Tag: investment bankers

Travel agents and investment bankers

The more I think about it, the more I’m convinced that travel agents perform a very similar role to investment bankers. In the olden days, not everyone had access to financial markets. In order to buy or sell stocks, one had to go through a brokerage company, who would be paid a hefty commission for his services. The markets weren’t that liquid, and they were definitely not transparent, so the brokers would make a killing on the spread. With the passage of time, advent of electronic trading and transparency in the markets brokers aren’t able to make the same spreads that they used to. Customers know the exact market price for the instruments they are trading, and this results in brokers not able to make too much out of these trades.

It is a similar case with travel agents. Vacation markets (flights, hotels, etc.) are nowhere as liquid as financial markets, and will never be. Sometimes, when you are booking holidays to a strange place, you know little about it, and hence commission a travel agent to find you a place to stay there. Given that you know little about that place, the agent can charge you hefty commissions, and make a nice spread. Of course, nowadays such opportunities are diminishing for agents, as you have websites such as Agoda which allow you to book hotels directly. Now, at one place you can compare the prices of different hotels, and have better information compared to what the agents traditionally offer you. The spread is on the downswing, I must think.

Then, don’t you think package tours are very similar to structured products? Structured products are nothing but a package of several risks packaged together. By acting as a counterparty on a structured product, a bank (even now ) can afford to charge fairly hefty fees. Structured products are illiquid,  and there is no publicly available “market price”, so it is easy for banks to make themselves good spreads on such products. However, all it takes to defeat this is an intelligent customer. All the customer needs to do is to try and understand the risks himself, and start “unbundling” them. Once he unbundles the risks, he can now trade each of them independently, on more liquid markets, and get a much better price than what bankers will offer him. The catch here is that he’ll need to put in that effort in unbundling.

It’s the same with package tours. Given the bundles, it is easy for the agents to make higher spreads. However, if you as a customer simply unbundle the package (hotels, transport, food, etc.), you can find out the price of each (available on sites like agoda and elsewhere) and find out for yourself the spread that the agent is making. And then you compare the agent’s premium with the “cost” of making all the bookings yourself and make an informed choice.

Apart from communication, among the greatest boons of the internet has to do with dismantling middleman monopolies. It is incredible how much use a little information can be of!

IPOs Revisited

I’ve commented earlier on this blog about investment bankers shafting companies that want to raise money from the market, by pricing the IPO too low. While a large share price appreciation on the day of listing might be “successful” from the point of view of the IPO investors, it’s anything but that from the point of view of the issuing companies.

The IPO pricing issue is in the news again now, with LinkedIn listing at close to 100% appreciation of its IPO price. The IPO was sold to investors at $45 a share, and within minutes of listing it was trading at close to $90. I haven’t really followed the trajectory of the stock after that, but assume it’s still closer to $90 than to $45.

Unlike in the Makemytrip case (maybe that got ignored since it’s an Indian company and not many commentators know about it), the LinkedIn IPO has got a lot of footage among both the mainstream media and the blogosphere. There have been views on both sides – that the i-banks shafted LinkedIn, and that this appreciation is only part of the price discovery mechanism, so it’s fair.

One of my favourite financial commentators Felix Salmon has written a rather large piece on this, in which he quotes some of the other prominent commentators also. After giving a summary of all the views, Salmon says that LinkedIn investors haven’t really lost out too much due to the way the IPO has been priced (I’ve reproduced a quote here but I’d encourage you to go read Salmon’s article in full):

But the fact is that if I own 1% of LinkedIn, and I just saw the company getting valued on the stock market at a valuation of $9 billion or so, then I’m just ecstatic that my stake is worth $90 million, and that I haven’t sold any shares below that level. The main interest that I have in an IPO like this is as a price-discovery mechanism, rather than as a cash-raising mechanism. As TED says, LinkedIn has no particular need for any cash at all, let alone $300 million; if it had an extra $200 million in the bank, earning some fraction of 1% per annum, that wouldn’t increase the value of my stake by any measurable amount, because it wouldn’t affect the share price at all.

Now, let us look at this in another way. Currently Salmon seems to be looking at it from the point of view of the client going up to the bank and saying “I want to sell 100,000 shares in my company. Sell it at the best price you can”. Intuitively, this is not how things are supposed to work. At least, if the client is sensible, he would rather go the bank and say “I want to raise 5 million dollars. Raise it by diluting my current shareholders by as little as possible”.

Now you can see why the existing shareholders can be shafted. Suppose I owned one share of LinkedIn, out of a total 100 shares outstanding. Suppose I wanted to raise 9000 rupees. The banker valued the current value at $4500, and thus priced the IPO at $45 a share, thus making me end up with 1/300 of the company.

However, in hindsight, we know that the broad market values the company at $90 a share, implying that before the IPO the company was worth $9000. If the banker had realized this, he would have sold only 100 fresh shares of the company, rather than 200. The balance sheet would have looked exactly the same as it does now, with the difference that I would have owned 1/200 of the company then, rather than 1/300 now!

1/200 and 1/300 seem like small numbers without much difference, but if you understand that the total value of LinkedIn is $9 billion (approx) and if you think about pre-IPO shareholders who held much larger stakes, you know who has been shafted.

I’m not passing a comment here on whether the bankers were devious or incompetent, but I guess in terms of clients wanting to give them future business, both are enough grounds for disqualification.

Recession notes

Over the weekend I spoke to a few friends, over phone and GTalk. And enquired about their business. Some interesting insights:

  • On Saturday, I spoke to this guy who is a banker in the City of London. He says that one major fallout of the global economic crisis is that the financial markets have become highly inefficient.
  • Knowing that they won’t get bonuses, he says, bankers have no incentive to arbitrage these inefficiencies. Sadly, people refuse to believe that investment bankers perform socially useful and productive work
  • Yesterday, I was talking to this guy who runs a manufacturing SME. He says that apart from one really bad month (January) when orders fell over 50%, he is doing quite well.
  • Thanks to the downturn, a few manufacturing shops have shut down in various places in Europe. Now, the erstwhile customers of these erstwhile manufacturing shops are looking towards India for their sourcing. My friend is hopeful of bagging one such contract.
  • Thanks to the downturn, firms are integrating their manufacturing. For example, a prominent stationery manufacturer has decided to manufacture 100% of its products from its plants in India. My friend has been a long-term supplier to the india plant of this particular manufacturer, and now expects to get more business from them.

Interesting stuff overall.

The Aftermath

Baada collaborated on the research leading up to his post. I hereby acknowledge his contribution and condemn his laziness for not blogging it himself.

One of the major problems of the financial crisis that has been happening for about two years now is that investment bankers, as a profession, stand discredited. Before this, they used to claim to be on the top of the intellectual ladder. And now, thanks to a handful (more than a handful; but still a small proportion) of phenomenally stupid investment bankers, the entire community stands discredited. Not just that, they have left the community of quants, of people who can be good at structuring, of finance people, of statisticians, all discredited. You say “all you need to do is to get a few ibankers into these jobs” and you’ll have people come at you like a pack of hounds, waving Mint and saying “look at the damage these buggers have caused, and you think they can solve this problem”.

So Baada and I were talking about cricket the other day. About how thanks to the demands of television, flat pitches are being prepared everywhere. Which is leading to tame and boring draws. Which has led to domestic cricket being effectively reduced to a one-innings game. Which has led to massive fourth innings run chases. Which has led to bowlers break down once every couple of seasons. And so forth.

The argument put forth in favour of flat pitches is that in order to maximise television revenues, you need the game to last five days. Excellent argument, and Baada and I agreed to it. But the friggin’ point is that if you have  a boring game, no one is going to watch it. If you have a game that is most likely to end up as a draw, it will have no audience. Advertisers would be paying through their nose for near-zilch viewership.

In the medium term, things should even out. Advertisers will realize that due to the boring nature of Test cricket, no one will watch it anyway, and will back away. Ad rates will fall. And TV rights bids will fall consequently. And the boards will understand their folly and take steps to make cricket interetsing again. (there is also the danger that boards will use this to say that no one watches Test cricket anymore and scraps it altogether). However, advertisers should not be so passive and wait for things to even out.

Given a large number of statistics, playing conditions, day of week seasonality and all such stuff, it shouldn’t be hard for the smart advertiser to figure out which are going to be his most profitable slots. And bid specifically for those. If one smart advertiser does that, then that advertiser stands to gain against other advertisers who will end up paying more money for less profitable slots. And so all advertisers will become smart. Now, the channels will stop seeing uniform demand patterns for their various advertising slots. They will now need to acquire smartness in order to combat the smart advertisers. This way, smartness will prevail in the system.

I’m sure that once something like this happens, natural balance will get restored. It will take much less time for TV channels to realize that three-day Tests on bowling pitches can get them greater revenues compared to runfests played over five days. And they won’t take much time to communicate the same to the boards who will then restore Test cricket back to glory.

The problem with a lot of advertising people is that they see themselves as “creative people” because of which they assume they don’t need to know and use maths. And they don’t do the smart calculations I described earlier. As for the brand managers, it is likely that a lot of them decided to pursue marketing because they either didn’t like quant or found themselves weak at quant. Apart from a few simple excel models, they too are likely to shun the kind of smartness required here.

So where are the white knights who can save the version of the gentleman’s game played in whites? Not currently in the ad agencies. Most likely not in the marketing departments. They are all out there. A few months ago, they were employed. Earning very good salaries, and grand bonuses. Earning amounts of money unaffordable to most advertising and marketing companies. Thanks to the financial meltdown, they are available now. Looking for a fresh challenge.

This is the best time for you to infuse quant to your business. You won’t get the kind of quant supply in the market that you are seeing now. Even if the financial industry doesn’t recover (in any case it will never go back to 2007 levels), supply side factors should ensure lower supply. Do that little experiment now. Acknowledge that numbers can do a lot of good for your business. Understand what structuring is all about, and estimate the kind of impact a good structurer can have on your revenues. Make that little bit effort and I’m sure you’ll get convinced. Go make that offer. An offer these ex-ibankers can’t refuse in the current circumstances at least.

PS: When I refer to investment banking, I also include the “outside-the-wall” side of the business (called “markets”; “sales and trading”; “securities” and various other names). In fact, I mostly talk about the outside-the-wall business, not having had any exposure inside the wall.