Category Archives: governance

Risk and return in the eye of the beholder

The corporate finance practice team at McKinsey & Co has joined the long line of people looking at the large cash hoard being assembled by corporations and asking “why?”. In an article in the McKinsey Quarterly, they suggest a surprising answer:

One factor that might go unnoticed, however, is the surprisingly strong role of decision biases in the investment decision-making process—a role that revealed itself in a recent McKinsey Global Survey. Most executives, the survey found, believe that their companies are too stingy, especially for investments expensed immediately through the income statement and not capitalized over the longer term. Indeed, about two-thirds of the respondents said that their companies underinvest in product development, and more than half that they underinvest in sales and marketing and in financing start-ups for new products or new markets. Bypassed opportunities aren’t just a missed opportunity for individual companies: the investment dearth hurts whole economies and job creation efforts as well.

The article provides a useful examination of biases in decision making. Many managers would concur that a million dollars lost on a bad investment in the recent past would tighten the finances of a company much more than a million dollars won would relax the constraint. This may be especially so in a period when creditors are deleveraging and equity holders are quite wary about bad news.

The McKinsey piece reminds us that a project is not just the Power Point slides and the numbers in a spreadsheet, but what these are in the eye of the beholder.  But how does that relate to the global picture of corporate cash hoards? It’s one thing to be humble about the quality of decision making and the biases that affect it. It’s an entirely other thing to connect those biases to the very large aggregate economic fluctuations in the global economy, including the cash that companies seem to think it is prudent to husband very carefully right now. When did prudence became a bias?

Is E.ON’s trading unit profitable?

E.ON, is a large European electricity and natural gas company. It manages its trading operations as a separate profit center. The traders are both responsible for optimizing E.ON’s own generation and other assets–sourcing inputs cheaply and maximizing the value of outputs–and also for running a proprietary trading book.

E.ON just announced its second quarter results and was very candid about the fact that the outlook for the trading unit this year is not good. Indeed, it’s forecasting a loss in trading for the full 2011 fiscal year.

So let’s look back at last year, FY2010, when the trading unit recorded a profit. The Annual Report details each unit’s return on capital employed (ROCE). Here’s what it shows:

The chart shows the reported ROCE for each of the separate units as well as the ROCE for the group as a whole. Not shown is the ROCE for the corporate center. But EON doesn’t report an ROCE for the trading unit. Why not?

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Distinguishing proprietary trading from hedging

Good internal risk controls involve carefully distinguishing between different types of trading. Many companies that do significant trading to hedge their market risks explicitly forbid proprietary trading. Others explicitly try to profit from proprietary trading, but it is still important to keep the proprietary trading book separate and under proper control.

So, for anyone interested in this issue, it is instructive to watch the implementation of the Volker Rule — section 619 of the Dodd-Frank Act — which restricts the proprietary trading operations at the major banks. Last week, Politico’s Morning Money posted a study by Deloitte discussing how regulators might identify proprietary trading and the measures banks would need to take to clearly mark transactions as “market making” or other permitted activities as opposed to proprietary trading.

While the Volker Rule is about banks, and this blog is about end-users, it will still be informative to end-users to watch how this process plays out at banks. After all, proprietary trading is proprietary trading, wherever it is pursued, and the fingerprints of proprietary trading are likely to be similar, too.

Two other good reads on the telltale markers distinguishing proprietary and other trading are a paper by NYU’s William Silber, and an old paper by Braas and Bralver in the Journal of Applied Corporate Finance (paywalled).

When is an end-user not an end-user?

When it’s a derivatives dealer.

On Tuesday, February 15, 2011, the U.S. House of Representatives held a hearing that focused on the regulations to implement the end-user exemption to the new clearing requirements for the OTC derivatives market. The New York Times covered the hearings, and reported that “the law exempted end users like United Airlines and Shell Energy from the clearing requirement.”

Is that true? Certainly the law didn’t expressly name United Airlines or Shell Energy. It simply exempted end-users—the very non-financial companies organized to produce real goods and non-financial services that trade derivatives to reduce the financial risk arising from their commercial activities. These are the types of companies and the type of risk management that this blog is expressly targeted to.

But I was taken aback to see the New York Times identify Shell Energy as an “end user” that “the law exempted … from the clearing requirement.” Of course, the average man-on-the-street thinks of Shell as a company with gas stations, refineries, storage tanks and oil wells. It is. But that’s not the whole picture. The average Wall Street investment banker running an energy derivatives trading desk also thinks of Shell Energy as one of its biggest competitors, dealing derivatives and running a proprietary trading business. Reproduced below is the awards list for the top 10 derivatives dealers in energy in 2009 as ranked by the financial industry magazine Energy Risk. Shell is at seventh place, following Morgan Stanley, Barclays Capital, Deutsche Bank, and others.

Surely the banks on this list don’t count as “end users” and neither should Shell’s dealer business. Shell the oil producer, refiner, shipper and marketer is an end-user, and Congress expressly drafted an exemption for this type of commercial activity—under certain circumstances and with certain provisos yet to be fleshed out in detail. But, Shell the derivatives dealer and prop trader? Why should they be exempted? Surely not because they happen to be owned by the same parent company that owns the wells, refineries, storage tanks and gas stations.

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GE’s CFO, on Forecasting, Financial Planning and Earnings Guidance

The Fall 2010 Journal of Applied Corporate Finance printed an edited version of a presentation by GE’s CFO, Keith Sherin, on “Financial Planning and Investor Communications at GE (With a Look at Why We Ended Earnings Guidance). The original talk happened at the University of Notre Dame’s Center for Accounting Research and Education (CARE) conference on “Financial Statement Analysis and Valuation: Forecasting Firm and Industry Fundamentals” held at Coral Gables, Florida on April 9, 2010. The video is available here. Sherin gives a clear exposition of the financial planning process at GE and its role in management, how they compare ex post performance to projections, etc.

Should corporates manufacture inflation hedges?

Reuters’ Breakingviews has a column suggesting that a number of corporates are issuing floating rate debt in order to service the demand of investors for an inflation hedge. Recent issuers mentioned are Berkshire Hathaway, General Electric and MetLife. The column is entirely conjectural on whether this is the actual motivation of these companies. And the column makes much of a tiny sample  and short window. But…

There is very good evidence that companies are more likely to choose a floating rate issue over fixed when the yield curve is steep as it is today and has been for a while. The recent literature began with a paper by Michael Faulkender (now at UMaryland) in the Journal of Finance. There has been a long stream following that. Faulkender studied issuance by companies in the chemical industry and found:
(i) their exposure to interest rates did not predict their choice of floating vs. fixed interest rate debt — i.e., hedging needs did not drive the choice, and
(ii) the price of interest rate risk did not predict their choice –i.e., they were not selling the highest value security.
Instead, the companies appeared to be choosing floating vs. fixed in order to:
(a) manage earnings, or
(b) ride the yield curve, a familiar and dubious speculative strategy.

The Reuters conjecture that corporates are giving bond investors the inflation hedge they deserve is at odds with Faulkender’s results. It matches explanation (ii) above, which the data did not support. In my mind, Faulkender’s results are very weak on (ii) because it is very hard to measure this sort of thing. So perhaps these issuers are providing the market something it demands. Right now, however, there is little substantive evidence in favor of the Reuters conjecture and good evidence that company financial officers have all the wrong incentives and are insufficiently monitored and disciplined for gambling on interest rates.

It’s Not Enough to Reward Performance

The most recent issue of the Quarterly Journal of Economics has an interesting article by Dean Foster and Peyton Young on the gaming of compensation schemes by portfolio managers. They demonstrate that any compensation scheme based exclusively on performance, without conditioning on any information about the actual underlying investment strategy, can be gamed. It’s not enough to reward performance alone. What’s necessary is transparency in managers’ positions and strategies. Then it’s possible to structure a viable compensation contract.

In an earlier post we emphasized that good governance of risk managers at non-financial companies requires making distinctions between types of strategies. The Foster/Young results, while developed for investment managers, have relevance for corporate risk managers, too. Only by scrutinizing risk managers’ positions and strategies can the company incentivize the right kind of hedging.

Sorting the Hedgers from the Speculators

Financial regulators are often in the position of attempting to proscribe or regulate certain types of trading activities. The Dodd-Frank financial reform legislation prohibits banks from proprietary trading. Futures regulators are often in the position of trying to distinguish hedging from speculating.

The task of sorting the different types of activities can be difficult. Cynics of all stripes exaggerate the impossibility of the task. Some belittle efforts to regulate by claiming that the different types of trading aren’t really different in any essential way, so that all regulations come down to arbitrary and ultimately counterproductive regulations. Others hype the ability of traders to evade any regulation by means of crafty relabeling, so that the regulation ultimately has no effect. These discussions are often poisoned from the start by the partisan nature of any debate about government regulation, so that it is impossible to get into a substantive discussion about real distinctions in different types of trading. But the need to make distinctions isn’t unique to the regulatory sphere. It is a general feature of good governance. Even corporate managers are tasked with defining the types of trading that the company’s own risk managers will be allowed to pursue on behalf of the shareholders.

Francesco Guerrera of the Financial Times called attention to a paper of William Silber’s in which he documents the distinctive footprint of proprietary trading. This is exactly the type of substantive discussion that is needed. Making the distinction is difficult, but that doesn’t make it impossible, and the distinction is critical.

Every non-financial corporation that seeks to hedge risks using derivatives needs to be able to make a similar distinction between hedging and speculation. It will want to prohibit its traders from conducting speculative trades. And all proprietary trading is speculation, so that’s a good place to start. The relevant footprint distinctions are going to be a little different from what Silber highlighted, since he was addressing financial institutions. But the idea will be the same.