Finance to the Rescue

by Melanie Merrifield

Capital solutions to today’s pressing business issues.

Back in the 1800’s Ralph Waldo Emerson observed, “A creative economy is the fuel of magnificence.” He could hardly have imagined the dozens of creative ways modern finance and risk management would evolve. Still, his words are a prophetic description of the myriad ways finance powers American business and today’s global economy.

From the birth of the index fund, to the creation of specialty business brokerages, catastrophe bonds, and hedge funds developed to serve the very rich, finance proves time and again to be a deft chameleon, adapting gracefully to solve business problems with natural ease.

The last thirty years have witnessed the birth of startling innovations and no small dose of financial wizardry. Sadly, the outcome hasn’t always been as magnificent as Emerson might have hoped.

Think Creative Solutions, Not Creative Accounting

Sarbanes-Oxley and the mutual fund controversy of 2003 are sharp reminders that while in skilled, honorable hands, finance can be applied in fresh ways to solve problems, there remains a distinction between financial innovation and “creative accounting.”

Problem-solving finance that fuels true magnificence first and foremost must serve the needs of investors without resorting to misrepresentation or distorting performance. Its delicate balance of risk and reward must further the goals of those with capital at stake, while affording managers a level of profit as well.

It’s a tall order. Yet not surprisingly, Hankamer graduates and friends number among the creative innovators proving up to the challenge in corporate and institutional finance, insurance and risk management and mergers and acquisitions.

Problem: Realizing Superior Returns With Palatable Risk for the Ultra-Wealthy and Institutional Investors

Solution: Liongate Capital Management’s Multi-Strategy Fund of Hedge Funds

Innovator: Jeff Holland, Fund Founder, (Baylor University, 1996), summa cum laude finance and accounting graduate, C.P.A., Master’s studies in finance at the London Business School.

Traditionally, hedge funds have served the unique investment needs of high net worth, individuals, typically with savings of $1 million or more. The first one was started back on the heels of the 1929 stock market crash.

They’re instruments distinguished by strong returns, performance-based management fees, and often a personal investment by the manager that ensures his interests mirror those of his clients. The funds utilize a variety of instruments, not equities alone, and are not constrained against investing in foreign markets.

Assets Under Management On The Rise

Since about 2002, hedge funds have become viewed increasingly as mainstream instruments and have seen tremendous investor inflows, with the number of active funds increasing to an estimated 8,000. Assets under management are estimated to have swelled from more than $500 Billion in assets two or three years ago to over $1 Trillion today.

“Most of this growth came on the back of the tech crash in the equity markets,” offers Baylor Graduate Jeff Holland, who with Partner Randall Dillard, founded London-based Liongate Capital Management.

“Investors who lost money in equities realized things weren’t always going to go up and there was a lot of risk in the equity market. Many experienced sleepless nights during the 3-year slump in the equity markets. A lot of investors lost years of savings. Even the Baylor endowment lost significant value in those years. That’s a problem hedge funds can help solve,” Holland observes.

“At that point both high net worth investors and institutions became interested in hedging strategies as a way to protect themselves from the volatility they had experienced in equities in 2001 and 2002.”

A Paradigm Shift In Acceptance

Many consider the wider acceptance of hedge funds a paradigm shift in investing. Holland concurs. “Perhaps fifty years in the future, people will look back and say ‘Gosh, can you believe people used to buy stocks and not hedge their downside risk. It was so crude.’”

Liongate, which manages $250 Million for investors, operates a ‘fund of hedge funds’, an approach that is not unusual among hedge funds. Holland explains: “The general investment idea is that we’ll perform due diligence on hedge funds and then put them into a basket so others can come and invest. By selecting 25-35 hedge funds, each of which is pursuing a distinct investment strategy, we achieve a stable, diversified return.”

Problem: Mid-Sized Oil Field Service Companies Underserved by Wall Street

Solution: Rockbrook Capital, LLP

Innovator: John W. Howton, Founder and Partner, (Baylor University, 1997, Finance and Accounting Major.)

For a man whose career includes stints in the Investment Banking Division of Bear Sterns Natural Resources Group and the Principal Investment Group of Enron North America, a firm specializing in mergers and acquisitions might seem a natural next step.

But the firm John Howton founded has a surprising twist. Rather than courting behemoth transactions, it caters to small to mid-sized oil field service companies.

“This is a market that’s been historically neglected by the large Wall Street firms,” says Howton. “We saw an opportunity to meet their unique needs and maximize the value of their businesses by providing strategic M&A advice by representing them through the process of selling their businesses or helping them to achieve a recapitalization – whether that means raising debt or equity capital.

An Underserved Market With Unique Needs

“Major players like Bear Stearns aren’t focused on this size company. In their mergers and acquisitions divisions, you have a group of investment bankers that spend their time calling on large public companies,” Howton explains. “They’re simply not interested in or well suited to execute $30 million size deals. This left a noticeable gap in the smaller size market, and presented a problem for owners seeking to maximize value through the sale of their companies.”

Rockbrook Capital specializes on the sell side of mergers and acquisitions. Firm principals advise and represent clients throughout the process, so owners can achieve liquidity and maximize value.

Fueling Financial Goals of Owners

“In some cases an owner, for whatever reason, will never go public and has no successor such as a family member or other trusted leader in the wings to assume management responsibility,” notes Howton. “We help him achieve his financial goals by merging or selling to a larger company. Many times this begins by clearly explaining how the firm will be viewed by acquirers and providing an accurate measure of the company’s worth.”

Once a company is valued, Rockbrook begins the delicate process of approaching prospective acquirers at the CEO level and presenting the company, with clearly understandable financial information, as a potential target for acquisition.

“Particularly in the oil service business, you see a lot of self-made men. They know a great deal about the energy business, and about running a strong company,” Howton reflects. “They may be millionaires many times over. But when it comes time to retire, they’re not in a position where they can sell or continue the company. Our efforts facilitate and can significantly influence the sale or recapitalization of these mid-sized companies. That’s how we solve their problems.”

Problem: Traditional insurance markets provide relatively limited financial protection from natural and man-made catastrophes

Solution: Catastrophe bonds (or “Cat” bonds)

Academic Expert: James R. Garven, Ph.D., Professor of Finance and Insurance, Frank S. Groner Memorial Chair of Finance and R.M.I. Program Director – Finance, Insurance and Real Estate

The very concept of insurance is based on risk. So it’s no surprise that important innovations in risk management and finance often come from the insurance industry. One such innovation that is growing in popularity is the so-called catastrophe bond, or “cat bond.”

“Common sense as well as theory suggests that proper diversification of any risk involving a remote possibility of enormous loss makes such a risk more manageable,” explains Dr. James R. Garven, Baylor Professor of Finance and Insurance. Traditionally, catastrophe, or ‘cat’ risk was transferred and shared through the insurance and reinsurance markets.

However, in spite of the dramatic growth in the magnitude of human and economic losses from natural and man-made catastrophes in recent years, it is surprising how little cat risk transfer actually occurs. “Property owners often fail to insure catastrophe risk, and even when they purchase insurance, their insurers tend to retain most of this risk rather than distribute it more broadly through the reinsurance market. The reason why cat reinsurance is so limited is due to inadequate global capacity and correspondingly high reinsurance premiums,” notes Garven.

Cat bonds came into existence due to this lack of capacity in the reinsurance market. Although they have been used primarily as an alternative to cat reinsurance, there are examples of corporations and other non-insurance entities issuing cat bonds. “For instance, during the summer of 1999, Tokyo Disneyland issued cat bonds because management found at the time that it was cheaper to have the capital markets insure its earthquake exposure than the insurance markets,” explains Garven. “More recently, the Fédération Internationale de Football Association (FIFA) issued a $260 million cat bond to protect itself against a terrorism-related cancellation of the 2006 World Cup in Germany.”

Cat bonds represent a form of insurance securitization in which risk is transferred to investors rather than insurers or reinsurers. Typically, an insurer or reinsurer will issue a cat bond to investors such as life insurers, hedge funds and pension funds. The bonds are structured similarly to traditional bonds, with an important exception: if a pre-specified event such as a terrorist attack or hurricane occurs prior to the maturity of the bonds, then investors risk losing accrued interest and/or the principal value of the bonds.

Although the cat bond market is still relatively small compared with the traditional insurance and reinsurance market, it is already having a particularly important effect on reinsurers. Since the cat bond market provides insureds with a credible alternative to traditional reinsurance, the cat bond market has forced reinsurers to become more competitive in their pricing and underwriting practices.

“Furthermore, investors value cat bonds in part because returns on these securities tend not to be very highly correlated with returns on other asset classes such as stocks, conventional bonds, commodities and real estate,” Garven offers.

Given the benefits that cat bonds offer both insureds and investors, the market for cat bonds is expected to continue to grow and exert an important check and balance upon pricing and underwriting practices in conventional insurance and reinsurance markets. “Ironically, the growth of the cat bond market is in turn fueling the growth prospects of the reinsurance industry, as a number of hedge funds that were early cat bond investors are now starting to launch their own reinsurance firms,” says Garven.

Problem: Mutual Fund Managers Profiting At Small Investor’s Expense

Solution: Low-expense Index Funds and Stewardship, Not Salesmanship

Innovator: Financial John C. Bogle, founder and former CEO of the Vanguard mutual funds.

If the small investor has a champion, his name is John Bogle. The President of the Bogle Financial Markets Research Center, and Former Chairman of The Vanguard Group, is a prolific author, life-long student of mutual funds, and a staunch believer that high investment costs exact an unforgiveable toll on investor returns.

It’s a theme Mr. Bogle has been proclaiming since the early 1970’s, even before he founded (read invented) the first index mutual fund, the Vanguard 500. He’s spent a lifetime expounding the virtues of maximize returns through low fees, strong performance and deferring taxes on principal invested. Even his senior undergraduate thesis at Princeton was entitled “The Economic Role of the Investment Company.”

According to Bogle, and it might seem to anyone with a lick of common sense, exorbitant intermediation expenses are more than just bad investing: they’re an ethical disservice to investors. These costs take a serious bite out of capital invested. And, compounded over time, represent a frightening loss for investors. To help correct this injustice, Bogle believes much stronger oversight is needed.

“It is time to abandon the managers’ capitalism that has shaken our society’s belief in the fairness of the system and return to the owners’ capitalism that built our nation,” Bogle challenges. “We need to build independent boards of directors who will provide prudent stewardship.

“We need controlling stockholders of corporate America – the mutual and pension funds – to act responsibly and solely in the interest of investors. . . .We need to form an independent federal commission to evaluate our new agency society, with a view toward restoring fiduciary duty and trust as its objective.”

“Mutual Funds Have Moved From Stewardship to Salesmanship.”

Follow Bogle’s eye-opening estimates of intermediation costs associated with the today’s investment system, and his position becomes easily understood.

In a February, 2005 speech sardonically titled “The Relentless Rules of Humble Arithmetic” Bogle estimates: “During 2004, revenues of investment bankers and brokers came to an estimated $220 billion; direct mutual fund costs came to about $70 billion; pension management fees to $15 billion; annuity commissions to some $15 billion; hedge fund fees to about $25 billion; fees paid to personal financial advisers, maybe another $5 billion. Even without including the investment services provided by banks and insurance companies, these financial intermediation costs came to approximately $350 billion, all directly deducted from the returns that the financial markets generated for investors before those croupiers’ costs were deducted.”

Most remarkably, these fees all detract from the return realized by investors, thus supporting another “Bogle’ism: ‘In investing, all of us together get precisely what we don’t pay for’.”

In the final analysis, expenses, not just gross returns, play a significant role in the investor’s actual return on investment. That’s one of the “relentless rules of humble arithmetic.” And unless these expenses are considered – and curtailed – investors will continue to pocket far less than they deserve.

Baylor Business Review, Fall 2005

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