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THE HIGH TIDE OF SECURITIES LENDING I S S U E T H I R T E E N • M AY / J U N E 2 0 0 6

Asia’s exchanges seek new alliances Sub-custody takes centre stage Hedge funds find new strategies

NORTHROP GRUMMAN & THE LORDS OF WAR THE GCC REPORT: BANKING ON FUTURE GROWTH

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F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 6

irst General Atlantic buys a strategic stake in Nymex, now comes the news that Boston-based private equity firm TA Associates will buy securities lending agent eSecLending, which was 65% owned by London-based Old Mutual, the London-based specialist insurance and asset management firm. Does it speak to a new trend? “It could make a statement about growth in the investment services industry and where that growth will come from,” says Chris Jaynes, managing director, eSecLending. It appears that TA Associates has its speculative figure on the Zeitgeist. According to the latest figures issued by securities lending specialists Data Explorers Ltd and printed in the trade title ISF, at least 74,554 securities are available in the market for lending carrying a value of €6.5trn, while 25,616 securities are out on loan with a reported value of €1.5trn. Those values are rising daily. Meanwhile, new technologies are promising to bring more transparency to the industry, while beneficial owners are becoming increasingly sophisticated and demanding. Consolidation in the industry argues for greater economies of scale and favours the global giants with large asset pools supported by distribution capacity from their prime brokerage operations. The question is whether TA Associates will be able to effectively leverage eSecLending’s specific niche and help the firm break into new territory. We try to answer some of the questions that the acquisition raises, in the context of wider developments (such as Basel II and MiFid) that are impacting securities lending today. Equity markets in the Gulf Co-operation Council (GCC) region have taken a drubbing since the start of this year. Since January, a series of market contractions have halted the upsurge in share prices that lifted off in the region a little over three years ago. From a peak of 20,634 points reached at the start of 2006, the Saudi Tadawul All Share Index has fallen by 30%; meanwhile in the wider region, equity markets lost around 20% of their top line value. Yet, in all GCC countries, precipitate falls in share values belie continuing good economic conditions. Saudi finances, for instance, are at their fittest in more than 20 years, with an economy growing 6.5% last year and a current account surplus now well in excess of $87bn. In a GCC context, the accumulated current account surplus in all seven GCC countries today tops $193bn. Add to that combined infrastructure spending projects in excess of $700bn over the next ten years and it adds up to a heady mix of opportunity—predicated, of course, on oil prices staying above $40 per barrel for the foreseeable future. We examine the long term effects of this planned prosperity on the region’s capital markets and banking sectors. Our cover story focuses on Northrup Grumman, which has restructured over the last ten years to become a lodestone for the Lords of War who will prosecute hostilities in tomorrow’s virtual—but still lethal—battlefields. If the underlying geopolitical context wasn’t so serious and hazardous, it would be a great ‘toys for the boys’ story. However, reality (sadly) bites. Nonetheless, Art Detman provides a magnetic insight into the re-emergence of the defence giant. Francesca Carnevale, Editorial Director April 2006

Contents COVER STORY COVER STORY: MINDWARE & THE LORDS OF WAR ........Page 44 When military aircraft makers Northrop and Grumman merged, it created one of the world’s largest and most successful defence contractors, even though today the company has no planes in production. Nowadays it is the leading provider of information technology services to the US government, which is a $3bn business all by itself. Art Detman examines the firm’s ‘adapt or die’ strategy for growth.

REGULARS MARKET LEADER

CHINA LEADS PETROCHEMICAL RESOURCES DEMAND ................Page 6

IN THE MARKETS

RAFI INDICES: FUNDAMENTAL TO INVESTMENT ..................Page 12

FACE TO FACE

Dave Simons examines the market impact of China’s consumption needs.

Why a return to bottom up investing makes sense

JSE LTD: THE EMERGING HUB OF PAN AFRICAN GROWTH......Page 14 The JSE is integrating social and governance issues into the investment mix

SPECIAL GCC REPORT:

LEARNING TO LIVE WITH VOLATILITY

........................................................Page 17 Will the volatility currently dogging local equity prices contribute to increased transparency in local corporate reporting and encourage necessary market reforms?

BANKING ON CHANGE

..................................................................................................Page 26 GCC banks are moving fast to expand their regional networks, through acquisition or new offices as new opportunities in both the retail and infrastructure sectors.

WILL RUSSIAN BONDS KEEP THEIR APPEAL?

REGIONAL REVIEW

..........................................Page 33 Lynn Strongin Dodds reports on the prospects for the rouble bond market.

THE GREECE REPORT:

GREEK BANKS LOOK EAST ..................................................................................Page 36 Are neighbouring countries a panacea for limited new business opportunities in Greece?

HOW GREECE BEAT THE ODDS

............................................................Page 40 Everyone likes Greek risk right now: Blazej Karwowski explains why

BRAZILIAN EQUITY ISSUANCE STILL ON THE RISE ..............Page 42 John Rumsey reports

ECNs MAKE A COMEBACK

EQUITY REPORT

INDEX REVIEW 2

......................................................................Page 62 Ian Williams reports on reinvigorated ECNs as new technology and regulation comes in

ASIAN EXCHANGES DASH FOR GROWTH

......................................Page 66 Rekha Menon explores the growing complex web of alliances with Asian exchanges Companies in this issue ..................................................................................................Page 85 Market Reports by FTSE Research ................................................................................Page 86 Index Calendar ..................................................................................................................Page 96

M AY / J U N E 2 0 0 6 • F T S E G L O B A L M A R K E T S

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Contents FEATURES SECURITIES LENDING REPORT

WHY TA BOUGHT INTO eSECLENDING

..........................................Page 49 How private equity is hoping to leverage growth in securities lending.

RIDING HIGHER

..................................................................................................Page 52 The outlook for the next few years is one of steady expansion backed by increased demand and a steady increase in supply as well as a string of new markets coming into play.

EQUILEND DEEPENS ITS FIXED INCOME BUSINESS

............Page 54 Brian Lamb, EquiLend’s CEO talks about the firm’s new business growth.

SUB CUSTODY AND THE BIG SQUEEZE

........................................................Page 57 Is European sub-custody under the cosh? For many of the smaller sub-custodian outfits that either lack the deep pockets required to build all-encompassing offerings or, indeed, the willingness to reorient their business models, the future appears increasingly doubtful. If that is not enough, they are also facing stiff and growing competition from depositories. Tim Steele goes in search of consolation.

SWALLOWING THE BITTER PILL OF CHANGE

................................Page 70 After years of uninterrupted profits and staggering margins, Big Pharma has been forced to revaluate in the wake of stiff generic competition, fewer new products and— believe it or not—government-backed pricing discounts. Can branded giants such as Pfizer Inc, which is the world’s largest pharmaceutical retail company, Merck & Co., Inc., and Indianapolis headquartered Eli Lilly & Co., maintain their lofty expectations in a rapidly changing market? Dave Simons reports from Boston.

ALTERNATIVES AND ALTERNATIVE INVESTMENTS SERVICES REPORT

STEPPING UP TO THE PLATE ......................................................................Page 74 Once the preserve of specialist investment service providers, alternative fund investment services have now moved into the mainstream. Key areas of operational excellence are emerging, including third party pricing verification, trustee and compliance services, front and middle office support and breath of service. In an increasingly sophisticated market place can every provider compete at the same level?

WHICH WAY IS ALPHA? ................................................................................Page 78 In current market conditions, many strategies that have long underpinned hedge fund performance cannot deliver the returns investors expect. Hedge funds are a resourceful bunch, however and Neil O’Hara explains the evolution of the current investment strategies employed by hedge funds in search of alpha.

HEDGE FUND PROFILE: LANDMARK INVESTMENTS

..............Page 83 While investors are cutting back allocations to diversified funds of funds, the money is not leaving the hedge fund industry. It is flowing to individual hedge funds – and specialised funds of funds, such as Landmark. Neil O’Hara talks to Landmark’s founder, Ahmed Fattouh, about its evolving investment strategy.

M AY / J U N E 2 0 0 6 • F T S E G L O B A L M A R K E T S

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Market Leader PETROCHEMICALS

Photograph: iStockphoto.com, March 2006

Liberalisation initiatives have helped spark a pattern of economic growth in China that has, in turn, increased the country’s rate of global-oil consumption to 9%, second only to the United States. What is more, analysts do not seem to see an end to the trend any time soon. Dave Simons reports. OUNTRIES THAT MAKE up the China Rim account for half of the world's entire population. Yet the area is only responsible for less than 10% of global crude-oil production. The useproduce ratio is even wider in China itself, a country with over 20% of the world population yet just 1.8% of the global oil output. Catalysts include rapid industrial development along with an astronomical growth in transportation needs that is particularly acute in China; where automobile ownership is expected surpass the US over the next 20 years. “Given the high oil intensity, or oil consumption per unit of economic output, and rapidly expanding economy, China’s demand for petroleum and petrochemical products is unlikely to abate in the near term,”offers Ma Shang, associate director for Fitch Rating’s Asia-Pacific Energy & Utilities team. Automobile mania has also enveloped India, where a surging economy has created an incessant demand for new cars, and, like China, a need for fuel, and lots of it. By 2030, India’s usage is expected to reach 10%, more than triple its current share of the global market. Already, India’s largest oil companies are busy nailing down potential deals with prospective petrochemical providers in order to

China leads PETROCHEMICAL RESOURCE DEMAND meet demand. Not surprisingly, a recent report revealed that the country’s top companies in net sales were all petrochemical producers, among them Indian Oil Corporation (IOC), Reliance Industries, Bharat Petroleum Corporation Ltd., and Hindustan Petroleum Corporation Ltd. Meanwhile a taskforce on Petroleum, Chemicals and Petrochemicals Investment Regions (PCPIR), headed by principal secretary to prime minister TKA Nair, has been launched with the aim of attracting petrochemical-based investors to the region. One thing is certain. The global petrochemicals sector is in the midst of a profound transformation with the majority of production activity gradually moving eastward. Analysts

point to a surplus in low-cost, Middle East-based feedstock, declining production for ethylene and polyethylene in higher-cost regions in the West, combined with a surge in petrochemical demand in the AsiaPacific. By 2010 the Middle East’s portion of the global ethylene market is expected to double, marked by a seismic increase in Asian net trade. At a February petrochemicals conference held in Dubai, Arie Hoogenboom, base chemicals strategy manager for Shell Chemicals Ltd., addressed the need for companies to respond to the rapidly evolving petrochemical business. “In the face of chemicals demand growth patterns, the industry will need to add capacity, with most new plants sited either in the growth markets of Asia or in the Middle

M AY / J U N E 2 0 0 6 • F T S E G L O B A L M A R K E T S

Market Leader PETROCHEMICALS Regionally, things are looking up for many of Asia’s leading petrochemical producers. Singapore, a major global supplier of petrochemicals and industrial chemicals, anticipates increased demand for products ranging from food chemicals and additives, epoxy and phenolic molding compounds, and ultrapure electronic materials. Photograph: iStockphoto.com, March 2006

East, which enjoys considerable feedstock resource advantages,”remarks Hoogenboom. “Developing new supplies and delivery chains to consumers, many of whom, for the foreseeable future, will remain heavily dependent on imports, will require major investment. To be successful, these investments must be cost-competitive, technologically sound and reliable, well served logistically and have good customer linkages. Moreover these investments will involve meeting significant challenges related to feedstock, financing, technology, project management and supply chain management. Where will they be located? Predominantly in regions where demand is growing fastest or where large-scale sources of competitive

feedstock is available: in other words, Asia Pacific and the Middle East.” Regionally, things are looking up for many of Asia’s leading petrochemical producers. Singapore, a major global supplier of petrochemicals and industrial chemicals, anticipates increased demand for products ranging from food chemicals and additives, epoxy and phenolic molding compounds, and ultrapure electronic materials. China’s BASF, which runs a petrochemical complex in Nanjing in conjunction with the China Petroleum & Chemical Corp (Sinopec), expects robust growth over the near term, as does China National Chemical Corporation (ChemChina), which recently announced that it would invest $9bn in a new complex in the Hebei Province city of Cangzhou. Skyrocketing oil prices have greatly boosted the fortunes of China's oil and gas exploration firms, with crude-oil yields making substantial year-to-year gains. Low P/E multiples and substantial growth potential typify issues such as PetroChina and China National Offshore Oil Corporation (CNOOC), while the recent easing of

government price controls is certainly good news for the likes of Sinopec, China's largest oil refinery, currently the cheapest at roughly 7.9 times earnings. Meanwhile, the exploration and conservation initiatives of China’s petrochemical industry have yielded positive results. In sharp contrast to the nearly 35% import rate from 2003-2004, a report by the Ministry of Commerce (MOFCOM) found that increased oil stockpiles and reduced oil refining held 2005 imports of crude oil to only 130m metric tons, representing a marginal 6% rise from the previous year. As a result, the country that represents one-fifth of the world’s population still only accounts for just 4% of its daily consumption. So powerful is China’s financial engine, in fact, that some observers believe that these initiatives alone have the potential to shift the balance of power, particularly among emerging petrochemical nations. One such region is Iran, which is expected to triple its share of the Middle East market with the completion of new petrochemical complexes in Marun, Pars, Ghadir and Borzouyeh. Of greater significance, however, is a proposed pact between Iran and China that would allow Sinopec to develop a major oil field in Iran while purchasing 10m tons of liquefied natural gas annually through 2030. The deal, valued at approximately $100bn, would be the fruition of an energy-development agreement signed in late 2004 and "following the rule of mutual benefits and respect in all bilateral cooperation," according to leaders from the two countries. Though Iran is just one stop on China’s petrochemical quest – in recent years the country has availed itself of investment opportunities in

M AY / J U N E 2 0 0 6 • F T S E G L O B A L M A R K E T S

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Market Leader PETROCHEMICALS 10

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international petroleum places such as Australia, Share prices respond to the incessant demand for oil... companies, is expected to Syria, Sudan and 550 play an important role in Indonesia – it is by far the 500 the development of a most contentious to date. 450 400 global market for natural The agreement comes on 350 gas,” says Mohammed Althe heels of a US-backed 300 Mady, vice chairman and initiative aimed at 250 200 chief executive officer for preventing Iran from 150 R i y a d h - b a s e d resuming production of 100 petrochemical firm Saudi uranium-based power, 50 Basic Industries which Washington believes Corporation (SABIC).“This could be used to produce FTSE Oil & Gas FTSE China Oil & Gas development will be nuclear weaponry. driven not only by growing In a recent Washington Source: FTSE Group (USD price returns). Data as at March 2006 demand, but also by the Quarterly report entitled desire of governments to Managing China: US Energy monetise an increasingly Competition in the Middle valuable resource where it East, authors Flynt Leverett “Since 2002, the Middle East has exists in excess of domestic and Jeffrey Bader noted the become the leading arena for Beijing's demands,”he adds. link between Beijing's efforts to secure effective ownership of The increased value of Middle-East policies and critical hydrocarbon resources,” state the natural gas also extends to the oil-producing authors, “rather than relying solely on the liquids that are objectives of the three extracted from associated major state-owned energy international markets to meet China's natural gas; including companies, the China energy import needs. There is every reason ethane, propane and National Petroleum to anticipate that China will continue and butane, that are all Corporation (CNPC), even intensify its emphasis on the Middle important petrochemical Sinopec and CNOOC. East as part of its energy security feedstocks, notes Al-Mady. “Since 2002, the Middle “As in the case of East has become the strategy.” So determined is China to petroleum liquids derived leading arena for Beijing's maintain oil-export parity that a potential from crude oil, we can efforts to secure effective military conflict with the US is not out of conclude that new ownership of critical the question, according to the report. petrochemical assets can hydrocarbon resources,” benefit from locations state the authors, “rather where light condensate, than relying solely on international markets to meet China's making it a new competitor to the natural gas, and natural gas liquids energy import needs. There is every United States for influence in the exist well in excess of domestic demands. This opens the door for reason to anticipate that China will Middle East,”they add. cooperation between A potential wild card on the extended continue and even intensify its emphasis on the Middle East as part emerging petrochemical front is petrochemical producers in the Middle Russia, currently a significant supplier East and Europe. Middle Eastern of its energy security strategy.” “It seems doubtful that Chinese of natural gas to the Asian markets. countries, with their natural resource energy companies' fledgling efforts to Observers believe that natural gas base can provide an excellent location lock up petroleum resources will could conceivably surpass crude oil as for manufacturing assets of European succeed in keeping a critical mass of an energy source over the next 25 petrochemical producers allowing oil reserves off an increasingly years, particularly as a worldwide them to reach the growing consumer integrated and fluid global oil market for liquefied natural gas (LNG) markets of Asia, Africa and the Middle market,” adds the report’s authors, develops. “Along with Middle Eastern East. We see this trend already taking “nevertheless, China’s search for oil is countries, Russia, in cooperation with place in a robust fashion.”

M AY / J U N E 2 0 0 6 • F T S E G L O B A L M A R K E T S

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In the Markets RAFI INDICES

Back to basics

market capitalisation weighted indexes, whose market value-based construction is susceptible to significant market volatility in response to shifting investor preferences and expectations. Do index funds that are weighted based on company fundamentals Fundamental indexes, by contrast, (that is, dividends, free cash flow, book value) outperform standard says Arnott, “show much less capitalisation-weighted indices? Research Affiliates and FTSE seem volatility and provide for more stable stock weightings”, this in turn he to think so, with the FTSE RAFI Index Series. says provides more favourable OBERT D. ARNOTT, chairman the United States as well as by Nomura returns for investors. Frustrated by the “problems” in of Pasadena, California-based Asset Management in Japan, and by Research Affiliates, LLC, the the UK’s PIMCO for its portable alpha traditional market capitalisation quantitative investment research closed-end fund firm. In addition, The indices, “If a stock is overvalued, a Public Employees market-capitalisation based index will boutique, which also has around $8bn California in assets under management, thinks Retirement System (CalPERS) is also overweight the stock,” he says, Arnott that there is a big future for reportedly considering the addition of began work on a “fundamental” index fundamental indexing. “Recent RAFI a fundamental index fund to its that weights companies by their studies indicate that fundamental portfolio. Arnott thinks that the “economic footprint,” back in 2002. in alternatives to indexes have produced consistently demand for investible products based “Interest higher returns, at modestly lower risk, on fundamental indices will grow capitalisation-weightings is growing, when compared to cap weighted exponentially and that within the as their weightings faults have become decade around “$500bn will be increasingly clear.”In recent times, the indexes, says Arnott. to funds tracking appeal of fundamental indices has also Canada’s Claymore Investments, allocated has obviously been listening, having fundamental indices”, with at least risen as by construction, they are introduced the FTSE RAFI Canadian $10bn being allocated to the sector by biased toward value and small caps, which have outperformed compared Index Fund (TSX: CRQ) in late the end of the 2006. Fundamental indexing selects, ranks to large cap portfolios. February, that will track the The size of a company depends on eponymous fundamental index which and weights companies, not by market uses factors such as sales, cash flow, capitalisation, but by financial what you use to measure it, so Arnott book value and dividends to fundamental measures of company created a series of indices that weight determine the rank and weight of its size; hence the focus on elements such companies based on six metrics: book component stocks. Arnott says that as sales, cash flow, book price and value, employment, and trailing fivefundamental indices produce dividends. Fundamental investing is a year averages for cash flow, revenue, consistently higher returns with signal departure from traditional sales and dividends. A composite index, equally weighting the four slightly less risk when most widely available compared to traditional Five Year Total Return Performance to 31 March 2006 metrics (book value, cash market-capitalisation (US Dollar Terms) 160 flow, sales and average weighted indices and 150 gross dividends), added an should theoretically avoid 140 average of 260 basis points overvalued equities in 130 120 to returns compared to capmarket bubbles. 110 weighting.“To do that with Claymore Investments is 100 an active manager would not the only investment 90 80 be impressive,”Arnott says, house to embrace this 70 “to do it with a passive thinking. A fundamental 60 index is remarkable. strategy has been adopted Fundamental indexing by PowerShares through its doesn't leave that money PowerShares FTSE RAFI FTSE RAFI 1000 Index FTSE USA All Cap Index on the table.” 1000 ETF (NYSE:PRF) in Source: FTSE Group/FactSet Limited. USD price returns. Data as at March 2006

M ar -0

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M AY / J U N E 2 0 0 6 • F T S E G L O B A L M A R K E T S

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No other benchmark beats the outperformance or low risk exposure of the FTSE RAFI Fundamental IndexesTM across bull and bear markets, expansions and recessions. Fundamental IndexingTM weights companies based on fundamental factors – sales, cash flow, book value and dividends – not market capitalization. To learn more about how to diversify your portfolio and mitigate risk with this patent-pending and award winning methodology, visit www.ftse.com/rafi or contact your FTSE representative. Winner of the William F Sharpe Indexing Achievement Award for Index Innovation: BEIJING +86 10 6515 9265 BOSTON +(1) 888 747 FTSE (3873) FRANKFURT +49 (0) 69 156 85 143 HONG KONG +852 2230 5800 LONDON +44 (0) 20 7866 1810 MADRID +34 91 411 3787 NEW YORK +(1) 888 747 FTSE (3873) PARIS +33(0) 1 53 76 82 88 SAN FRANCISCO +(1) 888 747 FTSE (3873) TOKYO +81 3 3581 2840 © FTSE International Limited (“FTSE”) 2006. All rights reserved. FTSE® is a trade mark jointly owned by the London Stock Exchange Plc and The Financial Times Limited and are used by FTSE under licence. “Research Affiliates” and “Fundamental Index” are trademarks of Research Affiliates LLC (“RA”). The FTSE Research Affiliates Fundamental Indices (“Indices”) are calculated by FTSE. All rights in the Indices vest in FTSE and RAFI. The trade names Fundamental Index, Fundamental Indexing, RAFI, the RAFI logo and the RA corporate name and logo are the exclusive intellectual property of RA. Any use of these trade names and logos without the prior written permission of FTSE or Research Affiliates, LLC is expressly prohibited. FTSE and RA reserves the right to take any and all necessary action to preserve all of their rights, title and interest in and to these trade names and logos. Patent Pending. Publ. No. US-2005-0171884-A1 and WO 2005/076812

Face to Face THE JOHANNESBURG STOCK EXCHANGE

JSE LTD: THE EMERGING HUB OF PAN AFRICAN GROWTH A relatively stable Rand, growing consumer demand fuelled by low interest rates and lower inflation, has made for a satisfying 18 months for the Johannesburg Stock Exchange (JSE Limited); particularly as the FTSE/JSE All Share Index rose by 42% over calendar 2005. While it has been a period of growth, it has also been a time of change as the exchange moves from a legacy IT infrastructure into a next generation technology solution. FTSE Global Markets talks to Nicky Newton-King, the exchange’s deputy chief executive officer (CEO) about the exchange’s growth plans in 2006 and beyond.

Nicky Newton-King, JSE Limited’s deputy Chief Executive Officer (CEO) acknowledges that the exchange probably “tries harder” than other mainstream exchanges.“South Africa is still an emerging market, therefore to stay in the mainstream, our regulations and operations often exceed accepted international standards. We are always trying to offer more.” Photograph supplied by the JSE, March 2006.

ISING CONSUMER DEMAND for goods and services, fuelled by low interest rates and low inflation, combined with a much broader income base in the country, has resulted in very good financial performance by South African companies. GDP growth in the South African economy sits at a comfortable 5% per annum. Government tax recovery efficiencies continue to improve and the possibility exists for a reduction in interest rates throughout the rest of this year. All these developments point to continued gains for the JSE. The exchange is the world’s 16th largest equities exchange, with a total market capitalisation of some R3.9trn (around $620bn). With over 400 listed companies and a market liquidity of 44%, the JSE believes it has an obligation to protect its world class status. As a result, JSE Limited has an ambitious growth strategy that encompasses both pan-regional and global elements. First off, following demutualisation and now shareholder and regulatory approval, the JSE will list on its own exchange within the next six months. Local investment bank RMB has been appointed as sponsor for the listing and the bank will be part of the advisory team as well. The JSE’s shares currently trade over the counter in-house with the exchange’s own secretariat facilitating the trades, which are then settled through STRATE, the JSE’s electronic system. The JSE’s unlisted share price is currently R140/share and it is adding up to a frenzy of optimism at the exchange. However, the exchange is pragmatic and careful and knows that high flying strategies need to be backed up by detailed groundwork. In preparation for its run for growth, the exchange has embarked on a wide ranging infrastructure modernisation programme. Called Project Orion, an important phase of the infrastructure transformation programme is about to

M AY / J U N E 2 0 0 6 • F T S E G L O B A L M A R K E T S

be completed. For an assortment of reasons, the JSE currently operates a number of legacy technology systems, servers and applications that, says Newton-King, have sometimes “restricted the degree of flexibility with which the exchange responds to customer requirements”. Newton-King explains that Orion’s chief objectives are to enable the exchange to move to a service-oriented, standardised architecture that facilitates increases and decreases in growth on a cost effective basis, “adhering all the while to industry standards and best practices. We are among the world’s first exchanges to adopt the fully integrated, multi-asset-class exchange model. To allow our model to work seamlessly and cost efficiently we need best-of-breed technology and Project Orion

underpins this process,”she adds. Project Orion has a phased migration approach, and the target for final system migration is the first quarter of 2006. “We have tried to make certain that we have had a smooth transition and managed the timeline through the use of best-of-breed, packaged solutions wherever possible,” she explains. To facilitate an easy changeover, the exchange has undertaken a number of “Dress Rehearsals”, or simulations of a normal trading day, will be run to ensure that the market and the respective participants function as or more efficiently in the new environment than in the old. The Dress Rehearsals will be mandatory and JSE customers will be involved at different times in different releases. Project Orion remains an internal restructuring, as the equities

market uses London Stock Exchange trading systems and will continue to do so says Newton-King. The JSE also utilises the Swiss settlement system, via a Sega inter-settle system, which the exchange bought off the shelf and customised for its own requirements. Although the overall system remains dependent on the operation of foreign suppliers, Newton-King says that the exchange has an enviable “zero failed trade”track record and therefore sees no need to change existing relationships, at least in the near term. One of the strategic imperatives of the new, improved JSE is based on local geography. South Africa is a resourcebased country and its economy is strongly underpinned by the mining sector. The country has only variously enjoyed economic growth facilitated by

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F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 6

Face to Face THE JOHANNESBURG STOCK EXCHANGE 16

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Many analysts believe that the exploration of new commodity explains. “The JSE is the centre for deposits. For varied reasons, it has liquidity for the African continent, it is regionalisation is inevitable for African become difficult for local exploration essential that we attract real interest stock markets as they struggle to companies to raise local finance for from African companies,” she adds. overcome poor liquidity and to attract Africa-based projects, as many South Her logic is compelling: Africa is a more foreign investment. The path has African investors view these investments resource-based continent, and South been cleared for dual listings on as too high-risk. Consequently, there is a Africa, as the economic heart of the southern Africa's stock markets lack of junior mining houses on the JSE, continent, should be the continent’s following several meetings of the with an attendant steady rise of South natural mining capital. “This will regional stock exchanges. Internally, as well the JSE has African junior companies often choosing remain one of the businessto list either in London or in Toronto. development unit’s top objectives for encouraged the capital-raising potential Numbers are hard to contradict and the next few years,”she says.“We spent of black-owned small businesses. The while there are less than 50 mining a lot of time working with the New JSE has worked closely with the National African Federated companies listed on JSE Chamber of Commerce Limited, the Toronto Stock FTSE/JSE Africa Index Series (Nafcoc), a local business Exchange (TSE) currently 225 association to promote the boasts more than 1200 200 exchange and in particular resource-based mining 175 the AltX as a solution for companies (often junior 150 raising capital in support of companies) on its board. 125 black economic In an attempt to change 100 empowerment (BEE) this misperception and 75 initiatives. An agreement, develop a strong junior 50 signed in May of 2004, has mining board, the South seen the implementation of African exchanges, an educational and including the two boards FTSE JSE Top 40 Index FTSE JSE All-Share Index FTSE JSE Resource 20 Index awareness-raising of the JSE, the main board FTSE JSE Industrial 25 Index FTSE JSE Financial 15 Index programme for local SMEs. and the AltX, the JSE’s Some 90% of Nafcoc's specialist small and Source: FTSE Group. Data as at March 2006 members are SMEs, and the medium sized enterprises (SME) cap listing board, embarked on Partnership for African Development AltX, with its less stringent listing a new strategy in March last year to (NEPAD),” continues Newton-King it requirements, is tailor-made for them. According to Newton-King, AltX bring business to the stock exchanges is an area that is very important for the rather than wait for business to come JSE.”The NEPAD strategic partnership complements the government's BEE to them. Although this strategy has arises from a mandate given to the five policies by creating a space for more only been in play for a short time, initiating Heads of State (Algeria, black companies to participate in the uplift in mining company listings on Egypt, Nigeria, Senegal, South Africa) JSE. AltX is geared to act as a the JSE has begun. Last year, Wesizwe by the Organisation of African Unity springboard for smaller companies Platinum, Miranda Mineral Holdings, (OAU) to develop an integrated socio- eventually to list on the JSE's main Oando, Chrometco, and Wescoal have economic development framework for board. The AltX exchange also offers all listed on the exchange and the Africa. “We have offered sub-Saharan reduced listing fees. Its operation is exchanges the opportunity to work supported by the full range of JSE AltX, respectively. Newton-King is also optimistic utilising our infrastructure or services - including the trading of about the future of the JSE to attract backbone [sic] at cost. This makes shares on the same system as the more companies as a result of the sense as the JSE is obviously the main board, market surveillance to irregularities, and economic growth that South Africa is biggest and most sophisticated eliminate experiencing. “In addition to this exchange on the continent and it settlement of AltX securities through internal growth strategy, the business- provides neighbouring countries the STRATE. Its listing requirements are development unit has adopted a new opportunity to leapfrog and attract appropriate for SMEs, placing programme of attracting African further institutional investment in emphasis on initial and ongoing disclosure of company information. companies to dual-list on the JSE,”she Africa,”says Newton-King.

M AY / J U N E 2 0 0 6 • F T S E G L O B A L M A R K E T S

GCC Report GCC REPORT: OVERVIEW

LEARNING TO LIVE WITH VOLATILITY For experts in the Gulf Cooperation Council (GCC) markets the volatility currently dogging local equity prices is not only overdue but also a good thing. They have it that market corrections may still have some way to go, but that over the medium term, today’s volatility will contribute to increased transparency in local corporate reporting, help curb speculative borrowing by firms and encourage necessary market reforms. Francesca Carnevale reports from the Gulf. “

S I WATCH the GCC asset market bubbles deflate and pop with a vengeance in front of me, my mind echoes with the wisdom of the good, the bad, the ugly and the leveraged”. So wrote financial journalist Matein Khalid in the Moneymaze column of Business Times, the United Arab Emirates-based (UAE-based) financial daily in midMarch this year. A veritable cri de cœur, Khalid’s swingeing polemic solidifies the heat that has seared local investors

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 6

and press commentators. Without exception, GCC investors have had a hard time coming to terms with a fall in the value of their equity portfolio. Since the start of the year, a series of market contractions have halted the bull run in share prices that lifted off in the region a slip over three years ago. Saudi Arabia’s stock market tells it whole: from a peak of 20,634 points reached at the start of 2006, the Saudi Tadawul All Share Index has fallen by 30%; equivalent to $260bn slashed from the exchange’s capitalisation. Yet, as in all other GCC countries, precipitate falls in share values belie continuing good economic conditions. Saudi Arabia’s finances, for instance, are at their fittest in more than 20 years, with an economy growing 6.5% last year and a current account surplus now well in excess of $87bn. Khalid’s exclamation aside, portents of a downturn had been writ large in the region for the past twelve months. Regional valuations had been stretched to capacity throughout 2005—relative to both oil prices and peer companies in other emerging markets—led in large part by Saudi Arabia, the United

Arab Emirates (UAE) and Qatar. At an international symposium held by National Bank of Kuwait (NBK) last December on GCC Equity Markets: Boom or Bubble? participants, including, Abdulla Al-Shaikh, chief economist of Saudi Arabia’s National Commercial Bank and Omar Abdallah, head of MENA Capital Markets at NBK agreed that while strong market fundamentals remain in place in 2006 and beyond, valuations had been expensive. Not only that. The “increased involvement of inexperienced investors, guided mostly by absolute price levels, poses a risk of pushing valuations to unwarranted levels,” stated an official NBK post-symposium release. As well, it also expressed misgivings about fast credit growth in GCC markets, which it said had led “to excessive speculation”. Jean-Christophe Durand, regional head of GCC Banking at BNP Paribas, in Bahrain explains, “Some portion of the good results announced are a result of capital gains for the corporates plus brokerage fees for the banks. There was certainly a sharp decline on most bourses in the region, but it is something that we expected and

GCC Report GCC REPORT: OVERVIEW

frankly, the fact that it has happened earlier rather than later is all for the better. It has stopped some of the excessive trading patterns that marred, for example, the stock market in the UAE. A dampener on this type of speculative activity is a positive development.” “The market correction was way overdue,”acknowledges Randa AzarKhoury, chief economist, economic research at NBK. Price to earnings (P/E) multiples have been supernaturally high in the region’s leading markets, “which has fed the belief that many stocks overshot their fair value,” she adds. Compare for example Bahrain, which had an average P/E ratio of 20, with the Tawadul, which recorded an average P/E ratio last year of 69. For the record, according to AME Info, the specialist Middle East data feed, by the end of 2005, the seven GCC stock markets had a combined 528 listed companies with a total capitalisation of $1.16trn, led by Saudi Arabia with a market cap of $685.3bn. The UAE followed with a $230.7bn, Kuwait at $135.1bn, Qatar at $82.5bn, Bahrain at $18.7bn and Oman at $12.8bn. According to figures supplied by HSBC in Dubai, domestic investors account for slightly less than 50% of this market capitalisation; GCC nationals account for around 25% of the market, while non-GCC nationals account for $104bn of the total. In 2005, with $141bn worth of trading, the UAE accounted for 10% of the total trading activity in the GCC. Saudi Arabia dominated with 81 per cent of the total value of trade, while Kuwait came third with 7% and Qatar followed at 2%. The region is dominated by Saudi Arabia’s Tawadul, which has a market capitalisation in excess of $600bn, accounting for around 49% of the current free float in the region, and is (to boot) the world’s biggest ‘growth

National Bank of Kuwait building in Kuwait City. Photograph: NBK. April, 2006

market’ stock exchange. The kicker is that non-GCC national direct participation in the Tawadul is closed, leaving the smaller markets more able to capitalise on growing investor interest in the region; but also more vulnerable to pullouts by foreign institutional investors. “Kuwait, the UAE and Egypt account for more than 80% of the opportunity set for nonGCC nationals,” explains Mukhtar Hussein, chief executive officer, corporate, investment banking and markets, Middle East & North Africa at HSBC in Dubai. The markets remain attractive in spite of current volatility says Hussein. He points out that GCC countries have delivered superior earnings growth in aggregate during 2004 (45.8%) and 2005 (by an estimated 43.6%). Compare that with other emerging markets, which

have risen by around 37% and developed markets which are up by around 22.5%. In fact, ruling out the possibility of a steep drop in oil prices any time soon, the region’s stock markets are set fair for further growth thinks Steve Brice, regional head of research, MEPA & South Asia at Standard Chartered in Dubai, “Consumer confidence is at an all time high and government spending on infrastructure growing, the outlook for region's securities markets has never been so buoyant. Adding to this upbeat mood is a new cross market investment trend offering GCC investors a broader trading spectrum and wider stock options,” he adds. “As long as oil prices stay above $40 and that is likely over the medium term, the underlying drive will be to push up the stock markets.”

M AY / J U N E 2 0 0 6 • F T S E G L O B A L M A R K E T S

GCC Report GCC REPORT: OVERVIEW

Brice highlights structural issues that encourage this trend. “Free float remains limited in some countries due to government ownership in listed companies. This has placed some constraints on liquidity and indirectly pushes the market prices higher due to a shortage of supply," he explains. Again, Saudi Arabia provides a useful microcosm: there are only 78 stocks to trade, a fact that makes the Saudi market thin in spite of the colossal amount of funds seeking investment opportunities in the country’s growth story. Consequently, the market is vulnerable to sudden extreme swings. That in turn also places pressure on each of the GCC exchanges to both encourage more listings and, at the same time, diversify the range of companies on the GCC exchanges. “The market has considerable potential to grow much bigger and to rank with South Korea,”thinks Brice. Equally, rules governing equity issuance are also candidates for reform. “Although the initial public offering (IPO) market was excellent last year, there was some mishandling of the IPOs. Offerings were happening at par, which meant that the issuers gave away free money. Responsible

Adel El-Laban, group chief executive officer (CEO) and managing director of Ahli United Bank in Bahrain. Photograph supplied by AUB, April 2006.

valuations must be a feature of IPOs going forward,” says Ali Taqi, senior manager, MENA capital markets at NBK. “But there was no alternative in some cases,”he explains.“In Qatar and the UAE IPO issuance at par was obligatory under the law. Some people say it was a means of wealth distribution, with the average investor seeing returns of five, six even seven times the value they paid for shares.” Individual equity markets in the GCC are now obligated to re-evaluate their processes and procedures and introduce regulation that will provide

GCC Countries: selected economic indicators 2005 Economic Indicators

Bahrain

GDP Nominal GDP growth (%) Consumer price inflation Population Per capita GDP (US$) Current account balance ($bn) Current account balance as % of GDP Foreign exchange reserves ($bn) Total external debt ($bn) Total external debt as a % of GDP Debt service ratio, paid (%)

12.9 25.2 2.7 0.7 18,429 1.5 11.7 2.4 6.8 52.7 5.9

1. 2. 3. 4. 5.

Kingdom of Saudi Arabia 301.7 20.4 0.6 24.6 12,264 85.5 28.3 30.3 34.5 11.4 1.8

Kuwait

Oman

Qatar

72.5 30.2 3.7 2.9 25,000 31.1 42.9 9.8 15 20.7 2.3

31 25 1.1 2.8 11,084 4.5 14.7 4.7 4.5 14.6 5.9

35.4 24.2 7.8 0.8 44,250 9.2 26.1 4.9 21.1 59.6 9.8

United Arab Emirates 118.4 14.8 6 4.7 25,191 26.2 22.1 23.5 30.2 25.5 1.8

Aggregate GDP few at 20.9% to $571bn in 2005 Average per capita GDP exceeded $25,000 in UAE, Qatar & Kuwait GCC current account surpluses aggregated to an all time high of $158bn (27.6% of GDP) Comfortable debt ratios for all states Rising consumer inflation in the UAE and Qatar. Source: HSBC Dubai, March 2006

bedrock for future market growth. Part of that will be “educating local investors that equity markets do not always rise in value,” acknowledges HSBC’s Hussein. The evidence of the last two months in the GCC points to the fact that local investors—particularly high net worth investors—were simply not prepared or ready for a correction in the market and have in part panicked. In Kuwait, for example, stock market corrections brought people on to the street in protest. Elsewhere, investors put direct pressure on the bankers and brokers that tempted them to invest in the local stock exchange. According to one ‘off the record’ banker in Qatar:“we, like all the banks in the region, have had local investment clients insisting that we give them their money back—but at values at the top end of the market, not at today’s values in the exchange.” Many investors, it seems were happy to take the upside but refuse to accept any downside, particularly those who had borrowed heavily from banks to buy shares. In Kuwait, for example, lending for securities purchases had increased by 337% to $3.6bn since 2000, according to a February 2006 Credit Suisse research report entitled

M AY / J U N E 2 0 0 6 • F T S E G L O B A L M A R K E T S

GCC Report GCC REPORT: OVERVIEW

Gulf Equity Markets: Powered by Oil, written by research analysts Jonathan Garner and Alexander Redman. “In some cases companies have leveraged themselves by up to 200%,” says Wafa Mohamed Al-Rashed, director of the Kuwait Stock Exchange’s (KSE’s) technical bureau department. That is a worry over the long term and has “spurred the KSE to begin establishing procedures that will place a cap on amount of debt that listed companies can leverage. It is a move that will help bring transparency and stability to the market,”she says. It is a view widely held. According to Adel El-Laban, group chief executive officer (CEO) and managing director of Ahli United Bank in Bahrain, “The current market contraction is a litmus test; the markets will have to strike a balance between market discipline and investor protection.” “The issue now is educating investors of the importance of long term market stability,” says Al-Rashed, “and that involves local investors accepting that market corrections are necessary to ensure share valuations properly reflect market conditions.” In Kuwait and elsewhere, the first response by governments has been to use up valuable liquidity to shore up local stock markets and to pressure high profile investors to do the same. Saudi Arabia’s Prince Alwaleed bin Talal, chairman of Kingdom Holding, reportedly helped stabilise confidence in the Tawadul, in the mid-March with an announcement in the local press that his company plans to invest at least $1.3bn in Saudi stocks. This is but a temporary palliative, acknowledges Al-Rashed. Volatility in the markets is likely to continue in the short term, not only for structural reasons, she thinks, “but also for wider geopolitical uncertainties caused by the rise of civil unrest in neighbouring Iraq and increasingly

escalating tensions between the United States and Iran. It is a no brainer,” she says pointedly. The UAE has been prominent in trying to establish market discipline; taking both direct and indirect action. The UAE’s Ministry of Economy and Planning reportedly asked Dubai Islamic Bank (DIB) in late March to postpone its planned $820m rights issue to a so far unspecified date. The Wafa Mohamed Al-Rashed, director of the Kuwait UAE is also now considering Stock Exchange’s (KSE’s) technical bureau department. new regulations designed to fix a level for maximum allotments in on the Dubai International Financial IPO subscriptions, in an effort to curb Exchange (DIFX) in mid April. excessive exposure by large investors According to Nasser Al Shaali, chief {and some banks] and at the same time operating officer (COO) of the DIFX, allow retail investors to benefit more “one of the ways we are managing from public share issues. Currently, there expectations is the vigorous process we is no maximum allotment. A large have put in place for listings. It requires institutional investor could, theoretically full transparency and helps deflate subscribe for the whole of an IPO. In a some of the speculation.” A recent initiative that has recent press conference, Sultan Nasser Al Suweidi, governor of the UAE central contributed to this trend is the creation bank, stated: “Companies must set a of the ‘Hawkama’ body, an institute for limit for subscriptions in public offerings corporate governance, established by so that the small investor gets an equal the Dubai International Financial chance and IPOs do not get heavily Centre (DIFC) and other international organisations including the Union of oversubscribed,”he said. However a test case for the new, Arab Banks and the International more cautious approach to IPOs, is the Finance Corporation. The organisation share sale of Emirates aims to promote corporate sector telecommunications provider Du, reform, assisting countries in the whose upcoming listing is already region to develop and implement reportedly oversubscribed a whopping sustainable corporate governance with the 167 times, with pledges from 225,000 strategies. Together investors totalling $109bn, easily the establishment of a robust rule book at largest amount raised pre IPO in UAE the DIFX, it aims to help the region to listings history. The Emirates Securities integrate economically and financially and Commodities Authority (ESCA) with the rest of the world. There is a lot has reportedly guaranteed a swift at stake, acknowledges Al Shaali. refund of surplus IPO subscriptions; “Developments here in Dubai although local press reports in the complete an important bridge, both closing days of March announced that between the region itself and the East, Du would refund oversubscriptions involving the Indian sub-continent, after April 3.The stock is expected to list Singapore and Japan, for example; but

M AY / J U N E 2 0 0 6 • F T S E G L O B A L M A R K E T S

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GCC Report GCC REPORT: OVERVIEW

also with the West, attracting in investment dollars. In that respect, we need to create a stable environment for issuers while providing local, regional and global distribution capacity, all from the DIFX platform.” Another confidence building measure being considered elsewhere is the likely authorisation for expatriates to invest in the Saudi stock market. There have also been calls for market makers to be created to buy and sell as needed to stabilise the market and stop the market oscillating wildly between peaks and troughs, and among other financial institutions, the Saudi Public Investment Fund has been suggested as a possible candidate for the role. Major upcoming state divestments in various GCC countries are likely to maintain investors' enthusiasm for buying shares at least in the medium term. The agenda includes the proposed privatisation of parts of Saudi Arabian Airlines and the sale of the General Organisation for Grain Silos and Flourmills as well as the state's shares in Samba Financial Group. GCC exchanges are also looking at establishing regional alliances that allow for dual listing and cross border trading. The Cairo & Alexandria Stock Exchanges (CASE), for example, signed an agreement with the Abu Dhabi Securities Market at the end of March that covers dual listing as well as measures to promote investor protection and market efficiencies. “Volatility in the markets is part and parcel of capital market growth but it is the ability to absorb these shocks which will determine the strength and resilience of our markets,” concedes Ahli United Bank’s El-Labban. However, he points out, “Time and resources are on our side. The Gulf is a region of major untapped potential for investment, banking and capital markets activity. ”

FTSE AND DIFX TO ESTABLISH A FAMILY OF EQUITY INDICES.

TSE Group (FTSE) and the Dubai International Financial Exchange (DIFX) have signed an agreement to develop a range (or family) of conventional and Shariah-compliant equity indices. Yasaar Research Inc. will carry out independent screening of each current and prospective company within the indices, in accordance with Shariah scholars from Yasaar Limited a specialist financial research house. The indices are intended to become chosen benchmarks for the performance of the principal Middle Eastern markets, including the DIFX and specific markets of interest to DIFX participants. It is a major step for the DIFX and is a signal indication of its aspirations to become a regional stock exchange. The DIFX opened for business in September 2005 and is the centrepiece of the Dubai International Financial Centre (DIFC). The DIFX is now building up a market for listed products including equities, bonds, futures and options. “It will also promote an active Islamic product market and it is within this context that the new Shariah index family makes sense,” says Nasser Al Shaali, chief operating officer (COO) of the DIFX. “The index products will provide an important cross section of the regional principal stocks,” continues Al Shaali. “FTSE and the DIFX are working together to create a family of indices suitable for the creation of financial products, such as index funds, warrants, certificates and Exchange Traded Funds. The indices will also facilitate the creation of exchange traded index derivatives that will list and trade on the DIFX.” From FTSE Group’s side, the initiative was carried through by Donald Keith, the index provider’s deputy chief executive; a

reflection of the growing important that FTSE is placing on the Middle East. FTSE already has a family of Shariah compliant indices, the Global Islamic Indices (GIIS) that track the performance of leading publicly traded companies whose activities are consistent with Islamic principles and are calculated at the regional level. “Our experience across Europe and Asia, including developing indices in accordance with Islamic investment principles, provides the basis from which we can create an index family to capture the specific requirements of DIFX’s new market,” said FTSE’s Keith, when the DIFX initiative was announced at the end of February. Importantly, continues Al Shaali, initiatives such as index family, will “enable the DIFX to better function as a gateway to institutional investment in the region.” Co-branding the creation of a set of indices with FTSE was a significant step on this path maintains Al Shaali. As well, he adds “FTSE indices are well recognised by issuers and investors and they will help to create a respected and viable family of indices that will be widely traded on our market.” Over the short term, Al Shaali envisions the structure of the DIFX trading and settlement system to mirror the silo structure of the Deutsche Börse. “We did that purposefully and consciously, to catalyse development. Once the basis for that structure was put in place, then creation of a family of indices that will help deepen the product offerings on the DIFX will, in turn, add further impetus to the process. As we mature, we will continue to look at both revising the model to fit the region and to continue to offer a diversity of investible products.”

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GCC Report GCC REPORT: THE BANKING SECTOR

Leading banks in the GCC are moving fast to expand their regional networks, through acquisition or new offices as new opportunities in both the retail and infrastructure sectors pick up pace. Project financing opportunities estimated to be worth over $500bn over the coming decade are still largely dominated by foreign banks that have built up relationships and expertise over various project rounds since the early 1980s. However, the growth of Islamic finance is also adding new texture and depth to the market, offering local corporates more funding choices and investors a broader range of investible securities. It is also providing local banks with opportunities to get into project financing. Who will win out in the new race for business?

GCC Banks Gain IN CONFIDENCE HEN JEAN CHRISTOPHE Durand, regional head of GCC banking at BNP Paribas, went to Paris at the end of March for a strategy meeting at BNP Paribas’ headquarters in Paris, the GCC markets were high on

management’s agenda. “Strong growth in the region’s markets means that the Middle East is a strategic market,” says Durand who explains that the bank has had a presence in the region for the last 35 years, with Durand himself working in the

market for some 16 years. BNP Paribas has steadfastly built a growth business in the region around its core specialisation of corporate and investment banking, retail services and asset management. Now it is readying itself for the avalanche of corporate financing and capital markets business up for grabs over at least the next ten years. BNP Paribas is noted for its project finance expertise and, in particular, has been an instrumental player in arranging project financing in support of building of Qatar’s extensive liquefied natural gas (LNG) and now growing liquid to gas (LTG) capacity. Even though higher oil prices are generating windfall profits, given the magnitude of the investments required, there are increasing calls for project finance and long-term structured funding solutions. The GCC region has the second largest share of project finance in the world—an industry that, worldwide is worth somewhere between $100bn to $150bn a year—with power, water, oil and gas project predominant; and within that mix Qatar is a rising project star. According to Daniel Hanna, head of global markets at Standard Chartered in Qatar, “the country has massive natural wealth, thanks in part to 900trn cubic feet (cu/ft) of gas, with an exploitation capacity that will run in excess of 300 years at current extraction levels. Current projects in the oil and gas sector in Qatar currently amount to more than $60bn, including Ras Laffan’s RasGas Onshore Expansion Project Trains, which are expected to produce 15.6m tons of (LNG) per year. Some 15% of the world’s total proven gas reserves are located in Qatar’s North fields, the third largest gas field in the world. According to the Organisation of Petroleum Exporting Countries’ (OPEC’s) Monthly Oil Market Report,

M AY / J U N E 2 0 0 6 • F T S E G L O B A L M A R K E T S

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GCC Report GCC REPORT: THE BANKING SECTOR

Qatar’s production of oil has risen to 810,000 barrels per day. "Project finance presents enormous financing and capital market opportunities as well as challenges for the regional banks, which are already aggressively competing with global banks for market share, higher fee income at senior levels, and which are working hard to develop or strengthen their banking relationships with the project companies, such as Qatar Petroleum," says Steven Brice, regional head of research, MEPA and South Asia at Standard Chartered in Dubai. With its huge investments in the energy sector, Qatar has emerged as the second largest issuer of project finance debt after China.“The national focus is on project finance,” acknowledges Mohammed Moabi, executive manager, economics and research at Qatar National Bank (QNB). Qatar will soon reach top billing, with “projects valued in excess of $100bn planned over the next five years” says Moabi. The country’s fiveyear energy sector expansion needs more than $80bn in investments, while roads, airports and utilities need about $10bn in investment. Qatar issued $20bn in project finance last year with $8.1bn of that financing going to the Ras Laffan expansion projects and over $4.5bn to the Qatar Gas II project. The latter project involves new LNG trains, terminals and shops. Abu Dhabi too is also investing heavily in infrastructure development. It will award more than $13bn worth projects this year, according to Steve Brice at Standard Chartered in Dubai. Financing will support, among other projects, the Al Reem Island Development, the Abu Dhabi International Airport expansion, the Mohammed bin Zayed City, and the Shams Abu Dhabi project. Banks in the Emirates have been pedalling fast to raise capital,

usually through Euro Medium Term Note issues, explains Brice, to help them take advantages of the deals in the pipeline. A $900m issue by Abu Dhabi Commercial Bank is the single largest issue so far, while Emirates Bank has raised $1.53bn in recent years. National Bank of Abu Dhabi and NBD meanwhile have recently completed two large issues of $850m and $700m respectively, and NBD is reportedly about to tap the markets for a further $1bn. National Bank of Abu Dhabi (NBAD) the largest commercial bank in the country, recently proposed a capital hike by way of a privately placed 10-year Convertible Subordinated Note up to approximately $694m. Traditionally, long-term structured funding structures in the region have been arranged by large global banking institutions, usually in support of companies either winning construction or project related offtake contracts. Up to now, the global players enjoyed both the necessary political clout to warrant alliances with oil and gas majors and western equipment suppliers (when negotiating new projects with GCC sponsor governments) and sufficient scale supporting underwriting capabilities. The $2bn debt financing of the Shoaiba III combined cycle power and desalination water plant in December last year demonstrates the increasing competitiveness of local institutions. Two of the four mandated lead arrangers of the $947m term loan are Saudi (Riyad Bank and Saudi Hollandi) and one is from Jordan (Arab Bank Plc). Of the remaining 22 lead and senior arrangers, nine were GCC based. “We feel comfortable working on this size of transaction,” says Talal Al-Qudaibi, president and CEO of Riyad Bank. “We have invested considerable resources in developing our project and

investment banking capabilities and are well placed in Saudi Arabia to compete with international institutions for mandates. Meanwhile some 36 banks were chosen to underwrite the $3.6bn 15 year commercial debt portions of Qatar Gas II. Additionally, the deal was backed by US and European export credit and insurance agencies, supporting long term import contracts. The Export Import Bank of the United States, for example, pumped in $450m, in support of the fact that Qatar will be the US’s single largest provider of LNG for at least the next 30 years. Additional insurance cover for the deal was provided by Istituto per i Servizi Assicurativi del Credito al’Esportazione (SACE), Italy’s official export credit insurance agency. What made Qatar Gas II interesting though was the inclusion of a $530m Islamic tranche at the same tenor and pricing as the commercial loan but structured on a Shariah compliant sale and leaseback structure. A further pointer was provided by the mix of banks involved in the tranche: a mix of pure play Islamic houses, such as Kuwait Finance House and Dubai Islamic Bank as well as the more conventional project players such as HSBC, BNP Paribas and Gulf International Bank. It is not a new development. Islamic financing had played a role in the Bahrain Petroleum Company’s (BapCo’s) financing for its Sitra facility earlier last year in which the $1.01bn debt package included a 15-year $370m commercial bank facility and an 11.5 year $330m Islamic sale-leaseback facility. What the deals have done is give local financing houses the confidence to be involved in this latest round of infrastructure development in the region and, at the same time, deepen the Islamic product range. In particular, local bankers and regulators expect the

M AY / J U N E 2 0 0 6 • F T S E G L O B A L M A R K E T S

Mukhtar Hussein, chief executive officer, corporate, investment banking and markets, Middle East & North Africa at HSBC in Dubai.

concentration on Islamic finance to reap dividends for Bahrain’s expanding roster of financial institutions.“Bahrain will continue to perform very well as its banking sector carries on developing, particularly as a hub for Islamic banking,” says A. Rahman Moh’d Al Baker, executive director of financial institutions supervision at the Bahrain Monetary Agency (BMA). “The increasing sophistication of Islamic banks in real estate development, more latterly project finance and fund management will continue to improve the investment choices for both Bahraini and GCC customers.” “The quality of the supervisory body is an important element to BNP Paribas

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 6

being in Bahrain,” agrees Durand. Though with the development of the Bahrain Financial Harbour and fast improving telecommunications links in the region, particularly in Bahrain, it makes sense, he thinks to develop further business from Manama rather than extending the bank’s remit through new offices elsewhere. “The human resources element here is important. Salaries are going sky high in the region and the Bahraini authorities are very open to bringing in people from outside and well as providing a strong local workforce. There are no quotas at work whereby you have to recruit a ratio of locals to outside specialists.”

The BMA has been at the forefront of Bahrain’s efforts to establish itself as a regional centre of excellence for Islamic finance in the GCC. Ironically, Bahrain’s relative lack of hydrocarbon resources has helped it to become one of the most diversified financial centres in the region. In particular, the BMA has been instrumental in deepening the Islamic financing market through the development of its short term sukuk issuance programme and through the introduction of standardised contracts for its dealings with Islamic banks. A new law is expected to buttress its regulatory prowess by pulling together, for the first time, laws on banking, insurance, capital markets and other financial services into one, streamlined, legislative package. Now the traditional role of the BMA has been replaced by a central bank that will focus on banking and investment companies. This step by the BMA has certainly eased the increasing pressure of licensing new companies in the Kingdom. The new central bank will also focus on listing approvals for companies on the Bahrain Stock Exchange (BSE) and controlling the procedures and listing requirement regulations. We believe that this is also one of the critical development as BMA will now focus entirely on the transformation of Bahrain into a financial hub of the Middle East in the near future with several large scale projects in pipeline. “A key aspect is the need for Islamic financial firms to develop critical mass so that they can take advantage of the opportunities, particularly in the project finance sector, in the region,”says Al Baker. It is an increasingly successful strategy. The three largest Bahraini banks – Ahli United Bank (AUB), National Bank of Bahrain (NBB) and Bank of Bahrain and Kuwait (BBK) – all

GCC Report GCC REPORT: THE BANKING SECTOR

reported robust profits last year, based not only on increased retail lending, but also on growing corporate finance, advisory and project work. “Income sources have been diversified and retail lending is showing strong growth across the board and these trends are expected to continue in 2006,” says Adel El Labban, Group CEO & Managing Director at AUB. That growth potential is also being applied in a purely Islamic context. A new Islamic investment bank, United International Bank (UIB), is about to set up in Bahrain, with a reported $3bn investment, making it one of the largest Islamic banks in the region. The bank is to be established as a Bahraini closed shareholding company, and will be involved in wholesale Islamic investment banking activities, backed by paid up capital at launch of some $1bn. The bank's paid-up capital is $ 1bn, which will be raised through a private placement. It is grist to Bahrain’s mill as the island continues the expansion of its Islamic banking and insurance sectors and that expertise now goes back some way. As early as 2002, the Liquidity Management Centre (LMC), a specialist bank to develop Islamic financing techniques, had been set up and the BMA has “been

extending the boundaries of Islamic finance ever since,” says Al Baker; who points out that now the focus is on establishing Islamic mutual funds, both in the GCC and in selected European markets “where there are large concentrations of Muslims who would like to invest in Islamic funds.” In spite of growing competition from newer regional financial hubs, such as Dubai and Qatar, Manama’s prime position in the Gulf as a centre of excellence for Islamic structures is not under imminent threat. According to Douglas Dowie, chief executive officer of National Bank of Dubai, “Bahrain is emerging as a centre for Islamic Finance and Dubai has become recognised as the finance centre for the region”. However, the leaders in long-term Islamic finance in the region - often touted as a key differentiator of the regional finance industry -are still the large European players such as BNP Paribas and HSBC. It is easy to understand why. Not only do the foreign banks enjoy economies of scale, cross-border experience and extensive local relationships, they also benefit from the fact that Islamic finance is also an attractive option. “Whether it is Islamic or standard financing, there is no real difference in cost to the borrower. The difference is

GCC Countries: the $1trn project pipeline 2006-2015# COUNTRY Bahrain Kingdom of Saudi Arabia Kuwait Oman Qatar United Arab Emirates

PROJECTED SPEND BY SECTOR (in $bn) Infrastructure Energy Tourism Airlines 3 1 8 0 216 121 27 0 0 23 0 3 3 0 15 0 13 75 17 15 141 22 35 10

Other 10 0 40 9 15 0

TOTAL 23 466 70 28 138* 218

TOTAL

376

943

242

102

# According to Steven Brice, head of research at Standard Chartered (Dubai) this total is rising by approximately $4m each week * The figure for Qatar is in dispute with some analysts projecting $120bn in spending alone between 2006 and 2012; with another potential $30bn in spending between 2012 and 2015. Source: Standard Chartered Bank (Dubai) and the Middle East Economic Digest magazine, March 2006

that Islamic Finance is asset backed finance,” explains NBD’s Dowie. “In the past, in the GCC region, governments have enjoyed large surpluses and never had to approach the international capital markets, so that generally there has been low government debt in the region,” adds Dowie. “But for the future with huge infrastructure projects coming up, these need to be financed through the capital markets”he says,“and that will open up possibilities both for international bank and local banks either offering standard financing or Islamic structures.” A number of banks have been spurred to set up Islamic financing subsidiary operations to leverage the growing demand for Shariah compliant structures. QNB was the first bank in Qatar to establish an Islamic subsidiary, “prior to April last year the central bank of Qatar prohibited commercial banks from offering Islamic banking to retail customers,”explains Moabi. The bank has moved quickly to establish its Islamic financing credentials and at the end of February, together with its subsidiary QNB Al Islamic lead managed the first-ever corporate Islamic bond issue (or sukuk) in the country. The issuer is the Qatar Real Estate Investment Company (QREIC) that raised a $375m sukuk to finance real estate projects in Doha. Although formally led by QNB and QNB Al Islami, the Sharia-compliant facilities will be jointly arranged by Dubai Islamic Bank, Gulf International Bank and Standard Chartered Bank. “The recent success of the $1.1bn Al Rayyan Bank initial public offering (IPO),”says Moabi, is a clear example of our ability to manage complex pan-GCC transactions. Only 80% of the issue was sold down to Qatari nationals, the rest being sold throughout the GCC.

M AY / J U N E 2 0 0 6 • F T S E G L O B A L M A R K E T S

“More regional co-operation within the financial sector, with partnerships and strategic alliances being formed to promote the growth of Islamic finance will increasingly be a feature of banking in the GCC zone,” says QNB’s Moabi, “particularly as demand from the retail sector grows.” In mid March Gulf Finance House (GFH) and Qatar Islamic Bank (QIB) announced their agreement to launch the first dedicated Islamic investment bank in Qatar, with capital of $1bn and formally requested a licence from the Qatar Financial Centre Regulatory Authority. The new investment bank will originate and package Shariah compliant investment opportunities in infrastructure and real estate direct investment, as well as private equity, venture capital direct investment and structured products. GFH and QIB will each own 15% of with the balance being offered to clients. Listing of the bank is planned in the near future in accordance with stock exchange regulations.“The trend in the US and Europe is for private equity houses to pool their resources through the formation of consortiums to bid for assets that previously they could not buy because they did not have the capital to do so. We recognise the importance of this trend and have decided to be the first bank in the GCC to take specific action to position our clients to be able to complete substantial projects and acquisitions leading to greater fees and income for Gulf Finance House, QIB and shareholders of the new bank,” said Esam Janahi, GFH’s CEO AUB, meanwhile, aims to win significant market share in all GCC countries, has set the tone of its growth strategy with a series of local acquisitions, including a 15% strategic stake in the Bank of Kuwait and Middle East as well as an acquisition in Qatar, underlying its regional aspirations. NBB will soon open its

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 6

Mohammed Moabi, executive manager, economics and research at QNB. Photograph supplied by QNB, April 2006.

first branch in Saudi Arabia. According to Adel El Labban, Group CEO & Managing Director of AUB, “globalisation, liberalisation and technology pose the biggest challenges for banks in the Gulf region, which will have to compete head on with the larger global banks which have a broader product offering, a greater capacity to absorb risk and lower capital adequacy requirements. International players also enjoy efficiencies of scale. Gulf customers’ loyalties will be tested due to increased choices and product offerings by domestic and cross-border competitors.” El Labban makes the incisive point that in today’s cross border world size matters and that fragmentation of banking market shares while maintainable in the short term will not address longer term core survival issues. AUB, like the other GCC major houses, knows that the only adequate responses are organic growth and consolidation through acquisition to create larger institutions with better resources to leverage their local knowledge and enhance distribution capabilities. “The GCC markets have witnessed triple digit capital market growth in the past two years. With such phenomenal growth levels, it is

inevitable that international players are looking to tap into regional markets. The GCC countries now offer the opportunity of high sustainable potential returns,”says El Labban. The strong macroeconomic performance of the Gulf region has led to significant deposit inflows to banks in the region. According to a recent Credit Suisse analysts report, net foreign assets in flowing into the GCC’s commercial and central banks has increased from $99.9bn in 2000 to $213.6bn in 2005. Saudi Arabia accounts for the largest bulk of inflows over the period (around $50bn). There has also been a significant increase in the deposit base of commercial banks in the region. Totalling $224.2bn in 2000, commercial bank deposits have increased to $359.2bn in 2005—a rise of 60%. Commercial bank claims on the private sector have increased in response to the improvement in bank deposits, rising from $158.4bn in 2000 to $268.2bn in 2005 (up 69%) a trend that indicates that the banking system in the region as a whole has become more willing to take on private sector lending risk. As AUB’s El Labban acknowledges, despite the booming times, there are considerable challenges ahead for GCC local banks, which while being backed by substantial market liquidity still, must actively seek to diversify from capital-intensive investment or loan propositions into more fee oriented business models. They also need to build size, establish differentiated products, and articulate a simple well defined value proposition. To secure a more sizeable share of the regional funding market, regional banks will focus on both improving Islamic offerings as well as targeting conventional lending on an arranger as opposed to participation basis. It’s a two handed strategy that non-GCC banks will be watching with interest.

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Regional Review

The Russian corporate rouble bond market produced stellar results in 2005. Volume grew by a hefty 81% reaching RB387bn – equivalent to around $13bn – with new borrowers making their debut and existing players returning. Although analysts are mixed as to whether this year will see a repeat performance, they are optimistic about its long term growth prospects. Lynn Strongin Dodds reports. NE OF THE darker clouds hovering over the Russian market is the same as that lingering over many financial markets – the direction of United States’monetary policy. The Federal Reserve (the Fed), the central bank of the US, has increased interest rates 14 times to its current 4.5% level in the past two years, and the jury is out as to whether the ascent will continue. As the Russian corporate bond market has matured, it is affected by the same trends as the more developed markets, according to Petr Minin, an analyst with AVK Analytics, a St Petersburg-based investment firm. “At the moment, it seems that Fed policy is having much more influence in the Russian corporate

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 6

RUSSIAN CORPORATE BONDS

WILL RUSSIAN BONDS KEEP THEIR APPEAL?

The Russian government has given its tentative approval to a programme that aims to develop the domestic capital markets and includes the creation of a Russian pension fund industry. Photograph supplied by Dreamstime.com, Photograph by Petr Gnuskin., March 2006.

bond market than the actions of the Russian Central Bank.” So far, placements and announcements have been fewer this year. However, Renaissance Insurance hopes to make its mark with a $27m issue – the first ever by a Russian insurance company – while Agency for Mortgage Lending, a mortgage lending bank, plans to issue $400m worth of rouble corporate bonds. Kuibyshevazot, one of Russia’s leading producers and exporters of chemicals placed a five year bond issue worth Rb2bn in the domestic bond market, adding to the relatively scarce list of chemical firms that have tapped the market. The last time Kuibyshevazot tapped the bond market (also a domestic issue) back in June 2003 in a public offering worth Rb600m that was lead managed by Alfa Bank and underwritten by Guta Bank and Menatep SPb. That deal was unusual in that the coupon varied over its tenor. Kuibyshevazot was paying 11.25% for the first two years, then 12% for the next 18 months, 9% for the following eighteen months, falling to 8.9% for the next six months, with a final coupon of 1% for the last six

months. The chemical firm is paying a flat 8.8% coupon for this latest issue, which was lead managed by Bank Zenit and underwritten by Evrofinance Mosnarbank, Sberbank and Bank Centrocredit. The first quarter of 2006 closed as Talusto, a manufacturer of ice cream, frozen foods and pastry, debuted with an Rb1bn, three year issue. Alexei Mironov, business development director with Fitch Ratings in Moscow, says, “The performance of the Russian rouble bond market was strong last year and we see it growing by about two to three times its current size over the next three to five years. About $8bn of new bonds was raised out of a total market size of $37bn in 2005, with the main issuers being banks. State-owned Russian Railways was by far the largest nonfinancial company, raising in excess of $1bn including a Rb10bn (about $350m) issue in mid-Jan this year.” The rouble corporate bond market is the second largest and the fastestgrowing part of the Russian debt market. The bonds are traded on MICEX (Moscow Interbank Currency Exchange) and in the over-the-counter

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In the Markets mark. Started in 2000, the corporate bond market has seen high profile companies such as Gazprom, Tyumen Oil Company, Unified Energy System, ALROSA Co Ltd, a diamond manufacturer, Magnitogorsk Metal Plant (MMK), a steel producer, as well as telecommunication companies, issue bonds. Banks are by far the largest players with Vneshtorgbank, the Russian specialist trade financing bank, Alfa-bank, Russian Agricultural Bank and Rosbank being the most active. Figures from AVK Analytics show that as of the start of this year, banks accounted for 19% of the Russian corporate bond market, followed by telecommunications at 14%, food and consumer groups 1%, and the machine industry 10%. Other notable mentions include the metal industry, at 7% and the chemicals sector with 4%. Analysts believe there will be an increase in food and consumer companies as well as the retail and construction sectors issuing bonds on the back of a strong rise in household income and consumer spending.“These firms desperately need to raise funds to make investments to meet the growing demand for their services,”explains Minin. Mironov adds, “I expect that the companies that have already tapped the market such as Vneshtorgbank, and regional fixed-line telecoms will return before the year end. However, I also see significant growth in the number of smaller companies who, for example, only need $30m-$50m and will access the domestic bond market because it is cheaper than going to the international markets and they do not need international financial reporting standards (IFRS) accounts for that.” The market is also expected to see a rise in the number of mid-sized companies who have not yet made it to the premier league and do not yet have the cash or the profile to attract an international following. As AVK Analytics’ Minin notes,“Often a bond

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 6

issue is a first step towards going public – this was the case of OAO Razgulay Group, the agricultural group, and IRKUT Corp (aerospace manufacturer). The company need not have worried. OAO Razgulay Group’s IPO in early March was six times oversubscribed, launching at a share price of $4.80 per share, at the top end of its anticipated range and ended its first full day of trading at $5.35 per share, up 11.5% on its issue price. Investors were attracted by the Russian farm sector, which has been boosted by high commodity prices and consolidation following its postSoviet collapse. OAO Razgulay Group is the parent company of a group that includes grain and sugar companies that control 10% of the Russian grain market, 15.8% of the cereals market, 11.8% of the sugar market and 3.2% of the flour market. The group’s shareholders are the Cypriot offshore companies Janitar Investments Ltd (30%), ëeperlino Trading Ltd (19%), Balkontore Investments Ltd (16%), and Wise Island Investments Ltd (14.99%). Austria’s Globalco Holding AG and Vnesheconombank (VEB) have 10% each,VEB having bought the shares in a repo deal.“For the larger borrowers, the domestic market sometimes looks preferable when taking into consideration the cost of foreign exchange rate hedges,” adds Minim. “They often choose international markets mainly because they can not raise the amount of money they need in the domestic market.” State owned companies such as Gazprom, Sberbank, Vneshtorgbank and Rosneft may also not have a choice to return to the corporate bond markets if the government decides to pass antiinflationary measures such as placing restrictions on their external borrowings. Minin notes, “If the restrictions come into force, which is highly likely, then they will have to increase domestic

Alexei Mironov, business development director with Fitch Ratings in Moscow. Photograph supplied by Fitch Ratings (Moscow), March 2006.

borrowings which will give the domestic market a new momentum.” Foreign investors remain interested in the rouble corporate bond market despite the narrowing of the spreads between the Russian and more developed markets. The yields to maturity are already low, between 6.0% and 7.5% for the blue chips and between 7.5% and 10.0% for the second tier bonds. However, the strengthening of the Russian rouble against dollar and euro continues to make the Russian market attractive for international investors. Overseas investors are a relatively new and growing sector of the domestic corporate bond market segment. Local banks hold over 50% of the issues and although the share of the international investors is hard to estimate, Minin believes they account for about 25% of the market volume. The remainder is distributed between private investors, pension funds, mutual funds and insurance companies. The corporate bond market is also expected to be given a boost if the securities industry’s three year financial market reform proposals, are implemented. The government has given its tentative approval to the programme that aims to develop the domestic capital markets and includes the creation of a Russian pension fund industry, the modernisation of the financial markets infrastructure and strengthening of investor protection measures.

Regional Review GREEK BANKING LOOKS EAST

Massourakis, senior manager, strategy and economic research at Alpha Bank in Athens. “Progressively it has been about expanding retail services in the area, thus the concentration on the expansion of branches,”he adds. His research shows that credit With the new direction of European Union (EU) enlargement penetration in the Balkans stands at a pointing south-eastwards, Greece hopes to position itself as a dramatically low 26%, against 81% in centre of economic activity. With Balkan states signalling Greece. The prediction is that this willingness to align their policies in the EU, Greece may have just figure should and will increase nearly the lever it needs for its strategic play in the converging markets two-fold by 2010, to 45%, demonstrating the growth potential in of the region. Blazej Karwowski reports. corporate and household lending. The REEK BANKS WILL continue them, through a combination of long-term strategic goals of Alpha to outperform the economy organic growth and acquisitions, they Bank and its peers further corroborate and post favourable gains, say have established a network of over the attractiveness of the Balkan region. local analysts. “In terms of growth, 700 branches. Greece’s banks are, in By 2008, the bank plans to operate 436 banking sector is truly one of the fact, entering the all important south- branches in the South East Europe avant-garde industries in Greece. It eastern European markets in tandem (SEE), significantly more than its has been growing, providing jobs and with other Greek companies that are current retail network in Greece. Consequently, by the end of the raising productivity,” says Plutarchos direct investors in the region. Sakellaris, chairman of the council of According to the Prime Minister, decade Alpha aims to establish itself Karamanlis, Greece’s as a regional leader, with a 15% share economic advisers at the Ministry of Kostas Economy and Finance. Last year the investment in the region exceeded in the market. According to Phaedon National Bank of Greece, country’s $8bn at the beginning of this year, and Tamvakakis, managing director with largest financial institution, upped its apart from the banks, some 3,500 an independent fund manager Alpha net profits to €727m, a 250% increase Greek corporate investors now Trust, by around 2010 the Greek on the 2004 operating year. operate in the area. While the banks banking sector aims to derive 30-40% Meanwhile EFG Eurobank and Alpha are servicing Greek companies of its profits from the Balkans. This Bank also posted near-equal results of working in the region, they are also shift from rapidly maturing Greek €500m and €502m respectively. determined to tap underleveraged market with its tightening spreads Among the sector’s second tier Balkan retail customers. “The game is towards the countries that still knock players, Piraeus Bank has expanded its not just played with Greek on EU’s door is termed the “cascading says Michael effect” by Massourakis. “The real branch network by 45% and doubled corporates,” question for investors is its net profits to €264m. whether this exposure will However, while the story FTSE Greece vs. FTSE Developed Europe make difference to is one of continued growth 350 profitability,” says Alpha at home, it is backed up by 300 Trust’s Tamvakakis, but he even more growth 250 contends the Balkan potential in south-eastern markets retain their Europe, a region that is 200 strategic importance. fast becoming a Greek 150 “In Romania, which is banking hinterland. 100 the most lucrative market Over the past few years, 50 for banks at the moment, local banks have secured a we have seen tremendous presence in virtually every capitalisation of the one of the still significantly FTSE Greece FTSE Developed Europe economy and very under-banked markets in consistent structural the Balkans. Between Source: FTSE Group (Euro price returns. Data as at March 2006)

EXPLOITING THE CONVERGENCE FACTOR

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reforms,” says Platon Monokroussos, branches in Romania, which has a issues have this far deterred Greek head of financial market research at population of 22m. The purchase of business from more significant EFG Eurobank. To emphasise his view, CEC could actually be one of the few commitments across the Bosporus strait. he cites the recent privatisation of remaining opportunities to acquire a That is about to change. “The trend is big retail bank in the region and in that clearly upward for a closer and larger Banca Comerciala Romana (BCR). BCR attracted an unprecedented context the government’s move is economic relationship between the two countries,” says Sakellaris commenting amount of bids. Austria’s Erste Bank rather smart. The process of cascading towards on what the Greek side heard from AG outpaced competitors from Greece and other countries to acquire a 62% less and less developed markets is set Turkey’s economic minister Ali Babajan in the bank stake last December. With to continue. “Ukraine is an area during a recent meeting of SEE finance a price tag of €3.75bn, the deal hit the everybody is looking at, and there are ministers in Athens. In 2005 Turkish top of the list for transactions in still lots of small banks in the country, exports to Greece picked up by 53%, Central and Eastern Europe. Following indicating a fairly easier buy,” says while conversely Greek exports climbed the deal, however, commentators Gikas Hardouvelis, head of research at by 36%, albeit from a very low initial began to moot that Balkan assets are EFG Eurobank. In his opinion, Greek base. Greek investments in Turkey overvalued and that Erste might have banks are still in the position to account for 3.5% of country’s FDI inflow, overpaid for a stake in Romanian exploit opportunities Western banks with 80 companies having established growth. All the same, the Austrians might consider too high-risk, but a direct investment operations to date. Then, at the beginning of April have last year’s stellar results of BCR as line needs to drawn at some point. their own unique form of consolation, “Some small Greek banks moved all came the announcement that NBG is the way to Armenia and Georgia and to buy a large strategic stake in with deposits up 31% to €6bn. Meanwhile National Bank of Greece they lost money pulling out,”he adds. Finansbank, Turkey’s fifth largest bank and EFG Eurobank are among the The Balkan states provide the for $2.77bn, with a view to securing a institutions filing non-binding bids for apparent stability factor of looking at majority share by the autumn. For Casa de Economii si Consemnatiuni the EU to anchor their policies, thus now, NBG is set to buy 46% interest in the bank, an equivalent of 437m (CEC), Romania’s state owned savings significantly reducing the risk. Concurrently, it has become tradable shares, from its owner, FIBA bank. In a shock move, the Romanian government has reportedly upped the somewhere between difficult and Holding. When completed in the third stakes in the planned privatisation of impossible for Greek financial services quarter of this year, the transaction CEC. It is understood that bid providers to ignore Turkey, and more so will constitute the largest foreign structures for the bank had varied because recent privatisations have met direct investment by any Greek between 50% and one controlling such strong demand from multinational corporate to date. The new entity will share and offers involving a purchase banks, determined to purchase assets in hold $70bn in assets across seven of up to 70% of the bank. Throughout the country. Underlying geopolitical markets of the SEE region. NBG reportedly February, the Romanian outpaced Citigroup, which government had vacillated Greek Banking Looks East also took part in the over the bids, but then 150 bidding for a strategic stake surprised everyone by in Finansbank. At the announcing in early March 125 agreed price of TL7.16 per that it would increase the 100 share, the deal put a value number of shares on offer. 75 of $6bn on the Turkish The move was widely 50 institution, or 3.6 times its condemned as a cynical pro forma book value at the ploy to leverage a higher 25 end of 2005. NBG also price for the bank, which 0 announced that in the has a reported book value second half of this year it of €250m. CEC is a will launch a mandatory tempting offer nonetheless, FTSE Greece Banks National Bank of Greece Alpha Bank Piraeus Bank EFG Eurobank offer to Finansbank’s as it owns or controls minority shareholders with almost half of all the bank Source: FTSE Group / FactSet Limited Euro price return. Data as at March 2006s

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an aim to acquire a 4.01% additional stake, thereby assuming a majority stake. If NBG secures less than an additional 4.01% stake, FIBA Holding and its affiliates have agreed to sell sufficient shares to NBG for it to secure a majority. In a further twist, the acquisition does not include the international operations of Finansbank in Romania, Russia, Switzerland and the Netherlands, which will be purchased by FIBA Holding for $580m. Credit Suisse and Goldman Sachs advised NBG on the deal, while Morgan Stanley acted for FIBA Holding. Given the high profile of the Turkish bank in its domestic market, concerns mount whether NBG has bitten off more that it can chew, both in business and in political terms. "Although, strategically, the acquisition fits well with NBG's ambitions to be present in neighbouring markets with high growth potential, and could strengthen the group's aggregate profitability, taking over Finansbank and operating in a high-risk, potentially volatile environment are meaningful challenges," says Elena Iparraguirre, credit analyst with Standard & Poor’s. Given the sensitivity involved, the general perception of market insiders is that, before any moves have been made, the acquisition has been discussed at length on ministerial level. The fact that NBG is indirectly state-controlled seems to further corroborate this view. For the time being, NBG looks set to preserve the current Turkish management and the Finansbank brand. “With the rapidly improving fundamentals and Turkey’s European orientation, we think the risks are overrated and we have seen that earlier than others,” says Paul Mylonas, chief economist and chief of strategy at NBG. Apart from the benefit of accessing the fast-growing financial services market in Turkey, Mylonas points towards a more distant goal of

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synergising NBG’s SEE operations with Finansbank. “Our plan with Finansbank is to take advantage of their experience in credit cards and our experience in mortgages, to build on this expertise and develop synergies,” he adds. The transaction is now awaiting final approval from the Turkish Banking Regulator (BRSA) and the Bank of Greece. Michael Massourakis, senior manager, strategy and Over the coming months, economic research at Alpha Bank in Athens. Photograph Mylonas notes the most supplied by Alpha Bank, in Athens, March 2006. important task ahead for NBG is the successful completion of a planned rights offering, with subscription rights listed on the Athens Stock Exchange, which is expected to raise €3bn to help finance the entire cost of the acquisition. To secure the offering, NBG has received a preunderwriting commitment from a syndicate of international investment banks. A general meeting for NBG shareholders to approve the rights offering is expected to take place in May and the subscription period will begin in June, with the new shares expected to begin trading in July this year. Platon Monokroussos, head of financial markets research Massourakis from Alpha at EFG Eurobank. Photograph supplied by EFG contends Turkey should be a Eurobank, March 2006. natural part of the Greek business environment because of its translate into deals soon. According location, but he remains sceptical at to Hardouvelis the expansion the notion that local banks could play strategy of a Greek bank in Turkey a bigger role in the market.“I do not will not necessarily use the same see the advantage a bank with a ‘follow the customer’ approach Greek flag might have while doing employed in the Balkans: “The game business in Turkey,” he says. Even so, has changed now as the banks will without their clients EGF Eurobank’s Hardouvelis is move positive the opportunities can necessarily present in the market.”

Regional Review GREEK ECONOMIC GROWTH

HE REAL CHALLENGE for the Greek economy began only after the 2004 Olympic Games closed. Structural inefficiencies in its public sector, high debt levels and a budget deficit meant that the country found itself between a rock and a hard place. Either the government had to come to terms with a continuous breach of the Maastricht criteria, or it would have to drift towards tight fiscal consolidation that would curb public expenditures and dampen growth. By the start of this year, however, it became clear Greece will achieve the unachievable: record substantial growth while limiting the levels of public spending. With a 3.7% increase in gross domestic product (GDP) last year, the country outpaced its Eurozone peers by a good length. On top of that, it recorded a 2.3% decrease in its budget deficit that had ballooned up to 6.6% of its GDP back in 2004. Plutarchos Sakellaris, chairman of the council of economic advisers at the Ministry of Economy and Finance is content to note,“the reduction is among the largest that a country in the Eurozone has seen in the last few years”. The country’s economic growth was underpinned by sustained levels of consumer spending which offset the inevitable contraction in gross fixed capital formation witnessed after the Olympics. Perhaps more importantly, the government’s ability to deliver tangible results has had a positive effect on credibility and business confidence, thinks Sakellaris. Like last year, 2006 is pivotal for the Greek economy. Several landmark reforms, such as laws on liberalisation of labour rules in public enterprises and development of coastal areas, are in the implementation stage. Others, particularly the legislation on publicprivate partnerships (PPPs), are expected to be a feature of local infrastructure projects by the end of the year. As a working example, Sakellaris cites a new airport in Crete, that is

How Greece beat the odds

Greece has largely avoided the expected postOlympic economic slowdown. This year challenges in its internal economy persist, but they are increasingly matched by the proliferating opportunities in the broader region. Will Greece look attractive enough for regional start-ups to anchor themselves in its newly found Eurozone stability? Blazej Karwowski reports from Athens.

Greek Finance Minister Giorgos Alogoskoufis speaks during a news conference in Athens last year. Photographer: Thanassis Stavrakis. Photograph supplied by EMPICs/Associated Press, March 2006.

currently under discussion with a potential PPP partner from the Greek private-sector. Meanwhile on the fiscal front, the ruling New Democracy (ND) government has vowed to bring the budget deficit firmly below the Maastricht-envisioned 3% ceiling. In an uncommon demonstration of consensus on the prospects of the budgetary discipline, the plan has

received a vote of confidence from nongovernment economists. “There seems to be a major change in state’s ability to collect taxes; a change we observed during the last six months,” says Gikas Hardouvelis, chief economist with EFG Eurobank Ergasias (EFG Eurobank). Meanwhile, Michael Massourakis, senior manager, strategy and economic research at Alpha Bank

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points in addition that the current income policy introduces further discipline into the state’s balance sheet and provides a strong argument in favour of curbing public expenditures. “Compared to the average over the last several years, the recent policy on salaries of public employees has been rather austere. A 3% increase we have this year is more or less the same rate as inflation,”he says. Greece remains a highly unionised country. While that fact will not change for a long time to come, there are signs that its influence on wage demands undergoing change. In an unprecedented move, for example, the country’s major banks recently refused to negotiate collective agreements through OTOE, which is an umbrella organisation of bank labour unions. Instead, they chose to deal with each respective union on an individual basis. The banking sector is also champing at the bit to eliminate what they regard as restrictive practices, such as rigid opening hours and restrictions on the relocation of employees, and thereby improve their competitiveness. In response, the unions scheduled strikes in March, but participation rates were a meagre 2% to 3% of the sector’s workforce—a fact which has buoyed management in the industry.“At the end of the day we are going to see a much more liberal environment for our operations,” says Massourakis. Elsewhere, in what might be considered as a primary effort to dismantle the unionised labour regime, the incumbent telecommunication services provider OTE is no longer obliged to provide lifetime contracts to the new staff. Privatisation is identified as a recurring theme in 2006, with the state seeking to divest some of its stakes in the banking sector. Emporiki Bank of Greece, which remains under state control in 41%, is slated for gradual privatisation together with Agricultural Bank of Greece (ATE, in which the state

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has an 85% stake) and Postal Savings Bank, a 100% public enterprise. With regard to privatisation, it has been a long-standing view of the minister of finance and economy George Alogoskoufis that introducing foreign players into the market will bring expertise, efficiency and spur competition—particularly in the banking sector. This may indicate that the mooted sale of a 20% stake in Emporiki, for one, will be sold to the French group Crédit Agricole, which already holds 9% of bank’s shares. EFG Eurobank’s Hardouvelis is sceptical of the added-value multinational institutions might bring. “There are foreign banks already in Greece and they have not necessarily increased competition or pushed the spreads down just because they belong to a huge group,” he notes. This view seems to reverberate in the assertion of Michael Massourakis that the local banking industry will continue the scrutiny of the whole privatisation process, and consider taking part themselves in the eventual sell offs. Even though revenues from privatisation are set to decline this year to $1.6bn, against $2.1bn the year before, Plutarchos Sakellaris asserts the process is“nowhere near its end”. Some analysts signal that 2007 might be a year for privatisation of the country’s infrastructure, as port and airport operators are slated for sale, although the official framework will not be published until autumn. Here strongly, Greece’s “location play” enters the equation, as Greek ports enjoy an enviable position of the first stop for European Union ships exiting the Suez Channel. Ports in Crete, Salonika and Piraeus have been reportedly earmarked for development. According to shipping industry insiders, Chinese delegations are said to meet with Greek officials on a regular basis to discuss the possibility of the establishment of a maritime trade hub.

Plans for regional expansion and increased synergy are also evidenced in the capital market. A common trading platform between the Athens Stock Exchange (ASE) and the Cyprus Stock Exchange is due for launch in the first half of this year and a company from Former Yugoslavian Republic of Macedonia debuted in Athens recently, marking the first listing from the Balkans. Panos Papapetrou, head of Société Générale Securities Services (SGSS) points out that Greece is moving to expand it reach in the broader region. He says that ASE has recently been discussing cross-border cooperation and potential trading links with a number of other exchanges, including those in Istanbul, Belgrade and Tel Aviv. In line with these ambitions, SGSS aims to establish itself as THE regional custodian with a clearing and settlement platform based in Athens, although it may have some competition from EFG Eurobank and BNP Paribas, which also has a presence in Athens. These developments however provide grist to the mill for Greek investors, which have historically felt discouraged from supporting local securities. “The asset management industry is going against European trends, with net outflows from funds,” remarks Tamvakakis from Alpha Trust. For Papapetrou the situation additionally owes to the fact that Greek high net worth individuals, shipping industry tycoons in particular, continue to choose Switzerland or Luxembourg over the local market. Still he is convinced the introduction of new, alternative small-cap market in Thessalonica and the rumoured launch of first exchange traded funds this year will expand investment opportunities and provide investors with incentive to channel their assets into the domestic market.

Regional Review BRAZILIAN IPOS Illustration supplied by Istockphoto.com, March 2006.

Brazilian IPOs: broader, deeper and pricier Paulistanos like to boast that if you cannot buy it in São Paulo you cannot buy it anywhere. Walk through one of the walls-just-dry shopping centres in the towering suburb cities such as Morumbi and it is clear that conspicuous consumerism is enjoying a boom. Consumer-fuelled growth is also tickling investor interest in the growing stack of Latin American equity issues, particularly from Brazil. John Rumsey reports. RAZIL HAS BEEN the frontrunner in Latin American equity issuance, accounting for 10 of last year’s initial public offerings (IPOs) and close to two thirds of the total dollar amounts raised in the subcontinent. As a region, Latin equity issuance markets started the year with a bang, in large part thanks to consumer companies raising funds. By midMarch, the region’s equity markets had already generated more than $2.3bn in new issuance. Compare that to the

value of the 21 IPOs worth $5bn that came to market in 2005, the very slim $2.16bn raised by initial public offerings (IPOs) in 2004 and the less than $100m issued throughout the whole of 2003. The upsurge in issuance is being driven in large part by Brazil, a market that has surged forward over the last three years. The Bovespa index (Ibovespa) was up a hefty 27% in local currency terms last year (compared to a still very healthy 18% in 2004) and nearly 44.8% in dollar terms in 2005. It

powered up close to another 20% by late March of this year. Investors continue to see value in Brazilian equities. Jules Mort, Latin America fund manager at Threadneedle who manages $1.7bn, points out that despite the significant re-rating that Brazilian equities have enjoyed, valuations are still cheap. The Brazilian market Enterprise Value/EBITDA average is 5.5 compared to 9.2 in India and 6.4 in Mexico, for example. That means there is plenty of scope for further rises in equity prices without taking valuations for any kind of stretch. Additionally, the orthodox economic policies of the Lula regime appear to have created market stability. The Republic posted a trade surplus of some $41bn last year and has a current account surplus of 2% of GDP. “Until recently, listings in Brazil have been stop-and-go because a stable economic platform has not been in place. Consumers have more confidence now, that they will not lose their jobs and that inflation rates will stay low,” says Gilberto Nagai, a fund manager at ABN Amro Asset Management in São Paulo who manages $1.5bn. In the consumer sector, the most widely-talked about deal has been Natura, a cosmetics company that raised $243m through its IPO last year. The deal, listed on the Novo Mercado, seemed a quintessentially Brazilian story: the country’s cosmetics industry is a growth story and is now the seventh largest in the world and Natura sources its products from the Amazon. The whole consumer sector is getting a make-over. Lojas Renner’s secondary offering has been a riproaring success. The mid-range Brazilian chain of clothes-oriented department stores carried out a deal that brought 100% of its free float to public investors, the first time this has ever been carried out in Brazil. The

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deal was placed 43% in the US and 35% in Europe with the balance going to domestic investors. The company earned BRL774m ($350m) through the offering and, in spite of the deal’s size Renner’s shares have performed spectacularly, moving from BRL37 at issuance to BRL118 in mid March. Mort—whose fund is over-weighted in consumer discretionary products at 9.1%— explains that the performance is in large part because the group’s operations have improved so rapidly. The firm posted gross sales revenue of BRL1.29bn in 2004, a 22% increase over 2003. As well, Mort points out that not all deals have been as lucrative for investors as Renner. “Shoemakers Grendene is a warning of what can go wrong with Brazilian retailers,”he says. The firm, which makes plastic shoes, debuted at BRL30. By late March, the firm’s shares were trading down at around BRL20. Grendene’s story is perhaps exceptional: the firm uses petrochemicals in the manufacturing process and has seen its input prices go up. Second, as a highly international distributor the strength of the Real has hurt its international sales. There is one possible fly in the ointment for pure consumer plays— the arrival of giant discounter WalMart in Brazil. “Wal-Mart is sending shudders down the backs of some Brazilian companies, such as Pão de Açucar,” believes Mort. However, Chris Palmer, head of Latin America and developing markets for Gartmore Investments, argues that Brazilian companies “have some advantages that are going to be difficult for foreign firms to replicate. For example, many of the Brazilian firms have well established and fragmented value chains. Gap could not just come in with its China model because of tariff protections and the ‘Brazil cost’such as value added taxes that tend to keep foreigners out.”

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Other deals that play on the growing ability of the consumer include the discount airline and travel site Gol, which raised $283m. Gol is directing the proceeds to start a price war with the better established names in the field, Varig and TAM. The bookstore owner and legal and educational publisher Saraiva is also in the next wave of companies planning to come to market with a secondary offering. The stock is already listed, but is relatively illiquid. As Nagai points out, even though there are fair amounts of new consumer listings, there are simply not enough to meet investor demand. “Many family owned companies are well capitalised and do not need to raise money,”he says. “There are not enough consumer plays in Brazil,” agrees Mort. “That means that you have to be innovative in tapping the consumer. Banks are a possible way to do this because loan growth has been surprisingly strong at 20-25%,”he adds. There is a caveat however. These days all sorts of companies are selling themselves as retailers, an ugly sister trying to fit into Cinderella’s glass slipper, “to jump on the consumer bandwagon. These firms want to command the kind of multiples that are seen in the consumer area,” notes Nagai. Car rental firm Localiza, which raised some BRL250m last year, is one example, he says. Building companies too are capitalising on the IPO boom. Last September São Paulo-based developer Cyrela raised almost $350m through an IPO. At the same time, it merged with Brazil Realty, which it already controlled and had a small public float and consolidated operations. Rossi Residencial and Gafisa have also tapped equity markets to pay for expansion. That said the multiples for Brazilian builders are starting to look toppy. Newcomer Rossi is trading at 17

times estimated 2007 earnings and that looks high compared to Mexican companies that have longer track records, notes Mort. It is these higher prices that are being commanded that is starting to worry investors. The imbalance in the supplydemand picture, too many investors chasing a small pipeline of consumer companies, and the performance of shares in the after markets might point to a frothy market. There is certainly a sense of trepidation that deals are getting priced richly now, according to Nagai. “We are starting to see some investor fears and investor resistance about the higher prices that are being asked for consumer companies at the time of IPOs. Some IPO valuations are starting to look stretched,”he says. Mort also sounds a note of caution. With markets heading northward at this pace, a correction is inevitable at some stage. Still, he sees the correction likely to come much later, possibly in a couple of years. If markets do continue to perform well in the shorter term, it is possible that the next wave of equity issuance could be from a relatively new source, believes Gartmore’s Palmer, who predicts that 2007 will be the year for infrastructure deals. “There is a huge need for toll roads, bridges, shopping malls, pipelines and electricity grids,” he notes. The pension funds in Brazil have run up big surpluses and could help fund these deals. They will be looking for yield as interest rates fall and government bonds become less attractive. There will also be scope for equity investments, as the government will encourage the splitting of project financings into equity and debt portions. “We’ve already seen these [kind of] deals do phenomenally well in India and some deals getting done in Mexico. Brazil is ripe for them to take off too,” Palmer believes. That really would start to make Latin markets feel wide and deep.

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COVER STORY: NORTHROP GRUMMAN

This image shows Northrop Grumman Corporation's concept of a Future Combat Systems-class Army groundcombat armored vehicle with a solid-state laser that would be used to defeat incoming threats like mortars and rockets. Photograph supplied by Northrop Grumman, March 2006.

MINDWARE AND THE LORDS OF WAR Adapt or die. Northrop Grumman is living proof of this maxim’s wisdom. Few companies in any industry have adapted to changing times as successfully. With revenues approaching $31bn and a 9.6% operating margin, the Los Angeles-based company is America’s third-largest defence contractor, with 125,000 employees and operations in all 50 states and 25 foreign countries. Just how successful its adapt-or-die strategy has been is dramatically illustrated by this simple fact: had Northrop and Grumman remained primarily in the aircraft manufacturing business, either separately or together, almost certainly they would have disappeared by now, joining such famous aviation names of yesteryear as Consolidated, Convair, Douglas, Fairchild, McDonnell, North American and Vultee. Art Detman examines the firm’s strategy for growth. HEN MILITARY AIRCRAFT makers Northrop and Grumman merged, it was only the first step in creating one of the world’s largest and most successful defence contractors. Although both Northrop and Grumman achieved fame by producing outstanding military aircraft – think of the P-61 Black Widow, F-89 Scorpion and B-2 stealth bomber from Northrop or the F6F Hellcat, A-6 Intruder and F-14 Tomcat from Grumman – today the company has no planes in production. Nowadays it is the leading provider of information technology services to the US government, which is a $3bn business all by itself. The company, in the words of Ronald D. Sugar, Northrop’s 57-year-old chairman, president and chief executive officer, is really in the “mindware”business.

To be sure, Northrop still bends metal to produce awesome weapons of war. It is the world’s largest military shipbuilder, America’s only builder of nuclear-powered aircraft carriers (at its shipyard in Newport News,Virginia), one of only two US builders of nuclear-powered aircraft carriers and submarines (at its shipyard in Pascagoula, Mississippi), and a builder of naval support ships and the occasional oil tanker (at its shipyard in New Orleans). It also designed and built the Global Hawk unmanned reconnaissance aircraft, which is likely a harbinger of a future remote-controlled Air Force whose pilots fly their planes from computer stations on the ground. It is a principal subcontractor on the F-35 Joint Strike Fighter programme. It is one of two contractors seeking to build

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The Air Force's first deployed production Global Hawk rests in its hangar on the flight line of this forward operating location in the Persian Gulf region. Air Force photo by Tech. Sgt. Mike Hammond. Photograph supplied by Northrop Grumman, March 2006.

the US Navy’s DDX ships, and, with Europe’s EADS, it is preparing a bid to build air tankers for the US Air Force. Right now Boeing is the sole provider of KC-135 tankers, which refuel in flight many of the Air Force’s long-range planes. Morton Siegel of Value Line terms the tankers “ancient,” and the Air Force desperately wants to begin replacing them. A bizarre proposal by Boeing to lease tankers to the Air Force blew up in scandal, and now the programme is up for grabs. Sugar has imaginatively proposed that Northrop fill the Air Force’s needs. True, Northrop does not have the capability to build air tankers, but not to worry. EADS, the manufacturer of the Airbus family of jetliners, will be Northrop’s principal subcontractor and while EADS intends to build a factory in Mobile, Alabama, Northrop intends to build one right next to it. “EADS will have acres associated with building the airplane, and we will have acres associated with militarising the airplane,”Sugar explains.“At the end of the day, it is going to be the best plane for the taxpayers and the war fighters.” Even if the Air Force accepts Northrop’proposal, Boeing may not lose out. Sugar can easily envision a split order, in which Boeing produces a number of tankers based on its design, and Northrop/EADS produces a number based on an Airbus design. “This programme should last for decades if we do it right. If the Air Force buys 15 or 20 tankers a year, before we recapitalise the entire fleet, the youngest tanker in the fleet today will be almost 80 years old. So once we win this job, we are going to be building

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tankers for a long time.” The air tanker proposal illustrates the unique nature of the American defence contractor industry. It is Boeing’s partner in the F-18 fighter programme, which produces around 45 planes a year. In the tanker programme, however, Northrop is Boeing’s major competitor. Although Boeing might consider Northrop’s proposal dirty pool – after all, EADS is a foreign company – it is common in America’s defence industry that two companies can be partners on one programme and competitors on another (and, truth be told, suing each other on a third programme). If won, the tanker programme will be undertaken by Northrop’s Integrated Systems Sector, one of eight sectors, each headed by a president and each comprising several business units. Most of these businesses came into being through a diversification effort that, from 1993 through 2002, resulted in more than two dozen major acquisitions. In the process, some of America’s most famous names were subsumed in whole or in part into Northrop, including Aerojet-General, Grumman, Litton Industries, Logicon, Newport News Shipbuilding, Ryan Aeronautical, TRW and Westinghouse. “Our last major acquisition was TRW, in 2002,” Sugar says. “That was a huge acquisition, and it formed a cap on our growth from a manufacturer of military airplanes only. That took us from a second tier level to a first tier level.” The need to grow was painfully clear.“As we got toward the end of the Cold War, the world changed on us as the

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Sugar has imaginatively proposed that Northrop fill the Air Force’s needs. True, Northrop does not have the capability to build air tankers, but not to worry. EADS, the manufacturer of the Airbus family of jetliners, will be Northrop’s principal subcontractor and while EADS intends build a factory in Mobile, Alabama, and Northrop intends to build one right next to it.“EADS will have acres associated with building the airplane, and we will have acres associated with militarising the airplane,” Sugar explains.“At the end of the day, it is going to be the best plane for the taxpayers and the war fighters.”

military aircraft market dramatically declined,” says Sugar, who was president of Litton when it joined Northrop Grumman in 2001. “The company had to decide if it was going to stay in business at all and, if so, how it was going to transform itself for the future. There would not be enough demand for military combat aircraft to support all the competitors in the marketplace. So what we did, and I credit my predecessor Kent Kresa in this, we tried to determine what the world would require for defence in the future and position the company to do that.” The answer was high tech: hardware and software integrated into complex systems for use on the ground, at sea, in the air and in space – systems that enhance navigation of aircraft, missiles and spacecraft; improve battlefield command and control capabilities; process information; gather and analyse intelligence; conduct surveillance and reconnaissance missions; and enable the precise strike of munitions. On consequence is that Northrop’s Electronic Systems Sector alone is a $6.7bn business, comprising such segments as aerospace systems ($1.4bn), navigation systems ($886m) and space systems ($486m). All told, Northrop has about 30 sectors spread among its businesses, the newest of which is Technical Services, which was formed in January.“We are doing a tremendous amount of technical services work today,” Sugar says. “What we have not done is to focus on this. The growth rate in technical services is probably higher than the growth rate for original equipment. While we will have orders to build planes and spacecraft and ships and other things, we are going to have an increasing demand for maintenance, repair, overhaul and technical services support. I realised we were not focusing on it correctly, and so we took a lot of businesses from our existing sectors and put them into this new sector, and put a new executive in charge, a very aggressive guy who knows this business.” The target markets are solely governmental. “It will be primarily defence work but also non-defence governmental work,” Sugar says. “For example, Department of Energy work, Homeland Security work and other federal agencies [sic]. What we will not see, though, is any strong play in commercial services.” Indeed, unlike rivals Boeing and General Dynamics, Northrop has all but abandoned the commercial market, which now accounts

Ronald D. Sugar, president and chief executive officer, Northrop Grumman. Photograph supplied April 2006

for perhaps 10% of total revenues. “We are looking at expanding into non-defence government work, state and local governments, but not commercial work,”Sugar says. The reason is synergy. The various parts of Northrop lend themselves to working together on different government projects, a collaboration that would be difficult in the civilian market because so many of Northrop’s technologies are for government use only. For example, among the company’s current programmes are fire control radars for the US Air Force F-16 and F-22A fighters and construction of four Arleigh Burke class destroyers for the US Navy. In the civilian world, there is really no demand for airborne fire control systems or warships. Then, in addition, the skills necessary to market to commercial customers are entirely different from those needed to reach prospective government customers. In any event, what is important to note is that Northrop is not some investment trust that happens to have a collection of government-related businesses. “We do not run this firm as a holding company,” Sugar says. “We run this as an integrated operating company with a collegial, cooperative management team. We work together to do bigger things than any one sector can do individually. We have a high level of collaboration across the company. Each sector president has his own domain of responsibility, anywhere from $3bn to $7bn in yearly revenue.” Even as the Technical Services Sector was being assembled, Sugar was making plans to exit a $728m business, its Enterprise Information Technology unit, a value-added reseller of computer equipment and software that was the result of Northrop’s many

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Northrop Grumman's high-energy laser for the U.S. Missile defence Agency's Airborne Laser is comprised of six modules shown here. Officially known as the Chemical Oxygen Iodine Laser (COIL), the modules were installed inside a scrap 747 fuselage in the System Integration Lab (SIL) at Edwards Air Force Base, Calif. The view is looking down the center of the aisle formed by the V-6 configuration of the laser layout. A US Air Force photograph, supplied by Northrop Gumman, March 2006.

acquisitions. “It is a business that has large revenues but low margins,” Sugar says. “We found over time that the margins continued to deteriorate because the business has gotten much, much more competitive. And frankly there is not much that Northrop can do in reselling computers and software to add a lot of value.” After a fruitless search for a buyer, Sugar decided to phase out the business over the current year. Any outstanding contracts will be transferred to other parts of the company. As for the several hundred affected employees, Sugar believes most will remain with Northrop. “Many of them have multiple skills and we can use them in other parts of our company because we are hiring significant numbers of people.”As for the shutdown itself, Sugar thinks that will send a message to Wall Street: “We know how to exit business as well as buy business because what we are trying to do is improve the value of the company.” The break in the acquisition programme – remember, the last major one was TRW in 2002 – reflects Sugar’s determination to digest previous acquisitions and improve the bottom line.“If you think about the process of making major acquisitions, it was a risky business,”he says.“We placed our bets. We got almost all of them right. We assembled a significant company, and about the time we finished our last acquisition, I picked up the reins of the company. The challenge was, now that we have put this thing together, how

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in the world are we going to make it work? As well, how are we going to make it produce a return to shareholders regarding the promises we made about the future? It is one thing to have a strategy. It is one thing to have a vision. It is quite another thing to be able to integrate a company, put it together, and get the full benefit of it. And that is what we have been working very hard at for the past three years.” By any reasonable metric, Sugar and his lieutenants have been successful. Revenues rose from $26.2bn in 2003 to $30.7bn in 2005, a 17% gain. Net profits rose 63%, to nearly $1.3bn. Operating margins expanded from 8.5% to 9.5% (and are projected by Value Line to rise another full point to 10.5% this year). Earnings per share rose 84.7%, to $3.86. Likewise, the returns on total capital and shareholders’ equity rose sharply as well. “Focusing on the company’s operating excellence has really paid off for us in the past few years,” Sugar says. “We also worked very hard on the redeployment of our cash flow for the benefit of shareholders.”Translated from corporate-speak, this means a higher cash dividend, which was increased for the first time in 11 years in 2004 to 89 cents and again last year to $1.01, with increases likely this year and next. It also means an aggressive multi-billion dollar stock buyback programme, which by the end of next year is expected to have reduced shares outstanding by 11.7% since 2003. The stock price has responded nicely. Since hitting a low

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Working towards bigger things – Northrop Grumman Corp vs. FTSE Developed Aerospace & Defence Index 120

110

100

ar -0 6 M

Ja n

Fe b-

-0 6

90 De c- 0 5

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EADS

Boeing

General Dynamics

FTSE Developed Aerospace & Defence Index

Northrop Grumman

Source: FTSE Group / FactSet Limited USD price returns. Data as at March 2006

A test run for the Global Hawk UAV-3(b). Photograph supplied by Northrop Grumman, March 2006.

of about $40 in 2003, it recently topped $68, a 70% gain. Indeed, just since Christmas Northrop has risen 15.7%, a stronger gain than the overall market but about in line with most of its major competitors. Boeing was up only 6.4%, but General Dynamics matched Northrop’s gain and Lockheed Martin rose 17.5%. Most security analysts believe that Northrop and other giant defence contractors are fully valued today and that further gains will reflect mainly growing revenues. Nevertheless, they do see continued gains. For example, Troy Lahr at Stifel Nicolaus expects 2006 revenues to rise to $31.2bn and 2007 revenue to be $33.2bn, generating earnings per share (EPS) of $4.35 and $4.90 respectively. Ronald Epstein of Merrill Lynch is willing to look even farther out. He sees revenues of $36.2bn in 2010 and EPSs of $5.40, up 28.7% from 2005. In a world that still remembers the dot-com boom, these gains may not seem like much. However, they are remarkable because they are coming at a time when the US is engaged in two wars that are consuming more than a billion dollars a week. Normally, the threat of war is good for defence contractors but actual war is bad because it diverts money from long-term weapons systems to short-term needs such as combat pay, ammunition and medical services. For a while, the US Congress – worried by rising budget deficits – considered cutting back on big-ticket items such aircraft carriers, submarines and fighter aircraft. In the end, it was decided to economise by cutting the number of active duty military personnel, a move that will reduce spending immediately whereas shutting down purchases of big systems takes years to show meaningful savings. It is still to be seen if the proposed troop reductions actually go into effect, but for fiscal 2007 (beginning October 1) America’s total core defence budget (not counting operations in Afghanistan and Iraq) will be $439.3bn, up 4.8%. Of this amount, $84.2bn – an 8% increase – is designated for the purchase of weapons systems. Some $2.6bn will be available to begin

construction of two DDX advanced destroyers. One will be built by Northrop, the other by General Dynamics. The Navy will test them both and select one for serial production, which Sugar expects will be split between Northrop and GD. The Navy will spend an additional $793m on further DDX research. The budget contains other good news for Northrop: appropriations of $1.3bn for the F-35 fighter, $1.7bn for unmanned surveillance planes and vehicles, and $9.8bn for space operations.“We are positioned right in the sweet spot of what we believe will be an expanding need for the national defense,”Sugar says.“If you look at the Quadrennial Defence Review, what you see is that the capabilities outlined are precisely lined up with what we do.” True enough, but is the ambitious American defence programme really sustainable? No, not under present budget projections, which indicate that by fiscal 2011 the Pentagon will not have enough money to pay for all the projects previously approved. Yes, if you look at defence spending as a share of the US gross domestic product. Currently, it is about 3.7%, down sharply from the 11% to 12% of the 1950s or even the most recent peak of 6.2%, reached during the Reagan administration. In other words, Congress votes for the defence programmes, confident that somehow the money will be there. For good or ill, the defence industry is a growth industry, and this may mean that Northrop will one day resume its acquisitive ways. There are a number of companies – Goodrich, Rockwell Collins and even Bombardier – that could fill market segments not served by Northrop and still be large enough to make an impact on the bottom line.“We wouldn’t speculate on any particular company we might want to acquire,” Sugar says. “But I will tell you that we have now positioned ourselves at a size and a range of capabilities that make us very comfortable with our portfolio. We do not have to keep making acquisitions. That said, we will always look at potential smaller acquisitions that will bring our company new special skills or enable us to grow in another dimension.”

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SECURITIES LENDING: eSEC LENDING

Is private equity looking to leverage the growth in investment services provision? General Atlantic’s purchase of a strategic stake in the New York Mercantile Exchange (NYMEX) is one pointer; and now comes another significant investment: TA Associates has bought a controlling stake in securities lending specialist eSecLending. What does it all mean?

WHY PRIVATE EQUITY LIKES SECURITIES LENDING HE NEWS THAT Boston-based private equity firm TA Associates (TA) will buy securities lending agent eSecLending, currently majority-owned by insurance and asset management specialist Old Mutual, took the securities lending market by surprise in late March. It surprised the market for any number of reasons. First is the fact that a private equity firm should buy into a specialist securities services segment such as securities lending, albeit that it is a burgeoning and multi-trillion dollar business. Second people were surprised that it bought into eSecLending in particular and wonder where the value will come from in the deal (the terms of the deal remain confidential). In addition to Old Mutual’s controlling a 65% stake, there are also other non-employee shareholders, and TA is also buying equity from them. However, existing management and employees will retain a stake in the firm acknowledges Chris Jaynes, managing director at eSecLending, “this was an important element for existing employees, as it provides ongoing incentives.” eSecLending manages customised securities lending programs for large global institutional investors, principally through an auction process, although it also operates as an agent lender performing the full operational and administrative functions typically performed by traditional custodial or 3rd party agents. The firm has auctioned more than $750bn worth of assets across multiple asset classes since it began in 2000 and currently has over $300bn in lendable assets. eSecLending’s client base includes several of the largest pension funds in the world as well as major investment management companies such as F&C Asset

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Chris Jaynes, managing director of eSecLending in London

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eSecLending acknowledges that TA in size from $50m to an upper Management, Janus Capital, was not the only private equity firm limit of $300m. TASDF II will Russell Investments, and SEI provide subordinated loans to Investments. looking at purchasing the securities middle-market growth While Old Mutual had lending provider. “TA really took time companies primarily in provided the seed capital for and resources to look into our opportunities developed and the establishment of market,” explains Jaynes, “to better led by TA. The private equity eSecLending, the securities understand what we do and where fund meanwhile will invest lending specialist was not a to look for growth...” along with equity provided by core part of the insurance current TA funds, including TA and investment giant’s portfolio. “It was not Old Mutual’s core business and IX and TA Atlantic and Pacific V; an $800m private equity fund therefore the decision for our majority shareholder to exit raised in 2004, primarily from non-US investors. TA has provided us with a springboard to find a more suitable invested over $1.2bn so far in financial services firms, partner to create a stronger business. We began to look including GlobeOp Financial Services, a specialist hedge around and identified TA as a potential investor,”says Jaynes fund services boutique and the AIM Management Group. TA tends towards a ten year investment horizon, although eSecLending acknowledges that TA was not the only private equity firm looking at purchasing the securities lending the typical investment horizon in a private equity firm would provider. “TA really took time and resources to look into our be a five to seven year period. While there is little pressure market,”explains Jaynes,“to better understand what we do and on eSecLending to provide liquidity in the short term, Jaynes where to look for growth. Retaining our independence is a key acknowledges, “Things will be done to TA’s natural cycle.” benefit of teaming up with TA. Having no conflict with an Once the deal is concluded, TA members will take over existing agency queue or affiliated borrower provides eSecLending board positions vacated by Old Mutual objectivity to our process that is unique in the industry.”For TA, executives. C. Kevin Landry, CEO of TA Associates, will also added value is provided by its own limited partners, which in join eSecLending’s board, which says Jaynes “shows the many cases also include some of eSecLending’s founding commitment on TA’s part to the firm.” “Does it speak to trends?”asks Jaynes rhetorically.“It could clients, such as the California Public Employees’ Retirement System (CalPERs), ABP Investments and Hermes, as well as make a statement about growth in the industry and where other large institutional investors that it can approach with that will come from. Frankly, as a group we are excited about commercial introductions to eSecLending’s securities lending the deal, as it will revitalise our efforts, our employees and services. Given that eSecLending’s business model is built allow us to develop some new relationships,”comes the reply. The rise of auction systems has obviously been a tempter around exclusive arrangements, it makes sense for the firm to leverage TA’s global limited partner contacts as a route to for TA and the reality is that eSecLending’s service offering is still undersold, particularly outside the US and the major additional business. Founded back in 1968, TA specialises in investments in asset management firms in Europe. Nonetheless, Jaynes technology, healthcare, consumer, finance and business holds that “we have seen increasing acceptance of our services sectors primarily in the US—though it also looks at business model over the last few years.” At a meeting with companies in Europe—and in navigating the companies in eSecLending at the beginning of this year, Jaynes reported which it invests towards public offerings and acquisitions.TA new mandates and new business lines, including new “US operates in a broad middle-market, characterised as ranging mutual fund based clients: which has been interesting to us on the low end from profitable-stage minority ownership and the industry.” In addition, like other securities lenders, investments through to middle-market buyouts. The firm Dublin and Luxembourg have proved fertile hunting focuses on deal origination, flexibility in structuring minority grounds for new business. He acknowledged in a meeting and majority positions and has a reputation for forming in early March that in its start up period eSecLending faced strong supportive partnerships with its management teams. significant resistance from traditional providers who TA would also be a valuable supporting resource to help criticised the auction model, but says Jaynes,“over the last eSecLending expand into new markets, such as Asia; a year the tone has changed dramatically, with many region into which over the longer term, eSecLending would traditional providers now stating that they had been like to extend its operational reach. Jaynes also maintains managing auctions for years.”Even so, TA will be expecting that the involvement of TA will provide eSecLending with a volumes to uplift significantly, even in a relaxed initial post stronger operational focus. In this context, says Jaynes, the investment period and it will likely encourage eSecLending to step up its international sales effort and, at the same deal made good sense. eSecLending’s impending owner is also cash rich. Prior to time, to scout for potential acquisitions—the traditional announcing the eSecLending deal TA had just closed two private equity growth strategy. “We are confident,” says new funds: TA X LP, a $3.5bn private equity capital fund and Jaynes that the underlying trends in the industry, including a $777.5m captive subordinated debt fund, called TA unbundling, increased use of specialists and the growing Subordinated Debt Fund II LP (TASDF II) that brings the acceptance of auctions remain strong for our business total capital managed by the firm to $10bn, of which $5bn is outlook.”How that growing confidence plays in the global currently invested. Typically, TA Associates investments range securities lending market is now to be seen.

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Get out of the queue. Tired of waiting in the queue? You have alternatives. eSecLending takes an active approach to securities lending by managing customized programs for institutional investors. Unlike the traditional agency approach, where many lenders’ portfolios are grouped together and their securities wait in line to be borrowed, eSecLending markets each client’s portfolio individually and awards lending rights to the optimal bidders. Our clients receive

more lending revenue over their traditional programs, because eSecLending introduces objective competition via an auction process. Rather than the traditional “best efforts” approach, our clients can count on their lending revenue because borrowers pay guaranteed fees in exchange for exclusive borrowing rights. eSecLending clients achieve all this while maintaining conservative risk parameters and close control over their lending programs.

Europe +44 (0) 207.002.6700 United States +1.617.204.4500 info@eseclending.com www.eseclending.com

eSecLending provides services only to institutional investors and other persons who have professional investment experience. Neither the services offered by eSecLending nor this advertisement are directed at persons not possessing such experience. Old Mutual (US) Trust Company, an eSecLending company, performs all regulated business activities. Past performance is no guarantee of future results. Our services may not be suitable for all lenders.

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SECURITIES LENDING: KEY TRENDS

N AN INCREASINGLY complex marketplace, it remains difficult to predict long term directions. In the early days of the industry, securities lending was straightforward and lending was handled primarily by a custodian bank on behalf of its client. Today, although the bulk of the business is still in the hands of custodians, lenders now have a variety of different routes to market. An increasing number of non-custodian agent lenders have entered the market and institutions such as Dresdner Kleinwort Wasserstein (DKrW) have picked up substantial business as a third party agent provider. Custodians themselves act as agent lenders and no longer limit their horizons to assets held in their custody. Then again, independent auction systems have materialised such as eSecLending and specialist auction platforms such as EquiLend, which enjoys referral business from its extensive ‘owner members’. Both systems offer a choice of either customised and standardised transactions. Side by side with this growing complexity, developments such as increasingly specialised securities deal structures and greater focus on proxy voting have made securities lending decisions more challenging.“The increased awareness of auctions has certainly changed the way people think about securities lending,” acknowledges Brian Staunton, head of securities lending for EMEA at Citigroup. The ability to secure volume, thinks Staunton, is imperative if a securities lending operation is to survive long term, as “spreads are not what they used to be, therefore lenders are increasingly reliant on volume and the reduction of costs.” Traditional areas of revenue are also eroding: emerging markets will develop securities lending opportunities while developed markets become more mature, with increased

RidingHigher John Arnesen, head of securities lending at Bank of New York in London. Photograph supplied by Bank of New York, April 2006

The outlook for securities lending is set fair for the next few years. The outlook is one of steady expansion fuelled by increased demand for a broader range of securities from hedge funds and a concomitant steady increase in supply from beneficial owners as well as a string of new markets coming into play. Where’s the catch? Francesca Carnevale reports.

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previously could only be offered supply. In addition, external factors such through synthetic structures that as tax harmonisation in Europe will involve a swap, warrant or a form of gather momentum which will lessen the equity linked note.. We created an opportunities for arbitrage. For today’s alternative more traditional solution in securities lender: it all comes down to response to an increasing level of where the firm can add value to clients. demand from London based broker Service is paramount, but an ability to dealers, typically supporting hedge fund create additional opportunities for activity.” Second, the larger houses, revenue will be the most important which can take on the dual role of aspect of any programme. “There has custodian and agent lender, have a been some compression in spreads,” natural advantage in gaining new agrees John Arnesen, head of securities clients because the nature of the lending at Bank of New York in London. underlying custody business should “It is true both of corporate and Brian Staunton, head of securities lead to regular increases in the government fixed income securities,” he lending at Citigroup. Photograph portfolios available to lend. It is because adds. Bank of New York does not get supplied by Citigroup April 2006 of this the costs of operating the involved in auction platforms, says Arnesen,“there’s no real need to do so.” Instead, the bank business can be low on a per client basis. It is just plain uses its wide distribution of borrowers to seek its own and simple economies of scale.” Direct market access (DMA) whereby beneficial owners exclusive arrangements where appropriate.” Staunton believes it is that very approach to securities (or investment institutions) lend their securities directly, lending that will eventually concentrate in the hands of without using an intermediary, is also a feature of today’s the large global players for two reasons: the first being able market. As well, exclusive lending arrangements are also to offer a large supply in many different markets, increasingly common. It is a development that some particularly securities in more exotic markets or at least traditional players look upon with something approaching markets for which demand is high. “In January, we disdain. “There are certain characteristics of exclusives,” completed the first lending transaction in Taiwan says Fred Francis, vice president of RBC Dexia’s securities securities,” explains Staunton, “a market where exposure lending business. Exclusives, he explains are for a set

A fresh perspective on investor services RBC Dexia Investor Services combines the strengths of RBC Global Services and Dexia Fund Services — two recognised leaders in global custody, fund and pension administration and shareholder services. See how our fresh perspective can support your strategic objectives and enhance your business performance. Visit us at www.rbcdexia–is.com. RBC Dexia Investor Services Limited and its affiliates are licensed users of the RBC and Dexia trademarks, which are registered in the name of their respective owners. RBC is a registered trademark of Royal Bank of Canada. RBC Dexia Investor Services is the brand name under which RBC Dexia Investor Services Limited and its affiliates conduct their global custody and investment administration business. RBC Dexia Investor Services Limited is a holding company that provides strategic direction and management oversight to its affiliates, including RBC Dexia Investor Services Trust which is authorised and regulated in the U.K. by the Financial Services Authority.

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period, a set amount, a set price and a set book of business. “People who turn to exclusives cannot be bothered with active trading,” maintains Francis, “it favours the institutions that approach the market directly. After a while, they realise that they are leveraging only a particular piece of their book, which may or may not be the best way to maximise additional revenue. Then again, if next year those assets are no longer special, then the price of the exclusive will change and then what happens? Do those assets stay exclusive?” RBC Dexia also bestrides the custodian/agent lender divide, although Francis’s business model is based around the broker/dealer acting as principal. This means that in every securities lending transaction the borrower only ever sees RBC Dexia as counterparty. RBC Dexia’s approach means according to Francis that the firm is “particularly careful with whom it deals and that cash collateral is limited to a small portion of the total collateral that we accept.” For this approach to work effectively, “the technology infrastructure supporting the business must be extensive. On a proprietary basis, RBC Dexia has a loan and collateral inventory that “provides us with an asset management capability that is needed to handle large volume business,” he adds. This is particularly meaningful following the merger with Dexia Fund Services, which has broadened “our offering to Dexia’s large European client base. Having that direct reach now is fantastic,”says Francis. The global players also benefit from the entry of new markets into the global securities lending mix. Regulatory trends around the globe: reviewing the trend towards relaxation of legal limits to lending by the regulators worldwide will increase the lending pool of assets. A number of developments are emerging here: the mainstream new markets, such as Taiwan, India and China, where securities’ lending is beginning to come into play. The Korean Securities Depository, India’s Securities Exchange Board, and the Taiwan Stock Exchange, for example, have been steadily liberalising their regulatory regime to encourage securities lending. However, while the new regulations have opened doors for buyers and sellers, some challenges remain. In Taiwan, for example, there are still penalties for failed trades a mis-match in the settlement system between buys and sells and added to that, the Taiwanese tax authority still imposes a local tax on income generated by all internal lending transactions. The Hong Kong market has also been strong as a source of supply over the last eighteen months, as the territory continues to be a centre for issuance of Chinese equities, with Chinese H shares in particular demand. Australia too is a hive of activity, backed up by strong markets and high deal activity, particularly mergers and acquisitions. In Europe, meanwhile there is a signal shift away from established and liquid markets, such as Germany and Scandinavia. According to other securities lending houses, Austria, Italy and Luxembourg are also beginning

Brian Lamb, CEO, EquiLend Holdings LLC. EquiLend provides automation to the global fixed income community in places where it did not exist before and more specifically in the area of operational functions between Dealer and Bank. Automation of comparison processes will continue to deliver value in this space. Photograph supplied by Equilend, April 2006.

EquiLend: deepens its fixed income offerings FTSE Global Markets talks to Brian Lamb, Chief Executive Officer, EquiLend Holdings LLC. EquiLend began operations in 2001, following an initiative by ten financial institutions, including Goldman Sachs, JP Morgan Chase & Co.; Lehman Brothers, Merrill Lynch; Northern Trust Corporation; State Street Corporation; Barclays Global Investors and UBS, to work together to establish a specialist, automated securities lending platform that standardises and centralises front and back of office processes. Since its launch, EquiLend has more than doubled its client base, introduced a number of new functions and functional enhancements, and has introduced the platform to the global fixed income securities finance community. Before he joined EquiLend as its CEO last September, he had been lead programme manager at Barclays Global Investors (BGI) and one of EquiLend’s original board members. He succeeded former president and CEO Dirk Pruis. Lamb has nearly 20 years of securities finance experience, with particular strengths in fixed income, a market that EquiLend aims to expand even further into over the coming years.

Continued on page 56

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Brian, in the release announcing your appointment as CEO last September you stated: "Continued client growth, functional enhancements and major inroads into the global fixed income market indicates how the industry is evolving. It is clear that EquiLend has been at the forefront of this evolution, and I am excited to be in the position of continuing to lead this trend." Does this still apply? Last year was undoubtedly a milestone. Not only have nine clients gone live on the platform since September of last year, but also we have managed to deliver a number of new functions and introduced EquiLend’s trading and operations solutions to the global fixed income community. Signing up new clients and expanding the usage of our services among our existing client-base will allow continued growth. Companies look for cost effective solutions that add value and can be introduced easily into existing business processes. EquiLend was formed by a group of leading financial institutions to develop a global platform for the automation of securities lending transactions. I understand that there are 10 or so founding firms, including BGI and UBS among others. Has the membership increased? How far do you think Equilend has achieved its ambition of becoming a truly global platform? Since we launched, we have been global. We needed to be because the securities finance business is global. That being said, some processes and innovations are embraced more readily than others, which brings up an important fact. EquiLend is not a vendor, contrary to what many believe. We are regulated by the Securities and Exchange Commission and the Financial Services Authority just like our clients. This is a deliberate decision. To be monitored and to comply with industry regulations is clearly a different business model. EquiLend exists to meet a very specific need in securities finance, and servicing both sides of the market in the most open way possible seems to work for us. In March last year EquiLend launched AutoBorrow ExpressSM—an adjunct to it AutoBorrow service and aimed at smaller volume users. How successful has the launch been and what has been the uplift? AutoBorrow Express is the trading function that is delivered with one of our solution suites. It is exciting to witness how firms use it. Smaller volume clients are using AutoBorrow Express to gain access to the larger firms, while the larger firms are using it for coverage that is more complete. The symbiosis is incredible. What is the total value of transactions now conducted through EquiLend’s services? What are the principal reasons for the uplift in volume? We have been averaging approximately $10bn trading value per day. The primary reason for the uplift is increased client usage. Our existing client-base continues to expand their functional usage and/or leverage the platform for other parts of the business, either different markets or additional products, such as for Fixed Income. How is EquiLend’s US Treasury and Agency borrowing and lending business faring? This is where we really get excited about the value. EquiLend provides automation to the global fixed income

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community in places where it did not exist before and more specifically in the area of operational functions between Dealers and Banks. Automation of comparison processes will continue to deliver value in this space. What is the biggest competitive challenge to EquiLend’s business growth plans and how is the company responding to that challenge? Conversely, where does EquiLend see opportunity and how is the company preparing to leverage it? Everyone is reporting increased supply.Where is it coming from? Our biggest challenge is behavioural and cultural; phones and terminal systems will not go away! That being said, no technology will ever replace human interaction and, with a business that is and will continue to be relationship-driven, technology serves as a facilitator; an enabler to more efficiently, more cost-effectively manage business. Just like our clients, we are responding by developing stronger relationships with our client-base in order to understand their challenges and respond to them accordingly. Increased supply could be the result of a few things: Smaller firms adopting technology to increase their coverage and lending institutions having broader distribution. The business is definitely growing, and much of this is due to solutions becoming available allowing the growth to happen. Are you leveraging the regulatory changes around the globe which are encouraging securities lending? EquiLend is an active participant on many industry committees related to securities finance. For example, we have helped drive many of the requirements for the Agency Lender Disclosure (ALD) initiative. We are at the centre of the industry, so it makes sense that we have valuable insight, knowledge to share and are in a position to respond. We do not monetarily leverage services and/or functions mandated by the industry. In fact, we provide ALD and Automated Return Management (ARMS) at no additional cost to our clients. These services should add value to firms, not take it away. How can the industry improve its lobbying efforts in emerging markets? Industry organizations such as the Risk Management Association (RMA), the International Securities Lending Association (ISLA) and the Pan-Asian Securities Lending Association (PASLA) are already doing a number of tremendous things in emerging markets. For example, this year’s PASLA conference was held in Bangkok because the Thailand exchange invited the conference to be held there. Outreach by individual countries to the industry is evidence that relationships are being built and efforts continue to happen. Do you find that your clients require more customised services? We are experiencing the opposite. Most firms are seeking greater standardisation. Standardisation provides the means for firms to scale and grow their business more efficiently. Of course, every company has unique needs that require some bit of customisation, but we are seeing that kind of customisation happening within the boundaries of those standards.

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to provide lending and borrowing opportunities; while Greece, Israel and eastern European countries also offer longer-term business potential. Even so, but to the outsider it sometimes appears a fickle and fashion led business. Italy is a case in point. First, there is a frenzy of demand, then interest dies down and securities lenders have to provide supply from elsewhere. As well, demand is rising steadily. Hedge funds strategies have broadened and deepened, providing more work for agent lenders. A bull market typically encourages new deal activity, both in terms of new issuance and mergers and acquisitions, both of which encourages additional hedging of equity and convertible bond positions. “Growth in demand emanates from long holders of securities,” while yet another source of different demand “will come from the push for shorter settlement cycles, thus driving up the demand for more efficient coverage,” says Andy Clayton, head of securities lending at Andy Clayton, head of securities lending at Northern Trust. Photograph supplied April 2006. Northern Trust. “Add to that more mergers and acquisitions activity,” he says. At the same time additional supply will likely come AMRO Mellon’s iBID auction service, or straightforward from the growing transparent nature of the securities benefits such as prompt payment of cash dividends on lending business which leads to a greater acceptance by payment date irrespective of whether or not the money comes into the bank from the paying agent, or again portfolio managers of securities lending, says Clayton. However, the business is increasingly complex and providing client-customised reports. For the moment then, securities lending is riding a rising competitive, encouraging ever increasing investment in technology and product differentiation. It can involve tide of both demand and supply. A number of challenges, offering clients, if they need it, an increasingly customised particularly in the European business theatre could upset business; offering specialist technology, such as ABN the proverbial apple cart. “Basel II and the Markets in Financial Instruments Directive—otherwise referred to as MiFiD—will have a significant effect on the European capital markets per se,”says Northern Trust’s Clayton. One Side by side with this growing of the main objectives of MiFiD is to increase market complexity, developments such as transparency and efficiency. It will lead to harmonisation increasingly specialised securities of national rules on the provision of investment services deal structures and greater focus on and the operation of exchanges, with the ultimate aim of creating a pan European securities rulebook. MiFiD hopes proxy voting have made securities to enhance protection for investors and, among a host of lending decisions more challenging. other things, establishes the principle of pre-trade “The increased awareness of transparency obligations whereby firms trading outside auctions has certainly changed the regulated markets will be obliged to disclose the prices at way people think about securities which they will be willing to buy and sell to their clients lending,” acknowledges Brian for transaction of a “standard market size.” “The directive clarifies distinctions between home markets regulation Staunton, head of securities lending and host market regulation,” explains Arnesen. “If your for EMEA at Citigroup. services are permitted by the home market regulator, you can use or ‘passport’ them into other markets.”

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THE BIG SQUEEZE GENT BANKS, OR sub-custodians, have long acted as the intermediary between the global custodian on the one side and market infrastructures on the other. Typically they offer a tightly-focused, market-specific solution to meet the in-country custody, settlement, corporate actions, income collection, and securities lending/borrowing needs of institutional investors and intermediaries. However, that may soon be a thing of the past. The diversification and regionalisation of investment portfolios means an increasingly sophisticated and diversified client base is today looking for greater geographic reach and access to a broader, more esoteric product set when it comes to choosing a sub-custody provider. On top of that, national and supra-national depository organisations (their influence strengthened following a series of mergers) look better placed than ever to make a long-predicted move into the commercial space that was previously the sole preserve of custodian banks. For many of indigenous custodians that lack the deep pockets required to build a more all-encompassing offering or that lack the willingness to reorient their business models could face an increasingly bleak future. Certainly, there has already been marked consolidation within the European sub-custody sphere. This has been driven on the one hand by strategic reviews within individual banks, pace the respective mergers in France of BNP and

EUROPEAN SUB-CUSTODY

Is European sub-custody under pressure? For many of the smaller subcustodian outfits that either lack the deep pockets required to build all-encompassing offerings or, indeed, the willingness to reorient their business models, the future appears increasingly doubtful. If that is not enough, they are also facing stiff and growing competition from depositories. Tim Steele goes in search of consolation.

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Photograph supplied by Istockphotos.com, March 2006.

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consideration for clients, who want to avoid the disruption that chopping and changing providers invariably entails. Jim Harris, senior manager, network management at RBC Dexia Investor Services – a buyer of sub-custody services – does not see how a mono-market provider will be able to survive over the coming decade. “Even in the short term the product set needs to be wider than traditional custody product suite, including offerings such as clearance, fund administration and derivatives processing, and there is also a need to incorporate cash management tools in a much bigger way,”says Harris.“What you are looking for is someone who can give you the best level of servicing in a panregional environment, so providers need to be in the Euronext markets to even to have a foot in the door, and going forward it will be increasingly important to a joined up service provision throughout Central and Eastern Europe. In addition, we are increasingly finding that there is a move away from having contact points on a market-by-market basis, towards having a single contact for the overall relationship.” Mark Kelley, head of securities and fund services, EMEA, at Citigroup, says that the continued compression of margins and profitability is forcing James Hogan, global head of custody and clearing at HSBC Securities Services, which in European players to reassess how addition to being a leading regional sub-custodian within Asia-Pacific also services clients in committed they are to this business. three Mediterranean markets.“Whichever part of the world you are looking at, when one looks “More and more we are seeing people at the costing dynamics it is a lot easier for a global custodian to deal with a sub-custodian questioning whether it can in fact be with a regional view of the world,” he says. Photograph supplied by HSBC, March 2006. justified,” he says. “When all is said and Paribas and more recently the securities and financial services done, it is hard to run a business profitably in just a few branches of Crédit Agricole and Groupe Caisse D’Epargne to markets.” Europe, to Kelley, means “Lisbon to Moscow”, create CACEIS Investor Services. On the other hand, it is and operating a single platform across all markets not only driven by banks choosing to focus only on those business allows greater efficiency but also means certain functions – lines where they can build significant scale and/or market SWIFT messaging, for instance – can be offered from a leadership – which for many no longer includes sub-custody. single point. “We do use third-party agents in a few Casualties include Dresdner in Germany, Bank Leu in markets, but generally we believe there is significant added Switzerland, CSFB in Russia and ABN AMRO, which sold out value from operating in-country ourselves, he adds. Technology spend is where “the rubber is hitting the its eight-market network to Citigroup in 2004. Citigroup is one of a select group of pan-regional road” for smaller service providers, he adds. “If you look providers, which also includes BNP Paribas and Deutsche back over the past five years or so, we have seen the euro Bank that today offer an expanded portfolio of products transition, Y2K, the transition to the new ISO 15022 and services across multiple European territories while also messaging standards, and if you only need to address those promising clients enhanced efficiency and lower costs on changes across one platform – while still feeling the the back of the economies of scale they can leverage. benefits of those changes in 18 markets – then you are Moreover, by dint of their scale and their investment in clearly in a better position than a bank [that] has to technology and other resources, such regional providers implement those changes market by market,” he argues. are deemed in some quarters to display a clear long-term Local market nuances remain a challenge, and mean a commitment to the business, another important provider’s straight-through processing and exception

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With remaining indigenous providers typically offering a strong vanilla sub-custody product, regional providers obviously need to up the ante, he adds. “You need additional products above and beyond the core offering, such as broker servicing, derivatives processing, and collateral management,” says Chew.

management capabilities come to the fore. “Having a proprietary network makes resolving problems that much simpler and faster, as there is no ‘middleman’,”says Kelley. The European Commission’s harmonisation efforts under the aegis of its Financial Services Action Plan bring their own challenges, he adds. The upcoming Markets in Financial Instruments Directive (MiFID) will have require service providers to deal with new documentation, the reclassification of client types and accounting for new types of outsourcing that will impact across the EU. Meanwhile Basel II is bringing significant changes as the Commission seeks to align accounting for both regulatory and economic capital. “Providers will have to spend time and money to ensure they and their clients can meet their new regulatory requirements, so having significant resources is more important than ever,”says Kelley. Scale is key in the modern sub-custody business, believes James Hogan, global head of custody and clearing at HSBC Securities Services, which in addition to being a leading regional sub-custodian within Asia-Pacific also services clients in three Mediterranean markets. “Whichever part of the world you are looking at, when one looks at the costing dynamics it is a lot easier for a global custodian to deal with a sub-custodian with a regional view of the world,”he says.“The number of interfaces that would normally be required is reduced, so costs are lower and there is also a consistency of service, but at the same time we can act as the client’s eyes and ears on the ground.” Steve Chew, head of sales and relationship management for financial intermediaries at BNP Paribas Securities Services, whose European sub-custody network spans 12 markets, notes that – while mono-market providers’ intimacy with the workings and kinks of their local market is held up as one of their unique selling points—BNP Paribas can offer the same within a pan-regional offering. “Having purchased JPMorgan’s network back in the mid1990s, we have a physical presence in every location and, just as importantly, we can also offer local agreements and local servicing in each and every market rather than using a number of processing hubs,”says Chew. With remaining indigenous providers typically offering a strong vanilla sub-custody product, regional providers

obviously need to up the ante, he adds.“You need additional products above and beyond the core offering, such as broker servicing, derivatives processing, and collateral management,” says Chew. Global clearing and settlement, direct access to markets, the integration of services around execution are other services that can be included in a package “tailored” for individual clients. “The key is to be able to provide flexibility while maintaining scale,”he adds. However, for all the odds supposedly stacked against mono-market sub-custody providers, they are proving remarkably resilient. Stephen Lomas, head of custody in Western Europe in Deutsche Bank’s Global Transaction Banking – whose regional operations take in eight Western European markets as well as five Central & Eastern territories (and another 15 elsewhere in the globe) – does not dispute that regionalisation is driving some banks out the business: “A good example is Dresdner Bank here in Germany, which despite having a great product and client base, decided that as a single market provider it could not justify providing sub-custody in the long term, and hence the time was right to get out,”he says. “That said, there are many local providers that are still battling away – something I find rather fascinating and which underlines the resilience of the local sub-custody model here in Europe,” Lomas continues.“All these banks are doing custody for their domestic client base anyway, so the additional costs of offering selective sub-custody services to other institutions are marginal, or possibly not transparent.” He recalls when he first heard it suggested that sub-custodians were on the brink of extinction: “It was in 1990.Yes, things are going that way, but it is going to be a long-term process. A number of the buying organisations might have decided to consolidate with a regional provider, but plenty of others are still sitting on the fence. In the end sub-custody is about more than scale and processing muscle – there is such a large relationship element.” Andrew Osborne, senior vice-president, head of worldwide network management at Northern Trust, a buyer of sub-custody services, says that while in Asia-Pacific and Latin America the bank is more dependent on the international banks that are established across those regions its options in Europe are somewhat different.“Part of that is down to some of the financial crises that have blown through those other regions, which have weakened the standing of some of the indigenous banks,”he says,“whereas in Europe there remain a broad range of credible domestic sub-custody providers.”He recalls a request for proposal (RFP) process in France a decade ago in which 10 domestic banks participated: “Today you would be hard pressed to find three – but for all the rationalisation and exits, there are still very good strong domestic providers in France, Germany, Spain, Austria, the Nordics, the Netherlands.” Northern Trust adheres to a ‘best of breed’ approach when appointing agents.“A regional arrangement can be a case of buying administrative ease at the cost of really assessing the true quality of available providers,”Osborne says.“That said, in some parts of Europe we do use one bank in multiple

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locations, which does allow some efficiencies, but only if they are delivering the best service in those markets.”However, he notes that in Central & Eastern Europe most of the domestic banks have been replaced by international providers: “Citigroup, ING, Bank Austria/HVB and Deutsche are all very active, and there is more opportunity to leverage a regional relationship than in some of the more sophisticated European markets.” The inability of global custodians to penetrate or build critical mass in key European as fast as they would like means that they are now forging alliances with smaller indigenous providers, which clearly boosts both parties long term prospects in the region: most notably The Bank of New Steve Chew, head of sales and relationship management for financial intermediaries at BNP Paribas York which has partnered with Securities Services, notes that – while mono-market providers’ intimacy with the workings and kinks ING Bank in the Netherlands, of their local market is held up as one of their unique selling points—BNP Paribas can offer the same Allied Irish Bank in Ireland and within a pan-regional offering. Photograph supplied by BN Paribas, March 2006. Natexis Banques Populaires in France. The trade off typically sees the local bank taking on in insulating their clients from the ongoing process of all the global custodian’s business in that market, while all consolidation and harmonisation within Europe: in recent its own global custody needs are serviced by the years, the securities industry has weathered a lot of change that has been operationally disruptive as well as international partner – a classic ‘win-win’. However, Jim Harris at RBC Dexia counsels caution expensive. “We certainly benefit from the ongoing regarding the longer-term prospects of such ventures. development of the systems environment that exists “Given our own recent merger [between RBC and Dexia between the agent bank and the depository,” he says. Fund Services], which is a true joint venture, the key Moreover, as HSBC’s James Hogan adds, sub-custodians question for me is about the structure of the underlying also play a valuable role as conduit to national authorities partnership,”he says.“Does it just extend to being an agent and regulators. “On-the-ground relationships within for the partner? Is there any systems integration? How markets at all levels are very important – in a utopian quickly can the cultural and social issues be managed – scenario regulators might like to have a dialogue with all their importance to the ultimate success of such ventures ultimate investors so as to better understand their needs, but in reality it is the sub-custodians that they will cannot be underestimated.” The threat of large global custodians opting to go direct in approach to get those views,”he says. Stephen Lomas believes it is “dangerous”to extrapolate European markets, cutting sub-custodians out of the process, remains a very real possibility. Northern Trust an existing central securities depository relationship into already self-clears and self-custodies in the US, UK/Ireland other markets and activities. “The central securities and Canada, and Euroclear’s planned integrated custody depositories (CSDs) are at a more basic level of servicing, and settlement engine could be an attractive proposition, as to some extent their users and owners want them to admits Andrew Osborne. “When you self-clear and self- be,” he says. Furthermore, he argues it is very expensive custody, you structure yourself in a particular way, bringing to maintain a direct relationship to a CSD.“A depository those functions that a depository cannot offer in-house – does not treat you as a ‘client’, rather it treats you as a but to do that you would have to build your own participant,” says Lomas. “Once or twice a year it will infrastructure to service those assets and manage the come up with a series of systems changes and users have attendant changes to the risk dynamics,”he says.“However, a certain period of time to ensure their systems and if at some point there was a centralised clearing and practices comply, whereas normally a sub-custodian will settlement mechanism for Europe, you could see a number perform a buffer role and make those changes once on behalf of all its clients. So you have to be very big before of global custodians actively pursuing that option.” While he also sees direct market access as a valid future going direct makes economic sense – and even then it option, Jim Harris notes the role that sub-custodians play might not.”

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THE OUTLOOK FOR ECNS

Professor Maureen O’Hara of Cornell suggests that the title for any article on the Electronic Communications Networks (ECNs) in the financial markets should be entitled: The rise and fall of the ECNs - and then their rise again. A combination of technology and new regulation, especially the SEC’s new National Market System (Regulation NMS) has re-opened the financial markets to the type of competition that seemed be dying down after a Darwinian round of mergers and closures among ECNs. Ian Williams reports from New York. NDER THE UNITED States’Exchange Act every stock can be traded on any exchange, no matter where it is listed. Now Regulation NMS, which is about to come into effect this June, mandates that trades must be routed to the best price available electronically. It signals bad times ahead for the old traders and specialists on the floor, who still survive on the New York Stock Exchange (NYSE) like the financial equivalent of the emblematic buggy whip makers. Adding to the pressures is the demutualisation of the exchanges, with NYSE listing this March. There is something incestuously recursive about the fact that both NASDAQ and NYSE are now themselves quoted

Here’s to

on their own boards. Ironically, NASDAQ only traded with the penny stocks on its over-the-counter (OTC) board after it went public, before it made the grade. However, it has since trebled in price over the last year, becoming its own best-performing stock with a stunning 244.9% rise. Its modest price to earnings (P/E) ratio of 73 is overwhelmed by NYSE's exuberant 231 times P/E ratio. One cannot be sure whether such valuations are a logical consequence of the resurgence in trading volume for stocks, or are the bubbles on the top of the froth of an over-exuberant market. O’Hara thinks, “It is fun to be in exchanges right now. Volumes are going up. Transaction costs are going down – they are miniscule compared with a few years ago. All around the world exchanges are trading at high price to earnings (P/E) ratios, some of which are justified, others

ECNs? Bob Greifeld, right, president and CEO of NASDAQ, and Gordon Macklin, left, first NASDAQ president 1971-1987, lead a toast in celebration of the NASDAQ stock market 35th anniversary in New York, Wednesday Feb. 15, 2006. The market was celebrating its 35th anniversary as the pioneer of electronic trading. Photograph supplied by EMPICS/Associated Press. Photograph by Bebeto Matthews. Photographs supplied March 2006.

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ar -0

O’Hara explains, “The just euphoria. People think merger with Archipelago that there is money to be From the viewpoint of economic reflects the fact that for a made in the markets. theory, the result of these moves should very liquid stock, the Remember, exchanges exchange provides very make money from volume, be closer to the mythical entity of a little added value since the so they do not care perfect market, and Cox muses that specialist does not really do whether it is [sic] up or “market fragmentation leads to wider anything. NYSE has down, as long as there is spreads, so will concentration narrow worked very well for trading.” them? It will be interesting to see if the companies in which there Five years ago, there merger brings the bid/ask spread on the has not been much were almost 30 ECNs liquidity, low volume competing with the NYSE, floor closer to Archipelago. That would trading. However, that has NASDAQ and a few, tell you that there is less noise in the changed. Before, when almost residual, regional market as a result.” trading fragmented it was exchanges. However, while very hard to find liquidity, the ECNs could cope with but now, with the smart the high volume trades in routing systems, robotpopular stocks, many of NASDAQ vs. FTSE MV Exchanges Index 700 trading systems, and them had such little 600 algorithmic trading systems market share that they had 500 whether liquidity is at difficulty providing Archipelago, or the Boston liquidity for smaller or 400 Stock Exchange, the less-traded issues. 300 routing systems can just go Additionally, their fierce 200 and find them. You do not pricing competition drove 100 need a trading floor.” down transactions costs – 0 Adding to the pressure and revenue as well. When since they have gone it began, Instinet was public, both exchanges charging 1.5 cents a share NASDAQ FTSE MV Exchanges Index have to build trading – and now NASDAQ has it volume because now their down to 0.0002 cents. Source: FTSE Group / FactSet Limited USD price returns. Data as at March 2006 biggest source of income is Even with the churning of day-traders to drive up volume, there was no way that not listing fees, but the sale of trading data, the revenues they could compete effectively. Those that survived, such as from which are allocated based on volume. Their newly Archipelago, Brut and Instinet, did so by teaming up with acquired ECNs are a major component of that income the small regional exchanges that were prepared to share stream. For example, data sales account for around 50% more revenue than listing fees for NYSE. the much more lucrative data sales revenue with them. Professor James Cox of Duke University sees the real Implicitly validating the principle that if you cannot beat them, buy them, NYSE absorbed Archipelago while struggle as being less between the established exchanges and NASDAQ swallowed Brut and then Instinet. With NYSE in the ECN's and more between NASDAQ and NYSE.“A lot of particular, the merger and its initial public offering (IPO) in what is happening at the NYSE is concern about where March signalled a major shift. Shareholder pressure will NASDAQ is going rather than with ECNs generally. Why progressively reduce the role that the NYSE once had as a would companies that are shouting about the paperwork sort of guild to protect the interests of dealers and from Sarbanes Oxley (SOX) and Securities Exchange specialists. It will have to adopt the best that technology Commission (SEC) requirements be prepared to pay for the offers. Although the NYSE claims that it offers the best privilege of complying with additional NYSE rules? Especially prices 88% of the time, Regulation NMS will see them when you see you can have liquidity for your shareholders, and pretty good pricing in your shares in an electronic market, bypassed unless they offer those prices electronically. As O’Hara comments musingly, “The specialists have a that’s off-floor and so has none of the NYSE regulations.” challenging future. They and NYSE have to decide how NASDAQ in particular sees the ECN revolution as a they adapt to the market changing.”At present, NYSE has consolidation of its own comparative strengths and wants to been introducing a trial hybrid trading system, which in carve even deeper into NYSE's 72% share of listings. NYSE itself is now in a quiet period because of an effect links the specialists and the floor traders electronically. Like the committee that set out to design a impending secondary offering, so its spokespeople were not horse and ended up with a camel, it is not elegant, but it able to comment, but Cox points out the commercial offers some pointers on how NYSE can maintain a pressure means that NYSE has to offer unique products. While everyone talks about transparency, it is not always competitive edge.

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actually wanted. Retail investors benefit from completely open markets, but often fund managers do not want to advertise large-scale sales or purchases because of their effect on prices. Therefore, Cox says, NYSE has a comparative advantage, “for example, if a money manager wants to dribble out a large bunch of securities while hiding in the crowd, and thinks the auction method is the best way of doing it, then you have a floor to go with it. But if you want speed of execution, then now NYSE can offer that as NYSE/ARCHIPELAGO: Marshall Carter, top center, the Chairman of the New York Stock Exchange, and well with Archipelago.” John Thain, top right, CEO of the NYSE, watch as the first shares of the exchange are traded Wednesday, Cox adds that “They are March 8, 2006 in New York. The exchange completed a merger with electronic trading company hoping that price execution on Archipelago on Tuesday, March 8th 2006. Now that the NYSE is a publicly traded company, its agenda, Archipelago is going to be better staying competitive with faster all-electronic markets, will remain in place even as its corporate structure than on some ECN located changes. Photograph supplied by EMPICS/Associated Press. Photograph by Mark Lennihan. somewhere else, because it is Photograph supplied March 2006. more likely that the floor market, some specialist post is going to be linked to Archipelago require orders to be routed to the top of the book, so the way and its prices, otherwise there is not going to be an to make sure you have an order at the top of the book is to make sure you have lots of books.”As a result, she claims, advantage over staying on the floor.” From the viewpoint of economic theory, the result of “Now everyone and his brother are building new ECNs.” For example the Philadelphia Stock Exchange (PHLX) a these moves should be closer to the mythical entity of a perfect market, and Cox muses that “market fragmentation pale shadow of its former glory and which only handles 1% of leads to wider spreads, so will concentration narrow them? the US shares currently traded, is abandoning its old specialist It will be interesting to see if the merger brings the bid/ask model and in effect converting itself into an ECN. The Pacific spread on the floor closer to Archipelago. That would tell Exchange, Boston Exchange and Amex all similarly now sense a new market opportunity and broker dealers such as you that there is less noise in the market as a result.” O’Hara agrees that while NYSE will have to fight harder Citigroup are moving into partnerships with them. The combination is more potent in that it provides some than before, it begins with a strong position. It is she reminds, “still the big boy on the block, they have Archipelago and the guarantees. On the face of it, shares could be traded on floor, and the biggest share of the market. And as NYSE looks eBay, but O’Hara points out,“There is more to buying and for ways to consolidate the markets, and moves into bonds selling than just having a venue. eBay’s current law cases and options, it will be trying to figure out what will provide the with Tiffany are a great example of the problems that exchanges could face.That is why, in order to get to an ECN, profits, increase market share.” There was some apprehension that the NYSE and you have to go a broker, someone who is guaranteeing NASDAQ, having swallowed their major rivals among the these trades, someone handling the electronic plumbing ECNs, and both under stockholder pressure to increase that goes into making these things work.” While these new venues will certainly provide a usefully revenues, might abuse their monopoly position to raise transaction fees. But having tasted homeopathically diluted corrective competitive pressure, NASDAQ and NYSE start transaction costs on the diminutive scale that they have, off on the high ground, and even as they battle between traders are not going to revert easily. Keefe Bruyette & them, the new ECNs will face an uphill struggle to make Woods analyst Richard Herr in a recent report concludes significant games from them. “It’s NYSE and NASDAQ's that “a NYSE-NASDAQ duopoly is unlikely and any pricing game to lose, rather than the challenger's such as PHLX increases by these exchanges will likely be muted.” He and Direct Edge to win,”observes Herr. “We will still have markets of course, but I am not sure that points out that the brokers have explored other channels for their order flow and in anticipation of Regulation NMS they we will have this great cathedral on Wall Street,” concludes have been buying off-the-shelf ECNs ready to get into the Cox. In this brave new electronic world, the sweat and tension of the trading pit are almost certainly on their way to game, and teaming up with the regional exchanges. According to O’Hara “The SEC has given ECNs a new join the dinosaurs. In the end, NYSE and NASDAQ are both lease of life, with the new national market system rules that on the way to becoming ECNs, albeit giant ones, themselves.

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ASIAN EXCHANGES

In a fast moving and consolidating world, ‘remaining relevant’ is uppermost as a strategic imperative among Asian exchanges. As a result, in addition to the deepening of local investible products, Asia’s exchanges have embarked on a flurry of regional and global alliances: all with the same aim in mind—to stay alive and flourish as a regional hub. Not all will succeed. Rekha Menon explains the first moves in a long drawn out game of survival in the 21st century.

LOOKING FOR THE RIGHT FIT South Korean Finance and Economy Minister Han Duck-soo, centrebottom, and representatives from securities industry attend the opening ceremony for the Year 2006 trading at the Korea Exchange in Seoul Monday, Jan. 2, 2006. Photographer: Ahn Young-joon. Photograph supplied by EMPICs/Associated Press, March 2006.

HE THIRD QUARTER of 2006 will see a new commodities derivatives exchange commence operations in Asia. Promoted jointly by the Singapore Exchange (SGX) and the Chicago Board of Trade (CBOT), the Joint Asian Derivatives Exchange (JADE) will run on CBOT’s electronic trading platform, with SGX providing the risk management and clearing infrastructure. The exchange plans to offer products such as a palm oil futures contract priced using Bursa Malaysia’s crude palm oil settlement price. “Given the enormous demand from countries such as India and China, the consumption of commodities in Asia is very high and there is a strong requirement among international investors to trade on Asian commodities,” explains Robert Ray, senior vice president of business development for CBOT. Asia, he says, is an extremely important market for the exchange, which has extended its trading hours specifically to target the Asian market and has reported a “sizeable” volume uptick after it had dedicated a set of traders to the region. While this partnership gives CBOT an opportunity to tap the Asian market, it helps consolidate SGX’s strategy of being the ‘investment gateway to Asia.The CBOT partnership is the latest in a long line of alliances that SGX has forged over the years. Back in 1984, SGX established a mutual offset agreement with the Chicago Mercantile Exchange (CME) which enabled around the clock trading of CME's and SGX's interest rate products. In 2001, SGX in conjunction with the Australian Stock Exchange (ASX) launched ASX Link to support cross border trading between the two exchanges. The service provides seamless end-to-end trading, clearing, and settlement for investors in both markets. More recently, SGX has entered into an agreement with Bursa Malaysia for a similar linkage.“Our strategy of being an investment gateway to Asia has three main aspects, establishing Singapore as a risk management hub, increasing the number of foreign listings, and, partnerships with international exchanges,”states John Gollifer, head of investor relations and corporate communications at SGX. These partnerships and linkages, says Gollifer, bring products from global markets to the region, while in return enabling international players to gain access to the Asian markets. Importantly, Gollifer, points out, the recent JADE joint venture also serves to address some of the operational and risk management concerns created by the fragmented regional marketplaces across Asia. “Unlike some of the regional commodity markets such as Malaysia, Jakarta and

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Singapore which offer local products, JADE aims to be a nearly all Asian exchanges have established a growing pan-Asian commodities exchange bringing together diverse network of alliances with other exchanges as well as with regulators and governments. Last year, the New York Stock products and offering a bigger pool of liquidity,”he adds. Indeed, it is this effort to grow regional presence and Exchange (NYSE), which already has several cooperative international eminence that has led to structural understandings with exchanges in Asia such as the transformation across exchanges in the Asia-Pacific region, Shanghai Stock Exchange and KRX, signed a namely between stock and derivative exchanges within a Memorandum of Understanding (MoU) with the Jakarta country, enabling them to move from an era of monopolies Stock Exchange to work together to further develop their and inefficient systems to one marked by globalisation, marketplaces and assist each other in the maintenance of fair and orderly markets. competition and technological innovation. Collaborations help reduce barriers that would otherwise SGX incidentally, is one of first vertically demutualised and vertically integrated stock and derivative exchanges in limit the growth of individual markets or increase the cost the region. It was created in 1999 through the merger of the of cross-border investment activity, remarks Li-May Chew, Stock Exchange of Singapore (SES) with the Singapore analyst at the Capital Markets Advisory Service at Financial International Monetary Exchange (SIMEX). At the same Insights.The formation of explicit linkages between markets time, the Hong Kong Stock Exchange (HKSE) merged with also leads to significant cost reductions for investors that the Hong Kong Futures Exchange to form the Hong Kong take positions across national boundaries. “Today, this Exchanges and Clearing (HKEx). Recently, at the beginning region’s equity markets comprise approximately 18% of of 2005, the Korea Exchange (KRX) was formed through total world market capitalisation, with Asia/Pacific the combination of the Korea Stock Exchange (KSE), the (excluding Japan) at just 9% of that total. In contrast, US markets comprise 47% of Kosdaq Stock Market and global market capitalisation, the Korea Futures Exchange with Western Europe markets (KOFEX). According to local However, the biggest impediment taking up 27%. market reports, similar to fruitful partnerships and growth of Since Asia/Pacific integration plans are also on individual exchanges in Asia remains exchanges still face the cards for Taiwan, considerable competition Thailand and Australia. The local regulations. Giving the example from their much larger global Taiwan Stock Exchange of Hong Kong and China, Li May counterparts, integration is Corporation (TSEC), the says that even as they transform particularly useful for smaller over-the-counter Gre Tai from two independent entities to a exchanges to build critical Securities Market (GTSM or single country, there are policies mass,” says Li-May. GRETAI), and the Taiwan that intentionally use non-integration Fragmented liquidity pools Futures Exchange (TAIFEX) imply that these exchanges markets have begun as a tactic to approach different have to strive harder to preliminary talks on segments of investors. appeal to institutional merging, but it is forecast to investors and attract global take a long time to achieve. funds. But with exchanges In the meantime, each of the markets will continue to Market capitalisation of equity markets by region combining their strengths and achieving efficiencies not develop new businesses. otherwise possible in silos, One is a special board at the region has better TSEC that will list local prospects to compete on companies in US dollars, to level ground with more try to prevent Taiwanese established global exchanges companies listing on Hong for the same pool of order Kong or other Asian flow, she adds. exchanges. John Gollifer of SGX Consolidation has helped concurs stating that the fuel greater operational Singapore Exchange is efficiencies by allowing users looking to increase its links to connect to a single trading with others in the system rather than to Association of South East several, increased access to Asian Nations (ASEAN) the respective marketplaces region such as Thailand, and created a barrier to Asia ex - Japan 9% Western Europe 27% Indonesia, Malaysia and potential entrants. Japan 9% Others 8% Philippines. The aim is to Additionally, like SGX, US 47% Source: Financial Insights, April 2006.

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exchange in the US. Last year, collaborate and heighten the CME became the first region’s profile to compete Rumours are now circulating that overseas derivatives exchange successfully against the in China no existing exchange will be to open an Asian North-Asian, Indian and allowed to list equity futures. telecommunications hub in Middle Eastern exchanges. Singapore to improve access Notably, a majority of Instead, the CSRC is asking the and reduce connectivity costs these cooperative Shanghai and Shenzhen stock for current and potential arrangements in Asia in exchanges and the Shanghai Futures CME market users in the recent years are focused on Exchange to set up an entirely new region. In addition, the the derivatives market. For exchange for the purpose of Exchange, which has existing instance, New York launching futures contracts this memorandums of Mercantile Exchange understanding with the Tokyo (NYMEX) and the London summer. There are many sceptics on Stock Exchange and KRX, Mercantile Exchange (LME) the ability of the authorities to get recently signed MoUs with have signed a MoU with the the new exchange up and running six leading Chinese Multi Commodity Exchange before SGX launches its announced exchanges to pursue the of India; meanwhile, the A shares futures contract based on potential development of Chicago Board Options futures products relevant to Exchange (CBOE) has a the FTSE Xinhua A50 Index. the Chinese marketplace. MoU with Shenzhen Stock Although experts in Exchange, Eurex with Osaka Stock Exchange and the Sydney Futures Exchange (SFE) general commend the efforts towards greater cooperation, has an MoU with the Hong Kong Exchanges and Clearing they also question the value of all these alliances. “While Ltd. This trend is driven by the fact that derivatives are far well intentioned and interesting, in actuality a majority of more international in nature and it is easier to trade them these deals come to naught and remain only on paper. A cross-border, says Gollifer of SGX. The securities market on few years ago Japanese exchanges signed a number of such the other hand, is more constrained and focused on deals, but nothing much happened beyond information domestic capital formation. More importantly, the sharing,” remarks Neil Katkov, senior analyst at research derivatives focus is a reflection of the immense potential for firm, Celent, who is based in Japan. Given the huge interest growth in the emerging derivatives space in Asia. In recent in China, he says, it is not surprising to see that several of years, Asia Pacific has been contributing to over a third of the recent agreements have been with Chinese exchanges, the world’s exchange traded derivatives volumes, and it is but these Katkov contends will not have much impact on not surprising therefore to see global players eager to the market. “The Chinese capital markets are still unorganised, very volatile and very small. Any participate in the growth. However, it is not all plain sailing. Rumours are now development will happen only in the very long term.” Shuman of the CME agrees that the Chinese capital circulating that in China no existing exchange will be allowed to list equity futures. Instead, the CSRC is asking the markets are still not very well developed, but she says that Shanghai and Shenzhen stock exchanges and the Shanghai the purpose of the MoUs is knowledge sharing which will Futures Exchange to set up an entirely new exchange for the positively impact the Chinese market. “Of course, at purpose of launching futures contracts this summer. There present other Asian markets such as Japan, Singapore and are many sceptics on the ability of the authorities to get the Hong Kong have much more activity, but we believe that new exchange up and running before SGX launches its China is a long term opportunity. We are looking to develop products and announced A shares futures expand interest in contract based on the FTSE The FTSE MV Exchanges Index & FTSE ASEAN 40 Index derivatives in China.” Xinhua A50 Index. 450 While agreeing that “The Asian market is 400 several partnerships going through exciting 350 between exchanges transformations and offers 300 remain restricted to the immense growth potential. 250 200 information sharing, We have long believed in 150 knowledge transfer stage, Asia’s potential and it is a 100 she says that MoUs are an key part of our global 50 important first step, growth strategy,” says Ann signaling the desire to Shuman, managing explore commercial director, corporate FTSE MV Exchanges Index FTSE ASEAN 40 Index opportunities down the development at the CME, road. Not all MoUs remain the largest futures Source: FTSE Group (US Dollar price returns). Data as at March 2006

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on paper however, Shuman states, pointing to a multi-year agreement that CME signed with the China Foreign Exchange Trade System (CFETS) in May this year, two years after signing a memorandum of understanding. Under this agreement, Chinese financial institutions and investors will gain access to electronic trading of CME foreign exchange (FX) and interest rate products. Li-May Chew of Financial Insights suggests that a lack in harmonisation of business strategies often creates barriers to cooperation and the development of meaningful alliances between exchanges. Growth at some exchanges may be driven by revenue and shareholder value, while others could be motivated by the desire to create trading opportunities for members. Alternatively, there could be technological barriers to cooperation. For instance, the SGX-Bursa Malaysia cross-trading linkage, which has been under discussion since 2004, and was initially supposed to go live by the end of 2005 has been repeatedly delayed due to the exchanges upgrading their trading platforms and is now expected to be further delayed beyond 2006. However, the biggest impediment to fruitful partnerships and growth of individual exchanges in Asia remains local regulations. Giving the example of Hong Kong and China, LiMay says that even as they transform from two independent entities to a single country, there are policies that intentionally use non-integration as a tactic to approach different segments of investors. There exist restrictions to limit movements of cross-border funds, prohibit foreign shares listings on mainland China exchanges, and prevent cross listing of shares

in more than one of the three exchanges in the region.“With the Asian financial crisis still fresh in their minds, regulators are reluctant to grant open access to their markets, and government policies such as currency restrictions and high tax levies remain impediments for the exchanges. Having a transparent and laissez-faire market would create a conflict between attracting international businesses and protecting the local market participants,”she says. Many a time regulations can adversely affect the pace of growth for an exchange, as has been experienced by the Australian Stock Exchange which is currently planning to merge with the SFE. Seven years ago, a similar proposal to merge with the SFE was stalled by the Australian Competition and Consumer Commission, on the grounds that it would create barriers to entry, while other regions like Hong Kong and Singapore went ahead with their consolidation plans. Some industry analysts suggest that the current merger discussions are seven years too late and that ASX has lost the potential lead it could have achieved had the regulators been a bit more prescient about the wave of global consolidation and rationalisation of exchanges that has subsequently followed. Regulations are obviously necessary but costly constraints, notes Li-May, “Regulatory harmonisation can lower trading costs and definitely reduce hindrances to exchange expansions. With the rapid changes in capital market landscape, regulators need to acknowledge the requirement to adjust the rules to improve competition and assist their exchanges in remaining relevant.”

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BIG PHARMA Last year only 20 new drugs made it to the FDA, almost half the number from 2004. Industry experts cite the ever-increasing cost of research and development – since 1987, annual expenditures have ballooned from $396m to a record $38bn last year. Additionally, significant advances in technology that have accelerated earlystage research have yet to reach later-stage trials, resulting in a lack of followthrough, say analysts. Photograph: Istockphoto.com, March 2006.

After years of uninterrupted profits and staggering margins, Big Pharma has been forced to revaluate in the wake of stiff generic competition, fewer new products and – believe it or not – governmentbacked pricing discounts. Can branded giants such as Pfizer Inc, which is the world’s largest pharmaceutical retail company, Merck & Co., Inc., and Indianapolis headquartered Eli Lilly & Co., maintain their lofty expectations in a rapidly changing market? Dave Simons reports from Boston.

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T THE TURN of this century the US pharmaceutical industry was seemingly untouchable, piling up quarter upon quarter of staggering profits while issuing a dazzling array of new wonder drugs. At the time, the industry’s sense of well being was well justified. Since the early 1990s, prescription expenditures had nearly tripled, reaching an all-time in 1999 making Big Pharma the most profitable group in the country. It has been a very different story though in the years since. As the US economy weakened, Americans found it increasingly difficult to absorb the escalating costs of basic prescription drugs. Many prescription users began seeking lower-cost alternatives – including generic substitutes and Canadian imports – or simply going without. By 2004, spending on prescription drugs was less than half of its

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Mark Lainer, left, and Robert Gordon, lawyers for two New Jersey men suing Merck & Co., whisper during witness proceedings at Atlantic County Civil Courts Building in Atlantic City, Tuesday, March 7, 2006, in a trial against Merck, the maker of Vioxx. The trial, in its second day, focused on Thomas Cona, 59, of Cherry Hill, and John McDarby, 77, of Park Ridge, who allegedly suffered heart attacks while taking Vioxx and are now among thousands suing the Whitehouse Station-based drug maker in a class action. Photograph: Associated Press/EMPICs: Photographer: Jose F. Moreno. March 2006.

late-1990s peak, as the industry fell to third place in the profitability standings behind the mining and crude oil production sectors. Recent financial reports from the nation’s largest drug manufacturers have underscored the dramatic reversal of fortune. Mainline trends, such as patent expirations, key product withdrawal and a lack of marketable new drugs, have combined to give New York-based Pfizer, the industry’s leading drug maker, its worst showing in years, with 2005 profits falling 7%. Rival Merck & Co., had its own share of woes thanks in part to the discontinuation of its Vioxx product. Merck had announced a voluntary withdrawal of Vioxx (otherwise known as Rofecoxib) from the US and Mainline trends, such as patent expirations, worldwide market due to alleged safety key product withdrawal and a lack of concerns of an increased risk of marketable new drugs, have combined to give cardiovascular events (including heart attack New York-based Pfizer, the industry’s leading and stroke) in patients using Vioxx. Vioxx was a popular prescription COX-2 selective, drug maker, its worst showing in years, with non-steroidal anti-inflammatory drug 2005 profits falling 7%. (NSAID) with widespread application and thereby appeal. It been approved by US Food and Drug Administration (FDA) back in May 1999 for the relief of development – since 1987, annual expenditures have some of the signs and symptoms of osteoarthritis, for the ballooned from $396m to a record $38bn last year. management of acute pain in adults, and for the treatment Additionally, significant advances in technology that have of menstrual symptoms. Vioxx was later approved for the accelerated early-stage research have yet to reach laterrelief of the signs and symptoms of rheumatoid arthritis in stage trials, resulting in a lack of follow-through, say adults and children. In an effort to stem the tide, last year analysts.“Growth in general is driven by new products, and both Merck and Pfizer began slashing jobs and closing there just wasn't anything terribly exciting” during 2004 select facilities, resulting in the elimination of some 25,000 and 2005, notes Miller Tabak & Co. analyst Les Funtleyder. Yet another stumbling block for the industry is the positions, according to recent estimates. Part of the problem, say observers, has been the rapid government’s upgraded Medicare prescription drug reduction in completed clinical trials (the multi-tiered programme, which went into effect on January 1. Under the evaluation process used to determine the safety and new plan, 28% of all prescription drug expenditures will be efficacy of a new drug). From 1997 through 2003 the Medicare-covered, a 14-fold jump from 2005. Who benefits number of new products presented to the FDA for approval the most? Not the drug companies – for sure. They, by all fell by 50%, according to the Tufts Center for the Study of accounts, may only see a fractional increase in revenue over Drug Development. Last year only 20 new drugs made it to the short term. In a significant policy shift, in mid-March the FDA, almost half the number from 2004. Industry the Republican-led Senate, eager to shore up support experts cite the ever-increasing cost of research and among seniors, voted to extend the programme’s

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generic area where it will be extremely dominant, but in the proprietary area, as well,” remarks Frost, “we have always tried to emphasise our efforts in places that we consider immature markets where growth prospects are greater. I think we are going to be very well positioned to have one of the fastest growth rates in the industry.” Generics have not been the only ones out shopping. In March, Merck made an unsolicited play for Germany’s Send in the clones Meanwhile, opportunistic generic drug makers have Schering AG a leading manufacturer of birth-control continued to gain market share at the expense of Big Pharma. therapies. Though Merck’s $18bn cash buyout bid was Companies such as Teva Pharmaceutical Industries hone in on quickly rejected, speculation helped fuel a stock buying the brand-name big sellers. The strategy employed by these spree. “When large-cap players go after mid-cap players, companies often involves waiting for patents to expire, then the impetus is generally to acquire a blockbuster product or mass-producing a marginally altered generic equivalent, to acquire an important technology,”offers Gbola Amusa of without having had to spend too many dimes on research and Sanford C. Bernstein & Co., Inc, an investment research development (R&D). It cuts both ways as consumers as well as unit of Alliance Bernstein. Others, including Pfizer and Johnson & Johnson, could companies benefit. The figures easily benefit from wellare substantial: the result is a Yet another stumbling block for timed acquisitions in an savings to consumers currently effort to stimulate growth, approaching $10bn annually, the industry is the government’s say observers. according to FDA estimates. In upgraded Medicare prescription If there is a potential 2005 generics posted sales in drug programme, which went into blockbuster in the bunch, excess of 20%, powered by the effect on January 1. Under the new many believe it will come un-patenting of drugs such as plan, 28% of all prescription drug from the biotech end of the Fexofenadine (an spectrum. Industry leader antihistamine used to relieve expenditures will be MedicareGenentech Inc. continues to hay fever and allergy covered, a 14-fold jump from 2005. draw a crowd with an array symptoms), Azithromycin of promising new cancer(used to treat certain infections caused by bacteria), and Transdermal Fentanyl (a potent fighting agents such as Avastin, a highly regarded treatment for colorectal cancer, as well as Rituxan, which synthetic opioid sometimes used in cancer treatment). Some $23bn worth of drug sales will be lost to patent is used to combat non-Hodgkin's lymphoma. Though expirations this year, among them Merck's cholesterol drug exceedingly volatile and outrageously overpriced, Zocor and Pfizer's antidepressant Zoloft. Pfizer alone may biotechs such Genentech and rival Amgen Inc. offer the shed upwards of 20% in sales over the next three years due greatest potential for rapid appreciation. Genentech’s to generic competition, says Arthur Wong, an analyst at shares, for instance, doubled in just six months during the Standard & Poor’s. “The growth of generics demonstrates latter half of 2005. Strategic alliances may bode well for Big Pharma going the increasing influence that third-party payers are exerting as they switch patients to lower-cost therapy options,”adds forward. In Corporate Partnering Status Report: Out of a Marc Benoff, practice leader for Pricing and Market Access Need for New Products, BioPharma is Flexible with Deal at IMS, the pharmaceutical industry intelligence specialist. Terms, a specialist sector report written by Robert C. Rech Meanwhile, leading generic firms such as Teva and and William J. Kridel, Jr. of advisory firm Ferghana Watson Pharmaceuticals have buttressed their positions Partners Group, stresses that corporate partnering offers a through various mergers and acquisitions. In March, unique opportunity for companies dealing with R&D Watson paid a cool $1.9bn for generic manufacturer Andrx productivity issues and flattened revenues. “To be Corp., a move that gave Watson third place among US competitive in winning a partnering transaction against generic pharmaceuticals, according to the company. Shares equally incentivised rivals, Big Pharma (and Big Biotech of Tiva have soared nearly 40% following last year’s $7.4bn and even Medium Pharma) has demonstrated its purchase of the Miami-based generic Ivax Corp. In the final willingness to be flexible on economic and operational quarter of 2005, the Israeli company, which currently boasts deal terms, thereby suggesting that creative deal making a market capitalisation approaching $33bn, reported net will continue. With partnering demand expected to income of $304.9m, or 45 cents per share, two cents ahead remain strong, chief executive officers (CEOs) at innovator companies need to consider carefully the of analysts’ expectations. To keep up the momentum, Phillip Frost, Teva’s vice optimal time and context to partner out their drugs. chairman and former Ivax CEO, indicated the company’s Clearly, corporate partnering can offer both a complex willingness to explore possible brand-name opportunities. challenge to overcome, as well as a golden opportunity to “I think ours is a company that will expand not only in the further the evolution of both parties to the transaction.” enrolment period while at the same time giving the government authorisation to negotiate discounted drug prices with the pharmaceuticals. The move represents an ironic twist for the drug industry, which has consistently thrown financial support behind Republican candidates in recent elections.

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Pfizer Chairman and Chief Executive Officer Hank McKinnell speaks to the media after meeting with analysts in New York, Friday Feb. 10, 2006. Pfizer Inc., the world's largest drug maker, forecast earnings for this year that are below current Wall Street projections and said its sales will be essentially flat. Photograph: Associated Press/EMPICs: Photographer: Henny Ray Abrams. March 2006.

Better days ahead? Despite the various challenges facing the pharmaceutical industry, many believe the future still holds promise. Already, cost-cutting initiatives have helped spur a mini comeback, with shares of both Merck and Pfizer ahead 12% during the first three months, and Johnson & Johnson and Eli Lilly showing marginal gains. Deutsche Bank analyst Barbara Ryan sees “little downside to the group.” Attractive earnings multiples and solid dividend yields will enable Big Pharma to ride out pricing and patent issues over the near-term, argues Herman Saftlas, Standard & Poor’s senior equity analyst. “We think pharmaceuticals remain one of the healthiest and widest-margin US industries,” says Saftlas, who recently upgraded the sector to “positive” in a research report. “We see longer-term prospects enhanced by demographic growth in the elderly accounting for about 33% of industry sales, and by a healthy number of products in the pipeline.” In 2005, prescription drug sales rose 5.4% to $251.8bn. Increased volume – mainly the result of higher Medicarebased expenditures – will eventually alleviate some of the downward pricing pressures, say analysts, particularly for higher-margin branded companies. Diana Conmy, corporate director for Market Insights at IMS, sees strong demand continuing through 2006, with revenues rising fractionally – between 1% to 2%. Growth is expected in the 5% range for the remainder of the decade, driven by new product arrivals, recovery from Cox-2 withdrawals and increased Medicare utilisation. “Prescription volumes are

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increasing, demonstrating growing demand for pharmaceutical products at lower prices than the market has sustained in the past,”says Conmy“We expect this trend to continue throughout the year as millions of seniors begin receiving prescription drug coverage under Medicare.” “The Medicare drug benefit is one of the most significant changes in the healthcare industry in decades,” observes Marc Benoff of IMS “While there will be a small near-term benefit to the market, we expect many long-term opportunities, as well as challenges, including downward pressures on pricing and a greater push to generics utilisation.” The affect of the Medicare programme is already being felt on cross-border sales, with prescriptiondrug imports from Canada having dropped by as much as 30% since the beginning of the year. “Importation is no longer as significant a market issue as it was two years ago,”adds Benoff. Responding to last year’s marked decline in FDA approvals, Standard & Poor’s Arthur Wong contends that “the pipelines are not empty,” and points to forthcoming drugs from Pfizer including Sutent, a treatment for stomach and kidney cancer, as well as insomnia fighter Indiplon. Others see even brighter prospects for the generic industry, particularly if there aren’t enough new products to fill the void left by un-patented brand names. Even with thinner margins, generics are well poised to exploit the expanding market wrought by Medicare – not to mention the potentially explosive demand that may be in store as baby boomers move into the twilight of their years.

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FUND ADMINISTRATION

STEPPING UP TO THE PLATE Once dominated by boutique players, the stakes have been raised in the provision of fund administration services for alternative investments. While alternative investments are becoming part of the mainstream, increasing interest in hybrid structures is introducing a greater degree of complexity into service provision. However, fund administration providers have it all to play for and the still healthy fees associated with the service mean that providers are readily upgrading their services. PMORGAN WORLDWIDE SECURITIES Services (WSS) acquired the middle and back office operations of Paloma Partners Management Company, part of a privately-owned investment fund management group, based in Greenwich, CT in February. Following the acquisition, JP Morgan will merge Paloma’s valuations services with its existing JP Morgan Trenaut fund administration business to create JPMorgan Hedge Fund Services. It is a ‘complete solution’according to a JP Morgan spokeswoman for hedge fund operations and administration.The move“allows us to immediately offer our hedge fund clients a high quality option – built on top of a hedge fund-specific platform – for outsourcing their daily operations,” says Liz Nolan, global head of Alternative Investment Services at JP Morgan. “We aim to lead the industry in servicing clients with complex alternative investment strategies, and the next step in the growth of our integrated Alternative Investment Services unit is today’s acquisition of Paloma’s middle and back office operations.” In addition, the JP Morgan and Paloma agreed to enter into a multi-year contract for the bank to provide daily operational services to fund management group. Outsourcing these functions to JPMorgan“allows us to bring even greater focus to the investment side of our business,” says S. Donald Sussman, Paloma’s founder and owner of the company that manages the Paloma funds. The Paloma acquisition also signifies the market launch of JPMorgan’s

Alternative Investment Services business unit, a suite of products that includes services for hedge funds, private equity funds, global derivatives and leveraged loans. The provision of fund administration services for alternative investments is a growing business. In a rapidly evolving segment, the pressure on custodian providers of fund administration services to claim their slice is growing and there has been something of a rush in the marketplace to jump aboard the alternative fund administration bandwagon. For one thing, fees within alternative fund administration are still healthy. Furthermore, there are no signs of this changing as the growing complexity in alternative investment strategies and the growing sophistication of the services required in administering this complexity means that fee structures are rarely challenged.“An increasing number of our hedge fund customers are interested in finding a trusted third party to run their operations for them” says Bhagesh Malde, global business head of JP Morgan Hedge Fund Services. “Not only can this service lower the cost of operations for hedge funds, but it frees managers from operational issues so they can focus on what they do best - making trading decisions.” Alternative fund administrators are riding a rising tide of business, backed by a growing number of hedge funds in the market clambering to outsource. Demand for alternative fund administration support shows no sign of abating. In spite of an investment environment that has been more challenging for hedge funds, the number of funds entering the market shows no signs of abating. Last year, for instance, was another record year for the registration of hedge funds in the Cayman Islands. For the first nine months of 2005, according to the Cayman Islands Monetary Authority (CIMA), more than 960 funds were established, with 361 funds being registered in the third quarter of 2005 alone, a year on year of 15% increase over the same period. Driving this trend is a significant increase in the funds allocated to the alternative investment sector in all jurisdictions, including Japan, Gulf Cooperation Council (GCC) countries, and offshore jurisdictions in the Caribbean, such as Cayman. Annual growth forecasts for the hedge fund industry vary ranging from 10% to 20% over the next three to five years, with hedge fund assets expected to double from $1trn currently under management to $2trn by 2008 or 2009. In addition, given the continued anaemic performance of major global financial indices, the trend looks steady to continue for some time. Overall, the level of assets invested in hedge funds around the world rose in 2005, largely as the result of pension fund assets that were invested into

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alternative investments vehicles, with a special emphasis on Japan. More than $2.5bn in pension funds were invested in alternative vehicles in Japan in the first nine months of 2005, primarily through hedge funds domiciled in the Cayman Islands. Hedge fund managers, it has to be said, are prime candidates for outsourcing. Their lack of infrastructure increases their dependency on a service provider for a complete front to back-office solution.This might also include a trade order management solution as well as the usual analytical tools that support a hedge fund’s trading decisions. A hedge fund taking on illiquid investments also faces a host of more technical issues.They have a shorter operating history and more varied and complex investment programmes which means that hedge fund managers are perhaps more focused on performance than operational issues. Fund administrators have also benefited from the growing transparency in the hedge fund industry. The increase in participation in hedge fund investing (directly or indirectly) by traditional portfolio managers and institutional investors has meant that they are demanding greater transparency around the overall design and effectiveness of the internal control over their hedge fund investments and of the hedge funds they invest in.“These

institutional investment managers are demanding the same level of reporting they have come to expect for their traditional fund investments. They are looking for robust operating environments with high straight through processing (STP) rates, daily NAVs, transfer agency reporting as well as electronic interfaces to all parties. They want access to all this information online with full drill down capability. Citigroup has recognised this convergence and in response has developed its hedge fund administration offering on the same platform as its traditional fund offering. Our hedge fund clients benefit from the institutional operational environment developed for our traditional fund business, which includes all the complex reporting tools, while our traditional clients benefit from receiving similar reporting across all fund types on the same strategic platform that is built to handle complex securities and structures, ” says Fergus Healy, global product head, Alternative Fund Servicing, Citigroup in Dublin. As well, pension fund involvement is also driving new hedge fund structures, including the use of side letters, a type of special arrangement for select fund contributors. Side letters are often needed to allow a pension fund to invest in a hedge fund without violating the terms of the

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pension fund’s charter documents or ERISA provisions. “It is all about quality of service build around a service platform, and having the capability to service all kinds of products,”says Sean Flynn, CEO and managing director, of UBS Fund Services (Cayman) Ltd. Around 50% of our client’s single managers and the other 50% are fund of hedge funds, although it is a customer segment that is growing more rapidly.” The increased complexities associated with administering fund of funds do mean more challenges for service providers, “but they also present an opportunity to expand the product range and gain new business,”says Flynn. Providers should offer real time system interfacing and straight-through processing for traditional and more complex funds. Systems need to be flexible enough to keep pace with the changing nature of investment funds, which, while representing a significant cost in terms of technology, mean providers can deliver efficiently. As well, there has been a notable increase in regulatory pressure on hedge funds, most notably for US registered funds, which has fed into increased business opportunities for the alternative fund administrators, although according to UBS’s Flynn “many funds had already been registered and it has had very little impact on fund administration.” In parallel with the continued growth in the number of hedge funds, is the current resurgence of the private equity markets, as many buyout firms are utilising investment capital commitments from institutional investors that they raised in 2004 and 2005. In tandem, these trends are being driven by the continuing inclusion of emerging markets in large investment portfolios – particularly Asian and the Middle East – and the growing demand for higher returns on the part of institutional and individual investors alike. The globalisation of private equity is also an important trend: in terms of both deals and the range of investors wanting to participate in the resurgence of the sector. HSBC’s Alternative Fund Services launched a customised private equity administration platform, as the year opened, tailored to the specific needs of HSBC’s private equity customers at the tail end of last year that supports comprehensive limited partnership administration. “As an asset class that involves investment in primarily unlisted vehicles with a myriad of configurations, private equity managers require a tailored administration offering. Therefore the platform is based on the specific requirements of the private equity sector,” says Andrew Ritchie (job title) at HSBC. This includes calls, closings, incentive and fee calculations, distributions, profit and loss allocations, financial and management reporting and extensive analytics. The move signals the growing importance that banks such as HSBC and JP Morgan and other custody giants are according the alternative investment market. As well, it also points to the growing emphasis on independent valuations, particularly for assets that are perforce more illiquid than traditional investments in securities. HSBC currently has $10bn in private equity assets under

administration being serviced from six locations globally. “The attraction of investing in a private equity fund is the return over stock market performance. Pension funds in the Nordic region and in the UK tend to allocate a portion of their portfolio to private equity, and at the moment that portion is still small, but potentially there is a much larger universe of limited partners out there.” explains Ritchie. “Historically, our group has focused primarily on the development of platforms for the single manager hedge fund strategies and fund of hedge fund managers,” he adds. “But, I think that we recognised that to differentiate the firm in this marketplace and to provide a true outsource opportunity to this asset class, we had to invest in the right technology.” Private equity funds and hedge funds seem to be moving closer in terms of structure and strategy. Convergence is both hedge fund participation in private equity-style investing and the cohabitation of private equity and hedge funds under one roof. Over the past year, there have been numerous high-profile examples of hedge funds taking on the type of long-term control investing previously the domain of private equity funds. What accounts for this newfound appetite? Some suggest that the foray of hedge funds into private equity stems from an overcrowding of the hedge fund marketplace, where the influx of new managers means fewer pricing inefficiencies and fewer arbitrage opportunities. Others suggest huge inflows of capital into hedge funds means capital can be deployed more diversely, including in illiquid investments. Others point to lengthening lockup periods—a trend that took root even before the US SEC’s new rule requiring hedge fund adviser registration. Longer lockups enable a hedge fund to make more illiquid investments by easing the pressure to provide liquidity immediately to redeeming investors. Convergence is not something that fund administration specialists have necessarily taken to heart. “They are two quite separate investment styles and we treat them separately in two different fund accounting systems,” explains Marc Russell Jones, head of alternative fund administration at Northern Trust, in London. “The accounting principles are, of course, the same, but the ways in which funds are valued are quite different.” Irrespective, notes Russell Jones, “whether you look at hedge funds or private equity, you agree the valuation process up front before the fund is launched.” However, Russell Jones acknowledges that for providers of alternative fund administration flexibility and the ability to administer a broad range of assets will be a prime determinant of future business. “Alternative’ asset classes still only account for a small portion of overall investment portfolios; and that ratio is still in single digits. Ultimately a balanced portfolio will contain a larger proportion of alternative investments, be that property, private equity, hedge funds and more latterly, Islamic investments. Investors are driving the business and they will define the asset class for which we have to provide administrative solutions. We look forward to the new business that brings.”

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NEW HEDGE FUND STRATEGIES

WHICH WAY

ALPHA? Carl Icahn has reinvented himself as a champion of shareholder interests. Icahn has launched campaigns against media conglomerate Time Warner in the US, Fairmont Hotels & Resorts in Canada and KT&G, South Korea's largest tobacco company, among others. Activism ratchets up the risk because hedge funds have to buy strategic stakes that concentrate their portfolio exposure. Photograph supplied by EMPICs, March 2006.

A flat yield curve has killed off most US dollar carry trades, tight credit spreads have curbed fixed income arbitrage opportunities and low equity market volatility has left convertible arbitrage and equity long short players struggling to make a buck. In current market conditions, many strategies that have long underpinned hedge fund performance cannot deliver the returns investors expect. Hedge funds are a resourceful bunch, however and Neil O’Hara explains the evolution of the current investment strategies employed by hedge funds in search of alpha. HEN TRADITIONAL INVESTMENT strategies no longer pay off, nimble hedge fund investors put their money to work elsewhere. Some have donned the mantle of shareholder activists. They take a significant stake in a company and push management to boost shareholder returns through higher dividend payouts, stock buybacks or strategic changes that unlock hidden value. Others have turned to foreign markets, smaller US companies and even private equity. The

diagram Hedge Funds: Estimated strategy composition by assets under management, fourth quarter 2005 shows the breakdown of hedge fund assets by strategy by the end of last year. The quest by hedge funds for excess returns (or alpha) comes at a price: higher risk. As an example, Jim Hedges, president and chief investment officer of LJH Global Investments LLC, an advisory firm based in Naples, Florida, cites hedge funds making private investments in public equities (PIPEs), which he believes are “impossible

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to price, totally illiquid and very difficult to hedge.”Unless an independent third party can price the securities, investors must rely on the manager's valuation, which opens the door to manipulation – or worse. In addition, illiquidity introduces a duration risk: the liquidity a hedge fund offers to its investors may not match the liquidity of the underlying positions. Hedge funds have entered other niche markets in search of yield too. They are active buyers, for example, of equity tranches of collateralised debt obligations (CDOs) that bear the first dollar loss in the event of default. Hedges, who does not expect the economy to slow, believes the play will pay off because robust growth will keep default rates at today’s low levels. Even so, CDOs are a thin market, however. During the market turmoil after the rating agencies downgraded Ford and General Motors to junk status last spring, CDO prices swung far away from theoretical values as panicked investors facing margin calls dumped their positions. The market did recover, but not before some hedge funds suffered severe losses. Hedges is not ready to write off traditional hedge fund strategies, though. Convertible arbitrage has a dismal track record for the past two years, but Hedges thinks the market could rebound when disgruntled investors stop pulling money out. “Everybody has been puking convertible bonds since July of last year, then again in September, and there was a mass of redemptions at the end of 2005,” he says,“These things may start looking cheap in the next six months.” Many top performing hedge funds in 2005 made big bets in Japan and emerging markets such as India and South Korea, according to Ferenc Sanderson, a research analyst at White Plains, the New York-based Lipper HedgeWorld. “What we have seen over the past couple of years is a breakdown in the Asian crisis phobia,” he says, “Many people were burned when that happened.” A rising tide floats all boats, however, and Sanderson questions whether funds that backed Asia last year relied on leveraged market exposure – beta – rather than alpha. It is hard to justify hedge fund fees (typically 2% of assets and 20% of the increase in net asset value) when index funds deliver beta at a fraction of the cost. Shareholder activist hedge funds did well last year both in the US and abroad, Sanderson says. He draws an obvious parallel to the corporate raiders who were the bane of management in the 1980s merger boom. Indeed, Carl Icahn, a well known figure from that era, has reinvented himself as a champion of shareholder interests (please refer to FTSE Global Markets, Issue 10, November/December 2005, page 49). Icahn has launched campaigns against media conglomerate Time Warner in the US, Fairmont Hotels & Resorts in Canada and KT&G, South Korea's largest tobacco company, among others. Activism ratchets up the risk because hedge funds have to buy strategic stakes that concentrate their portfolio exposure. The positions are often unhedged as well, which introduces more directional risk. Sanderson also sees

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 6

Estimated Strategy Composition by AUM Q4 2005

Convertible Arbitrage

3.32%

FI: High Yield

0.79%

Distressed Securities

4.70%

FI: MBS

2.63%

Emerging Markets (Total) 4.03%

Macro

Equity Hedge

Market Timing

30.02%

10.68% 0.37%

Equity Market Neutral

2.23%

Merger Arbitrage

1.40%

Equity Non-Hedge

4.51%

Regulation D

0.24%

Relative Value Arbitrage

11.08%

Event-Driven

13.77%

FI: Arbitrage

2.57%

Sector (Total)

4.77%

FI: Convertable Bonds

0.08%

Short Selling

0.30%

FI: Diversified

1.78%

hedge funds moving into land deals and private equity in emerging markets; indeed Argent Financial has just announced that it has launched the first Dubai-based hedge fund (please see page 26). “As the middle class grows in India outside of the main conurbations there will be demand for new communities and suburbs,” Sanderson adds. Similar pressures are driving up land prices outside Moscow, too – and attracting some hedge funds. To manage the lack of liquidity, hedge funds either launch new vehicles or create “side pockets” that extend lockup periods to match the expected duration of these investments. If hedge funds are finding it hard to make money the old fashioned way, funds of funds, which add another layer of fees, face even greater pressure. “You have to take some exposure,” says Richard Rego, a principal and portfolio manager at Alpha Capital, a fund of funds manager based in Glastonbury, Connecticut. “You can not get return without risk. You either have to take illiquidity risk or volatility risk or both, and probably do it away from the typical markets.” Alpha Capital has increased its exposure to funds that focus on non-US markets in the past year, a move that took Rego on the road. In general, he finds that hedge fund managers in London are more internationally oriented than are their counterparts in the US. Regulators sometimes create opportunities for hedge funds, albeit unintentionally. Rego has looked at funds that invest in German bank loans, which some institutions are selling as they adjust their loan portfolios to comply with

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who have established track Basel II capital records at higher risk levels requirements. The rather than pushing workout period may be as existing managers to long as 12-18 months so change their stripes. the funds impose longer Among event-driven lockups than Alpha hedge funds, Crerend sees Capital offers its own managers reaching for investors. Rego is acutely yield in less liquid aware of the mismatch. securities as they encroach “You can’t do too much of on turf that was once the it,” he says, “You have to exclusive preserve of balance the two.” private equity firms. Hedge Alpha Capital has funds deploy their capital increased its exposure to faster than a typical private commodities through equity firm will commit, funds that trade crack creating an arbitrage spreads in oil or calendar opportunity to finance spreads in oil, natural gas companies in need of and copper. Rego has money, whether for a jacked up volatility by specific transaction or to adding unhedged meet operating commodity exposure as Jim Hedges, president and chief investment officer of LJH Global requirements when well. “Volatility, illiquidity, Investments LLC, an advisory firm based in Naples, Florida, cites conventional credit sources and markets outside the hedge funds making private investments in public equities (PIPEs), dry up. Although some mainstream,” he says, which he believes are “impossible to price, totally illiquid and very managers have long “Everything we do to difficult to hedge.” Photograph supplied by LJH Global Investments participated in direct loans, increase returns is using LLC, March 2006. more hedge funds are one of those levers.” Rego blames poor returns at US hedge funds on the getting into the game, according to Crerend. Managers are also taking on more risk through higher underlying performance of the US economy. GDP growth has been so steady for the past three years it has dragged sector concentration. In some cases, the herd instinct is at down volatility and kept credit defaults low. “US focused work: when sectors like energy and housing made big distressed managers could use a recession,” Rego says – moves in 2005 Crerend believes some managers (although none in EACM's stable) felt they had to go along to stay only half in jest. On average US hedge fund returns have been declining competitive even if they had no related expertise. He also for years, in part because risk free interest rates have worries about funds that increase their non-US exposure: dropped to levels not seen in decades. Bill Crerend, do they have the resources to cope with multiple currencies president of EACM Advisors, a fund of funds manager and settlement systems? “The key is to make sure you are based in Norwalk, Connecticut, notes that a margin of not outreaching the quality of the available manager pool,” about 400 basis points (bps) over LIBOR seems to satisfy he says. He is sceptical of some newer players in Asia that institutional needs – a hurdle his firm has managed to clear have not demonstrated their ability to perform “in an for the past five years. Looking forward, he believes hedge environment that is not an upward hockey stick.” EACM believes volatility will head higher and credit funds will earn higher absolute returns now that short term interest rates have ticked up although he does not expect spreads will expand. To take advantage of those moves, the firm has placed money with managers positioned to the spread over LIBOR to widen. Crerend says hedge fund managers have been pressed to benefit. Timing is critical, however, because the underlying take on more risk. Investors and some funds of funds – Chinese (reverse) arbitrage trades – long senior and short though not EACM – have suggested that funds with high subordinated corporate bonds, for example – have a Sharpe ratios (a measure of return relative to the risk negative cost of carry. Disappointing returns are driving funds of funds away assumed) should accept more volatility to boost absolute returns. That could entail greater concentration in position from merger arbitrage and relative value trades, according size, more leverage, wider stop-loss limits or modifying a to Jeff Gabrione, a research consultant at Mercer fund’s risk discipline.“We are not really proponents of that Investment Consulting. He sees money flowing to activist approach,” Crerend says,“We think if you want to take on managers who typically have a longer lockup period, a more risk with the object of increasing return you ought to more concentrated book and tend to be more directional change the manager mix.” For investors seeking higher than traditional hedge funds. US funds of funds are doing returns, EACM has shifted its portfolio toward managers more due diligence on European and Japanese hedge

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ar -0

funds, too, Gabrione says. It seems Alpha Capital's Rego is the hedge fund industry more than tight spreads over the risk free interest rate. After all, pension funds have an not the only manager racking up frequent flier miles. Like other observers, Gabrione sees hedge funds getting actuarial nut to crack: they need to make the assumed into direct loans and PIPEs, flirting around the fringes of discount rate on future liabilities regardless of where private equity but not yet making core investments. He interest rates are.“If you are not meeting that 8% absolute also finds conventional long only managers are creeping return year after year how do you fund your obligations to into some traditional hedge fund strategies.“We are seeing your plan participants? It makes it harder to sell if you are a lot of the benchmark strategy managers who run a very not delivering that,”Gabrione says. As hedge funds pursue alpha in ever more exotic niches, tight risk controlled approach going short a fixed investors who think they percentage of their bought into traditional portfolios. They run these In search of Alpha – FTSE Hedge Index Series 250 strategies like equity long 130% long, 30% short short or convertible portfolios,”Gabrione says. 200 arbitrage may be in for a In a switch that may shock, according to LJH’s come back to haunt them, 150 Hedges. They may Gabrione believes most discover equity managers funds of funds have given 100 now have concentrated up on dedicated activist positions or heavy convertible arbitrage, 50 exposure to small preferring to get exposure capitalisation stocks. through multi-strategy Convertible arbitrage managers who can take FTSE Hedge CTA/Managed Futures funds have gone into advantage of opportunities Equity Hedge Event Driven illiquid PIPEs, while fixed as they arise. The concept Source: FTSE Group. Data as at March 2006 income players have may make sense in principle, but Gabrione points out that fund of funds risk loaded up on emerging markets bonds – a bet that often undermining their raison d'etre. “At what point do you has a strong directional element tied to commodity prices. have so much exposure to multi-strategy managers that “If investors knew what was really going on inside their you put yourself out of business?” he asks, “Why do you hedge fund portfolios they would never stop throwing exist?” Gabrione believes low absolute returns are hurting up,”Hedges says.

KEY FEATURES OF A FUND OF HEDGE FUNDS

here are reportedly 14 different hedge fund strategies and market specialists say it is important to understand the differences between them because all hedge funds are not the same. An easy way to increase exposure to a variety of hedge fund styles is to invest in a fund of hedge funds. Some hedge fund strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds. A successful fund of funds recognises these differences and blends various strategies and asset classes together to create more stable long-term investment returns than any of the individual funds. A fund of hedge funds manages a diversified portfolio of generally un-correlated hedge funds, that may be diversified by geography, sector or investment approach. Generally a fund of hedge fund will try to deliver more consistent returns and in consequence is an increasingly preferred investment of choice for pension funds, endowments and high net worth families as they provide access to a broad range of

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 6

investment styles, strategies and hedge fund managers for one easy-to-administer investment. The benefits of a fund of hedge fund include: • Provision of an investment portfolio with lower levels of risk that can deliver returns uncorrelated with the performance of the stock market. • More stable returns under most market conditions due to the fund-of-fund manager’s ability and understanding of the various hedge strategies. • Reduced individual fund and manager risk. • Elimination of the need for time-consuming due diligence otherwise required for making hedge fund investment decisions. • Easier administration of widely diversified investments across a large variety of hedge funds. • Access to a broader spectrum of leading hedge funds that may otherwise be unavailable due to high minimum investment requirements. • Improved access to a wide variety of hedge fund strategies, managed by many of the world’s premier investment professionals, for a relatively modest investment.

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The FT Sustainable Banking Awards, created in association with the International Finance Corporation, have surpassed expectations, drawing 90 entries from 48 institutions around the world. The awards, dedicated to recognising banks that have shown leadership and innovation in integrating social and environmental objectives into their operations, will be presented at a special dinner in London on June 12. To coincide with this event, a Special Report on Sustainable Banking will appear in the FT. Entries: Bank of the Year:

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Emerging Markets Bank of the Year: ABN Amro Real, Brazil ACBA Leasing, Armenia Banco Bradesco, Brazil Banco del Desarrollo, Chile Banco do Brasil Banco Interfin, Costa Rica Banco Itau, Brazil Bankinvest, Denmark Charity Bank, UK Eco Enterprises Fund, the Nature Conservancy, US Financiera Compartamos, Mexico HSBC, Mexico ICICI Bank, India Nedbank, South Africa Planters Bank, Philippines Priorbank, Belarus Standard Chartered, UK TBC Bank, Georgia Yes Bank, India

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To register your interest in attending the dinner, please contact Serene Lim at serene.lim@ft.com. For infomation on advertising in the Special Report, please contact Dominic Perkins at dominic.perkins@ft.com. For more information about the awards, go to: www.ft.com/sustainablebanking

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Fine tuning the specialist approach

NE FUND OF funds has found the key to success in specialisation. From the outset, Landmark Value Investments has taken a different tack. Many funds of hedge funds strive for low volatility. However, this is a strategy Landmark’s founder, Ahmed Fattouh, believes can result in excessive diversification. A typical portfolio may have 30 to 40 managers who each have between 30 to 40 underlying positions.“You start to look and smell a lot like an index,”Fattouh says,“That is why many of them have a hard time outperforming the indices.” Landmark eschews conventional relative value and arbitrage hedge fund strategies in favour of managers who follow the classic Graham and Dodd principle of value investing: buy $1 worth of assets for between 60 and 70 cents. Therefore, the firm looks for managers that analyse companies as if they were private equity investors, poring over the operations to understand how they generate cash flow, studying the balance sheet, estimating the liquidation value and what the company would be worth to a buyer. The private equity approach can also flag short candidates: companies whose cash flow cannot service their debt or where Landmark’s managers suspect accounting irregularities or fraud. The strategy does have a long bias, but the higher volatility of a directional bet does not worry Fattouh.“We are trying to create an equity return product,” he says, “We are not managing it to minimise volatility per se.” Landmark grew out of Baron Advisors, a merger and acquisition advisory firm Fattouh set up in 1998. Fattouh and two partners, Sebastian Stubbe and John Salib, applied their experience in mergers and acquisitions to advising private companies valued at $200m or less. As the business evolved, they saw an opportunity to develop an asset management product for clients who sold their companies and needed to invest the proceeds. Landmark struck a rich vein. Assets under management grew so fast that in 2003 the partners decided to drop their merger advisory work and concentrate on the hedge fund business. At about the same time, they sold a 10% interest in the management company to the Barry Diller and von Furstenberg family office. “It gave us deeper working capital at a point when we had fewer assets under management than would justify the infrastructure we built The tight credit spreads, low volatility and flat yield curve that have depressed US at that time,”Fattouh explains. funds of funds returns have not affected Landmark's value niche. Fattouh believes

HEDGE FUND OF FUND PROFILE: LANDMARK

Frustrated by fund of funds returns that do no more than match hedge fund indices, investors are cutting back allocations to diversified funds of funds. The money is not leaving the hedge fund industry, however. It is flowing to individual hedge funds – and specialised funds of funds, such as Landmark. Neil O’Hara talks to Landmark’s founder, Ahmed Fattouh about its evolving investment strategy.

more funds of funds will specialise as the industry evolves. Photograph supplied by Istockphotos.com, March 2006.

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 6

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valuing companies, so we Landmark likes can do that analysis,” managers to have the Fattouh says, “We are not courage of their second guessing the convictions. That is why manager, but we do speak Fattouh prefers portfolio the same language and can concentration at the question their manager level – a typical assumptions.” manager has no more Landmark’s rigorous due than 10 core names that diligence underpins its represent about two thirds preference for managers of portfolio assets. who favour those Landmark allocates to companies which shareholder activist funds, mainstream institutions too, which often have and Wall Street firms even fewer core positions. neglect. In other words, “As a fund of funds, we small and mid-cap names can increase the number which are more likely to be of managers if we want a mis-priced than heavily higher level of Landmark's founder, Ahmed Fattouh. Some foreign markets are less scrutinised large caps. diversification,” Fattouh efficient than the US, but Fattouh also finds more international Landmark gravitates points out. managers are adopting the value investing style Landmark favours. toward smaller managers Today, Landmark has 11 Already in 2006, Fattouh has travelled to Europe, the Middle East, too, because large funds staff and manages about Asia and Latin America to visit managers and potential investors. need elephantine $350m, of which the lion's Photograph supplied by Landmark Investments, March 2006. opportunities. “If a $3bn share is in its flagship hedge fund finds an value fund of funds. The firm runs two additional funds of funds that carve out opportunity in a $200m market cap company, it will pass. portions of the core portfolio. One is devoted to Buying $5m or $10m worth is not going to move the needle shareholder activist managers, while the other invests only at all,”Fattouh explains. The firm does not use leverage to enhance returns at the in managers who trade in international markets. Although deep value opportunities may arise in any market, equities fund of funds level, nor do most of its underlying make up more than 90% of the underlying positions. managers. Value investors make their money by buying Distressed securities and special situations in fixed income assets at a discount, a margin of safety that cushions potential losses – in effect, a partial hedge. “We would account for the rest. Landmark runs a hedge fund of its own, too. Fattouh rather be in net long deep value situations than market notes that for many managers in his stable a handful of neutral in a bunch of growth names where the business positions drive returns, while third party managers may have can change dramatically overnight,”Fattouh says,“It is not good ideas smothered in portfolios that are too diversified about leveraging some micro-inefficiency the way it is in for Landmark’s taste. The portfolio of Landmark’s hedge the arbitrage and relative value game.” The tight credit spreads, low volatility and flat yield curve fund comprises the best ideas the three principals come across while they are reviewing hedge fund managers – that have depressed US funds of funds returns have not affected Landmark's value niche. Fattouh believes more whether or not the firm invests with those managers. Geographically, the flagship portfolio remains skewed funds of funds will specialise as the industry evolves. As toward the United States, although Landmark’s institutions switch from funds of funds to direct investment international exposure is rising. Some foreign markets are in hedge funds, asset aggregation alone will not add less efficient than the US, but Fattouh also finds more enough value to support fund of funds fees, which are international managers are adopting the value investing usually 1% of assets and 10% of net gains in addition to the style Landmark favours. Already in 2006, Fattouh has underlying hedge fund fees. Landmark expects to benefit from a shift toward coretravelled to Europe, the Middle East, Asia and Latin satellite strategies in alternative assets. Frustrated by fund America to visit managers and potential investors. Fattouh and his partners delve into the portfolios of each of funds returns that do no more than match hedge fund manager to pinpoint the key positions that will influence indices, investors are cutting back allocations to diversified performance. That way, if results fall short of expectations, funds of funds.“What’s the point of paying a professional they can determine whether the manager's premise was manager all sorts of fees to put together that portfolio for flawed. If the opportunity remains intact and the market you?” Fattouh asks. The money is not leaving the hedge price has merely swung further from intrinsic value, fund industry, however. It is flowing to individual hedge Landmark will up the ante. “We have spent our careers funds – and specialised funds of funds, such as Landmark.

M AY / J U N E 2 0 0 6 • F T S E G L O B A L M A R K E T S

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Company Name

Page

ABN AMRO 56 ABN AMRO Asset Management 43 Abu Dhabi Commercial Bank 28 Abu Dhabi Securities Market 24 Aerojet-General 46 Agency for Mortgage Lending 31 Agricultural Bank of Greece (ATA) 41 Ahli United Bank (AUB) 21,22, 29, 30 Al Rayyan Bank 30 Alfa-bank 33 Allied Irish Bank 60 Alpha Bank 36,37 Alpha Capital 80 Alpha Trust 36 ALROSA Co Ltd 33 AltX 16 AME Info 18 Amgen Inc 72 Andrx Corp 72 Archipelago 63 Argent Financial 80 Association of Southeast Asian Nations (ASEAN) 68 Athens Stock Exchange (ASE) 41 Australian Competition and Consumer Commission 69 Australian Stock Exchange (ASX) 67 AVK Analytics 31 Bahrain Monetary Agency 29 Bahrain Petroleum Company (BapCo) 28 Bahrain Stock Exchange 29 Balkontore Investments Ltd 35 Banca Commerciale Romana (BCR) 36 Bank Austria 60 Bank Centrocredit 31 Bank Leu 56 Bank of Bahrain and Kuwait (BBK) 29 Bank of Kuwait and the Middle East 30 Bank of New York 60 Bank Zenit 31 Banque Nationale de Paris 56 Banque Paribas 56 Baron Advisors 83 BASF 8 Bedfordshire County Council Pension Fund 65 Bharat Petroleum Corporation Ltd 6 BNP Paribas 17, 28, 41, 60 Boeing 46 Boston Exchange 64 Bovespa 43 Brazil Reality 43 BT Fund 65 Bursa Malaysia 67 Business Times (UAE) 17 CACEIS Investor Services 56 Cairo & Alexandra Stock Exchange 24 CalPERS 12 Casa de Economii si Consemnatiuni (CEC) 38 Celent 68 Chicago Board of Trade (CBOT) 67 Chicago Board Options Exchange (CBOE) 68 Chicago Mercantile Exchange (CME) 9, 67 China Foreign Exchange Trade System (CFETS) 69 China National Chemical Corp (ChemChina) 8 China National Oil Corporation (CNOOC) 8 China National Petrochemical Corporation (Sinopec) 9 China National Petroleum Corporation (CNPC) 9 Chrometco 16 Citigroup 56

Company Name

Page

Claymore Investments 12 Credit Agricole 41, 56 Credit Suisse 38, 56 Cyprus Stock Exchange 41 Cyrela 43 Detusche Bank 60, 72 Deutsche Borse 24 DPN Mellon 75 Dresdner Bank 56 Dubai International Financial Centre (DIFC) 22 Dubai International Financial Exchange (DIFX) 22 Dubai Islamic Bank 22, 28 EACM Advisors 81 EADS 46 eeperlino Trading Limited 35 EFG Eurobank 36,40 Eli Lilly 72 EM Applications 10 Emirates Securities and Commodities Authority (ESCA) 22 Equilend 7 Erste Bank 36 Eurex 68 Euroclear 61 European Commission 60 European Union (EU) 36 Evrofinance Mosnarbank 31 Export Import Bank of the United States 28 Fairmont Hotels and Resorts 80 Ferghana Partners Group 72 FIBA Holding 38 Fidelity Institutional 26 Financial Insights 68 Finansbank 38 Fitch Ratings 6 Ford 80 Fortis Investments 26 FTSE Group 12 Fund Forum 26 Gafisa 43 GAIM 32 Gap 43 Garanti Bank 59 Gartmore 43 Gazprom 33 Genentech Inc 72 General Dynamics 47 General Motors 80 General Organisation for Grain Silos and Flourmills 24 Globalco Holding 35 Gol 43 Goldman Sachs 38, 65 Grendene 43 Gresham Investment Management 65 Groupe Caisse D'Epargne 56 Gulf Finance House 30 Gulf International Bank 28 Guta Bank 31 Hermes Asset Management 65 Hong Kong Futures Exchange 67 Hong Kong Exchanges and Clearing Ltd (HKEx) 67 Hong Kong Stock Exchange (HKSe) 67 HSBC 18, 28, 56, 60 HVB 60 IMS 72 Indian Oil Corporation 6 ING Bank 60 IRKUT Corporation 33 Ivax 72 J Sainsbury Pension Scheme 65 Jakarta Stock Exchange 68

FTSE GLOBAL MARKETS â&#x20AC;˘ MARCH/APRIL 2006

Company Name

Page

Janitar Investments 35 Johanesburg Stock Exchange (JSE Ltd) 14 Johnson & Johnson 72 Joint Asian Derivatives Exchange (JADE) 67 JP Morgan 65 Korea Exchange (KRX) 67 Korea Futures Exchange (KOFEX) 67 Korea Stock Exchange (KSE) 67 Kosdaq Stock Market 67 KT&G 80 Kuibyshevazot 31 Kuwait Finance House 28 Kuwait Stock Exchange 20 Landmark Value Investments 83 Lehman Brothers 65 Lipper HedgeWorld 80 Liquidity Management Centre (LMC) 29 Litton Industries 46 LJH Global Investments LLC 78 Lockheed Martin 49 Logicon 46 London Mercantile Exchange (LME) 68 LPFA 65 Magnitogorsk Metal Plant (MMK) 33 Menatep 31 Mercer Investment Consulting 81 Merck & Co 71 Merrill Lynch Investment Managers 65 Miller Tabak & Co 71 Ministry of Commerce (China) (MOFCOM) 8 Ministry of Economy and Finance (Greece) 36 Ministry of Economy and Planning (UAE) 22 Miranda Mineral Holdings 16 Morgan Stanley 38 Moscow Interbank Currency Exchange 33 Multi-Commodity Exchange of India 68 NASDAQ 62 Natexis Banque Populaires 61 National African Federated Chamber of Commerce 16 National Bank of Abu Dhabi (NBAD) 27 National Bank of Bahrain (NBB) 29 National Bank of Dubai (NBD) 25 National Bank of Greece (NBG) 38 National Bank of Kuwait (NBK) 17 National Commercial Bank 17 Natura 43 New Partnership for African Development (NEPAD) 16 New York Mercantile Exchange (NYMEX) 68 New York Stock Exchange (NYSE) 62 Newport News Shipbuilding 46 Nomura Asset Management 12 Northern Trust 60 Northrop Grumman 45 Novo Mercado (Brazil) 43 Oando 16 OAO Razgulay Group 33 Organisation of African Unity 16 Organisation of Petroleum Exporting Countries (OPEC) 25 Osaka Stock Exchange 68 OTOE 41 Pacific Exchange 64 Pao de Acucar 43 PetroChina 8 Pfizer 71 Philadelphia Stock Exchange (PHLX) 64 PIMCO 12, 65 Piraeus Bank 36

Company Name

Page

Postal Savings Bank 41 Qatar Fianncial Centre Regulatory Authority 30 Qatar Gas II 25 Qatar Islamic Bank 30 Qatar National Bank (QNB) 19,26 QNB Al Islamic 29 Ras Laffan 25 RBC Dexia Investor Services 53, 60 Reliance Industries 6 Renner 43 Research Affiliates 12 Rosbank 33 Rosneft 35 Rossi Residential 43 Russian Agricultural Bank 33 Ryan Aeronautical 46 Samba Financial Group 24 Sandford C Bernstein & Co 72 Saudi Arabian Airlines 24 Saudi Basic Industries Corporation (SABIC) 9 Sberbank 31 Schering AG 72 Servizi Assicurativi del Credito al'Esportazione (SACE) 28 Shanghai Stock Exchange 68 Shell Chemicals Ltd 6 Shenzhen Stock Exchange 68 Singapore Exchange (SGX) 67 Singapore International Monetary Exchange (SIMEX) 67 Sinopec 8 Societe Generale Securities Services 41 Standard & Poor's 38, 72 Standard Chartered 18,26 State Street Global Advisors 65 Stifel Nicolaus 49 Stock Exchange of Singapore 67 Sydney Futures Exchange (SFE) 68 Taiwan Futures Exchange (TAIFEX) 69 TAM 43 Tawadul 18 Teva 72 The Gre Tai Securities Market (GTSM or GRETAI) 69 The Taiwan Stock Exchange Corporation (TSEC) 69 Threadneedle Investments 43 Time Warner 80 Tokyo Stock Exchange 68 Trade Tech 34 TRW 46 Turkish Banking Regulator (BRSA) 39 Tyumen Oil Company 33 UAE Central Bank 22 UBS 65 Unified Energy System 33 United International Bank (UIB) 29 US Air Force 46 US Congress 49 US Department of Energy 47 US Food and Drug Administration 71 US Navy 49 US Securities and Exchange Commission (SEC) 64 Value Line 46 Varig 43 Vnescheconombank (VEB) 35 Vneshtorgbank 33 Wal-Mart 43 Watson Pharmaceuticals 72 Watson Wyatt 65 Wescoal 16 Wesize Platinum 16 Westinghouse 46

COMPANIES IN THIS ISSUE

FTSE Global Markets Company Directory

Au st F FT TS rali SE E A a A C B e us lg tria iu FT m/ AC SE Lu x C FT A SE ana C De da A FT nm C SE ar k Fi AC n FT l S an FT E F d A SE ran C Ge ce FT SE FT rma AC ny Ho SE AC Gr ng Ko eec e ng FT Ch AC SE in Ir a A e C FT land SE AC I ta FT FT ly SE SE A FT Ne Jap C SE th an e Ne rla AC nd w s Z FT eala AC SE nd A FT No SE rw C Po ay FT rtu AC SE g Si ng al A a C FT por e S FT E S AC FT SE pai FT SE Sw n A SE Sw ed C Un itz en A ite erl C a d Ki nd ng AC d FT om SE A US C A AC

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MARKET REPORTS BY FTSE RESEARCH

FT SE

MARKET REPORTS 13.qxd Page 86

FTSE Global Equity Index Series – Global Q1 2006

30 December 2005 to 31 March 2006

FTSE All Cap Regional Indices (USD) 130

FTSE Global AC

120

FTSE Developed Europe AC

FTSE Japan AC

110

FTSE Asia Pacific AC ex Japan

100

FTSE Middle East & Africa AC

FTSE Emerging Europe AC

FTSE Latin America AC

FTSE North America AC

FTSE All Cap (AC) Regional Indices Capital Returns YTD (USD) 20

% 10

FTSE All-Emerging Country All Cap Indices – Capital Returns YTD

Dollar Value

Local Currency Value

-5

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

M AY / J U N E 2 0 0 6 • F T S E G L O B A L M A R K E T S

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FTSE All-Emerging Country Indices Capital Returns YTD 50 40 30

% 20

Dollar Value

Local Currency Value

FT SE

Ar ge FT ntin SE a B AC FT raz SE i l A F T Ch C ile S FT FTS E C A hi C SE E na Cz Col ec om AC h b Re ia A p FT ub C li S FT E E c A SE gy C Hu pt ng AC F a FT TSE ry SE In AC In dia do A FT nes C SE ia A C FT Isr S a FT E K el A SE or C M ea FT alay AC SE si FT M a A C SE ex ico FT Mor AC SE oc Pa co AC ki s FT FT tan SE SE AC Ph Per u i li FT ppin AC SE es AC Po F FT TS lan SE E R d A S o us C sia ut AC FT h A SE fric FT Ta a A i SE w C Th an FT ail AC SE an Tu d A rk C ey AC

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FTSE Global All Cap Sector Indices – Capital Returns YTD (USD) 20

Capital

Total Return 5

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Stock Performance Best Performing FTSE All-World Index Stocks (USD/%) Shenzhen Investment (Red Chip) 145.2 Great Wall Motor Company (H) 101.8 Shanghai Zhenhua Port Machinery (B) 94.9 91.1 Guangzhou Inv Chaoda Modern Agriculture (Holdings) 89.0

Overall Index Return FTSE Global AC Index FTSE Global LC Index FTSE Global MC Index FTSE Global SC Index FTSE All-World Index FTSE Asia Pacific AC ex Japan Index FTSE Latin America AC Index FTSE All Emerging Europe AC Index FTSE Developed Europe AC Index FTSE Middle East & Africa AC Index FTSE North Americas AC Index FTSE Japan AC Index

Worst Performing FTSE All-World Index Stocks (USD/%) Yukos -65.2 CBS -63.2 Invoice Inc -39.0 -38.7 AWB Lear Corp -37.7

No. of Consts

Value

3 M (%)

7,969 1,194 1,746 5,029 2,940 1,818 196 103 1,544 197 2,760 1,351

359.70 342.31 495.51 451.02 213.47 434.59 782.55 765.33 389.81 616.23 318.91 418.79

7.4 5.9 8.9 12.0 6.7 7.9 15.2 18.7 11.3 13.2 5.0 5.8

6 M (%) 12 M (%) Actual DIv Yld (%)

10.7 8.8 13.8 15.7 10.0 12.4 20.2 25.0 13.3 24.9 6.9 18.6

19.2 15.7 25.4 26.3 18.2 25.4 65.1 72.8 19.5 53.7 13.6 34.4

1.92 2.07 1.61 1.45 1.98 2.72 3.04 1.54 2.42 2.38 1.68 0.83

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 6

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MARKET REPORTS BY FTSE RESEARCH

MARKET REPORTS 13.qxd Page 88

FTSE Global Equity Index Series – Developed ex US Q1 2006

30 December 2005 to 31 March 2006

115 115

FTSE Developed Regional Indices – Large/Mid Cap (USD) FTSE Developed (LC/MC)

110 110

FTSE Developed Europe (LC/MC)

FTSE Developed Asia Pacific (LC/MC)

105 105

FTSE All-Emerging (LC/MC)

100 100

FTSE Developed ex US (LC/MC)

FTSE US (LC/MC)

FTSE Developed Asia Pacific ex Japan (LC/MC)

FTSE Developed Regional Indices – Capital Returns YTD (USD) 14

FTSE Developed ex US Sector Indices (LC/MC) – Capital Returns YTD (USD)

Capital

Total Return

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

M AY / J U N E 2 0 0 6 • F T S E G L O B A L M A R K E T S

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Stock Performance Best Performing FTSE Developed ex US Index Stocks (USD/%) Shenzhen Investment (Red Chip) 145.2 Guangzhou Inv 91.1 Chaoda Modern Agriculture (Holdings) 89.0 66.8 Lonmin Natexis Banques Populaires 62.5

Overall Index Return

Worst Performing FTSE Developed ex US Index Stocks (USD/%) Invoice Inc -39.0 AWB -38.7 Neptune Orient Lines -33.3 Wheelock Properties (S) -32.6 Softbank -30.7

No. of Consts

Value

3 M (%)

1,343 717 2,060 880 505 772 286 3,753 561 1,746 5,029

239.52 537.44 206.62 385.06 232.78 233.91 345.44 404.84 373.18 486.43 528.44

9.0 3.8 6.3 11.7 10.6 6.3 6.4 9.5 8.5 11.7 12.7

FTSE Developed ex US Index (LC/MC) FTSE USA Index (LC/MC) FTSE Developed Index (LC/MC) FTSE All-Emerging Index (LC/MC) FTSE Developed Europe Index (LC/MC) FTSE Developed Asia Pacific Index (LC/MC) FTSE Developed Asia Pacific ex Japan Index (LC/MC) FTSE Developed ex US AC Index FTSE Developed ex US LC Index FTSE Developed ex US MC Index FTSE Developed ex US SC Index

6 M (%) 12 M (%) Actual Div Yld (%)

12.9 5.8 9.2 20.6 12.5 14.5 5.1 13.5 11.8 18.3 18.0

22.5 11.0 16.4 45.6 18.3 30.0 18.8 23.2 21.1 29.1 29.0

2.13 1.77 1.95 2.40 2.50 1.50 3.29 2.07 2.22 1.61 1.45

FTSE Global Equity Index Series – Asia Pacific Q1 2006 30 December 2005 to 31 March 2006

FTSE Asia Pacific All-Cap (AC) Regional Indices (USD) 110

FTSE Global AC FTSE Developed Asia Pacific (LC/MC) FTSE Developed Asia Pacific ex Japan (LC/MC)

105

FTSE Asia Pacific (LC/MC) FTSE All-Emerging Asia Pacific AC

100

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Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 6

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17:22

Page 90

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MARKET REPORTS BY FTSE RESEARCH

FTSE Asia Pacific Regional Sector Indices – Capital Returns YTD (USD)

Stock Performance Best Performing FTSE Asia Pacific Index Stocks (USD/%) Shenzhen Investment (Red Chip) 145.2 Great Wall Motor Company (H) 101.8 Shanghai Zhenhua Port Machinery (B) 94.9 Guangzhou Inv 91.1 89.0 Chaoda Modern Agriculture (Holdings)

Worst Performing FTSE Asia Pacific Index Stocks (USD/%) Yukos -65.2 CBS -63.2 Invoice Inc -39.0 AWB -38.7 Lear Corp -37.7

Overall Index Return FTSE Global AC Index FTSE Asia Pacific AC Index FTSE Asia Pacific Index (LC/MC) FTSE Asia Pacific LC Index FTSE Asia Pacific MC Index FTSE Asia Pacific SC Index FTSE Developed Asia Pacific ex Japan Index (LC/MC) FTSE Developed Asia Pacific Index (LC/MC) FTSE All-Emerging Asia Pacific Index (LC/MC) FTSE Japan Index (LC/MC)

No. of Consts

Value

3 M (%)

7969 3169 1300 522 778 1869 286 772 528 486

359.70 424.85 240.39 404.69 478.23 496.31 345.44 233.91 268.71 155.48

7.4 6.7 6.8 7.1 5.7 5.9 6.4 6.3 8.6 6.3

6 M (%) 12 M (%) Actual DIv Yld (%)

10.7 15.8 15.4 14.8 18.5 18.7 5.1 14.5 18.9 18.4

19.2 30.3 30.4 30.1 32.1 29.4 18.8 30.0 32.0 34.7

1.92 1.66 1.68 1.71 1.51 1.55 3.29 1.50 2.29 0.83

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

M AY / J U N E 2 0 0 6 2 0 0 6 • F T S E G L O B A L M A R K E T S

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MARKET REPORTS 13.qxd Page 91

FTSE Global Equity Index Series – Europe Q1 2006

30 December 2005 to 31 March 2006

FTSE European Regional Indices Performance (EUR)

108

112

FTSE Global AC (EUR)

110

FTSE Developed Europe ex UK LC/MC (EUR)

106

FTSEurofirst 300 (EUR)

104

FTSE Developed Europe AC (EUR)

102

FTSEurofirst 100 (EUR)

100

FTSE Eurobloc AC (EUR)

FTSEurofirst 80 (EUR)

FTSE Europe All Cap Indices – Capital Return YTD (EUR) 16

% 10

FTSE Developed Europe All Cap Sector Indices – Capital Returns YTD (EUR)

Capital

Total Return

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

MARKET REPORTS 13.qxd

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MARKET REPORTS BY FTSE RESEARCH

Stock Performance Best Performing FTSE Developed Europe Index Stocks (EUR/%) Lonmin 62.6 58.4 Natexis Banques Populaires 55.3 Arcelor Euronext 54.7 Banco BPI 52.3

Overall Index Return (EUR)

Worst Performing FTSE Developed Europe Index Stocks (EUR/%) Rank Group -27.4 Boots Group -21.2 A P Moller - Maersk B -18.9 A P Moller - Maersk A -17.3 BBA Group -15.8

No. of Consts

Value

3 M (%)

7969 1647 236 334 1077 1544 103 783 1084 300 80 100

359.70 375.22 404.92 480.08 511.71 370.92 728.24 392.68 396.81 1370.43 4843.90 4417.11

7.4 8.7 6.7 12.6 14.5 8.5 15.7 10.9 10.2 7.4 8.5 5.7

FTSE Global AC Index FTSE Europe AC Index FTSE Europe LC Index FTSE Europe MC Index FTSE Europe SC Index FTSE Developed Europe AC Index FTSE All-Emerging Europe AC Index FTSE Eurobloc AC Index FTSE Developed Europe ex UK AC Index FTSEurofirst 300 Index FTSEurofirst 80 Index FTSEurofirst 100 Index

6 M (%) 12 M (%) Actual Div Yld (%)

10.7 13.1 10.6 19.4 19.3 12.9 24.5 15.1 15.4 11.5 13.2 8.4

19.2 29.3 25.0 36.6 40.1 28.3 85.6 30.4 31.7 26.3 26.0 22.0

1.92 2.40 2.58 2.01 1.80 2.42 1.54 2.27 2.15 2.47 2.57 2.77

FTSE UK Index Series – Q1 2006 30 December 2005 to 31 March 2006

FTSE UK Index Series (GBP) FTSE 100

116 114

FTSE 250

112

FTSE 350

110 108

FTSE SmallCap

106 104

FTSE All-Share

102

FTSE Fledgling

100

FTSE AIM All-Share

ar -0 30 -M

6 28 -F eb -0

30 -D

-Ja

-0

FTSE techMARK

FTSE All-Share Sector Indices – Capital Returns YTD (GBP) 50 40 30

Capital

Total Return

ui pm

e O nt, O S e il & rv G ic a es s & Pro Di du st ce In C ribu rs du h tio Co e s ns tr mi n ia ca tr l M ls u El Ae cti ec et o ro n tr sp & Mi als on ac M ni ic & Ge e & ate ng El ne D ri a e In ctr ral efe ls In du ica Ins nc du str l E ut e st ial qu ria ria E ip ls l T ng me r in n S an e t Au up spo erin to po rt g m rt at ob Se ion ile rv s ice & Fo Be Pa s o Ho d ve rts P us ro rag He eh d es u al Le old cer t is G s Ph h C Pe ure oo ar are m E r s G ds ac q on o eu uip al od tic m G s al en T oo Fo s & t & ob ds od B S ac & iot erv co Dr ec ic u h e Ge ug nolo s Fi ne Re gy xe ra ta d l R ile Li et rs M ne T ai ob Te ra ile lec ve M lers Te om l & ed le m Le ia co u is Te So Ga m nic ur m a e ch ftw s, un tio no a Wa ic ns lo re te a gy & r E tio Ha Co & M lec ns rd mp ul tric w u tiu ity ar te ti e r li t & Se ies Eq rv ui ice No pm s nl en ife Eq Li In Ban t fe s k ui ty In ura s In s n ve Ge R urr ce st n ea an m er l E ce en al s t I Fi tat ns na e tr nc um ia en l ts

-10

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

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FTSE UK Indices – Capital Return YTD (GBP) 16 14 12 10 8 6 4 2

ch M AR F K TS 10 E 0

FT Al S E l-S A ha IM re

g Fl ed gl in

Sm FT SE

FT SE

Al l-S ha re

lC ap

35 0 FT SE

25 0 FT SE

FT SE

10 0

Stock Performance Best Performing FTSE All-Share Index Stocks (GBP/%) Aquarius Platinum London Stock Exchange Lonmin Vedanta Resources Chemring Group

Overall Index Return FTSE 100 Index FTSE 250 Index FTSE 350 Index FTSE SmallCap Index FTSE All-Share Index FTSE Fledgling Index FTSE AIM Index FTSE techMARK 100 Index

74.3 70.3 65.1 62.3 61.3

Worst Performing FTSE All-Share Index Stocks (GBP/%) Telent -62.7 iSOFT Group -62.4 Instore -41.4 Plasmon -39.9 Alba -39.6

No. of Consts

Value

3 M (%)

6 M (%)

100 250 350 336 686 284 1052 100

5964.57 9850.27 3098.93 3612.52 3047.96 4073.92 1198.89 1487.68

6.2 12.0 7.0 9.3 7.1 8.7 14.6 3.9

8.9 23.9 10.9 14.4 11.0 13.3 9.6 16.1

12 M (%) Actual Div Yld (%)

21.9 38.1 24.0 24.3 24.0 20.5 10.1 31.2

3.08 2.19 2.95 1.76 2.91 1.81 0.49 1.43

Net Cover

P/E Ratio

2.50 2.18 2.47 1.19 2.44 -0.84 -0.14 -

12.94 20.91 13.72 47.49 14.06 0 0 -

FTSE Xinhua Index Series 30 December 2005 to 31 March 2006

FTSE Xinhua Index Series (RMB/HKD) – Q1 2006 130

FTSE/Xinhua China 25 (HK$)

125

FTSE Xinhua All-Share (RMB)

120

FTSE Xinhua Small Cap (RMB) 115

FTSE/Xinhua China A50 (RMB) 110

FTSE Xinhua 600 (RMB)

105

FTSE Xinhua China Bond Total Return Index (RMB)

100

ar -0 6

06 28

30 -M

-Fe

n-Ja 30

30 -D

ec -0

FTSE Xinhua Index Series Index Name

Value

3 M (%)

6 M (%)

12 M (%)

Actual Div Yld (%)

25 11069.71 50 4377.56 997 2430.57 600 2636.66 397 1677.60 34 97.88

20.3 12.1 15.3 15.7 12.6 0.9

17.7 13.8 14.5 15.4 9.4 1.3

34.1 7.1 7.6 8.3 3.3 9.8

2.54 3.45 2.24 2.43 1.06 2.84

Consts

FTSE/Xinhua 25 Index (HK$) FTSE/Xinhua China 50 Index (RMB) FTSE Xinhua All-Share Index (RMB) FTSE Xinhua 600 Index (RMB) FTSE Xinhua Small Cap Index (RMB) FTSE Xinhua China Bond Total Return Index (RMB)

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 6

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FTSE Hedge Management Styles (USD) – 5-Year Performance 160

FTSE Hedge

140

FTSE All-World Directional

120

Event Driven 100

Non-Directional 80

ar -0 6 M

5 ar -0 M

03 p-

M ar -0

ar -0 3

02 pSe

ar -0 2 M

ar -0

MARKET REPORTS BY FTSE RESEARCH

FTSE Hedge Index Series

FTSE Hedge – Management Styles & Strategies (NAV Terms) FTSE Hedge Index * Directional Equity Hedge Commodity Trading Association (CTA) / Managed Futures Global Macro Event Driven Merger Arbitrage Distressed & Opportunities Non-directional Convertible Arbitrage Equity Arbitrage Fixed Income Relative Value * Based upon indicative index values as at 31 March 2006

Index Level*

3 M (%)

5350.72 3260.25 2286.70 2062.19 1988.61 3294.72 2102.82 2281.62 3063.90 1987.37 2072.07 2040.72

3.7 4.4 5.1 2.3 2.9 3.9 3.8 3.9 2.6 3.0 4.2 1.1

5-Year Ann 3-Year 6 M (%) 12 M (%) Return (%) Volatility (%)

5.0 6.5 6.2 6.6 7.0 4.4 3.3 5.5 3.1 2.8 5.4 1.5

6.3 8.2 10.9 1.1 6.9 6.7 4.8 8.5 3.0 1.9 4.4 2.4

5.6 7.6 8.4 6.7 5.8 4.0 1.2 6.5 3.5 6.6 4.1 1.5

3.2 5.2 4.4 12.5 6.7 3.2 2.1 4.7 1.6 3.7 2.3 1.5

FTSE EPRA/NAREIT Global Real Estate Index Series FTSE EPRA/NAREIT Global Real Estate Indices (Total Return Basis) – Q1 2006 135

EPRA/NAREIT Global Total Return Index ($)

130 125

EPRA/NAREIT North America Total Return Index ($)

120

EPRA/NAREIT Europe Total Return Index (€)

115 110

EPRA/NAREIT Eurozone Total Return Index (€)

105 100

EPRA/NAREIT Asia Total Return Index ($)

6 30

-M

ar -0

-0 6 -Fe b 28

-0 6 -Ja n 30

-D

ec -0

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

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FTSE EPRA/NAREIT Global Real Estate Indices (Total Return) Index Name

Consts

Value

3 M (%)

6 M (%)

12 M (%)

Actual Div Yld (%)

307 146 91 38 70

2873.52 3479.03 3039.44 3250.95 2112.97

14.0 14.3 17.8 21.4 9.3

19.3 17.1 20.8 16.2 21.9

38.3 38.3 46.5 48.7 39.4

3.78 4.44 2.75 3.57 3.32

EPRA/NAREIT Global Index ($) EPRA/NAREIT North America Index Index ($) EPRA/NAREIT Europe Index (€) EPRA/NAREIT Euro Zone Index (€) EPRA/NAREIT Asia Index ($)

FTSE Bond Indices FTSE Bond Indices (Total Return Basis) – Q1 2006 FTSE Eurozone Government Bond Index (€) FTSE Euro Corporate Bond Index (€) FTSE US Goverment Bond Index ($) FTSE Pfandbriefe Index (€) FTSE Gilts Index Linked All Stocks (£) FTSE Japan Government Bond Index (¥)

103 102 101 100 99 98

ar -0 6

6 -0

FTSE Euro Emerging Markets Bond Index (€) FTSE Gilts Fixed All-Stocks (£)

-M

-Fe b

n-Ja 30

-D

-0

FTSE Bond Indices (Total Return) Index Name

Consts

Value

3 M (%)

6 M (%)

12 M (%)

249 339 40 293 11 28 120 236 34

152.01 174.47 208.73 141.53 1998.79 1923.71 145.29 108.88 97.88

-2.1 -1.6 0.0 -1.6 -0.7 -0.6 -1.4 -1.3 0.9

-2.2 -2.0 -0.1 -2.3 2.8 2.1 -0.6 -1.1 1.3

1.9 1.3 7.1 1.4 8.4 7.4 2.1 -1.4 9.8

FTSE Eurozone Government Bond Index (€) FTSE Pfandbrief Index (€) FTSE Euro Emerging Markets Bond Index (€) FTSE Euro Corporate Bond Index (€) FTSE Gilts Index Linked All Stocks Index (£) FTSE Gilts Fixed All-Stocks Index (£) FTSE US Government Bond Index ($) FTSE Japan Government Bond Index (¥) FTSE China Government Bond Index (RMB)

Actual Div Yld (%)

3.87 3.84 4.55 4.29 1.41* 4.24 5.00 1.58 2.84

* Based on 0% inflation

FTSE Research Team contact details Andy Harvell Head of Research andy.harvell@ftse.com +44 20 7866 8986

Andreas Elia Research Analyst andreas.elia@ftse.com +44 20 7866 8013

Kamila Lewandowski Index Development Executive kamila.lewandowski@ftse.com +44 20 7866 1877

Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 6

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Page 96

CALENDAR

Index Reviews April – September 2006 Date

Index Series

Review Type

Effective Data Cut-off (Close of business)

Late April

FTSE / ATHEX

Semi-annual review

31-May

31-Mar

12-May

Hang Seng

Quarterly review

9-Jun

31-Mar

17-May

MSCI

Annual review

31-May

30-Apr

Early Jun

Russell US Indices

Annual/ Quarterly review

30-Jun

31-May

Early Jun

ATX

Quarterly review

16-Jun

31-May

Early Jun

KOSPI 200

Annual review

9-Jun

31-May

Early Jun

IBEX 35

Semi-annual review

3-Jul

31-May

Early Jun

CAC 40

Quarterly review

16-Jun

31-May

Early Jun

OBX

Semi-annual review

16-Jun

31-May

1-Jun

OMX C20

Semi-annual review

16-Jun

31-May

2-Jun

DJ Global Titans 50

Annual review of index composition

16-Jun

30-Apr

2-Jun

OMX S30

Semi-annual review

30-Jun

31-May

5-Jun

DAX

Quarterly review

16-Jun

31-May

7-Jun

FTSE UK

Quarterly review

16-Jun

7-Jun

FTSE All-World

Annual review - Emgng Eur, ME, Africa, Latin America 16-Jun

31-Mar

7-Jun

FTSE techMARK 100

Quarterly review

16-Jun

31-May

7-Jun

FTSEurofirst 300

Quarterly review

16-Jun

2-Jun

7-Jun

FTSE eTX

Quarterly review

16-Jun

2-Jun

9-Jun

NASDAQ 100

Quarterly review/ shares adjustment

16-Jun

31-May

12-Jun

NZSX 50

Quarterly review

30-Jun

31-May

13-Jun

S&P MIB

Quarterly review - shares only

16-Jun

14-Jun

DJ STOXX

Quarterly share adjustment

17-Jun

14-Jun

S&P/ ASX 200

Quarterly review

16-Jun

6-Jun

16-May

14-Jun

S&P US Indices

Quarterly review

16-Jun

14-Jun

S&P Europe 350/ S&P Euro

Quarterly review

16-Jun

14-Jun

S&P 500

Quarterly review

16-Jun

14-Jun

S&P Midcap 400

Quarterly review

16-Jun

14-Jun

S&P/ TSX

Quarterly review

16-Jun

31-May

15-Jun

PSI 20

Semi-annual review

30-Jun

31-May

Mid-June

Norex All-Share

Semi-annual review

30-Jun

30-May

1-Jul

TOPIX New Index Series

Semi-annual review

27-Jul

16-Jun

14-Jul

TSEC Taiwan 50

Quarterly & annual review

21-Jul

30-Jun

Mid July

OMX H25

Quarterly review

31 Jul

30-Jun

11-Aug

Hang Seng

Quarterly review

8-Sep

30-Jun

17-Aug

MSCI

Quarterly review

31-Aug

31-Oct

30-Aug

FTSE All-World

Annual Review / Japan

15-Sep

30-Jun

30-Aug

FTSE Goldmines Index Series

Quarterly review

15-Sep

21-Aug

Early Sep

ATX

Semi-annual review / number of shares

15-Sep

31-Aug

Early Sep

S&P US Indices

Phase 2 float adjustment

15-Sep

Early Sep

CAC 40

Annual review of free float

22-Sep

Early Sep

S&P MIB

Semi-annual constiuent review

18-Sep

1-Sep

SMI Index Family

Semi-annual review

30-Sep

31-Jul

4-Sep

DAX

Quarterly review/ Ordinary adjustment

15-Sep

31-Aug

4-Sep

Nikkei 225

Annual review

Late Sept/Early Oct

31-Aug

Sources: Berlinguer, FTSE, JP Morgan, Standard & Poors, STOXX

MARCH/APRIL 2006 • FTSE GLOBAL MARKETS

GM EDITORIAL 13

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