SOPHISTICATED FINANCE

HBS Perspective on the Financial Crisis

HBS Working Knowledge has a must read article for any one interested in understanding the current financial crisis. The commentary includes the perspectives of five faculty members including Dean Jay Light and Nobel prize winner Robert Merton. Dean Light summarizes the whole mess correctly as a matter of "liquidity, leverage and transparency".Merton comments that financial innovation always outpaces regulation--particularly germane. Also noteworthy are historian David Moss' comments that whenever the government writes "risk insurance" there is a risk that the markets will take greater risk--what Moss calls moral hazard.

I wonder if Moss would accept my death penalty proposal in this previous post on the financial crisis?

Note: I got the $250 billion stage one amount correct. My analysis of this article is a bit thin for fear of incurring the wrath of the copyright lawyers at HBS Publishing.

Project Finance Modeling in Excel

I began my career as a lending officer at Chase Manhattan Bank in New York. In my second job there I was involved in several project financings in Latin America. Project financings typically involve a take-or-pay contract for some natural resource such as minerals or petroleum and require the construction of a huge infrastructure in some very remote part of the third world. For the Cerro Matoso nickel project in Colombia, which I worked on, to successfully commercialize the nickel deposit required the building of a power plant, a three hundred mile railroad spur and a port. Debt financing is typically the largest part of the capital structure and the debt covenants to control cash flow are the most complex that I have seen. In summary, I know enough about project finance to be dangerous.

The remainder of this post is a guest post by Rickard Warnelid, Director of Navigator Project Finance. Navigator, based in Sydney, Australia, specializes in preparing the sophisticated excel models required for project financings. Rickard's post contrasts the modeling requirements of a project financing and a private equity deal and makes very clear the all important point--the model must meet the requirements of the financing source (and not what you think is important). You should now be hearing the drum roll to welcome the first guest writer to Sophisticated Finance--Rickard Warnelid.

"Financial models are developed at different stages of a project/company for a number of different reasons which results in very different structures depending on the purpose. Some people assume that ‘a financial model’ is a universal description of a tool that can be used to solve any problem in relation to the financing situation, but nothing could be less true.

The scoping phase of the development of a financial model is often the hardest part. This is when the modeler’s expertise is tested to make sure that not just a general financial model is constructed, but one that is tailored and optimized for the users’ current needs. To illustrate this I will give you some examples of the difference in a private equity transaction model and a project finance debt model. This will highlight the major differences in focus between these two otherwise closely related areas of finance and clearly show why it is important to make sure what the purpose of the model is before one starts the modeling of the transaction

Timing

Private equity

A private equity model generally has a lower timing resolution than a project finance model, but the biggest difference is generally the modeled operational life. Private equity transactions are often based on a valuation of a company as a going concern and very little focus is spent on anything beyond an assumed ‘exit’ for the PE investor.

Project Finance

Project finance models are often (in transactions including a construction phase) modeled monthly during construction and quarterly during operations. As the construction can extend to 5+ years on larger infrastructure deals the banks will analyze the debt draw down on a monthly basis during this time. The modeled operational life is commonly extended 20-30 years, depending on the type of asset that is being modeled. Resources project generally have a shorter life, as banks are reluctant to bank on reserves extending past 10 years. Flexible timing in a financial model is shown here.

 

Valuations

Private Equity

The valuation section is the core component of a private equity model as the main reason for analysis is to make sure that the right exit multiples are achieved and that the investment is worthwhile. Often a number of different valuation techniques are used to cross-check findings before making an investment decision. Using scenario analysis investors try to work out structures that will protect their investment in downside cases and at the same time does not restrict the upside potential in the investment.

^{_{Project Finance}}

The valuation component (if any) of a project finance model is generally limited to project and equity NPV and IRR. More detailed models would have a comparison of pre-/post-tax effects but in general this section does not get much attention as the model was built primarily to facilitate the bank’s analysis of debt recovery in downside scenarios.

Debt Modeling

Private Equity

 

Private equity models are commonly extremely simplistic in regards to the debt analysis compared to a project finance model. Drawdown dates, refinance terms, margins, covenants and other assumptions are not focused on in much detail.

^{Project Finance}

This is the heart of a project finance transaction and often where the majority of the complexity sits. Features like revolving facilities, borrowing base calculations, cash sweeps, refinances, debt sculpting, lock-ups, debt service reserve accounts (DSRA), look-forward/look-back-DSCRs can make the modeling daunting for inexperienced modelers as it can sometimes be modeled in +1,000 lines of Excel code." An example is here.

About Navigator Project Finance

Founded in 2004, Navigator Project Finance Pty Ltd (Navigator) is the project finance modeling expert. This fast growing, dynamic company based in Sydney , is raising the global benchmark in financial modelling services to the project finance sector. Navigator’s main service is designing and constructing financial models for complex project financings, as well as offering comprehensive training courses throughout the Middle East, Asia and Europe, and conducting independent model reviews of project finance transaction models. Navigator is focused on delivering fast, flexible and rigorously tested project finance services that provide unparalleled transparency and ease of use.

More information and Free Tutorials on financial modeling for project finance are here:"

 

 

Despierta America Features FIU Entrepreneurs

Univision's morning show in Spanish, Despierta America, featured BabySpot this week. BabySpot is like Facebook for new parents. Founded by two FIU entrepreneurs, I promote it here unabashedly. The Despierta America video is here.

Financial Market Bailout

I have restrained myself in proposing a bailout strategy for the U.S. financial markets in the hopes that Washington would come up with a solution. Ever the optimist, it now looks like they will agree on a package albeit the wrong one. With elections "approximately 40 days" away we have few people in Washington with the integrity to put politics aside. I applaud McCain for suspending his campaign, but I doubt that this time even he can forge a good, workable compromise. A bit of history before I present my solution.

In my life time this is the third real estate meltdown I have been through. First there was the REIT crisis in the late 1970s, then there was the savings and loan scandal in the late 1980s which resulted in Resolution Trust Company (RTC) and now we have the mortgage derivative "mess". In each of the three cases real estate financing was combined with financial engineering to over stress the market by executives who ignored risk analysis in favor of greed (in many forms). In the case of the REITS, it was special tax legislation that lead to poor lending practices. In the savings and loan debacle, it was junk bond financing. In the current situation it is derivatives combined with leverage which have done us in. In summary, as financial markets become more and more sophisticated, these tools are used to over stress the real estate market in the U.S. Just like the sun comes up each morning, Wall Street over stresses the real estate market with the newest tools about every 15 years. It is only a matter of time before this nonsense re-occurs.

There are two possible solutions:

1. Death penalties--like in China--for gross negligence that puts society in jeopardy (could also be applied to drug manufacturing executives that kill innocent people, etc.)
2. A more gentle alternative--reinstate the Resolution Trust Company. The RTC would have the authority to takeover institutions that do not meet minimum capital requirements or have serious liquidity issues. Could be used for all forms of financial institutions (banks, hedge funds, investment banks). All senior management would be fired with no golden parachutes as a condition of the takeovers. RTC worked well before so we should try it again.

Both of my solutions ignore the common people who are defaulting on their mortgages. This is not the important issue. The issue is to restore confidence in the U.S. credit markets. Financial institutions need to know that the other financial players they deal with are creditworthy or under the management of RTC. I think we should start with $250 billion in capital for RTC and see if it has a positive effect. I think it will. Am I smarter than Hank Paulson, Secretary of the Treasury--no--but I am not a politician either and therefore I can propose a rational, staged approach to the problem rather than a dramatic, newsworthy solution.

A bit of proper regulation can come later. First time I have agreed with President Bush in eight years. Given the current economic mess, I think Bush is now the undisputed worst U.S. President in history. Ulysses Grant and a few others were in the running, but this latest debacle clearly puts Bush at the top of the list.

 

Miscellaneous Items

A few posts of interest on unrelated themes.

1. The GSMA Association, which represents over 750 GSM mobile operators has announced a major green initiative to establish renewable fuel sources to power over 118,000 mobile base stations in the developing world. This is further proof that the private sector is going to lead the environmental transformation that we need.
2. AWS, Amazon's web services in the cloud, has announced a new agreement with Oracle whereby licensed Oracle products can be installed on the AWS infrastructure with support from both Oracle and AWS. I believe that this is the first case where a major software company (excluding Microsoft) has offered a licensed product for use in cloud computing. I would expect that most major software companies will follow suit, allowing larger companies with more complex systems and processes to move their IT to the cloud.
3. Carl Icahn had two noteworthy comments in a blog post  today.

• The size of the real U.S. government debt according to the Petersen Foundation is $ 53 trillion, a staggering statistic
• Icahn used a new finance term (for me)--EBITDAT. Similar to the popular EBITDA term, EBIDAT is earnings before interest, taxes, depreciation, amortization and theft. Theft for Icahn is the excessive salaries, bonuses and shareholdings of under performing CEOs and CFOs in large companies. Maybe those people who monitor corporate governance should start calculating EBITDAT.

New Business Ideas 9-24-08

I have been working with some students at FIU on a new business idea. Their idea involves a new way to manage web content. Then I read a post on CenterNetworks about SlideRocket. Sliderocket is about the most advanced alternative to Powerpoint that I have seen and very slick. CenterNetworks says that SlideRocket's revenue model may be to charge for images that you can insert into a presentation.

With the proliferation of Web 2.0 not only is more content being developed but the expectation is that the content can be customized. We are not talking here just about social networking. The effect of customization will have a profound effect on software design, customer experience and search, just to name a few areas. I see two business opportunities developing:

1. I see search tools being developed that can search within an image, a video or a PDF file and extract the selected image/information. Evernote and Clipmarks are early examples of this trend. More sophisticated tagging concepts such as Calais, which I have discussed previously, will help to make the identification and extraction process easier. Imagine that you could search every movie from Paramount and extract a selected image--probably for a small fee. This brings us to the second opportunity.
2. Companies such as Paramount, Warner Bros. Records and research firms like McKinsey have huge libraries of images, videos, charts etc. which are not currently organized to be searched especially at the image level. For this information to be organized so it is searchable requires new tools and technology, but then it could be sold in a new way. Allowing this content to be sold at a nominal fee opens up a whole new revenue opportunity. Imagine that you could buy just a Gartner chart within a report rather than spend $1,500 to get a whole report. I think it would expand the revenue opportunities for most companies with huge libraries. Another application of these tools would be to automatically put a logo on every image extracted and let these libraries be used for free in non-commercial applications. This would create a new way to advertise a brand and reduce copyright issues. Imagine that you had access to every image of Beyonce that her record company owned. Next we put new images on an RSS feed and feed it to your Facebook page and millions more people would be reminded of her everyday. Nice.

Note: I have decided just to date stamp new business ideas rather than keep track of which number post this is.

Theory vs Practice

Back in Janauary I posted on Public Intellectualism. I am prompted to return to this subject and related matters by two items:

1. In Wired September 2008, they discuss Susan Jacoby's book The Age of American Unreason wherein she takes the position according to Wired that "long standing American values like rugged individualism and the need to question authority have metastasized into reflexive anti-intellectualism and disdain for "eggheads", "elites" and pretty much anyone who might be described as credentialed".
2. My friend Colleen has a series of recent posts (here and here) about the role of "theory" in business education at the university level. Perhaps the best part of the discussion is in the comments for each post wherein the students show their disdain for "theory" and their preference for practical course content and the professors point out that critical thinking can only be achieved if one has a grounding in theory.

In some ways the student disdain for theory alone is perhaps proof of Jacoby's point. Giving the students the benefit of the doubt, perhaps if they had more business background they could apply the theory themselves. However, it's not clear to me why students can not make the leap from the theory of discounted cash flow, for example, to realize that you can use this method to evaluate any cash flow stream--a bond, a project, a sales strategy, etc.

Probably the two most valuable bodies of theory applicable to business are micro-economics and finance.The concepts of sunk cost, marginal cost, supply-demand, time value of money, internal rate of return and cost of capital are probably the most fundamental concepts underlying most business decision making. As important as developing an understanding of the concepts is developing the intellectual ability to apply the concepts in new business situations. The request for practical examples from students in some ways runs counter to the need to be able to apply micro-economics and finance theory widely. 

I teach courses which the students describe as very "practical". That is actually not my intent. I may just be unintentionally disguising the theory better than most. Theory Rules!!

Wal-Mart Latin America

Last week I heard Craig Herkert speak as part of the Wertheim Lecture Series at the Business College at FIU. Herkert is the CEO of Wal-Mart Americas, which includes all countries in the Western Hemisphere except the U.S. and Canada and has annual revenue of $49 billion. In Latin America Wal-Mart focuses on the low income segment, which according to their estimates totals 300 million or the rough equivalent of the U.S. population. This segment excludes the poor, who can not afford to shop at Wal-Mart.

What was interesting about the speech was that whatever subject Herkert discussed--market positioning, green initiatives, working with indigenous suppliers--he always framed the issue in terms of product development and the customer. I have seen many, many retail CEOs present their companies because I used to present at quite a few retail industry investment conferences, but I have never seen a CEO who so consistently brought a presentation back to product and target customer.

Wal-Mart has been successful for so long because their CEOs are always "merchants", the executives that select, source and negotiate the purchases of products for the store floor. Herkert follows in this long tradition. Must be easy to work for him--just think about how every decision relates back to the customer. Not a bad rule for any business.

In an interesting response to a question, Herkert said that Wal-Mart is putting on a big push to expand their banking and financial services in Latin America because their clients are under served in this area. He said Wal-Mart had the lowest charges for a money transfer to Latin America. Nice business--two customers--every retailers dream. One customer has to walk through a Wal-Mart to initiate the transfer and the recipient has to walk through a Wal-Mart store to pick up their money. Also, Wal-Mart has 300 bank branches in Mexico, which makes them a formidable competitor there already. Look out Latin America, Banco Wal-Mart is coming and they already have brand recognition, locations and a reputation for providing low cost necessities to the underserved.

Maybe Wal-Mart would like to takeover running the U.S. government social programs for the under served! Everyone could become a Wal-Mart supplier ;)

Coke Acquisition in China

As I travel around Latin America I see the continuing expansion of China's influence. Chinese companies have invested billions of dollars to secure a natural resource supply and appear to be the contractors of choice for many government infrastructure projects.

Yesterday Reuters announced that Coca Cola will acquire Chinese juice producer Huiyan for $2.5 billion. With 2008 sales estimated to be $3.8 billion and revenue growing at about 30 percent per year, Huiyan is an attractive acquisition for Coke. One obstacle to completing the acquisition is China's new anti-monopoly law which was passed August 1, 2008. Would it not be ironic that after pushing China to more fully develop its legal system, the Chinese government then invokes the new law to block the largest acquisition in the history of China by a foreign company.

During the Carter administration President Carter met with the Premier of China. Carter was pushing the theme that civilized countries let their citizens immigrate at will. In response to this point the Premier replied, "how many Chinese would you like me to allow to immigrate to the U.S.--1 million, 10 million, 100 million?" Carter then dropped the point scared at the thought of 100 million Chinese immigrants moving to the U.S.

Another story told to me by a friend who was legal counsel to the securities underwriters (investment bankers) for some of the first securities issuances in overseas markets by Chinese government owned companies. In his preparation of the selling prospectuses much attention was paid to the risk factors related to the securities and frequently shortcomings in the Chinese legal system were cited as significant risks. Whenever the legal risk was specific enough, a governement official would ask my friend to draft a new law to make the risk factor go away. 24 hours after the draft law was prepared, the government official would return with an approved piece of legislation such that the risk factor could be deleted from the prospectus.

The Chinese government clearly understands the workings of foreign legal systems and it will be interesting to watch how the development of their own legal system evolves, is interpreted and implemented.

Blogs I Read

After yesterday's story a reader asked for a list of the blogs I read. A file in OPML format of all the blogs I read is available through the following link Download blog_list.opml To read this file just import it into any feed reader. In GoogleReader click Settings, click Import/Export and upload this file. All my blogs will now be part of your reading list. Delete as you see fit.

Another source of information that may be of interest are my Delicious bookmarks which currently contain about 200 blog posts from others related only to startups, VCs and related themes.The RSS feed for these bookmarks is in the lower left hand corner of the page.

For those looking for more convenience in following what I blog, tag and distribute you can follow me on FriendFeed. You can embed a widget of my FriendFeed in iGoogle for maximum convenience. FF includes my major postings all in one place except for Clipmarks. Clipmarks includes any part of a website that I have clipped, which frequently is tech cartoons. Search under "rhhfla" at Clipmarks.com (if the previous link does not work) and you'll find mostly what makes me laugh. Clipmarks also has an RSS feed for my clips.

If anyone has interest in reading my comments on other blogs, do a Google search for rhhfla. After the first 2-3 pages, the next 10-11 pages include my blog comments. I have not read all 13 pages, so it's possible somebody else uses the same "alias".

After this post I guess I am out of the closet. Geek and Proud.

Mentoring--A Key to Entrepreneurial Success

After my recent diversion to foreign affairs and politics, I am back to talking about startups, VCs and tech. I subscribe to about 200 blogs and read a minimum of 50 each day. I pick the blogs by subject--venture capital, web technology and entrepreneurship--with a few extra blogs on presentation, analysis techniques and scholarly business articles. I chose them based on the quality of the opinions, which basically means they have discussed something in detail and I agree with the analysis. I rarely read self-serving or promotional blogs.

One other characteristic of my blog reading is that I rarely drop a blog after reading it for more than a week. One exception to this rule is Seeing Both Sides, which I apparently lost somehow when I switched to NewsGator. Seeing Both Sides is written by Jeff Bussgang, a Partner in the former VC firm IDG now rebranded Flybridge. Jeff is one of the VC bloggers who I have actually met a few times pitching deals for clients. Jeff's blog is clear, analytical, to the point and always "spot on" in his conclusions. Jeff is the same way in person, even if he did pass on two deals (that others funded.)

In catching up on several months of posts by Jeff, after re-discovering the blog,I found a particularly relevant post related to my last series of posts on CEOs (here, here, and here). Jeff talks about entrepreneurs as CEOs being "in over their head". He counsels that you should have a feeling of control over 80 percent of the business and be in over your head about 20 percent of the time. Maintaining this balance is a key factor and the 20 percent of the time that produces the fun and excitement in being an entrepreneur needs to be managed.

In my courses and workshops I teach three keys to entrepreneurial success:

1. Pick the right opportunity
2. Mentoring
3. Access to capital

Jeff believes that mentoring is one of the best ways to maintain the proper 80-20 ratio. Jeff's specific recommendations to properly manage the 80-20 rule are quoted below:

1) Be self-aware.  It's ok to feel as if you are in over your head as an entrepreneur.  In fact, it's natural.  Don't be afraid to recognize it, admit it, and talk openly about it with your board and management team.  Figure out which side of the 80/20 rule you find yourself.

2) Learn your way out...with help.  Seek the advice of the wise men and women around you to learn how to step up and grow into the situation you find yourself in.  Don't close yourself off to outside advice for fear of appearing weak.  Instead, embrace smart, diverse opinions to help shape your own.

3) Accept life preservers.  Many entrepreneurs are terrible at accepting help.  After all, the reason they're entrepreneurs is that they enjoy being their own boss and are passionate and often stubborn about following their vision.  It's hard for them to admit they need help and, sometimes, need a life preserver to pull them out of the situation.  It may mean hiring a COO, hiring a CEO and moving into a chairman role, or other big moves that risk giving up control.

I see many entrepreneurs who incorrectly "thrive" in the environment of being over their head and never realize that they have broken Jeff's 80-20 rule. They are addicted to the thrill at the expense of their companies. 80-20.

Israel's Concern with Obama

Tom Evslin has an interesting post on his blog Fractals of Change which prompted today's post. Evslin is concerned that if Obama is elected President, the Russians will test him with an aggressive military action similar to their invasion of the country of Georgia. Students of history will remember that during the Cold War an assertive Russia tested many new U.S. Presidents. With our military resources stretched by Iraq and Afghanistan and a new, relatively naive inexperienced President when it comes to foreign affairs, the timing would be perfect for the Russians to take a bold step such as invading Ukraine.

Now imagine you are sitting in Tel Aviv and President Obama announces that he is going to start intensive negotiations with Iran to limit their nuclear development. This would be Israel's worst nightmare because long, drawn out "good faith"negotiations would just give Iran more time to further develop the nuclear weapons Israel fears. With these negotiations underway, it would be difficult for Israel to bomb the Iranian nuclear facilities. Therefore, the logical thing for Israel to do is to preemptively bomb Iran in the early days of the Obama administration before he can open a dialogue with Iran. This event would completely disrupt the world oil supply, probably increase oil prices to record highs and prompt terrorism at new levels around the world. Welcome to the White House President Obama! Forget eight years of idyllic social engineering. Foreign affairs, military preparedness and homeland security would be the only priority!

The Bush administration has been a complete disaster by any means of measurement, but now the U.S. has to live with the results. We have increased the number of our enemies, given up the moral high ground in world affairs and stretched our military capabilities to the breaking point. We in the U.S. can not ignore the current environment and "punish" the Republicans. Now is not the time for the U.S. to elect an inexperienced President with no practical experience in military or foreign affairs. I agree with about 90 percent of Obama's social agenda, but now is not the time for a social scientist as President. I am willing to set aside my strong reservations about McCain's positions on abortion and Supreme Court Justices because of my concerns about foreign affairs and how the U.S. will be tested if Obama is elected.

Previous thoughts on related themes are here and here.

Not To Be Forgotten

I should make the following an annual post.

"It is the soldier, not the reporter, who has given us freedom of the press. It is the soldier, not the poet, who has given us freedom of speech. It is the soldier, not the campus organizer, who has given us the freedom to demonstrate. It is the soldier, not the lawyer, who has given us the right to a fair trial. It is the soldier, who salutes the flag, who serves under the flag, and whose coffin is draped by the flag, who allows the protester to burn the flag."

Father Dennis Edward O'Brien, USMC

USMC--United States Marine Corp

Full credit for this post goes to young Mr. Casnocha. Thank you.

Angel Financing

I do not arrange angel financing for two reasons:

1. It is sometimes difficult to determine who is a serious investor
2. There is a higher risk of litigation with semi-professional investors (angels)

When I see deals that are suitable for angel investors I refer them to certain attorneys who have networks of angel investors. To determine suitability, here are some statistics from CenterNetworks that may prove helpful:

1. Angels fund about 8 percent of the new companies started each year (founders, friends and family fund 91 percent)
2. Typical angel round is $265,000
3. Target return for angel investors is 30X--30 times there initial investment

While the odds are better to find an angel than a VC to fund your company, the odds are daunting and dealing with angels can be as vexing as a VC. The advantage of angels is their preference for seed stage deals and the major disadvantage is that most angels only devote a portion of their time to their investments. When the company has a problem and the angel is on vacation in Thailand, you may not get your call returned for weeks. Recommendation: use friends and family money to build revenues to $1 million + and then approach the VCs.

A blog devoted to angel financing is here.