable line simply gets larger and larger as an overall percentage the more Groupon grows.
In fact, the accrued merchants payable line is greater than gross profits, which means that if Groupon had to pay their merchants immediately, the payment would consume all of the gross profit for that quarter.
What this means is that Groupon is essentially staying just one step ahead of having to pay the piper. Instead of having accrued liabilities go down as the company grows, the accrued liabilities expand. Such a model is somewhat equivalent to paying your rent with your credit card, prior to receiving your salary check, but the rent is larger than your salary each and every month.
The revenue trend at Groupon is the first metric that the public has focused on, particularly the media. It is certainly the incredible metric curve that the very high valuation is based upon.
However, if there was any lesson from the internet bubble era of ten years ago, it is that valuations based upon revenue alone are extremely risky. The minute an incredible revenue trend stops, the valuation the market is willing to place upon a stock drops dramatically.
Such a stock is somewhat comparable to the game of hot potato, where the goal is to acquire the stock and then pass it on as quickly as possible before the potato explodes.
We think that such a scenario is likely with Groupon, eventually, although it is difficult to predict when. Nothing keeps growing forever. The ticking time-bomb, however, is the money owed to merchants, and it's an ever increasing trend.

Unredeemed Coupons Are Key to Groupon's Financials 

Imagine, for instance, what the balance sheet would look like if Groupon paid all merchants their entire amount due at the time of the sale of a coupon, on a per-coupon basis, instead of waiting until the sale of coupons reaches a pre-arranged, negotiated level.
There would be no accrued merchants payable line on the balance sheet, except for the single day when the sheet is generated and issued checks are uncashed.
In such a scenario, the balance sheet would show negative current assets, meaning that there is no buffer of cash with which the company can operate on a daily basis. The situation is roughly equivalent to a company operating without any checking account at all.
What this all means is that the faster Groupon grows, the more of its accumulated cash is owed to the merchants, as a percentage of revenues, profits, and assets. However, Groupon needs the cash from unredeemed coupons to finance its daily operations. It is somewhat similar to a restaurant charging its customers in advance for a meal a week from now, and then using the payment to go out and buy ingredients and hire a chef.
With the Q1 2011 accrued merchant payable line at 45% of total revenue and 78% of cost-of-goods sold, it simply begs the question of why the merchants aren't being paid.
We think the accrued merchant payment line is going to become the critical metric to watch as Groupon grows.

Unredeemed Coupons Are Groupon's Working Capital

Groupon is funding its entire working capital needs with the money that is owed to its merchants.
This type of situation is fine as long as the company never stops growing at fantastic rates, and customers take months or years to redeem their coupons.
However, both of these trends are likely to recede at some point as Groupon gets larger.
Merchants that have sold coupons that haven't been redeemed, and therefore, haven't been paid by Groupon, are likely to eventually either demand their share of the cash, or withdraw from using Groupon as a marketing tool. After all, they haven't gained anything in such a situation.
Customers that fail to redeem coupons are not likely to continue buying coupons in the future. The initial thrill of Groupon occurs when services are bought for half the retail price. That thrill fades, however, as time goes on and the coupon is not used.
How many Groupon customers that have yet to redeem their coupon are likely to buy another one? At some point, purchasers of coupons that are unredeemed will change their view of Groupon from one of "a real bargain" to one of "an unnecessary impulsive purchase."
At the moment, the thrill of "getting a deal" is the driver behind the Groupon explosion of revenue. Someday, however, that thrill has to be backed up by the merchants increasing their business and receiving revenue and the customers returning to buy more coupons.

Conclusions

Groupon's entire business model depends on the time frame between the sale of a coupon and the time it is redeemed.
Certainly, they have sold a lot of coupons. But the scale of the unredeemed coupons is immense, and without it, the Groupon financial statements would look horrible, even with the incredible revenue trends.
How large is the market for persons who buy coupons and never redeem them? With a business model so dependent on customers being slow to redeem coupons, combined with delayed payments to merchants, Groupon's long-term investors have to make such an analysis for themselves. 
Your guess is as good as ours, but we do think that eventually, people who do not redeem the coupons they purchase are not a long-term viable customer base. At some point, the game collapses upon itself.
In the final analysis, customers need to receive actual value for their payments, not a perceived future value that is never delivered. We think the tone of the S-1 indicates that Groupon itself understands this issue.
You might notice, for instance, that Groupon is not selling any coupons for a 50% discount in their own stock offering.
Comments may be emailed to the author, Robert V. Green, at aheadofthecurve@briefing.com

Read more: http://www.briefing.com/investor/popuppages/articlepopup.aspx?articleId=NS20110623094414AheadOfTheCurve#ixzz1QA6eIJbp

After Years Without Change, Cracks Appear in I.P.O. Process

The last few decades have wrought a revolution in finance. One thing, though, remains stubbornly the same. It is the control that investment banks wield over initial public offerings.

The way companies go public looks almost identical to the Ford Motor Company’s I.P.O. more than 55 years ago. A company hires lead underwriters, which serve as the company’s spiritual and logistical advisers, helping the company prepare the necessary regulatory documents and marketing the offering to potential investors. The lead underwriters, and sub-underwriters hired by them, then build a book of investors who buy the shares. Through this process, an I.P.O. price is set and the company’s shares are sold into the public market.

The goal of the underwriting process is to provide a steady channel for companies to go public, and a vetting procedure to determine whether a company is ready to do so.

But today, the I.P.O. market is heated, and there is the specter of a bubble in social media Internet stocks as well as a postbubble hangover in Chinese issuers. During this period, the flaws in the current system become more apparent. Some of these flaws are significant and hurt investors.

The first crack to appear is in the gate-keeping function. Underwriters are set up by the regulatory system to be gatekeepers. Underwriters pass on some companies and certify others that their I.P.O. is worthy for the public. Theoretically underwriters should be doubly incentivized beyond the regulatory requirements to bring good companies to market. Otherwise customers will refuse to buy shares in future I.P.O.’s underwritten by that bank.

The wave of Chinese and social media I.P.O.’s shows that this gate-keeping function can become weak. Companies are being brought to market with uncertain prospects or because they are in a hot space. If a company is characterized as such, its main quality too often seems to be whether it can be sold instead of whether it should be sold. This is a rerun of the technology bubble.

In this type of market, not only is the gate-keeping function diminished, but the banks appear to be captive of the issuers. Take LinkedIn, which had questionable corporate governance in the form of a dual-class stock and a staggered board. But LinkedIn also deliberately stoked its first-day price rise by offering only a small number of its shares at a low price. The lead underwriters for its I.P.O. were Morgan Stanley, Bank of America Merrill Lynch and JPMorgan Chase.

There is a debate over whether this jump in share price was the fault of the underwriters or LinkedIn, but the bottom line is that the underwriters did not appear to do anything to damp the enthusiasm. This raises another problem with the gatekeeper function. Banks appear not only as weak gatekeepers in a hot market, they also dilute any negative impact on their reputation by spreading the wealth.

The Groupon I.P.O. has four lead underwriters, including Morgan Stanley. Groupon just announced the addition of six more banks to help it with its I.P.O.. The world of major underwriters is small, and they share the wealth by ensuring that those not chosen as lead underwriters are included in the sub-underwriting group. In other words, the potential impact on any one investment bank’s reputation is limited since they are all involved.

The second crack in the I.P.O. process is in the sales process. The current system does not benefit retail shareholders. Instead, investment banks sell I.P.O. shares to bigger institutional investors and rich individuals who have a relationship with the investment bank. And the profit from these sales can be large. I.P.O. gains average 10 to 15 percent in normal years, and a hot-market I.P.O., like LinkedIn’s, can have first-day gains greater than 100 percent. These are gains that retail shareholders not only miss but actually subsidize, since they must purchase in the more expensive aftermarket.

These two cracks highlight problems with I.P.O.’s, but perhaps the biggest problem is with the ones we do not see. Under the current system, underwriters have abandoned the small-issuer market. In 1996, according to Dealogic, 309 initial public offerings raised less than $25 million each. This number declined to 13 in 2010. Small companies, those with a market capitalization of $20 million to $250 million, are essentially locked out of the I.P.O. market. And this isn’t a Sarbanes-Oxley phenomenon, as the number of small I.P.O.’s declined to nine in 2001, before the act was passed.

The current underwriting system works, but only if you are a larger issuer or in a hot market. It also fails to serve as a check on an overly bubbly market. Instead, underwriters race to the bottom as they serve the demands of companies. How can any banker pass up being underwriter to an I.P.O. like LinkedIn’s, no matter the terms or quality?

Around the time of the Google I.P.O. in 2004, there was talk of trying to create alternative systems. Google abandoned the underwriting model and adopted an auction style that was more similar to how European I.P.O.’s were conducted before the American investment banks arrived there. The Google I.P.O. worked, but just barely. During the I.P.O. boom, Hambrecht & Quist and some other smaller investment banks also tried to start an auction-style I.P.O. system. None of these alternatives has gained traction.

There are advantages to the auction model. It brings retail investors back into the process because they can freely bid on issues. It also solves a related dilemma, which is that like commissions for real estate brokers, I.P.O. commissions are stubbornly uniform. They have stayed steady at 6 to 7 percent for years despite occasional attempts by issuers to lower them. Still, issuers don’t seem to care about this commission, and are instead willing to pay them to ensure good service at a propitious time in the company’s life.

Another alternative way for a company to get a stock market listing is through a reverse merger.

There are on average over 200 of these a year, according to the Reverse Merger Report. The Securities and Exchange Commission, however, issued a report last week highlighting the special risks inherent in these types of transactions. One reason was the lack of an underwriting vetting process.

So while retail investors would benefit from other models, they could also be hurt more in the long run by investing in unprepared companies that come to the market outside the traditional I.P.O. process.

Despite the criticisms, there does appear to be value in the underwriter model and its certification process. People simply trust these I.P.O.’s more. And with reason: companies that go public through the underwriting process appear to be of better quality.

The real issue thus appears to be how to get banks to serve as better gatekeepers and monitors. There is also a desperate need to encourage more small I.P.O.’s.

In other words, in this I.P.O. boom there is one big issue: how do you get underwriters to actually perform their underwriting function?

http://dealbook.nytimes.com/2011/06/14/after-years-without-change-cracks-appear-in-i-p-o-process/

Mckinsey on Finance on iPad

If you follow my blog, you may realize that I am a fan of Mckinsey. I used to wish to have McKinsey on my iPad/iPhone in order for me to read its material whenever I travel. Yesterday, I found it on app store. I would like to share it with you as well.

McKinsey on Finance on iPad

It is very cheap, only $0.99. It is a collection of all articles in Mckinsey on Finance, you can buy your convenience at a penny. I don't still understand how can the developer can earn a profit on this app. Developer of this app is Epsilon Mobile Pte Ltd.

The app is not so fancy, but it is fine. You can read documents with flipping, pinching and note taking. I used a number of other similar apps such as CloudReader, Goodreader, StudentPad (also Epsilon's app), iBook...but none of them have the same features.

I think the app will be more attractive if it has search, download on the go (don't let user download 10M+ app, I am reluctant to any 10M+ app) and an iPhone version.

For Activist Funds, a Long-Term Approach to Investing

Cevian Capital isn’t exactly a hedge fund, though it classifies itself that way in public filings.
It takes significant ownership stakes in companies for three to five years, but it isn’t really private equity, either.
Cevian, a $3.5 billion firm that is based in Europe with mostly American investors — Carl C. Icahn and the Florida Teachers Pension Fund among them — calls itself an “operational activist fund.” It is among a growing body of investors who eschew the limelight and push for longer-term operational changes at companies.
Funds like Cevian don’t grab headlines the way that investors like Mr. Icahn or William A. Ackman do, but some of them have done very well this year. Cevian is up 34 percent so far this year, after ending 2009 up about 35.7 percent. ValueAct Capital, based in San Francisco, which manages about $4.5 billion in assets, and Barington Companies Equity Partners are posting similar gains.
Activist funds are nothing new, of course. Where Cevian says it differs is its strategy, long lockup period and relatively low-profile approach and desire to get into the business and alter strategies and operations — not just shake up management.
About two-thirds of its roughly 150 investors are not allowed to withdraw their money for three to five years, a longer period than most activist hedge funds, Cevian says.
Cevian owns pieces of eight to 12 companies at a time, including Volvo and Demag Cranes of Germany.
“One great thing about the environment we’re in — everyone is super short-term focused,” said Harlan Zimmerman, a senior partner at Cevian who is based in London “They’re just reading the headlines and moving as quickly as possible.”
Other activist funds agree that with pressures on funds to produce short-term results or risk having their investors ask for the money back, those that can stay in for the long term can have a competitive advantage.
“It’s been the perfect environment for us,” said Jeffrey Ubben, founder of ValueAct. “I don’t think a lot of activist investors do what we do, because they either don’t want to get illiquid or don’t want to go as long.”
But hedge funds, even activist funds, face a challenge in being able to gain access to a stable capital base.
“That’s where everybody would like to be in the activist world, but it’s a tough balance,” said Damien Park, managing director of Hedge Fund Solutions. Sometimes managers have to give up their fee structure, he said, in exchange for longer lockup for capital.

Still, it is difficult to persuade investors to agree to long-term commitments. Many of them want the ability to withdraw money from hedge funds when there is turmoil. During the financial crisis, a number of investors found themselves unable to take out money.
The influential CFA Institute suggested recently that endowments and foundations, which provide a substantial portion of hedge funds’ assets, consider limiting or restricting investments in hedge funds that tie up capital.
The Investment Management Code of Conduct for Endowments, Foundations and Charitable Organizations warned that “such arrangements may affect future members’ ability to effectively manage the financial resources to meet the funding needs of the organization.”
To avoid the difficulty of long lockups, firms have adjusted. More hedge funds are creating so-called special purpose vehicles, highly specific investments tailored to just one acquisition, say lawyers who work with hedge funds.
“It’s happening more than it has in previous years,” said Marc Weingarten, a partner at the law firm Schulte Roth & Zabel. “Investors are more willing to lock up for that kind of play with the right manager.”
Other hedge funds are trying different approaches.
Philip Falcone, the embattled manager of the hedge fund Harbinger Capital Partners, bought a public shell company to avoid the whims of flighty investors. With the stable capital base of a public company, he doesn’t have to worry about redemptions, which can force managers to sell investments on the cheap.
Cevian likes to distinguish itself from other activists in the field by emphasizing its long-term commitment to the companies it invests in. Cevian executives typically spend six to seven months examining a company before they invest, speaking with managers, competitors, workers, suppliers and even those who have left the company.
Of course, they can also employ the same set of tools available to other activists, like layoffs, sales and public fights, and have not always been welcome among their target companies.
The downside is that their strategy is volatile and highly concentrated; in short, like most activists, they’re not very hedged.
“If you’re going on the board,” Mr. Zimmerman said, “you can’t be shorting companies.”
The coming year looks to be a good one for activist investors. A recent survey conducted by Schulte Roth and Mergermarket found that respondents expected shareholder activism to increase over the next 12 months.
That sort of activism stands to benefit operational activists as well as those who focus more on the balance sheet end of the spectrum.
Still, some analysts think that operational activists have a more sustainable model than hedge funds that agitate for change but are less inclined to go beyond financial engineering.
“Companies are getting more and more sophisticated about how to deal with activists, and so the number of sitting ducks is decreasing,’ said Michael Armstrong, an analyst at Monitor Group who studies activist investors. “If you really are going to create value going forward, you have to find a way of creating value above and beyond just agitating for change.”
That’s not to say that the more conventional activists won’t do well for themselves, and potentially for shareholders.
“There is fair amount of research that suggests the existence of a large, knowledgeable shareholder in the capital structure of the company has great benefits to smaller shareholders,” said William N. Goetzmann, professor of finance at Yale University School of Management. “Having an activist investor on your side by owning the same class of shares that you own — that’s a good thing.”

http://dealbook.nytimes.com/2010/12/20/for-activist-funds-a-long-term-approach-to-investing/?partner=rss&emc=rss

How the growth of emerging markets will strain global finance

Surging demand for capital, led by developing economies, could put upward pressure on interest rates and crowd out some investment.

Short-term doldrums aside

, the world’s corporations would seem to be in a strong position to grow as the global economy recovers. They enjoy healthy cash balances, with $3.8 trillion in cash holdings at the end of 2009, and they have access to cheap capital, with real long-term interest rates languishing near 1.5 percent. Indeed, as developing economies continue to pick up the pace of urbanization, the prognosis for companies that can tap into that growth over the next decade looks promising.
Yet all those new roads, ports, water and power systems, and other kinds of public infrastructure—and the many companies building new plants and buying machinery—may put unexpected strains on the global financial system. The McKinsey Global Institute’s (MGI) recent analysis finds that by 2030, the world’s supply of capital—that is, its willingness to save—will fall short of its demand for capital, or the desired level of investment needed to finance all those projects.1 Indeed, household saving rates have generally declined in mature economies for nearly three decades, and an aging population seems unlikely to reverse that trend. China’s efforts to rebalance its economy toward increased consumption will reduce global saving as well.
The gap between the world’s supply of, and demand for, capital to invest could put upward pressure on real interest rates, crowd out some investment, and potentially act as a drag on growth. Moreover, as patterns of global saving and investment shift, capital flows between countries will likely change course, requiring new channels of financial intermediation and policy intervention. These findings have important implications for business executives, investors, government policy makers, and financial institutions alike.

Surging demand for capital

Several economic periods in history have required massive investment in physical assets such as infrastructure, factories, and housing.2 These eras include the industrial revolution and the post–World War II reconstruction of Europe and Japan. We are now at the beginning of another investment boom, this time fueled by rapid growth in emerging markets.
Across Africa, Asia, and Latin America, the demand for new homes, transport systems, water systems, factories, offices, hospitals, schools, and shopping centers has already caused investment to jump. The global investment rate increased from a recent low of 20.8 percent of GDP in 2002 to 23.7 percent in 2008 but then dipped again during the global recession of 2009. The increase from 2002 through 2008 resulted primarily from the very high investment rates in China and India but reflected higher rates in other emerging markets as well. Considering the very low levels of physical-capital stock these economies have accumulated, our analysis suggests that high investment rates could continue for decades.
In several scenarios of economic growth, we project that global investment demand could exceed 25 percent of GDP by 2030. To support growth in line with the forecasters’ consensus, global investment will amount to $24 trillion in 2030, compared with about $11 trillion in 20083 (Exhibit 1). When we examine alternative growth scenarios, we find that investment will still increase from current levels, though less so in the event of slower global GDP growth.

The mix of global investment will shift as emerging-market economies grow. When mature economies invest, they are largely upgrading their capital stock: factories replace old machinery with more efficient equipment, and people make home improvements. But the coming investment boom will involve relatively more investment in infrastructure and residential real estate. Consider the fact that emerging economies already invest in infrastructure at a rate more than two times higher than that of mature economies (5.7 percent of GDP versus 2.8 percent, respectively, in 2008). The gap exists in all categories of infrastructure but is particularly large in transportation (for instance, roads, airports, and railways), followed by power and water systems. We project global investment demand of about $4 trillion in infrastructure and $5 trillion in residential real estate in 2030, if the global economy grows in line with the consensus of forecasters.

A decline in savings

The capital needed to finance this investment comes from the world’s savings. Over the three decades or so ending in 2002, the global saving rate (saving as a share of GDP) fell, driven mainly by a sharp decline in household saving in mature countries. The global rate has increased since then, from 20.5 percent of GDP in 2002 to 24 percent in 2008, as household saving rebounded in mature economies and many of the developing countries with the highest rates—particularly China—have come to account for a growing share of world GDP. Our analysis suggests, however, that the global saving rate is not likely to rise in the decades ahead, as a result of several structural shifts in the world economy.
First, China’s saving rate will probably decline as it rebalances its economy so that domestic consumption plays a greater role. In 2008, China surpassed the United States as the world’s largest saver, with the national saving rate reaching over 50 percent of GDP. But if China follows the historical experience of other countries, its saving rate will decline over time as the country grows richer, as happened in Japan, South Korea, Taiwan, and other economies (Exhibit 2). It is unclear when this process will begin, but already the country’s leaders have started to adopt policies that will increase consumption and reduce saving.4 If China succeeds at increasing consumption, it would reduce the 2030 global saving rate by around two percentage points compared with 2007 levels—or about $2 trillion less than China would have accumulated by 2030 at current rates.

Moreover, expenditures related to aging populations will increasingly reduce global saving. By 2030, the proportion of the population over the age of 60 will reach record levels around the world. The cost of providing health care, pensions, and other services will rise along with the ranks of the elderly. Recent research suggests that spending for the retired could increase by about 3.5 percentage points of global GDP by 2030.5 All of this additional consumption will lower global saving, either through larger government deficits or lower household and corporate saving.
Skeptics may point out that households in the United States and the United Kingdom have been saving at higher rates since the 2008 financial crisis, especially through paying down debt. In the United States, household saving rose to 6.6 percent of GDP in the second quarter of 2010, from 2.8 percent in the third quarter of 2005. In the United Kingdom, saving rose from 1.4 percent of GDP in 2007 to 4.5 percent in the first half of 2010. But even if these rates persist for two decades, they would increase the global saving rate by just one percentage point in 2030—not enough to offset the impact of increased consumption in China and of aging.
Together, these trends mean that if the consensus forecasts of GDP growth are borne out, the global supply of savings will be around 23 percent of GDP by 2030, falling short of global investment demand by $2.4 trillion. This gap could slow global GDP growth by around one percentage point a year. What’s more, sensitivity analysis of several scenarios suggests that a similar gap occurs even if China’s and India’s GDP growth slows, the world economy recovers more slowly than expected from the global financial crisis, or other plausible possibilities transpire, such as exchange-rate appreciation in emerging markets or significant global investment to combat and adapt to climate change (Exhibit 3).

Implications

Our analysis has important implications for both business leaders and policy makers. Businesses and investors will have to adapt to a new era in which capital costs are higher and emerging markets account for most of the world’s saving and investment. Governments will play a vital role in setting the rules and creating the conditions that could facilitate this transition.

Higher capital costs

Nominal and real interest rates are currently at 30-year lows, but both are likely to rise in coming years. If real long-term interest rates returned to their 40-year average, they would rise by about 150 basis points from the level seen in the autumn of 2010. The growing imbalance between the supply of savings and the demand for investment capital will be significant by 2020. However, real long-term rates—such as the real yield on a ten-year bond—could start rising even within the next five years as investors anticipate this structural shift. Furthermore, the move upward isn’t likely to be a one-time adjustment, since the projected gap between the demand for and the supply of capital widens continuously from 2020 through 2030.
Capital costs could easily go even higher. Real interest rates can also include a risk premium to compensate investors for the possibility that inflation might increase more than expected. History shows that real interest rates rise when investors worry about the possibility of unexpected spikes in inflation. Today, investors are beginning to anticipate higher inflation resulting from expansive monetary policies that major governments have pursued.
Finally, as the recent crisis demonstrated, short-term capital isn’t always available in a capital-constrained world. Companies should seek more stable (though also more expensive) sources of funding, reversing the trend toward the increasing use of short-term debt over the past two decades. The portion of all debt issued for maturities of less than one year rose from 23 percent in the first half of the 1990s to 47 percent in the second half of the 2000s. Financing long-term corporate investments through short-term funding will be riskier in the new world, compared with financing through equity and longer-term funding. To better align incentives, boards should revisit some of their inadvertent debt-oriented biases, such as using earnings per share (EPS) as a performance metric.

Changing business models

If capital costs increase, companies with higher capital productivity—greater output per dollar invested—will enjoy more strategic flexibility because they require less capital to finance their growth. Companies with direct and privileged sources of financing will also have a clear competitive advantage. Traditionally, this approach meant nurturing relationships with major financial institutions in financial hubs such as London, New York, and Tokyo. In the future, it might also mean building ties with additional sources of capital, such as sovereign-wealth funds, pension funds, and other financial institutions from countries with high saving rates.
Moreover, for companies whose business models rely on cheap capital, an increase in real long-term interest rates would significantly reduce their profitability, if not undermine their operations. The financing and leasing arms of consumer-durables companies, for example, would find it increasingly difficult to achieve the high returns of the recent past as the cost of funding increases. Companies whose sales depend on easily available consumer credit would find growth harder to achieve.

Shifting investor strategies

Investors will want to rethink some of their strategies as real long-term interest rates rise. In the short term, any increase in interest rates will mean losses for current bondholders. But over the longer term, higher real rates will enable investors to earn better returns from fixed-income investments than they have in the years of cheap capital. This change could shift some investment portfolios back to traditional fixed-income instruments and deposits and away from equities and alternative investments.
For pension funds, insurers, endowments, and other institutional investors with multidecade liabilities, the world’s growing infrastructure investment could be an attractive opportunity. Many of these institutions, however, will need to improve their governance and incentive structures, reducing pressure to meet quarterly or annual performance benchmarks based on mark-to-market accounting and allowing managers to focus on longer-term returns. This change would be required as institutions come to manage portfolios with a growing proportion of less liquid, long-term investments, since volatility in market prices may reflect market liquidity conditions rather than an investment’s intrinsic, long-term value.6
Emerging markets, though they may present attractive opportunities, also pose many risks and complexities, and returns could vary significantly across countries. As incomes in emerging markets rise and capital markets develop, nonfinancial businesses can expect healthy growth from investing in both physical and financial assets. Returns to financial investors are less certain, however, particularly in countries with low returns on capital or savings trapped in domestic markets by capital controls or a “home bias” among domestic savers and investors.7 These countries will remain susceptible to bubbles in equity, real-estate, and other asset markets, with valuations exceeding intrinsic levels. Foreign investors will need to assess valuations carefully before committing their capital. They will also have to take a long-term perspective, since volatility in these bubble-prone markets may remain higher than it is in the developed world.

A call for government action

Governments will need to encourage the flow of capital from the world’s savers to places where it can be invested in productive ways while minimizing the risks inherent in closely intertwined global capital markets. Governments in countries with mature markets should encourage more saving and domestic investment, rebalancing their economies so they depend less on consumption to fuel growth. Policy makers in these countries, particularly the United Kingdom and the United States, should start by putting in place mechanisms to sustain recent increases in household saving. They could, for instance, implement policies that encourage workers to increase their contributions to saving plans, enroll in pension plans, and work longer than the current retirement age. Further, governments can themselves contribute to gross national savings by cutting expenditures.
To replace consumption as an engine of economic growth, governments in these countries also should adopt measures aimed at boosting domestic investment. They could, for example, provide accelerated tax depreciation for corporations, as well as greater clarity on carbon pricing—the current uncertainty is holding back clean-tech investment. They should also address their own infrastructure-investment backlog, although this could require them to revise government accounting methods that treat investment and consumption in the same way.
In emerging economies, governments should promote the continued development of deep and stable financial markets that can effectively gather national savings and channel funds to the most productive investments. Today, the financial systems in emerging markets generally have a limited capacity to allocate savings to users of capital. We see this in these countries’ low level of financial depth—or the value of domestic equities, bonds, and bank deposits as a percentage of GDP.8 Policy makers should also create incentives to extend banking and other financial services to the entire population.
At the same time, policy makers around the world should create the conditions to promote long-term funding and avoid financial-protectionist measures that obstruct the flow of capital. This will require removing constraints on cross-border investing, whether through restrictions on pension funds and other investors or on capital accounts. Policy makers must also create the governance and incentives that enable managers of investment funds with long-term liabilities, such as pension funds, insurance companies, and sovereign-wealth funds, to focus on long-term returns and not on quarterly results that reflect market movements and can deviate from long-term valuations.
At this writing, global investment already appears to be rebounding from the 2009 recession. The outlook for global saving is less certain. A climate of costlier credit will test the entire global economy and could dampen future growth. The challenge for leaders will be to address the current economic malaise and simultaneously create the conditions for robust long-term growth for years to come.

https://www.mckinseyquarterly.com/Corporate_Finance/Capital_Management/How_the_growth_of_emerging_markets_will_strain_global_finance_2715?gp=1

http://i-connectx.net/node/185

Where the Bonuses Are Biggest

Bonuses make up a much larger share of earnings for employees in the finance and insurance industry than in any other major service-providing sector, according to a Labor Department report.

The chart shows the percent of gross earnings — defined as the sum of wages, overtime, bonuses, shift differentials and paid leave — held by bonuses. In financial services, bonuses account for 6.5 percent of gross earnings; the percentage for the next highest bonus-getter is less than half as large (professional, scientific and technical services, at 2.9 percent).

Within financial services, bonuses as a percentage of gross earnings were especially high for employees who work in securities, commodity contracts, funds and trusts. There, as you can see in the chart below, bonuses make up 12.7 percent of gross earnings. (The blue bars, labeled “supplemental pay,” also include overtime compensation and shift differential pay, which is a premium paid for working during hours that are less convenient than those of the typical workday.)

So why are bonuses so big — not only in absolute numbers but also relative to salaries and gross earnings — in the financial sector? The tax code appears largely responsible.

For example, some research has found that a 1993 change to the tax code intended to curb executive pay at public companies may have instead unintentionally increased it, and has had especially detrimental effects to pay incentives in the financial sector.

Update: Here is another (more comprehensive) paper on other Congressional efforts to discourage outsize pay, and the unintended consequences of those policies.

http://economix.blogs.nytimes.com/2010/04/28/where-the-bonuses-are-biggest/?partner=rss&emc=rss

Understanding Wall Street

Henry Blodget is doing some great reporting and analysis of the specifics of the very weak fraud charges against Goldman Sachs, but I think the general reaction to the fraud charges, i.e., the gut reaction by the man on the street, is that, "Yes, Goldman did commit fraud." This reaction comes from a failure to understand how Wall Street works.

Wall Street is essentially the land of dealmakers where, day in and day out, Wall Street brokers and investment bankers are approached to raise money, or create products. Most of the deals brokers and IB's are approached about are turned down because the brokers and IB's know that there is no one in their network to take the other side of the deal. If, say. Apple approaches a broker to sell some stock, the broker is likely to agree to the deal because he knows that he can sell the stock to his network. If Johnny down the street approaches a broker to sell stock in his company that hopes to someday capture flying saucers and turn them into tourist travelling air ships, a broker might have problems placing the deal, and turn Johnny down.

It's the same with constructing product, Goldman or any other broker is only going to take on the construction of a product for a client when Goldman knows it can place the opposite side of the product.

It might be a great idea right now to create a product that owns land directly under the Icelandic volcano that is erupting and short that product. Goldman isn't creating this product because it knows that no one would take the opposite side of that trade. Who afterall is going to buy land right at the core of the erupting volcano? On the other hand, when Paulson approached Goldman about creating a CDO that could be shorted, Goldman knew it could find investors who would be interested in taking the other side of that trade, i.e. people who thought real estate prices were going to continue to climb higher (Note to the SEC: In 2007, there were a few people who thought real estate prices were going to be climbing higher.)

When Goldman agreed, Goldman was doing what it does every day simply putting a deal together.

Now, the SEC further alleges that Paulson put the deal together. This is not true. Whenever anyone brings a potential deal to a broker or IB, they are going to try and get the best terms they can. When a company negotiates with a broker on the price of an IPO, the company tries to influece the broker for the highest price possible, i.e. one could say the company had input in setting the price.

In the same way, if Goldman is putting together a CDO for Paulson, Paulson is going to, very logically, want the weakest mortgage backed securities in the world in that CDO. There is nothing wrong with this. Paulson can suggest anything in the world. Goldman took it to an independent third party, ACA, to evaluate the securities Paulson wanted in the CDO. They allowed some, and disallowed others.

ACA and Goldman Sachs then bought some of this CDO. Got that? For all practical purposes, Goldman and ACA thought Paulson was an idiot for thinking the real estate market was going down. Goldman and ACA, which let me emphasise again was the independent third party brought in to evaluate the potfolio, bought part of the CDO. This was a regular everyday transaction on Wall Street. As far as Goldman failing to disclose that Paulson was on the other side of the trade, disclosure like that is simply never done on Wall Street. You do your own analysis and you take your chances. It is the only logical way to do things.How could Warren Buffett, for example, ever buy or sell stock if his broker had to disclose to the opposite party, "Hey, you are trading against Warren Buffett."

You would think that Robert Khuzami, Director of the Division of Enforcement at the SEC would understand this. Thus, it appears that the charges are complete grandstanding by the SEC for political reasons. It's feeding Goldman meat to the masses, now that Goldman CEO Lloyd Blankfein dissed President Obama, when Obama called for a sitdown.

Goldman raped America when Blankfein, in cahoots with then Treasury Secretary Hank Paulson, bailed out AIG for the benefit of Goldman Sachs. That was criminal, so it is hard to feel sorry for Goldman, but on the other hand, this charge against Goldman is not about justice, it is about big game politics, and there is not a more evil bunch of people on earth than government officials who will twist facts and situations to fit power agendas. Power agendas must always and everywhere be fought, and this move by the SEC and Khuzami is nothing but a power agenda move. If they get away with this one, the next time they may try it on you.

http://www.economicpolicyjournal.com/2010/04/understanding-wall-street.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+Economicpolicyjournalcom+%28EconomicPolicyJournal.com%29&utm_content=Google+Reader

Goldman-plated excuses

My first reaction, upon reading about the SEC’s complaint against Goldman Sachs was to shrug. Basically, the SEC claims that Goldman failed to disclose a conflict of interest in a deal the firm arranged, that perhaps Goldman even misdirected and misimplied and failed to correct impressions that were untrue but helpful in getting the deal done. If that’s the worst the SEC could dig up, I thought, there’s way too much that’s legal. Had you asked me, early Friday afternoon, what would happen, I would have pointed to the “global settlement” seven years ago. Then as now, investment banks were caught fibbing to keep the deal flow going (then via equity analysts who hyped stocks they privately did not admire). The settlement got a lot of press, the banks were slapped with fines that sounded big but didn’t matter, promises were made about “chinese walls” and stuff, nothing much changed.

But Goldman’s PR people have once again proved themselves to be masters of ineptitude. Haven’t those guys ever heard, “it’s not the crime, but the cover up”? The SEC threw Goldman a huge softball by focusing almost entirely on the fibs of a guy who calls himself “the fabulous Fab” and makes bizarre apocalyptic boasts. Given the apparent facts of this case, phrases like “bad apple” and “regret” and “large organization” and “improved controls” would have been apropos. It’s almost poignant: The smart thing for Goldman would be to hang this fab Fab out to dry, but whether out of loyalty or arrogance the firm is standing by its man.

But Goldman’s attempts to justify what occurred, rather than dispute the facts or apologize, could be the firm’s death warrant. The brilliant can be so blind.

The core issues are simple. Goldman arranged the construction of a security, a “synthetic CDO”, which it then marketed to investors. No problem there, that’s part of what Goldman does. Further, the deal wasn’t Goldman’s idea. The firm was working to serve a client, John Paulson, who had a bearish view of the housing market and was looking for a vehicle by which he could invest in that view. Again, no problem. I’d argue even argue that, had Goldman done its job well, it would have done a public service by finding ways to get bearish views into a market that was structurally difficult to short and prone to overpricing.

Goldman could, quite ethically, have acted as a broker. Had there been some existing security that Paulson wished to sell short, the firm might have borrowed that security on Paulson’s behalf and sold it to a willing buyer without making any representations whatsoever about the nature of the security or the identity of its seller. Apparently, however, the menu of available securities was insufficient to express Paulson’s view. Fine. Goldman could have tailored a security or derivative contract to Paulson’s specifications and found a counterparty willing to take the other side of the bet in full knowledge of the disagreement. Goldman needn’t (and shouldn’t) proffer an opinion on the substantive economic issue (was the subprime RMBS market going to implode or not?). Investors get to disagree. But it did need to ensure that all parties to an arrangement that it midwifed understood the nature of the disagreement, the substance of the bet each side was taking. And it did need to ensure that the parties knew there was a disagreement.

Goldman argues that the nature of the security was such that “sophisticated investors” would know that they were taking one of two opposing positions in a disagreement. On this, Goldman is simply full of it:

Extensive Disclosure Was Provided. IKB, a large German Bank and sophisticated CDO market participant and ACA Capital Management, the two investors, were provided extensive information about the underlying mortgage securities. The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world. These investors also understood that a synthetic CDO transaction necessarily included both a long and short side. [bold original, italics mine]

The line I’ve italicized is the sole inspiration for this rambling jeremiad. That line is so absurd, brazen, and misleading that I snorted when I encountered it. Of course it is true, in a formal sense. Every financial contract — every security or derivative or insurance policy — includes both long and short positions. Financial contracts are promises to pay. There is always a payer and a payee, and the payee is “long” certain states of the world while the payer is short. When you buy a share of IBM, you are long IBM and the firm itself has a short position. Does that mean, when you purchase IBM, you are taking sides in a disagreement with IBM, with IBM betting that it will collapse and never pay a dividend while you bet it will succeed and be forced to pay? No, of course not. There are many, many occasions when the interests of long investors and the interests of short investors are fully aligned. When IBM issues new shares, all of its stakeholders — preexisting shareholders, managers, employees — hope that IBM will succeed, and may have no disagreement whatsoever on its prospects. Old stakeholders commit to pay dividends to new shareholders because managers believe the cash they receive up front will enable business activity worth more than the extra cost. New shareholders buy the shares because they agree with old stakeholders’ optimism. The existence of a long side and a short side need imply no disagreement whatsoever.

So why did Goldman put that line in their deeply misguided press release? One word: derivatives. The financially interested community, like any other group of humans, has its unexamined clichés. One of those is that derivatives are zero sum contests between ‘long’ investors and ’short’ investors whose interests are diametrically opposed and who transact only because they disagree. By making CDOs, synthetic CDOs sound like derivatives, Goldman is trying to imply that investors must have known they were playing against an opponent, taking one side of a zero-sum gamble that they happened to lose.

Of course that’s bullshit. Synthetic CDOs are constructed, in part, from derivatives. (They are built by mixing ultrasafe “collateral securities” like Treasury bonds with credit default swap positions, and credit default swaps are derivatives.) But investments in synthetic CDOs are not derivatives, they are securities. While the constituent credit default swaps “necessarily” include both a long and a short position, the synthetic CDOs include both a long and a short position only in the same way that IBM shares include both a long and a short position. Speculative short interest in whole CDOs was rare, much less common than for shares of IBM. Investors might have understood, in theory, that a short-seller could buy protection on a diversified portfolio of credit default swaps that mimicked the CDO “reference portfolio”, or could even buy protection on tranches of the CDO itself to express a bearish view on the structure. But CDO investors would not expect that anyone was actually doing this. It would seem like a dumb idea, since CDO portfolios were supposed to be chosen and diversified to reduce the risk of loss relative to holding any particular one of its constituents, and senior tranches were protected by overcollateralization and priority. Most of a CDO’s structure was AAA debt, generally viewed as a means of earning low-risk yield, not as a vehicle for speculation. Synthetic CDOs were composed of CDS positions backed by many unrelated counterparties, not one speculative seller. Goldman’s claim that “market makers do not disclose the identities of a buyer to a seller” is laughable and disingenuous. A CDO, synthetic or otherwise, is a newly formed investment company. Typically there is no identifiable “seller”. The investment company takes positions with an intermediary, which then hedges its exposure in transactions with a variety of counterparties. The fact that there was a “seller” in this case, and his role in “sponsoring” the deal, are precisely what ought to have been disclosed. Investors would have been surprised by the information, and shocked to learn that this speculative short had helped determine the composition of the structure’s assets. That information would not only have been material, it would have been fatal to the deal, because the CDO’s investors did not view themselves as speculators.

I have little sympathy for CDO investors. Wait, scratch that. I have a great deal of sympathy for the beneficial investors in CDOs, for the workers whose pensions won’t be there or the students at colleges strapped for resources after their endowments were hit. But I have no sympathy for their agents and delegates, the well-paid “professionals” who placed funds entrusted them in a foolish, overhyped fad. But what investment managers believed about their hula-hoop is not what Goldman now hints that they believed. Investors in synthetic CDOs did not view themselves as taking one side of a speculative gamble against a “short” holding opposite views. They had a theory about their investments that involved no disagreement whatsoever, no conflict between longs and shorts. It went like this:

There is a great deal of demand for safe assets in the world right now, and insufficient supply at reasonable yields. So, investors are synthesizing safe assets by purchasing riskier debt (like residential mortgage-backed securities) and buying credit default swaps to protect themselves. All that hedging is driving up the price of CDS protection to attractive levels, given the relative safety of the bonds. We might be interested in capturing those cash flows, but we also want safe debt. So, we propose to diversify across a large portfolio of overpriced CDS and divide the cash flows from the diversified portfolio into tranches. If we do this, those with “first claims” on the money should be able to earn decent yields with very little risk.

I don’t want to say anything nice about that story. The idea that an investor should earn perfectly safe, above-risk-free yields via blind diversification, with little analysis of the real economic basis for their investment, is offensive to me and, events have shown, was false. But this was the story that justified the entire synthetic CDO business, and it involved no disagreement among investors. According to the story, the people buying the overpriced CDS protection, the “shorts” were not hoping or expressing a view that their bonds would fail. They were hedging, protecting themselves against the possibility of failure. There needn’t have been any disagreement about price. The RMBS investors may have believed that they were overpaying for protection, just as CDO buyers did, just as we all knowingly and happily overpay for insurance on our homes. Shedding great risk is worth accepting a small negative expected return. That derivatives are a zero-sum game may be a cliché, but it is false. Derivatives are zero-sum games in a financial sense, but they can be positive sum games in an economic sense, because hedgers are made better off when they shed risk, even when they overpay speculators in expected value terms to do so. (If there are “natural” hedgers on both sides of the market, no one need overpay and the potential economic benefits of derivatives are even stronger. But there are few natural protection sellers in the CDS market.)

Goldman claims to have lost money on the CDO it created for Paulson. Perhaps the bankers thought Paulson was a patsy, that his bearish bets were idiotic and they were doing investors no harm by hiding his futile meddling. Perhaps, as Felix Salmon suggests, the employees doing the deal had little reason to care about whether the part of the structure Goldman retained performed, as long as they could book a fee. It is likely that even if Paulson had had nothing to do with the deal, the CDO would still have failed, given how catastrophically idiotic RMBS-backed CDOs were soon revealed to be.

But all of that is irrelevant, assuming the SEC has the facts right. Investors in Goldman’s deal reasonably thought that they were buying a portfolio that had been carefully selected by a reputable manager whose sole interest lay in optimizing the performance of the CDO. They no more thought they were trading “against” short investors than investors in IBM or Treasury bonds do. In violation of these reasonable expectations, Goldman arranged that a party whose interests were diametrically opposed to those of investors would have significant influence over the selection of the portfolio. Goldman misrepresented that party’s role to the manager and failed to disclose the conflict of interest to investors. That’s inexcusable. Was it illegal? I don’t know, and I don’t care. Given the amount of CYA boilerplate in Goldman’s presentation of the deal, maybe they immunized themselves. But the firm’s behavior was certainly unethical. If Goldman cannot acknowledge that, I can’t see how investors going forward could place any sort of trust in the firm. Whatever does or does not happen in Washington D.C., Goldman Sachs needs to reform or die.

http://www.interfluidity.com/v2/784.html

Understanding the bad bank

https://www.mckinseyquarterly.com/Financial_Services/Banking/Understanding_the_bad_bank_2487?gp=1

Buffett Bets Big on Railroads’ Future

America’s best-known investor, Warren E. Buffett, is making his biggest bet yet on the nation’s economic future by buying, of all things, a railroad.

After deftly capitalizing on the financial crisis with a series of bold deals, Mr. Buffett on Tuesday agreed to buy the 131-year-old Burlington Northern Santa Fe Corporation.

A railroad might strike many people as a bit old-fashioned — more 19th century than 21st. But Mr. Buffett is wagering that as the economy revives, so will the demand for goods to be shipped by train. Burlington Northern carries coal and timber from the West, grain from the Midwest and imports arriving directly from Mexico and Canada, as well as through California ports.

And railroads, Mr. Buffett contends, are transportation for a fossil fuel-challenged future, since trains are generally more efficient and greener than trucks.

But for Mr. Buffett, the deal is also the fulfillment of a dream denied in childhood.

“This is all happening because my father didn’t buy me a train set as a kid,” Mr. Buffett joked in an interview.

His new toy will not come cheap. Berkshire Hathaway, the conglomerate he runs, will spend roughly $26 billion for the 77.4 percent of the railroad that it does not already own, paying $100 a share in cash and stock. As part of the bid, Mr. Buffett is splitting Berkshire’s class B shares 50-for-1 to pay Burlington Northern shareholders, breaking his rule of never splitting Berkshire’s stock. The split increases the total number of class B shares while avoiding fractional stock ownership for Burlington Northern shareholders.

“I stretched on this one," he said in an interview. “I went to the last nickel.”

Burlington Northern investors responded wildly to the news, pushing the company’s stock price up nearly 28 percent to $97 a share. While other transportation stocks also gained, the deal did not light a fire under the broader stock market. The Dow Jones industrial average fell 17.53 to 9,771.91.

Buying Burlington Northern is of a piece with the investments Mr. Buffett has made over the past year. He has positioned himself to profit from the mayhem in the markets and secure a legacy as one of the greatest investors of all time. While others were running scared last fall, Mr. Buffett invested billions in Goldman Sachs — and reached a far richer deal than Washington. He staked billions more in other blue-chip companies like General Electric and Wrigley.

The acquisition of Burlington Northern, based in Fort Worth, most likely concludes the investor’s search for an “elephant” acquisition, which he first described in one of his famed letters to Berkshire investors two years ago. His last major deal was in late 2007, when he agreed to buy a majority stake in Marmon Holdings, the conglomerate controlled by the Pritzker family.

“From my standpoint, it’s a lot easier to make a $32 billion investment than 10 $3 billion investments,” he said.

Even as the credit markets have improved and banks have become less skittish about lending, few companies can muster Mr. Buffett’s financial firepower. Berkshire will borrow $8 billion to supplement $8 billion in cash from its books, paying off the debt in three annual installments.

Investors big and small hang on Mr. Buffett’s pronouncements, and with good reason: if you had invested $1,000 in the stock of Berkshire in 1965, you would have amassed millions of dollars by 2007. He bases his philosophy on stable, reliable investments. “We’ll make a good return, not a great return,” he said of the Burlington Northern deal.

Mr. Buffett heeded his own rules of investing in making his latest acquisition.

One is to invest in companies that you understand. For Mr. Buffett, Burlington Northern fits the bill. He first bought a stake in the company in 2006, adding to shares held in two other railroad operators, Union Pacific and Norfolk Southern. Burlington Northern emerged as his choice, and he eventually built up a stake of 76 million shares in the company.

Another of his rules is to buy quality products at bargain prices. Burlington Northern’s stock price has stayed nearly flat over the past year, as its cargo load fell alongside the economy as a whole.

A third maxim is to move quickly — and Mr. Buffett did. On Oct. 22, Mr. Buffett arrived in Fort Worth as part of a visit to Berkshire’s portfolio companies. There, he met with Matthew K. Rose, the chairman and chief executive of Burlington Northern, who practiced an investor presentation with him.

Before he left, Mr. Buffett turned to Mr. Rose and said, “If you ever want a good home for Burlington, think of Berkshire.” Later, he spoke with Charles T. Munger, his trusted lieutenant at Berkshire, and began discussing a price for Burlington Northern.

The next night, Mr. Rose dropped by Mr. Buffett’s hotel, and within 15 minutes, the billionaire had delivered his bid. “There wasn’t much to say,” Mr. Buffett recalled on Tuesday.

By Sunday, Burlington Northern had retained advisers at Goldman Sachs and the boutique investment bank Evercore Partners, and the two sides began negotiating. Few issues emerged, other than Burlington Northern’s desire for a stock component to the bid, to allow its shareholders to choose a tax-free alternative to cash. By Thursday, lawyers from Munger, Tolles & Olson for Berkshire and from Cravath, Swaine & Moore for Burlington Northern began drafting deal documents.

Mr. Buffett said his goal was to have the deal sealed by Sunday at noon, when he was scheduled to have a root canal.

“I wanted to go into that with a mind that was at ease,” he said.

http://www.nytimes.com/2009/11/04/business/04deal.html?partner=rss&emc=rss

Futures contract

In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price.

A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract, but both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the commodity to the buyer, or, if it is a cash-settled future, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his/her position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations.

Futures contracts, or simply futures, are exchange traded derivatives. The exchange's clearinghouse acts as counterparty on all contracts, sets margin requirements, and crucially also provides a mechanism for settlement.

Standardization
Futures contracts ensure their liquidity by being highly standardized, usually by specifying:
The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate.

The type of settlement, either cash settlement or physical settlement.

The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.


The currency in which the futures contract is quoted.

The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. For example, the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulfur content and API specific gravity, as well as the pricing point -- the location where delivery must be made.


The delivery month.

The last trading date.

Other details such as the commodity tick, the minimum permissible price fluctuation

Margin
To minimize credit risk to the exchange, traders must post margin or a performance bond, typically 5%-15% of the contract's value.
Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position.
Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers' open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers.
Customer margin Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. Futures Commission Merchants are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value. Also referred to as performance bond margin.
Initial margin is the money required to open a derivatives position( in futures, forex or CFDs) It is a security deposit to ensure that traders have sufficient funds to meet any potential loss from a trade.
If a position involves an exchange-traded product, the amount or percentage of initial margin is set by the exchange concerned.
If a In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available. Often referred to as "variation margin", margin called for this reason is usually done on a daily basis, however, in times of high volatility a broker can make a margin call or calls intra-day.
Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the right to close sufficient positions to meet the amount called by way of margin. After the position is closed-out the client is liable for any resulting deficit in the client's account.
Some US Exchanges also use the term "maintenance margin", which in effect defines by how much the value of the initial margin can reduce before a margin call is made. However, most non-US brokers only use the term "initial margin" and "variation margin".
The Initial Margin requirement is established by the Futures exchange, in contrast to other securities Initial Margin which is set by the Federal Reserve in the U.S. Markets.
A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level.
Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in his margin account.

Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he doesn't want to be subject to margin calls.

Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit.

Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchange's perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The Annualized ROM is equal to (ROM+1)(year/trade_duration)-1. For example if a trader earns 10% on margin in two months, that would be about 77% annualized.

Settlement
Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:
Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long). The Nymex crude futures contract uses this method of settlement upon expiration.

Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. A futures contract might also opt to settle against an index based on trade in a related spot market. Ice Brent futures use this method.
Expiry is the time when the final prices of the future is determined. For many equity index and interest rate futures contracts (as well as for most equity options), this happens on the third Friday of certain trading month. On this day the t+1 futures contract becomes the t futures contract. For example, for most CME and CBOT contracts, at the expiry on December, the March futures become the nearest contract. This is an exciting time for arbitrage desks, as they will try to make rapid gains during the short period (normally 30 minutes) where the final prices are averaged from. At this moment the futures and the underlying assets are extremely liquid and any mispricing between an index and an underlying asset is quickly traded by arbitrageurs. At this moment also, the increase in volume is caused by traders rolling over positions to the next contract or, in the case of equity index futures, purchasing underlying components of those indexes to hedge against current index positions. On the expiry date, a European equity arbitrage trading desk in London or Frankfurt will see positions expire in as many as eight major markets almost every half an hour....

http://www.persepoliscapital.com/Training/futures-contract.html