The European Financial Review, April 2012: www.europeanfinancialreview.com

http://www.directorship.com/taming-risk-in-a-volatile-world/

In environments like these, financial companies face several alternatives. One is to embark on product innovation, another is to become more dynamic in managing balance sheets and risk, and yet another to leverage-up to keep the earnings targets unchanged. Of the three, the last is clearly the least preferable – it was precisely this behavior that got Goldman’s competitors in trouble over the past few years.

Goldman’s role in the Facebook transaction is not new. It had long presented itself as an “advisor, co-investor, and financier” to its clients. This gave the firm access to clients to whom it could sell products, access to companies looking for capital, and the ability to put its own capital to work profitably. With the Facebook deal the firm was able to achieve these objectives – and importantly, without excessive risk.

Goldman invested nearly $2 billion in Facebook, $450 million of its own money plus additional $1.5 million of Facebook it planned to sell to its U.S. clients. The SEC’s limit on shareholder sales proved to be a temporary stumbling block. If the sales of shares to Goldman’s U.S. clients exceeded 499 shareholders, the SEC would require substantial financial disclosure by Facebook – which neither Facebook nor Goldman wanted. After further consideration, Goldman decided to finesse the matter by selling shares only to foreign investors beyond the reach of the SEC, much to the unhappiness of some of their wealthy American clients who had been promised an opportunity to invest.

It’s clear that the deal fulfilled Goldman’s desire to simultaneously serve as advisor, co-investor, and financier. It connected the hottest company to investors who wouldn’t otherwise have access to it; it provided capital to a highly desirable company; and it invested a small amount of its own capital.

With the sale of shares of red-hot Facebook to clients, Goldman was able to charge much higher fees than customary brokerage commissions. As a combination of placement fees, maintenance fees, and a percentage of gains, the payout to Goldman is likely to resemble more of hedge-fund-type returns rather those of brokers or underwriters. In terms of Financial Darwinism, the Goldman/Facebook deal can be viewed as a business model transformation where hedge-fund-like returns were generated by an investment bank without putting a lot of its capital at risk. It’s a model that we can expect Goldman to continue to develop, as the company continues to look for innovative responses to environmental pressures and challenges.

http://chiefexecutive.net/ME2/Audiences/dirmod.asp?sid=&nm=&type=Publishing&mod=Publications%3A%3AArticle&mid=8F3A7027421841978F18BE895F87F791&tier=4&id=76ACB5AEB6B84771BB288C93998D0816&AudID=F242408EE36A4B18AABCEB1289960A07

In recent years, performance of AllianceBernstein’s $500 billion asset management business lagged competitors.  This, in turn, has led to significant investor redemptions that continued even as performance improved last year. With fewer assets under management and continuing fierce competition for assets that put pressures on fees, the firm’s profits dropped by a little more than half.  An adjustment to the business model was clearly in order.

According to CEO Peter Kraus’s Wall Street Journal interview, the firm’s updated strategic vision intends to leverage “first-class global research” in new businesses. AllianceBernstein has already begun raising money to buy troubled bank assets within Treasury’s Public-Private Investment Partnership program. It also started a business that invests in distressed commercial real estate properties.

Of particular significance, the firm is also re-entering the capital-markets business – helping companies to raise money in the public markets – a business it had abandoned seven years ago.  A good example is their recent participation in the IPO for retailer Dollar General IPO largely owned by private equity firm Kohlberg Kravis Roberts & Co. AllianceBernstein was brought into the offering and shared a portion of the $8.5 million underwriting fee, re-establishing itself as a credible player in the IPO market and adding to the bottom line.

The connection between research and capital markets business on Wall Street is particularly noteworthy: publishing research reports establishes a relationship with a client that subsequently can be used to solicit capital markets business. For years the two went hand-in-hand. Then in 2003, following landmark corporate fraud and defaults, Federal regulators imposed an enforcement agreement on ten banks that were alleged to have pushed their research analysts to issue favorable reports on IPOs. AllianceBernsetein was not among the accused, and has marketed the benefits of independent research to clients ever since. However, faced with competitive and earnings pressures, AllianceBernsetein has apparently concluded that running a research business without capital markets business may not be sustainable.

Response to competitive and earnings pressures speaks volumes about a company’s financial and cultural DNA. Some firms respond to pressures by taking more risk, the extent of which is often misunderstood and mismanaged. Others embark on business model transformations that leverage their brand and core competencies to make the business model more robust and performance more sustainable and non-cyclical. At least in terms of intent, AllianceBernsetein seems to be on the right path.

More rigorous, more consistent, and internationally-coordinated regulation will certainly help.  But it will not address the fundamental behavioral dynamic at the core of the recent financial crisis. The fact is,  executives in financial services  are compensated based on ROE, P/E, and other such performance metrics – in absolute terms and relative to peers. Meanwhile, equity analysts and investors look for companies to deliver consistent and growing accounting earnings – irrespective of the prevailing economic and market environment. The net result? Vicious circles that lead to bad decisions and destroy value.

Suppose a publicly traded financial institution – having just witnessed the collapse of Lehman Brothers, Bear Stearns, and AIG stemming from excessive risk-taking – decides to pare down risk and grow less volatile businesses, like wealth management, advisory services, market making, or commercial banking. Meanwhile, its peers are back into the swing of things, loading their balance sheets up with risk in every way imaginable. How strong is the resolve of the firm’s executives to follow their vision before the competitive pressures to deliver short-term earnings force them into excessive risk taking? How long before boards of directors run out of patience and replace these executives?

As this moment, financial institutions are having a heyday. After years of margin pressures preceding the latest financial crisis, the underlying economics of financial businesses has dramatically improved during the crisis, with yield curves becoming steeper, bid/ask spreads widening, underwriting fees and sales commissions increasing, and so on. But déjà vu is just around the corner.  Soon enough, calming markets and competitive pressures of fully-commoditized financial businesses will compress margins and fees – if not to the 2006 levels, then close to it. As a result, many financial institutions will go straight back into risk taking, the extent of which will often be misunderstood and mismanaged. The same vicious circle that created today’s financial crisis  will be repeated.

If this grim prediction comes true, such future crisis – just like the most recent one – will not be a failure of risk management. It will also not be a failure of mathematical models, rogue rocket scientists, or normal distributions, as the Church of Black Swan would like you to believe. It will be a crisis caused by the continuing disconnect between strategic decisions and risk management. In other words, risk practitioners fully understand pros and cons of different risk management models – and what these models can and cannot do. The problems arise when senior financial decision-makers and institutional investors misunderstand or misuse those models as they try to keep up with competition or fight earnings pressures.

The regulatory reforms now being mooted can’t easily address these realities.  There are a million different ways in which financial institutions can take on risk. Moreover, given the continuing lack of risk-based transparency and departure from mark-to-market accounting, financial markets, investors, and regulators will remain blind to the true riskiness of the balance sheets of financial firms until too late.

The burden on developing a strategic vision for the organization – one that explicitly incorporates risk management and makes use of the lessons learned from this crisis – remains squarely on the shoulders of boards of directors and executives.  For them the key challenge is  to foster corporate cultures that give risk management an equal seat at the table where strategic decisions are made. Financial institutions – and many non-financial companies – must explicitly acknowledge that risk plays a central role in their business models. Risk is already the key determinant of their ROEs, P/E ratios, earnings volatility, and more broadly, their value creation or destruction over time. The ways in which decisions are made on the most senior levels of financial institutions – and the ways that these organizations are structured and managed – must change to reflect that reality.

Crafting a sound strategic vision for financial service firms will be exceptionally difficult. It will take genuine leadership and resolve. It will need broad systemic knowledge as well as collective openness to new ideas. It will demand a longer-term horizon that fights the focus on short-term accounting earnings. Last but not least, it will require dynamism in the broadest sense of the word. All of this is hard work. But as difficult as these endeavors may be, they are far less painful than the alternative – a Darwinian failure to evolve followed by financial ruin.

This article has originally appeared in Harvard Business Review online.

The announcement sure seems to describe something awfully similar to a static business model, where a typical response to recent losses or an unfavorable market outlook is to scale a business down or exit it altogether. Is there a better response, the one that does not mechanically exit businesses at the bottom only to lose market shares, reopen these same businesses at the top of a cycle, suffer losses, and exit them again? Is there no value in being in real estate and securitization and structured products businesses going forward?  Or in municipal bonds, proprietary trading and commodities businesses?  The answer to these questions is a resounding “no.” Is retrenching to highly commoditized “red oceans” of equity trading and underwriting, merger advice and foreign exchange trading a better strategic decision? Highly debatable.

Static business models have been at the core of many ills that got financial institutions in trouble in the first place.  Following losses, they exited businesses, exposing themselves to loss of market share and opportunity costs. When the perception of the environment turned favorable, abandoned businesses were re-entered and existing businesses were scaled up. Throughout, the risks underlying these businesses always remained the same. Importantly, this latter feature is responsible for yet another highly undesirable and dangerous properly of static business models: the fact that they tend to respond to earnings pressures and low return environments with blind leverage and excessive risk taking.  The ongoing financial crisis is, in many ways, a manifestation of static business models in action.

UBS’s response poses a sharp contrast to other financial institutions that seem to be transforming their business models in the spirit of Financial Darwinism.  The Blackstone Group, for example, has been using its natural expertise in analyzing and advising companies to shift focus from leveraged buyout to advisory businesses. Note that it is not exiting private equity business altogether; it’s just supplementing it with other sources of revenue in an area where its natural expertise and competitive advantages can be leveraged.  As a part if its adaptive evolution, Blackstone has already advised Procter & Gamble Co. on the $4.5 billion sale of its Folgers coffee unit to J.M. Smucker Co. and worked with Microsoft Corp. on its proposed takeover of Yahoo! Inc. 

In all, according to Bloomberg, Blackstone earned fees from clients on 18 deals worth $12.3 billion in recent months.  The group’s profit almost tripled to $61.1 million in the third quarter of 2008 compared with a year earlier.  “The problems at all the major banks and securities firms are causing widespread cutbacks, distraction and personnel defections,” one of the firm’s executives said.  “This turmoil at our major competitors is clearly benefiting our advisory business.”

No one claims that organizational change is easy, but firms like Blackstone have shown that the effort can mean not only survival but long-term prosperity. Such actions are clearly a superior alternative to typical knee-jerk behavior of institutions with “static” business models .