FTSE Global Markets

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THE NEW FRONT LINE FOR COLLATERAL MANAGERS ISSUE SIXTEEN • NOVEMBER/DECEMBER 2006

Intel makes a comeback The battle for Heinz Mattel: Barbie fights back

ATON CAPITAL Making time for the perfect partner

CORPORATE-ACTIONS & THE POWER OF TECHNOLOGY

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©2006 Northern Trust Corporation. Northern Trust is authorised and regulated in the UK by the Financial Services Authority.

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Outlook EDITORIAL DIRECTOR:

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FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2006

N THE RUN UP to the end-of-year festivities, there is a whiff or two of something approaching whimsy in this edition. Likely as not it is a deliberate counterpoint to an increasingly worrisome geopolitical climate and the odd bearish signals issuing from three or more G7 markets. In fact, any whimsy is entirely limited to presentation. While one or more of our stories may look rather lively, two of our seemingly lighter offerings have some very serious messages indeed. Among these are Art Detman’s profile of Mattel, the world’s largest toy company and home to Barbie, the world’s most successful toy. After an overdue reorganisation and a strategic acquisition, the company now seems to be on the brink of a comeback, after a prolonged period outside the playpen. It has certainly been a testing time for the firm’s management and shareholders. The question now is whether the firm is showing sufficient innovation and speed to market to reclaim its out and out dominance?

Another highlight is Dave Simon’s searing account of the battle for control of the operating soul of Heinz.This fight for boardroom supremacy is the latest in a series of initiatives by mega-investors such as Carl C Icahn and Kirk Kerkorian, who, like Peltz, have secured large positions in public companies so that they can influence board members and make their mark on fiscal policy. While their aggressive strategies—which often include massive labour cuts and reductions in capital expenditures—can yield positive results and boost shareholder value, critics see a significant downside. In the specific case of Heinz, it could even involve the potential displacement of a regional icon. Who will win out?

A recurring theme in any current edition of this magazine is the sweeping changes taking place in the investment services industry. This time Neil O’Hara focuses on prime broking. Once upon a time, a prime broker used to be what the name implies: a central custodian of a hedge fund's assets that processed all its trades, financed positions, arranged stock loans and provided reports tracking the entire portfolio. Hedge funds had little leverage over their chosen broker and paid the freight as a cost of doing business. That is no longer the case. The bigger funds today have multiple prime broker relationships, sometimes playing firms against one another to get better terms. Who is winning and who is losing in this new battle for business?

Few events this year managed to drag out any last dregs of drama for as long as the Mexican elections did. With its knife-edge count, legal challenges and street protests it had all the hallmarks of an emerging market gone topside. Now that it is all over, to all intents and purposes, Mexico’s business community now seems to have returned to business as usual. Is it really?

Incoming president Felipe López Calderón faces some stiff challenges: not least a shaky relationship with its northern neighbour; and the need to clarify the country’s approaches to foreign direct investment in the face of a resurgence of extremist nationalism and vested local interests. Can Calderón turn the tide? Ian Williams checks out the strength of the counter-currents.

Our cover story this month focuses on Aton Capital; a gem of a Russian investment bank that has had more offers of marriage than Elizabeth Taylor. If there’s any action in Russia, Aton is usually in the throng. FTSE Global Markets talks to Alexander Kandel about the firm’s search for a perfect partner and its immediate strategic goals.

I

Francesca Carnevale, Editorial Director October 2006

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Contents COVER STORY COVER STORY: ATON: BRIDESMAID OR BRIDE?

........Page 45 Bulge bracket banks are now looking to Russia for business growth, bringing with them new competitive pressures. Many foreign banks are now looking for appropriate acquisitions opportunities and few brokerage houses in Russia are as appealing as Aton.

Variously courted by Goldman Sachs and other leading houses, and having rejected their advances, Aton knows it has to find the perfect partner to survive. Francesca Carnevale talks to Aton’s chief executive officer, Alexander Kandel in Moscow.

REGULARS MARKET LEADER

ENCOURAGING MARKET FORCES ..........................................................................Page 6

INDEX REVIEW

INTEREST RATES: ANATHEMAS AND INDICES ........................Page 12

Craig Donohue, CEO of the Chicago Mercantile Exchange argues for room for innovation in Europe’s central counterparty clearing services.

Simon Denham, managing director, Capital Spreads, reports on the impact of inflation.

WILL THE UK’s REITs REGIME HELP OR HINDER GUERNSEY? ....Page 14 Guernsey banks on UK REITs adding to its property trust reservoir.

IN THE MARKETS

ABSOLUTE RETURN UCITs FUND LAUNCHED ..............................................Page 16 Why Mellon thinks it’s leading the pack with an innovative UCITs fund.

THE EXPANDING UNIVERSE OF CHINA HEDGE FUNDS ........Page 18 Simon Coxeter, managing director, AsiaSource Capital explains the trends.

BAHRAIN’S NEW TRUST LAW LEGISLATION ..................................Page 28 Can Bahrain’s comprehensive regulations cement its role as a financial centre?

SOUTH EAST EUROPE: THE BENEFITS OF HARDBALL ......Page 31 Lynn Strongin Dodds on the advantages of impending EU membership

LATIN AMERICA’S PRIVATE EQUITY REVIVAL ..........................Page 36

REGIONAL REVIEW

John Rumsey reports on the new deals and dealmakers

LATIBEX’S NEW BRAZIL INDEX ..............................................................Page 40 The growing family of FTSE Latibex indices

THE PROSPECTS FOR POST ELECTION MEXICO

......................Page 42 Ian Williams reports on the challenges facing president-elect Calderon.

RUSSIAN PENSION REFORM

....................................................................Page 45 The government has finally woken up to pension reform, just in time for the elections.

DERIVATIVES

UPWARDLY MOBILE ..................................................................................................Page 52 Neil O’Hara reports on the relationship between index option trading and ETFs.

WAMU COMES TO EUROPE

DEBT REPORT

....................................................................Page 24 Why European covered bonds have appealed to Washington Mutual.

EXOTIC DEBT’S BANDWAGON STARTS ROLLING..................Page 26 Blazej Karwowski reports on the rarefied deals of the late summer.

2

AFTER THE GOLD RUSH

ALTERNATIVES

..............................................................................Page 74 Prime brokers benefit as hedge funds push into new markets. By Neil O’Hara

INDEX REVIEW

Market Reports by FTSE Research ................................................................................Page 86 Index Calendar ..................................................................................................................Page 96

NOVEMBER/DECEMBER • FTSE GLOBAL MARKETS

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OPTIONS FEE WAIVER October 1, 2006 June 30, 2007

INTEREST RATES

AGRICULTURAL

EQUITIES

METALS

CBOTÂŽ METALS COMPLEX

LIQUIDITY

MARKET DATA

Established Liquidity and Side-By-Side Options CBOT 100 oz.

ZGZ6

Gold

Last: Change:

BUY ORDERS QTY PRICE 15 20 28 35 20 40 30 35 20 20

647.5 647.4 647.3 647.1 646.9 646.8 646.6 646.4 646.3 646.2

For Illustrative Purposes Only

647.6 -14.0

SELL ORDERS PRICE QTY 18 16 30 25 30 35 25 20 25 17

647.6 647.7 647.8 647.9 648.1 648.3 648.4 648.5 648.7 648.8

The Chicago Board of Trade offers precious metals traders the best of both worlds - a 100% electronic futures trading platform for full-sized and mini-sized precious metals futures contracts and side-by-side options. As of October 1, 2006, the CBOT will waive all exchange transaction fees for all options-on-futures precious metals trading. With enhanced opportunities and incentives, the only choice for precious metals traders is the CBOT. Visit our online live book and discover the precious metals marketplace of the future. Just click it.

Live Books and Special Metals Report at www.cbot.com/metals The information herein is taken from sources believed to be reliable. However, it is intended for purposes of information and education only and is not guaranteed by the Chicago Board of Trade as to accuracy, completeness, nor any trading result, and does not constitute trading advice or constitute a solicitation of the purchase or sale of any futures or options. The Rules and Regulations of the Chicago Board of Trade should be consulted as the authoritative source on all current contract specifications and regulations. Š2006 Board of Trade of the City of Chicago, Inc. All Rights Reserved

www.cbot.com

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Contents FEATURES INTEL FIGHTS FOR MARKET DOMINANCE

..................................Page 58 After fumbles and stumbles that cost it market share, profits and prestige, the dominant maker of semiconductors counterattacks with price cuts, new products, a management shakeup, and widespread layoffs. The ensuing struggle with archrival Advanced Micro Devices will benefit computer users everywhere. Art Detman reports from California.

COLLATERAL MANAGEMENT TO THE FORE

................................Page 62 Hedge funds, which are always trying to improve their return on capital continue to push for measures that increase the efficiency of their collateral, including firm-wide collateral calculations. Hedge funds are on the cutting edge, of course, but traditional money managers may pose a bigger challenge – and opportunity – for collateral managers, who now see a rapid increase in the use of OTC derivatives by a greater range of players. Neil O’Hara reports

CORPORATE-ACTIONS TAKES CENTRE STAGE

........................Page 66 Over the past several years, the volume of corporate-actions messaging on a global scale has increased significantly. At the same time it has created a completely new set of challenges for custodians and others entrusted with relaying crucial information to the end user on time and error-free. While technological solutions continue to be bandied about, experts underscore the need for greater harmonization and increased commitment from all parties involved. Dave Simons reports from Boston.

HEINZ AND SHAREHOLDER ACTIVISM ..........................................Page 70 Earlier this year however, the traditional corporate values espoused by Heinz management came face-to-face with 21st-century shareholder activism. A group of dissident investors, led by billionaire Nelson Peltz of Trian Fund Management LP, squared off against Heinz’s board of directors in an effort to revamp Heinz’s ailing business model.

Dave Simons looks at the repercussions for Heinz and corporate America.

MATTEL MAKES A COMEBACK ............................................................Page 78 Chances are Bob Eckert never thought that running a toy company would be so hard, especially one with iconic brands such as Barbie, American Girl, Tickle-Me-Elmo, Hot Wheels and Matchbox. Revenues peaked in 1999 at $5.5bn, recovering weakly to $5.2bn last year. Now, after a long overdue reorganisation and a key acquisition, the company appears on the brink of a strong comeback. Art Detman reports

GLOBAL PLAYERS TAKE THE LEAD IN ASIAN SUB-CUSTODY ....Page 82 It is all change in the geography of Asian sub-custody. Increasingly, clients are selecting providers based on credit ratings, where global players also have an advantage. In most cases, the choice of provider is not determined by price and as a result it is more difficult for single market sub-custodians to make the required investment in overheads as the need to invest in services and people is immense. Rekha Menon reports

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NOVEMBER/DECEMBER 2006 • FTSE GLOBAL MARKETS

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Market Leader EUROPE’S CCPs: CENTRALISED OR MARKET SOLUTIONS?

What is the optimal structure of central counterparty clearing (CCP) services? In Europe, the debate focuses on the relative merits of a single large intermediary-owned (or controlled) CCP over a de-centralised system. Should Europe’s regulators actually mandate the establishment of a single monopoly provider of central counterparty clearing (CCP) services? Or, as Craig S Donohue, chief executive officer of the Chicago Mercantile Exchange (CME) believes, should CCPs be allowed to innovate in response to competitive market forces rather keep to official and centralised dictats?

A CALL FOR THE FREEDOM TO INNOVATE OR THE MOST part, the debate in Europe over the future of CCP services used to focus on the relative merits of a single large intermediary owned or controlled CCP versus a de-centralised structure with competing and differently organised CCPs, including for example, exchange-owned/controlled CCPs. Of course, large intermediaries, and the CCPs owned or controlled by them, distinctly favoured the so-called horizontal model, which assumes that a single, large intermediary-owned CCP will reduce clearing and settlement processing costs and cross-border trading expenses.

Surprisingly, the notion of mandating a single monopoly CCP still carries currency, even though an April 2004 European Commission (EC) communiqué recommended that a structure for clearing and settlement services in Europe should be decided by market forces, rather than by dictat — a position even the European Parliament agrees with. In February, LCH Clearnet presented a discussion paper to the European Commission’s Clearing and Settlement Advisory and Monitoring Expert Group (CESAME), calling for the “full consolidation of CCPs serving all European markets and asset classes.” Then, in May, Europe’s competition commission paper on Competition in EU Securities Trading and Post Trading argued that CCP services could and probably should operate in a competitive environment. However, both voiced their opposition to vertical integration and even the competition

F

6

Craig S Donohue, chief executive officer, Chicago Mercantile Exchange.

“Surprisingly, the notion of mandating a single monopoly CCP still carries currency, even though an April 2004 European Commission (EC) communiqué recommended that a structure for clearing and settlement services in Europe should be decided by market forces, rather than by dictat—a position even the European Parliament agrees with,” writes Donohue. Photograph kindly supplied by the Chicago Mercantile Exchange, September 2006.

commission found that, “vertical integration may result in foreclosure at all levels of the value chain and therefore lead to welfare losses. Whilst there may be efficiencies [sic], so far the commission has seen no convincing evidence to substantiate this.”

We need to go even a step further. A directive that creates a single monopoly provider of CCP services is, actually, inconsistent with a call for competition. The proposition, in fact, spells the end of competition for providing innovative and efficient clearing and settlement structures.

If competition is the real goal, then regulators and policy makers should support a competitive environment that fosters innovation and the development of new and alternative solutions which allow the market to advance.

The case for mandating a single monopoly provider of CCP services for all asset classes and all European markets has not been made properly. The true cost savings of moving to a single monopoly CCP or of creating interoperability among multiple CCPs, for example, has

NOVEMBER/DECEMBER 2006 • FTSE GLOBAL MARKETS

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EquiLend LLC and EquiLend Europe Limited are subsidiaries of EquiLend Holdings LLC (collectively, “EquiLend”). EquiLend LLC is a member of the NASD and SIPC. EquiLend Europe Limited is authorized and regulated in the United Kingdom by the Financial Services Authority. EquiLend Europe Limited is a company registered in England and Wales with Company Number 04608698, whose registered address is EquiLend Europe Limited, c/o Hackwood Secretaries Limited, One Silk Street, London, EC2Y 8HQ. All services offered by EquiLend are offered through EquiLend LLC and EquiLend Europe Limited using EquiLend’s proprietary technology and software. The promotion of investments and investment services in the United Kingdom is restricted by Section 21 of the Financial Services and Markets Act 2000 (the “FSMA”). The services offered by EquiLend Europe Limited are directed at persons (“Relevant Persons”) who are (a) persons having professional experience relating to investments falling within Article 19 of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 (the “Financial Promotion Order”) or (b) high net worth entities and other persons falling within Article 49 of the Financial Promotion Order or (c) other persons to whom itmay be communicated without contravention of Section 21 of the FSMA. The services provided by EquiLend Europe Limited are available in the United Kingdom only to Relevant Persons falling within (a) or (b) above and other persons should not act or rely on the content. EquiLend, and the EquiLend mark, EquiLend AuctionPort and AutoBorrow Express are protected in the United States and in countries throughout the world. © 2001-2006 EquiLend Holdings LLC. All Rights Reserved.

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Market Leader EUROPE’S CCPs: CENTRALISED OR MARKET SOLUTIONS?

not been quantified and explained. Post-trade processing, for instance, is only a small portion of overall trading costs and bid/ask spreads, frictional costs on large orders and intermediaries’ fees far outweigh any clearing and settlement processing costs.

A single intermediary owned controlled CCP with interexchange fungibility could, in fact, fragment market liquidity and have a negative impact on effective spreads and frictional costs.

Equally, there has not been enough discussion of the potential problems associated with an intermediaryowned/controlled CCP. While exchange-owned CCPs may seek to extract monopoly rents, it should be noted that intermediaryowned CCPs could limit CCP activities in some markets to maximise trading and dealing profits for their owners, at the expense of smaller members of the CCP and true endusers. Additionally, the conflicting interests of the exchange user/owners and the intermediary owners of certain CCPs can sometimes impair their efficiency, both in terms of technology development and bringing new business innovations to market. Advocates for a single monopoly CCP solution appear unconcerned about this potential loss of efficiency. Finally, there is clear evidence of the efficiencies created by exchange-owned CCPs providing tangible value to both intermediaries and end-users.

Let us examine these points in greater detail. Back in 2001, the Giovannini group identified fifteen barriers to reducing trading and settlement costs, the majority of which are directly related to differences in national policies (related to finality of settlement, settlement timeframes and taxation, for example). It is far from clear however that creating a single intermediary-owned/controlled CCP will eliminate any of these barriers, or lower costs. The barriers themselves then are the key. If they are not removed, a single monopoly CCP will still have to maintain the processes and procedures required by each national market. Today’s CCPs are optimised for the markets in which they operate and it is probably more efficient to continue in this vein rather than force a central CCP to create a superstructure that, by necessity, duplicates what already exists.

Arguments in favour of adopting a single intermediaryowned/controlled CCP focus on cost reductions through economies of scale and scope and capital efficiencies. LCH Clearnet in its presentation on The Need to Remove Structural Barriers to the Consolidation of CCP Clearing, made to CESAME in February this year, argues that cost reductions achieved by consolidation will drive additional trading activity, positively affecting European GDP.

8

However, this argument falls down on its assertion that modest CCP cost savings will have a significant impact on trading activity.

To increase trading activity significantly, the all-in cost of trading must be reduced substantially. CCP-related costs are only a fraction of total all-in costs, which include the bid/ask spread; ‘frictional costs’ on large orders; intermediaries’ fees, and minor exchange and CCP fees.

In 2005, slightly over 1bn futures and options contracts were traded at CME. If each of those trades happened at one-tick, the smallest possible bid/ask spread, a minimum of $12.7bn would have been paid in bid/ask spread by market participants. Each penny saved in clearing and settlement, however, would only eliminate $11m dollars from the all-in cost of trading, less than 1% of the impact of the bid/ask spread. If we use the 5 cent fee charged by the Chicago Board of Trade (CBOT) as a proxy for clearing and settlement costs, market innovation that yields a 1% change in the $12.7bn captured in bid/ask spread would reduce trading costs by $127m, a result that is almost $20m more than the $110m that could be achieved with the elimination of all clearing and settlement costs. In other words, CCP direct costs are negligible compared to other trading costs. However, the ownership composition and governance structure of CCPs can have a direct bearing on the adoption of CCP’s policies and practices that are critical to the creation of efficient markets.

Euroclear’s March 2005 position paper on Clearing and Settlement claimed that “no-one is likely to take a keener interest in the controls safeguarding their assets and demand more innovative services than the user/owners themselves.” Even so, large intermediaries are only a subset of market users. The European Central Bank and the Committee of European Securities Regulators’ Standard 13 states that “governance arrangements for entities providing securities & settlement services should be designed to fulfill public interest requirements and promote the objectives of owners and users”. The standard goes on to define public interest as the “safety and efficiency of the system”. While safety and efficiency are of paramount concern to all market users, true public interest transcends those factors. A single intermediaryowned CCP can and likely will establish policies and practices that promote the interest of large intermediaries with little or no regard for the best interests of smaller intermediaries or true end-users.

Experience shows that exchanges with vertically integrated clearing functions serve the public interest better by developing clearing services that can make markets more accessible, transparent and efficient. Why?

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Market Leader EUROPE’S CCPs: CENTRALISED OR MARKET SOLUTIONS?

CME’s CCP services Because exchanges are should enhance liquidity centralised transaction Post-trade processing, for instance, is and trading opportunity processors which act as only a small portion of overall trading for all market users. neither principal nor agent costs and bid/ask spreads, frictional costs on behalf market users. As Shareholder value-driven such, exchanges do not organisations can take on large orders and intermediaries’ fees seek to capture spreads or calculated risks and make far outweigh any clearing and settlement profit from large orders. speculative investments processing costs. A single intermediary Moreover, exchanges have that have the potential to owned/controlled CCP with inter-exchange no stakes in taking trading generate returns for their fungibility could, in fact, fragment market profits at the expense of shareholders. Intermediaryimproving market owned or controlled utilities liquidity and have a negative impact on transaction costs. are, in contrast, generally effective spreads and frictional costs.

Furthermore, a compelling rewarded for cost argument can be presented minimisation rather than that a demutualised, publicly owned exchange CCP growth and value creation for shareholders. In consequence, presents a stronger governance framework for end users they neither truly minimise costs nor create value. For that than an intermediary-owned CCP. reason, regulators and policy makers should more carefully The former will differ from the latter in two important assess the impact of the structure on innovation, market ways. Its shareholders will represent the full spectrum of development and industry growth. participants in the trading community and its success will Can an exchange-owned CCP really create efficiencies be measured in terms of shareholder returns and not and benefits for both intermediaries and end-users? While merely by its ability to operate “safely and securely.” By the EC may not be able to find examples of these measuring success in terms of returns to shareholders, efficiencies in European securities markets, there are clear policies will be determined based on their ability to attract and compelling examples to learn from in the US additional trading volume and maintain an appropriate derivatives markets. The CME’s common clearing link with level of risk controls. How better then to ensure that CCPs the Chicago Board of Trade (CBOT) for example, has truly serve the public interest than by ensuring they are reduced capital and performance bond requirements for publicly owned? market users by approximately $2bn, while creating Swapclear is a clear example of how an intermediary additional expense savings for clearing member firms. controlled CCP may not serve the public interest. Cross-margining agreements with the CBOT, SGX, the Swapclear caters to the interests of the 19 largest swap Options Clearing Corporation, LCH Clearnet, the New dealers rather than the broader universe of market York Mercantile Exchange and the Fixed Income Clearing participants. It has also limited its product set to plain Corporation meanwhile provide capital efficiencies to vanilla interest rate swaps in major currencies. Credit market users by including positions held in other derivatives and equity swaps, the highest profit-margin clearinghouses in the calculation of portfolio risk. product for brokers, have been excluded, benefiting dealer In truth, there is no evidence that either a vertical or a profitability at the expense of reducing systemic risks and horizontal market model is the right one in all situations transaction costs in these markets. or that either model is wrong in all situations. CCP In contrast to the limited participation, limited product behaviour — rather than the ownership and governance approaches taken at Swapclear, clearing houses controlled structure of CCPs — may be a more appropriate focus for by exchanges seek to bring the benefits of CCP services to ensuring the competitiveness of European securities a significantly wider audience.

For example, markets. The only way to ensure that markets develop FXMarketSpace, CME’s soon-to-be-launched joint venture efficiently is to provide sound regulation and allow market with Reuters will create an efficient, anonymous and forces to determine the structures and solutions that work centrally cleared alternative to the current spot and forward best. The best way to achieve that is to let market markets. FxMarketSpace will differentiate itself from participants have a voice in the governance of a existing platforms by linking to the CME clearinghouse and clearinghouse. What better way to ensure that clearing providing a level credit playing field to all market and settlement providers truly serve the public interest participants. The combination of anonymous trading and than by having them be owned by the public?

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NOVEMBER/DECEMBER 2006 • FTSE GLOBAL MARKETS

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“I need to weather the extremes.”

B R I A N O ’HE A R NE Managing Director, Environmental & Commodity Markets, Swiss Re Capital Management and Advisory

Managing the risks associated with volatile weather is an integral part of Brian O’Hearne’s job at Swiss Re, a leading global reinsurer. CME weather derivatives allow him and his counterparts in industries as diverse as energy, insurance, retailing and agriculture, to trade futures on weather in 29 cities in the United States, Europe and Japan — helping them manage the impact of weather on their operations.

By improving the way markets work, CME is a vital force in the global economy, offering futures and options products on interest rates, equity indexes, foreign exchange, commodities and alternative investments. For more about how CME can change your world, visit www.cme.com/info.

CME®, the Globe logo and Chicago Mercantile Exchange® are trademarks of CME. Copyright © 2006 CME. All rights reserved.

I D E A S T H AT CHANGE T H E W O R L D™

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Index Review INTEREST RATES: ANATHEMAS & INDICES

INTEREST RATES: ANATHEMAS & INDICES With inflation in the UK on the rise, the Bank of England has little in its armory to battle against it, say analysts. Money supply in the UK is running (almost) out of control as the government appears to print evermore IOUs in one form or another to keep the economy moving.

Some commentators say that if you strip government-related jobs and spending out of the growth equation the UK economy has barely moved in the last eight years. Rising interest rates are anathema to equity markets and dealers can be forgiven for taking the Bear road when other opportunities appear to offer better prospects. Simon Denham, managing director of spread betting firm Capital Spreads, reports on index trends and expectations.

E ARE NOW entering a rather more nervous period for equities, and therefore indices, as recent evidence suggests that the US economy may be slowing rather faster than expected. The US is still the main driver of the world economy and while the old chestnut “when America sneezes Europe catches a cold” may be hoary, but the sentiment is as crisp as ever, although nowadays we might want to transpose ‘Europe’ with the ‘the Far East’.

China is still forging ahead with double digit growth rates.

Its government is doing a handy job of balancing inflationary and expansionary pressure and exerting a strong grip on foreign exchange and interest rates, but inevitably problems will arise in such a potentially inflationary environment.

Unfortunately, as with all rapidly expanding economies, there is always the danger of boom turning spectacularly to bust—especially if a major trading partner suddenly cuts back on demand for your goods.

China’s economy is still too poor to be able to take up any slack resulting from

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a slowdown and is therefore (probably) the economy most in danger in the event of any US-led recession.

Japan is another story entirely, as it is the only really mature economy in Asia. The country has effectively stagnated for the last 15 years with deflationary worries continually swirling through the markets. Now, fears are rising that the trade surplus (the mainstay of the economy since the mid-1970s) has started to show signs of slipping. With interest rates effectively at zero percent (where they have languished for six years or more) investors now need to see good growth potential in order to be tempted back into the market. Right now, that simply does not look likely—particularly with the Nikkei 225 stalled at just below 16000.

The Yen is soaking up pressure. It is particularly noticeable on a basketweighted basis as the Yen has fallen dramatically against the Euro, Sterling and even the US Dollar. Over the past four years the Euro has increased by almost 30% against the Yen wiping out much of any potential investment gains.

A slowing or even recessionary economy is not necessarily bad for equities.

It can in certain

Simon Denham, managing director, Capital Spreads. Photograph kindly provided by Capital Spreads, August 2006.

circumstances be taken brightly by the markets. As economies slow so Central Banks will reduce rates and returns from equities will look ever more attractive. Equally, companies are always loathe to cut dividend levels even when prudence would suggest that they do so and, even in the absence of any identifiable growth, shares can continue to rally. Longer term investors also like to look through the current problems and identify turning points in rate expectations.

Although the US equity markets have done reasonably well over the past few years, price to earnings ratios are almost at a record low, with the S&P 500 currently in the mid-teens down from around sixty in 2001/2002.

The obvious reason for this is the constant stream of rate-hikes from the Federal Reserve which have made the holding of cash a much more desirable option to shares. Now though we are entering a rate-neutral (possibly easing) era and in this environment equities can be king again.

All this presupposes that inflation is kept under control which, in a slowdown, is normally taken as given.

Unfortunately for the UK it is only the discretionary spending inflation that is muted, the non-discretionary side is definitely not. Energy, taxation, housing (rental and sales) are well above ‘official’ inflation levels and we may find that the FTSE is caught between a rock and a hard place.

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In the Markets OFFSHORE FUNDS: PROPERTY

WILL THE UK’s REITs REGIME HELP OR HINDER GUERNSEY?

are continuing to see a substantial influx of new funds business into the Island despite new records being set each quarter for the value of funds in Guernsey.” Guernsey finance is the specialist promotional agency for the island’s finance industry.

In large part, Guernsey’s expansion has also been fuelled by the Channel Islands Stock Exchange (CISX’s) efforts to streamline listing applications as well as achieving recognition from various international regulatory authorities.

The UK’s Financial Services Authority (FSA) awarded the status of The total number of funds in Guernsey now stands at 845, up by Designated Investment Exchange to 110 from June 2005 (15%). By the end of June 2006, 58 the CISX in February 2004. This move, Qualifying Investor Funds (QIFs) had been approved since the together with its designation as a launch of the scheme in February last year. A root and branch Recognised Stock Exchange under review of investment sector legislation has been conducted this the UK’s Income and Corporation year and a set of proposals for revising the system of regulation Taxes Act 1988, has increased the will go before Guernsey's parliament early in 2007. Can the island’s appeal as an offshore Island’s efforts to dominate the offshore property fund market investment centre.

The CISX, which is based in continue unabated once UK REITS legislation comes in play?

Guernsey, is carving out something of UERNSEY HAS Guernsey stood at just under £115bn a niche for itself in the listing of ESTABLISHED itself as a at the end of June this year – a year on property funds. The CISX does not leading jurisdiction for the year rise of 37%. In an official have minimum asset requirements. establishment of offshore funds, statement, Peter Niven, Guernsey The spread of risk requirements are helped in large party by a regulatory Finance’s chief executive noted, “We rigorous, but not onerous and listing is cost effective. The environment. Guernsey CISX’s listing committee has streamlined its sits on a daily basis and application process the exchange is In large part, Guernsey’s expansion considerably. The island’s responsive to listing Financial Services has also been fuelled by the Channel documentation, with Commission (FSC) has a Islands Stock Exchange (CISX’s) response times reduced to fast track process that efforts to streamline listing a minimum. means that the launch of a applications as well as achieving A working party, fund is unlikely to be recognition from various international chaired by Guernsey delayed by regulatory advocate Peter Harwood, approvals, particularly regulatory authorities. The UK’s recommended earlier this where the promoter of the Financial Services Authority (FSA) year that the focus of fund is already known to awarded the status of Designated regulation should be on the Commission.

Investment Exchange to the CISX in the licensed Guernsey According to figures February 2004. administrator, reducing issued by Guerney’s FSC, the number and scope of funds under management funds that will be and administration in

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regulated directly and therefore making it easier and quicker to list and administer funds in the jurisdiction. Harwood’s working paper also recommended a number of regulatory changes that would make it easier for investment services providers to administer nonGuernsey funds.

If the island’s government does pass supporting legislation, it would broaden the scope of Guernsey’s remit substantially.

Given the island’s favourable regulatory regime in which to establish property funds, tax is only a part of the attraction for establishing funds in Guernsey. In 2007, the United Kingdom government is slated to introduce enabling legislation covering real estate investment trusts (REITs), in the hope of encouraging funds into a new investment sector that will effectively compete with offshore jurisdictions, such as Guernsey.

That fact puts the island on notice that it will have to pull the proverbial rabbit out of a magical hat to ensure that, at the very least, it will be able to play on a level field with the UK market. For the time being, Guernsey has time, albeit a short time, on its side. Right now, even as 2007 draws closer, the UK government still has not clarified the beneficial tax regime that will support the establishment of a substantive REITs market in the UK. The UK government will have to move fast, otherwise it could begin to see a further erosion of its fund industry, which has already new options in Dublin and Luxembourg to benefit from.

Equally, property specialists in Guernsey explains that the range of structures which are already readily available to UK investors provide most of the benefits of a REIT, and a number of houses insist that the evolution of

the UK REITs market will not have a detrimental effect on the island’s specialist property fund industry.

For the moment, fund administration is higher on the

Guernsey agenda. Proposals are being discussed that will recreate a regime similar to that in Jersey, where professional investor funds can be selfcertified by Guernsey administrators.

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In the Markets FUND LAUNCH: ABSOLUTE RETURN FUND

Photograph supplied by istockphotos.com, September 2006.

Mellon breaks new ground with UCITs absolute return fund Mellon Global Investments, the international distribution subsidiary of Mellon Financial Corporation, has launched what it claims to be an innovative global absolute return fund. Run by Mellon Capital Management Corporation, the group's quantitative investment subsidiary, the fund will leverage the wider investment powers granted by the European UCITs III product directive.

HE MELLON EVOLUTION Global Alpha Fund, a sub-fund within the group's Dublindomiciled Mellon Global Funds range, claims to set a new standard for UCITS funds, says Sasha Evers, director of business development at Mellon Global Investments. Evers explains that the new absolute return fund will use quantitative techniques to take long and short positions on “highly liquid securities, such as index futures”in a bid to capture alpha and manage risk. He adds that the fund will also use leverage when risk-adjusted returns are high.

The fund is aiming to deliver an

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annualised target return of 4% over a three to five-year rolling period above its one-month Euro Interbank Offered Rate (Euribor) benchmark.

The fund employs a systematic investment strategy, alternately known as global tactical asset allocation (GTAA), which takes advantage of relative valuation opportunities resulting from market inefficiencies across equity, bonds and currency markets. An “optimiser”, run twice daily, generates the portfolio’s risk allocation day to day. “The uniqueness of the fund is that it uses a quantitative hedge fund strategy,

within a traditional UCITs structure, with daily liquidity,” says Evers, “as opposed to traditional hedge funds which have monthly liquidity.”

Launched at the end of September, the open ended fund is aimed at institutional investors and in the first two weeks following launch has raised ?50m, tapping into “a huge demand across Europe for funds with absolute return objectives,” explains Evers. “Because the underlying instruments are so liquid, utilising bond and equity index futures,” Evers does not envisage any problems with capacity and expects assets under management by the fund to grow rapidly. He also says the fund will be rolled out to the retail market by the end of this year, after its registration in various European countries. The fund is denominated in Euros, but is also on offer in dollars and carries a 20% performance fee, applied to any performance in excess of the onemonth Euribor net of annual management charges.

Mellon back-tested the fund's investment strategy over the last five years, using actual returns from a representative account managed by Mellon Capital in the Global Alpha Low Restriction Strategy Compositecomprising multiple portfolios within Mellon Capital’s GTAA strategy and whose mandates allow a portfolio to be long and short in at least one asset class in at least one country. Mellon claims the fund outperformed its benchmark with a bond-like risk profile. The test used several risk controls, including a 7% active risk target and a value-at-risk limit of 5%.

Evers explains that hedge funds tend to be run on a higher standard deviation target (between 10% and 11%). Evers also points out that “over the long term” the fund exhibits “a generally low correlation to traditional securities markets”.

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In the Markets HEDGE FUNDS: INVESTING IN GREATER CHINA

The markets of the Greater China region (comprising mainland China, Hong Kong and Taiwan) by and large have low representation in global investment portfolios, particularly those originating in the United States. There are good reasons for this; particularly for mainland China markets with restricted access for foreign investors and historically unattractive valuations.

However, much has changed over the last five years. As investors direct more resource to the region, hedge funds are providing a viable new investment route. Simon Coxeter, managing director of AsiaSource Capital in Singapore, explains why.

CHINA AND THE OPPORTUNITY FOR HEDGE FUNDS T

HERE ARE APPROXIMATELY 70 hedge funds with a focused Greater China mandate, managing a total of $5bn in assets.

The number of funds has almost doubled since the beginning of last year, and in that time assets under management have more than doubled. While the space is still small, it is evolving rapidly. Its growth will be driven by a combination of factors.

First, the increasing depth and breadth of the underlying markets is creating a wider and deeper pool for investment. Second, the group of sophisticated managers tackling these markets is expanding. Third, asset allocators will dedicate more time and resource to this space as the relatively low correlation exhibited between mainland Chinese markets and other markets make them valuable as a source of portfolio diversification, and hedge funds are recognised for offering attractive exposure to those markets.

Although market correlations tend to increase drastically in times of crisis, diversification benefits of China

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exposure could still be meaningful.

China’s positive long-term growth prospects are well-researched and reported, as are the risks to China’s economic stability. We do not address these complex issues here but note that most economists forecast robust longterm economic growth. This should provide a positive backdrop for the markets in the Greater China region, although cyclicality may cause sizeable swings around this upward trend.

Greater China equity markets display relatively high levels of volatility, feeding the opportunity for hedge funds. Retail investors can exert considerable influence over asset prices. Walking into a retail bank branch in China, with dozens of customers transfixed by the equity trading screens, one often detects a similar atmosphere to that of a Macau casino. Inefficient pricing can also be attributed to sell-side research, which can be patchy and poor quality. In general, accurate data is difficult to obtain, creating the possibility of a significant information edge for sophisticated and experienced

investors with the cultural or linguistic wherewithal.

The recent strength of China’s A and B share markets reflects a combination of improving corporate fundamentals, capital market reform, improving access to A shares for foreigners and a narrowing valuation discount of B shares to A shares. Over the first eight months of 2006, the Shanghai A share index, Shanghai B share index, Hong Kong H share index and HIS, for example, rose by 42.8%, 48.0%, 29.1% and 16.9%, respectively. Taiwan’s TWSE 225 index, by comparison, barely rose by 1.0%. This is against a backdrop of a 4.5% rise in the S&P 500, a fall of -1% in the NASDAQ, and lacklustre performances from many other emerging markets during the same period. However, this must be put in perspective: at the end of August 2006 the Shanghai A share index was still 9% lower than it was at the end of August 2001.

Hedge funds are quite nimble in taking advantage of market inefficiencies. They are also unfettered by benchmarks, which is particularly relevant as we believe much of the opportunity lies outside the most common Greater China benchmarks.

Approximately 80% of the MSCI China index, for example, is comprised of state-owned companies, when much of the exciting activity is taking place in companies run by private entrepreneurs. Moreover, nearly 40% of MSCI China consists of only three stocks. Other available indices tend to be skewed to a few large oil and gas companies or banks.

While the Greater China hedge fund universe is long-biased in aggregate, there are funds with low net market exposure, and the shorting environment is improving. Foreign investors commonly have the perception that shorting is virtually non-existent in the region. Although

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In the Markets HEDGE FUNDS: INVESTING IN GREATER CHINA

there is a long way to go before the depth and breadth of the shorting market in the US is reached, we should not be completely dismissive.

There are approximately 280 shortable stocks on the Hong Kong exchange, another 200 on the Taiwanese exchange, and the stocklending market is growing. The cost of shorting is similar to mid/small cap stocks in the US. In Hong Kong, borrowing costs for large and mid caps average between 0.5% and 1.0% and between 1.5% and 3.0%, respectively. The mechanics of shorting in Hong Kong and Taiwan still present barriers to some investors, although there are interesting strategies involving ADRs which help to circumvent technical difficulties. Until recently, there has been no viable way to short mainland markets, but earlier this year the government announced the removal of restrictions on index and individual stock shorting, and on 5 September 2006 the Singapore Exchange (SGX) began trading the world’s first index futures based on stocks listed in mainland China.

The China Financial Futures Exchange opened in Shanghai on 8 September 2006, and it will also launch index futures based on domestic equity indices. On 27 August 2006, the Chicago Mercantile Exchange (CME), the largest US futures exchange, introduced futures and options on the yuan. We expect individual stock shorting to be introduced soon.

Generating returns from the short side is particularly valuable, and is certainly not achieved consistently by all managers, but it is possible to find sophisticated practitioners successfully utilising what the short side has to offer. Experience and discipline is important, but so is focus— one fund in the Greater China

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hedge fund universe, for example, rewards analysts more for successful short ideas than for long ideas.

Liberalising capital markets One of the factors weighing on domestic mainland markets historically was the substantial state ownership of many listed companies.

With approximately 60% of market capitalisation non-tradable and stateowned, concern centered on the management and reduction of this share overhang. After a couple of false starts in 1999 and 2001, the government initiated a comprehensive program which by the end of 2006 will probably have covered most companies listed on the Shenzhen and Shanghai exchanges.

The program compensates public shareholders for the release of nontradable state shares into the tradable market. Each company makes a proposal to public shareholders as to the terms of compensation, and they in turn have the right to accept, reject, or negotiate these terms.

Compensation features have varied, including the gifting of state shares to public shareholders, cash bonuses, warrants, guaranteed share buybacks at a predetermined price, or the simple cancellation of a portion of state shares. In addition, the release of state shares into the market will be managed in stages – some companies have, for example, limited the annual release of state shares into the market to 10% of total shares. These types of compensation proposals have generally been well received by investors, with approximately 90% of listed companies with state shareholding having successfully completed reform.

While international investors have long had access to China through the Hong Kong market, access to the mainland exchanges was first limited to

Simon Coxeter, managing director of AsiaSource Capital in Singapore. Photograph kindly supplied by AsiaSource Capital, September 2006.

the small and illiquid B share market, and later complemented by restricted access to the A share market through the Qualified Foreign Institutional Investor (QFII) scheme. QFII access remains modest in size, with the current total quota of around $10bn representing less than 3% of the total domestic market capitalisation of over $400bn.

However, the quota is likely to grow rapidly over the next few years, and the restrictive initial terms of the scheme are set to improve. On 26 August 2006, QFII rules were relaxed, making it easier for institutional investors to get QFII licenses, reducing custody risks, and better recognising the interests of underlying shareholders in exercising influence over corporate governance.

Manager selection The Greater China hedge fund environment will be very dynamic over the coming years given evolution of the markets, offering the potential for attractive and potentially uncorrelated returns. Unfortunately, selecting the best managers can be a daunting task in this region, and conventional approaches employed in mature markets do not necessarily yield intended results.

The first step in approaching this space is obviously to identify the funds. Third party databases, such as the one provided by EurekaHedge, are a good place to start. Other funds can be identified through conferences, prime broker capital introduction teams, and industry contacts. Some investors fail to identify funds with

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In the Markets HEDGE FUNDS: INVESTING IN GREATER CHINA

One of the factors weighing on domestic mainland markets historically was the substantial state ownership of many listed companies. With approximately 60% of market capitalisation non-tradable and state-owned, concern centered on the management and reduction of this share overhang. After a couple of false starts in 1999 and 2001, the government initiated a comprehensive program which by the end of 2006 will probably have covered most companies listed on the Shenzhen and Shanghai exchanges. Photograph kindly supplied by istockphotos.com, September 2006.

weaker marketing efforts, which is unfortunate as these can be hidden gems. Keeping apace of the fund universe requires active scouting.

When performing due diligence on funds, we are mindful of the question: “Does this manager have an edge in generating returns, and is this edge likely to last?”Certainly, an edge is possible in what remains an inefficient asset pricing environment. Edge can emanate from a number of sources, whether it is a significant information edge or experience and skills in a strategy few others have. There are managers in this universe with impressive contact networks (government, company management, private equity, sell-side and buy-side) and superior access to quality information; there are also managers who claim an information advantage when no such advantage actually exists. Within the universe, there are managers with skills and experience in strategies others may take several years to replicate, creating a real window of opportunity for superior returns. This is likely to remain true for some time to come, as strategies

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proliferate and managers from different backgrounds enter the fray.

After meeting with both underlying managers and asset allocators, we suspect that one useful area of due diligence is neglected, one that is helpful in verifying the existence of an edge. Discussing investment process with a manager is far more illuminative if you have some experience in the markets. Even a basic understanding of the Greater China markets can reveal weaknesses in a manager’s strategy. We are not suggesting market practitioners have a monopoly on selecting good funds, but we do believe capital is allocated to some funds with an inadequate grasp of strategy and edge. For example, a manager claims to have an activist approach, the purported edge in generating returns.

It is easy to make this claim, but more difficult to corroborate. Knowing the stocks involved, perhaps even knowing company management or other industry contacts familiar with that company, can go a long way in substantiating that manager’s investment strategy.

Operational due diligence on funds in this space warrants a separate article, but it goes without saying there are greater challenges than in developed markets. The relatively simple process of doing background checks on US managers cannot be replicated for a mainland Chinese manager who has never worked overseas or for an international firm. Performing adequate due diligence is time consuming, and relies more on information garnered through guanxi (relationships) than in developed markets, making it hard for investors to reach a level of comfort on some managers. How, for example, do you efficiently check for criminal records in China? Fortunately, many of the funds in our universe use reputable international law firms, accountants, administrators and prime brokers – but even for a westerner like me who speaks Chinese, there are areas of due diligence beyond my reach. It is no accident that one of the partners in our firm was a government official in China.

As one would expect with an emergent investment class, track records are short. Of the funds in the Greater China universe, over half have a track record of less than two years. Obviously, many investors focus on track record in evaluating a fund. Although research suggests younger funds outperform older funds (perhaps partly because younger funds assume higher levels of risk), younger funds also exhibit a higher failure rate. Some managers have previous track records at longonly funds; others have never run money before. There are examples of great sell-side analysts or long-only managers who fail to excel as hedge fund managers.

Performing thorough due diligence on managers is essential then, and can be challenging without the requisite blend of skills, experience, resource and focus.

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Jim wondered if there was an easier way to get his own copy of FTSE Global Markets...

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Debt Report COVERED BONDS: WAMU COMES TO EUROPE

WaMu leads US issuers in European covered bond Washington Mutual, the federally chartered savings institution, has launched a covered mortgage-backed bond in Europe, making the company the first US-based bank to complete a transaction of this kind in the $1.7trn European covered bond market.

ASHINGTON MUTUAL INC. (WaMu) is the first USbased bank to complete a deal in the European covered bond market with its sale of $5.1bn of eurodenominated covered bonds; the first element in a €30bn covered bond program. The issue was arranged by Barclays Capital, with ABN Amro and Deutsche Bank joining Barclays as joint leads and attracted a AAA rating from Standard & Poor’s.The bank reportedly intends to follow up the issue with a further $25bn deal in October.

Covered bonds are securities backed by mortgages or public sector loans. In this instance, the transaction is collateralised by a pool of mortgage loans secured by first-lien residential properties located in the US. The first transaction is intended to contain first-lien mortgages to prime quality borrowers with a fixed period of five years and an adjustable period thereafter. At the time of initial issuances, the loans will have a weighted average seasoning of approximately 20 months.

The deal could mark a watershed in the way that US mortgage banks raise capital. US home lenders are now looking to Europe for funding options outside the Federal Home Loan Banking (FHLB) system, as a response to proposed changes to how the system is regulated.

The FHLB, which regulates the 12 home loan banks, issued a proposal in March, that will cut dividend payouts

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until the home loan banks increased their retained earnings. Facing lower dividend payments, customer banks are expected to sell their stock in the home loan banks, in turn reducing their capital. All 12 banks and their customer banks reportedly oppose the scheme, but in the interim WaMu has led an alternative charge to foreign shores for cheaper funding, that might just attract more followers that the FHLB might like. WaMu also carries some clout as the system’s biggest single customer. Between 2001 and 2004, WAMU grew its residential loan-servicing portfolio through a series of large-scale acquisitions and mergers, which helped the bank become one of the

three largest mortgage lenders in the US (please see FTSE Global Markets, Issue 9, page 66). However, the jury is still out on whether this particular transaction will open the floodgates of US home lenders raising funding in euros. The dollar is still losing value against the European currency and it may be, that over the medium term, whatever short term problems the banks face, it may still be cheaper to raise funds in US dollars.

Nonetheless, the deal is interesting on other counts also. The US, like the United Kingdom and the Netherlands, has no explicit legal framework for covered bonds. In some jurisdictions, including Germany, Spain, Ireland, Sweden, Denmark, Norway, Finland, France, Portugal, and Italy, there is dedicated legislation that provides for asset segregation upon issuer insolvency without having to transfer assets off-balance-sheet. In this transaction a mortgage bond is created to serve as collateral for the covered bond.The residential mortgages are not the direct collateral of the covered bond, but flow through the mortgage bonds along with an associated swap,

WaMu’s covered bond transaction structure Washington Mutual Bank Mortgage Bond Issuer Cover pool

Deutsche Bank Trust Co. Americas (Mortgage Bond Indenture Trustee)

Floating-rate mortgage bonds

Floating-rate mortgage bond proceeds

Specified currency covered bond rate

WM Covered Bond Funding

Deutsche Bank Trust Co. Americas (Covered Bond Indenture Trustee)

Pledge of floating-rate mortgage bonds € covered bonds

Covered Bond Swap Provider

Covered bond proceeds © Standard & Poor’s 2006.

Covered Bond Investors

Reproduced with the kind permission of Standard & Poor’s, October 2006.

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assuring timely interest and ultimate principal on the covered bonds. This means that the transaction complies with existing techniques commonly used for a Federal Deposit Insurance Corporation (FDIC) regulated institution, including the pledge of assets. In US structured finance transactions, an FDIC insured bank may grant a perfected security interest in collateral, and the security interest, subject to certain conditions, will be enforceable against the bank and its receiver or conservator notwithstanding the insolvency of the bank.

The deal also carries substantial over-collaterisation. The structure provides for both a general recourse to WaMu assets and recourse to the

cover pool in an amount greater than the outstanding principal amount of the mortgage bonds (over collateralisation).

“The structure provides for the cover pool to be reassessed by Standard & Poor’s quarterly, and the over collateralisation to be reset to Standard & Poor’s levels,”according to the pre-transaction rating issued by the ratings agency.

Covered bonds are different from traditional mortgage-backed securities because the loans used to secure the obligations remain on WaMu’s balance sheet, which allows the bank to maintain control over the assets. The program “should make our debt more sought after on a global basis, ultimately reducing our

company’s cost of funds, as well as increasing our investor base beyond the US,”said Kerry Killinger, chairman and chief executive officer, in an official statement following the issue.

Killinger noted that the depth and liquidity offered by the European covered bond market were compelling as the company considered alternative funding sources, adding that WaMu plans to be a regular issuer in this market to complement its other borrowings in the US. The bonds are issued by WM Covered Bond Program, a specialpurpose entity which, in turn, purchases floating rate US dollar denominated mortgage bonds issued directly by WaMu (please refer to the transaction chart on the previous page).

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Debt Report EXOTIC EMERGING MARKET DEBT

The rolling bandwagon of EM debt issues A landmark $1.2bn financing for a Trinidad petrochemical project at the beginning of September; plus a benchmark debut for Mongolia culminated in a chain of explosive financings for more exotic emerging market issuers in the third quarter of this year, with more to come. Blazej Karwowski reports on some of the more rarefied deals of the last eight weeks.

T’S A GOOD time for exotics.

Emerging market borrowers have never had it quite so good, with financing cheaper than ever before and issuers showing renewed confidence in negotiating better terms. A ready example is the $1.2bn financing for Methanol Holdings Trinidad Limited (MHTL), the world’s second largest producer of methanol secured Trinidad’s largest transaction to date for a new petrochemical complex in Trinidad and Tobago. The entire facility was arranged and underwritten by KfW IPEX-Bank (IPEX). “While the transaction clearly stands out in comparison to other deals in Trinidad, it is also an important step for the bank, being by far our biggest underwriting commitment in the petrochemical sector,”explains Matthias Wietbrock, first vice president, basic industries at IPEX. Some 75% of the loan is covered by guarantees from Euler Hermes, the German export credit agency (ECA) which provided manufacturing risk mitigation and an export credit guarantee. The balance of financing was arranged on commercial terms.“The margins are very competitive for the Trinidad market. At the same time, both the margins and the collateral were attractive enough to ensure strong demand from lenders,”says Wietbrock.

The deal is the seventh large-scale transaction arranged by IPEX for Trinidad’s energy sector. According to Wietbrock, the deals demonstrate the growing sophistication in the structure of project financing packages supporting Trinidadian

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companies. While a facility in the mid -1990s would have comprised a plain vanilla non-recourse structure, these days loans are “much more complex and involve commercial tranches,” Elsewhere in the region, tapping the market for the first time as an investment grade company, Brazil’s Embraer secured a $500m stand-by facility in a deal that is the aircraft manufacturer’s largest fundraising and introduces new hedging protection ahead of scheduled debt repayments. It was overwritten in syndication, allowing the arranging banks to increase the size of the loan by $100m.

“We initially approached the market with $400m. Even with the increase, we were still oversubscribed,”says Cynthia Benedetto, finance director at Embraer.

The stand-by loan comprises two equal tranches. The first is a trade finance facility that can be disbursed within the next three years. It will have assigned a two year term from drawdown date and is to be used in either pre-export or import financing. The margin for preexport purposes is 40 basis points (bps), while import-related loans pay 45bps.

The other $250m is structured as a revolving credit facility. The term is to be determined individually for each drawdown, but will not exceed five years. The revolver pays a margin of 60bps.“This facility should become a tool in changing the profile of company’s short and long term debt,” says Benedetto. “It provides a hedging protection for the parts of debt which are soon due and will not be refinanced.”

BNP Paribas was sole book runner, and the syndicate featured mandated lead arrangers Banco do Brasil, Banco Bladex plus Sumitomo Mitsui Banking Corp.

According to Benedetto, Embraer was eager to get the deal done, as it cash position (over $500m net cash after first half of the year) is good, says Benedetto.

Cheaper financing and more banks willing to take on emerging market risk were important factors in the deal’s timing, she adds. The company also capitalised on its relatively high credit ratings. Embraer, whose production is mainly for export, received BBB- from Standard and Poor’s and Baa3 from Moody’s almost a year ago. Brazil is rated two notches below investment grade by all major rating agencies, but about a dozen of its largest exportoriented companies are not constrained by the country ceiling due to their strong cash positions in foreign currency.

Embraer receives the bulk of payments in foreign exchange, therefore its transfer and convertibility risk is perceived to be lower than that of Brazil.

Iron producer Samarco Mineração, is another above-sovereign rated corporate issuer and is one of Brazil’s top three mining companies. In August, it closed its largest financing to date, an $800m syndicated loan, which will be used to part-finance a new $1.2bn plant in Ponta Ubu in Espírito Santo state, near to the company’s two existing iron ore processing facilities. The plant will increase company output by 54% and increase Sanmarco’s share of the global seaborne pellets trade. It already ranks second in the world, behind its stakeholder CVRD. After the upgrade, its annual sales are expected to exceed $1.5bn versus $1bn now. Samarco is owned 50/50 s by CVRD and BHP Billiton and has benefited from a recently revised rating. Following a

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review of some country ceilings, Fitch Ratings upgraded the company’s foreign currency Issuer Default Rating to BBB- in June. Two months later the agency raised its rating again, to BBB, placing the company firmly in the investment-grade basket. The loan has an average margin of 60bps over London Inter-bank Offered Rate (Libor). “It would have been improvident not to take advantage of this situation. Despite the fact that it operates in Brazil, Samarco has a triple B rating,”says Clemente Rocha, Samarco’s financial manager for new projects.

Elsewhere, profiting from favourable conditions for many Middle Eastern borrowers, Energy Spring LNG Carrier SA, an Omani shipping company, refinanced its debts via a $136m project finance facility. The proceeds will be used to repay an outstanding 2004 company loan, to buy the liquefied natural gas (LNG) vessel Sohar. The original $116m loan still has 10 years until maturity, but Energy Spring decided to refinance it ahead of schedule in order to achieve better terms.The new loan has a 16-year tenor and, although it includes the vessel and a pledge of shares as collateral security, it is non-recourse to Energy Spring’s shareholders. Gulf International Bank (GIB), the merchant bank jointly owned by the six Gulf Cooperation Council states, provided both facilities.“Since the first financing, the market has obviously changed and there has been an improvement in pricings available to borrowers.The new loan was structured on an annuity repayment profile basis with a tenor of 16 years,”says Tarun Puri, vice president for project finance at GIB in Bahrain. Puri says that the 12-year loan was a standard in Middle Eastern shipping finance when it was arranged in 2004, but it now increasingly gave way to 18-year or 16-year deals, and the borrower aimed to restructure its debt accordingly. Puri adds that his team has

just completed another deal in the shipping sector, this time for $350m.

Vessel owners such as Oman Shipping Company and Mitsui have been increasingly active in servicing the needs of the fast-expanding LNG industry in the Gulf. Operating over 500 vessels, Mitsui is one of the world’s largest shipping organisations and it also acts as a technical adviser to many Omani shipping firms. “Things obviously look quite bullish as we see a huge demand not only in shipping, but in other sectors,” Puri says. However as the volume of new issuance grows, growing competition from international shipping finance specialists is putting a significant downward pressure on margins.

With costs of fundraising hitting new lows Oman Gas Company is another borrower to refinance outstanding debts. Owned by ministry of Oil and Gas (80%) and Oman Oil Company (20%), the firm signed a $234.5m facility this September. The loan has a margin of 0.5% over London Inter-bank Offered Rate (Libor) with a six and a half year maturity. It was arranged by Gulf International Bank (GIB) and syndicated to eight additional banks: internationals Mizuho Corporate Bank and Calyon participated together with six local houses, such as Oman International Bank or bank Muscat.

Oman Gas will use the proceeds to refinance the outstanding balance on its $410m credit facility which it raised in 2000. Among other collateral, the loan is secured against commercial mortgage as well as commitments of the shareholders of the company.

Cheap money also tempted Ukraine’s Industrial Union of Donbass (ISD) to secure a $350m financing facility that is the first part of a $2bn plus expenditure programme aimed at modernising its steel production. The move comes as syndicated borrowing is expected to increase significantly among Ukrainian corporates, due to the stabilising political

FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2006

situation and capital needs that are particularly pressing in heavy industries.

The loan divides into a $250m commercial tranche and $100m in a long term investment loan from the International Finance Corporation (IFC), the World Bank’s private investment arm. The commercial tranche has a five year tenor and pays a margin of 2.7% over London Inter-bank Offered Rate (Libor). Meanwhile, the IFC tranche has a tenor of seven years and is said to pay a slightly higher margin. Both tranches are collateralised with a pledge of fixed assets, namely ISD’s industrial complex Alchevsk Coke. Apart from the three coordinating mandated lead arrangers, Citigroup, Société Générale and IFC, the syndication involved 15 banks. First drawdown under the facility took place in late September.

Syndicated loans are a primary source of funding for Ukrainian metal and mining industries, says Ilia Poliakov, director, structured commodity finance metals and minerals, CIS and Eastern Europe at Société Générale Corporate and Investment Banking (SGCIB). The sector has produced just one Eurobond issue to date, leaving syndications to dominate corporate financing needs — mostly because they can be secured against export-related receivables. Up to 80% of Ukrainian steel production is sold on the international markets.“The reason why this latest loan is uncharacteristically secured against fixed assets is that ISD [has] already [been involved in two] large syndications in 2004 and 2005 both led

by SGCIB, which were collateralised with receivables,” says Poliakov. This latest transaction is ISD’s longestmaturity loan to date; although in size it matches last year’s benchmark preexport finance facility, which was worth $350m. Analysts, however, indicate the market is far from saturated, noting a broad need for capital in the steel and mining industries.

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Regional Review MIDDLE EAST: BAHRAIN TRUST REGULATIONS

Armed with growing confidence and a new moniker, the Central Bank of Bahrain (CBB), formerly the Bahrain Monetary Agency (BMA) has introduced a raft of legislation addressing financial services, Islamic financing, insurance and asset management that brings Bahrain in line with global standards and encourages a new breed of asset managers as the country’s investment business grows. The latest initiative is a new trust law, governing trustees and trust administration, that the CBB hopes will encourage an industry around the establishment, management and administration of private business interests and wealth in estates and trusts as well as reinforcing the Kingdom’s efforts to establish Manama as an international financial centre.

AbdulRahman Al Baker, executive director, financial institutions supervision, at the CBB. Photograph kindly supplied by the CBB, October 2006.

CBB deepens investment services regulation AHRAIN’S NEW TRUST law opens the doors for financial institutions to offer a broad range of services using the trust mechanism, such as real estate investment trusts and private pension schemes.“The law is aimed at providing a clear and sound legal foundation for trust business, which is showing potential for growth in the Middle East region,” says Mr. Abdul Rahman Al Baker, executive director, financial institutions supervision, at the CBB. While trusts are a widely used form of wealth preservation in developed countries, it is a fairly new phenomenon in the Middle East.. The potential for growth, however, is tremendous as the region boasts the world’s highest concentration of high net worth individuals, whose collective wealth is estimated at over $1.3trn.“The establishment of a trust, in a well-regulated environment, will broaden the available options for the

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transfer of business, property or other assets from one generation to another.

It will also enable the Bahrain-based wealth management industry to develop and extend more innovative products and solutions,”he adds.

In Bahrain, nearly 20 banks currently offer wealth management services. “We hope the enactment of the trust law in Bahrain will encourage some of these institutions to offer such a service to their clients in the Middle East region,”says Al Baker.

The new legislation provides for a trust to be established for a duration of a maximum of 100 years. It requires a trust, to be registered with the CBB. The trust property may comprise any form of property, moveable or immoveable, tangible or intangible.

Additionally, a trust may have one or more trustees, and the law details a trustees obligations quite thoroughly and requires a licence from the CBB for exercising the functions of a trustee. It

also expressly provides for high levels of confidentiality in the execution and administration of the trust.

The law is part of a raft of regulatory and supervisory rules covering investment business licensees that will lay out specific rules to be followed by investment firms in managing highlevel controls, risk identification and risk controls as well as regular and adhoc notifications to the CBB. The move is part of a comprehensive overhaul of Bahraini investment, insurance and banking regulation. “The new rulebook, in particular that element servicing asset management, fund administration and custody will create an environment of flexibility and encourage international best practice,” says Al Baker.

The CBB has just completed a consultation period, which ended at the end of September, prior to finalising the rules in their final form; the modules will ultimately be included in the CBB Rulebook, probably at the end of this year. “The current consultation advances CBB’s work on the

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Investment Business Rulebook, which constitutes Volume 4 of the CBB Rulebook,” explains Al Baker. “While most of the key regulatory requirements were issued in April 2006, this second phase will complete the full scope of rules applicable to investment business activities.” The CBB is seeing strong demand for its investment business licenses, says Al Baker, and once finalised, it will be the strongest and most comprehensive framework in the region,”he adds.

“If you want to be a financial centre, you must create investor confidence.

We have worked hard over the last 35 years to do just that and this latest round of regulation will encourage

that,”explains Al Baker. The trust law is another foundation stone to help deepen the Bahraini investment market he says, and in particular encouraging the development of alternative investment vehicles. For one, he says, “We understand private equity and we think there is a good appetite for it as well as private placements supporting private equity funds. We are also in the process of introducing professional investor schemes, catering for the establishment of alternative investment vehicles, such as private equity funds and REITs.” However, he notes that REITs will be “listed and will not operate as Islamic style trusts. Islamic trusts are aimed more at the family trust

market; and in some instances will be marketed to the retail sector”. It is a theme close to Al Baker’s heart. “There is a growing army of interested, educated, professionals in the Gulf Region and in Bahrain in particular who are looking for new investment opportunities, he maintains and he believes that the BMA has an important role in providing the right kind of environment to encourage the growth of a local retail investment market. “It could involve as much as 50% of the whole asset base of the region and it is of a size that we simply cannot ignore.

Therefore it is incumbent upon us to provide those professionals with a secure and long term investment

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environment. Proper regulation is a crucial element in that effort,” stresses Al Baker.

Al Baker believes that the applications of the trust law are wideranging. For one it “will help make Bahrain the place for establishing Islamic trusts in the Middle East,” thinks Al Baker. In the past, “it has been difficult to establish trusts that can operate in line with Sharia principles, we think this latest element in our strategy to make Bahrain the centre of innovation in the region not just for Islamic investment products, but also conventional and alternative investment products supported via the establishment of a trust.”

Bahrain has emerged as an increasingly popular centre for the listing of Islamic funds. In August, the BMA authorised the Islamic equity fund, sponsored by Global Investment House, the Kuwait-based asset management firm. The Global GCC Islamic Fund has raised $300m for investment in a portfolio of Shari’acompliant companies in the GCC region. The Bahrain-domiciled, US dollar-denominated open-ended fund, is the 23rd fund to be incorporated in Bahrain by Global Investment House, a leading asset management firm in the Middle East region. Global Investment House currently manages assets in excess of $6.3bn, and is listed on three bourses in the GCC region, including the Bahrain Stock Exchange.

There are around 100 Islamic equity investment funds, with combined assets of just under $6bn says Arab Banking Corporation (ABC). Growing at between 12% and 15% a year, they provide one of the fastest growing sectors within the Islamic financial system. Equally, the Islamic fund industry is a fast growing segment of Bahrain’s overall mutual funds industry, which has been posting phenomenal growth in recent years.

30

The total assets under management

by BMA-authorised mutual funds have grown 55% to $8.3bn in the past one year alone, while growth in the last four years has exceeded 180%.

Typically, Islamic equity funds tend to target high net worth individuals with investments in the funds ranging between $50,000 and $1m. Target markets for Islamic funds vary; some cater for their local markets, such as Malaysia and GCC-based investment funds, while others range more widely. The launch of Islamic equity funds in the early 1990s, has also spurred global index providers to set equity benchmarks, such as the FTSE Global Islamic Index Series and the Down Jones Islamic market index.

Regulations governing Collective Investment Schemes (CIS), issued by the BMA in 1992, are the cornerstone of mutual fund regulation in Bahrain, says Al-Baker. CIS rules regulate the structure and operation of mutual funds and provide a modern, forwardlooking platform for registering and managing mutual funds in and from Bahrain. The number of collective investment schemes (CIS) authorised by the BMA totaled 2,094 at March-end 2006, compared with 1,657 in 2005 and 1,256 funds in 2002.

Locally domiciled funds, particularly Islamic funds, have driven some of the growth in fund registrations in Bahrain,

says Mohammed Ayman Al Tajer, director, financial institutions supervision, at the CBB. Moreover, says Al Tajer, “Bahrain is fast becoming a prominent destination in the region for collective investment schemes particularly locally-incorporated investment funds.” There were 92 locally incorporated mutual funds authorised in Bahrain by the end of March this year, compared with 63 last year and 28 back in 2002. The assets under management of these locally incorporated funds were $2.8bn at March-end 2006.

Of this locally incorporated CIS 36 were Islamic funds, with a value of over $915m. “The average size of Bahraindomiciled funds, authorised during 2006, was $60m and the sponsors/managers of these funds are prominent institutions from outside Bahrain, including UK and other GCC states,”says Al- Tajer. Among the funds authorised by the BMA so far this year include those sponsored by Kuwait-based Gulf Investment Corporation, Mashreqbank (UAE), DTZ Finance (UK), Unicorn Investment Bank (Bahrain), Global Investment House (Kuwait) and Al Tawfeek Company for Investment Funds (Cayman Islands), among others. “Strong investment opportunities in the GCC and MENA region are increasingly attracting investors looking for portfolio diversification,”says Al Tajer. As a result, mutual funds with a regional investment focus have increased dramatically in recent years, with Bahrain proving a major destination for registration of such funds. The CBB is also implementing the Securities Settlement System (SSS), which will facilitate real-time, online settlement of all Government securities transactions, including sale/purchase, auction (issue/settlement) and Repo (repurchase) transactions. Both systems will be seamlessly integrated and are expected to go live during the first half of 2007.

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Ed Parker, sovereign credit analysts of Fitch Ratings adds,“EU membership is a strong underpinning for the current investment climate. It offers investors the protection of stability, transparency and a legal and regulatory framework. The corruption that has dogged many of these countries will not disappear overnight but there will be laws to deal with it.”

EUROPE: SOUTH EASTERN STATES VIE FOR EU BENEFITS

Playing hardball gets results Now that Central and Eastern European markets are looking more mainstream, investors are scouting around for alpha generating opportunities in the less developed South-eastern European region.

Bulgaria and Romania are the jewels in the crown, but hidden gems may be found in Croatia, Serbia and Bosnia and Herzegovina. As with any emerging market country, though, fund managers are advised to tread carefully. Lynn Strongin Dodds reports.

ACH COUNTRY POSES it own challenges but there is no doubt that the prospect of European Union membership is giving Southeastern Europe its new found lustre.

Romania and Bulgaria are slated to join the club in 2007. Croatia is next in line, set for a 2009 entry although most analysts believe 2010 is more likely. Serbia and Bosnia meanwhile will probably not be members for another five to six years. Albania,

E

Macedonia and Montenegro are even further down the EU curve but are currently laying the groundwork. The latest potential roadblock for full fledged membership for Romania and Bulgaria is the respective four and six conditions set out by the European Commission this past May. As Sandor Gardo, an economist with Bank Austria Creditanstalt, which is a member of UniCredit Group, notes, “I think both countries

FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2006

will be ready by 2007. Ed Parker, sovereign credit analysts of Fitch Ratings adds, “EU membership is a strong underpinning for the current investment climate. It offers investors the protection of stability, transparency and a legal and regulatory framework. The corruption that has dogged many of these countries will not disappear overnight but there will be laws to deal with it.”

However, Parker notes that, “Given

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the timescale, it is unlikely that Bulgaria will solve all its corruption problems at home but not every EU country is corruption free. I think the most important thing is that the Bulgarian government shows it is making progress.”

Bulgaria’s particular check list is longer and more sensitive than its South Eastern neighbour whose issues are mainly technical and focused on agricultural criteria.

Romania needs to finish setting up fully operational agencies for EU farm aid and to maintain proper veterinary standards and proper facilities to collect and treat animal by-products. Last but not least, the country must ensure its electronic tax system is compatible with the EU to allow proper collection of value added tax.

Several of Bulgaria’s so-called red flags also involve agricultural issues such as the animal registration

mechanism and the lack of facilities for collection and treatment of animal by products. However, tackling corruption is top of its priority list if it wants to join the exclusive EU fold. The country has made significant progress and won plaudits for its recent constitutional amendments reducing the scope of immunity of members of parliament and moves to launch high level anti corruption investigations. There is also a new legal framework to deal with high-level corruption and organised crime, including a new unit in the prosecutor’s office, a new general director of police and undercover agents.

There is still a lot of work that needs to be done. Europe’s Commission wants to see clear actions and not just words in battling organised crime networks. It is also pushing for more effective and efficient laws to be implemented that

fight against both fraud and money laundering. Over 100 mafia style contract killings were recorded since 2001 and they have all remained unpunished. The Commission noted in its latest report card that “indictments, prosecutions, trials, convictions and dissuasive sentences remain rare in the fight against high level corruption.”

In response, the Bulgarian Parliament this past June put another screw in its anti-money-laundering law. Amendments to the Measures against Money Laundering Act oblige banks to ask for information concerning the individuals behind company accounts, the origin of funds, and the reason for spending.

Financial institutions must also inform authorities of suspicious activity by their clients while offshore transfers will be closely monitored. Despite the challenges that lie ahead, the financial community are bullish on the

European Commission’s President Jose Manuel Barroso, left, listens to Romanian president Traian Basescu, right, at the Cotroceni presidential palace in Bucharest Romania on September 27th, 2006. Barroso visited Romania a day after Romania and Bulgaria were cleared to join the European Union on January 1st, 2007. Photograph by Vadim Ghirda, supplied by EMPICs/Associated Press, October 2006.

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Regional Review EUROPE: SOUTH EASTERN STATES VIE FOR EU BENEFITS

prospects for both countries and the main attractions. The Bucharest Stock snapping up shares in the Black Sea region in general. Romania and Exchange also turned in the most state’s electricity monopoly. More Bulgaria followed by Croatia and impressive performance in the region, power firms are in the pipeline for this Serbia have made great strides on the boasting a 60% gain last year. year as well as the eagerly anticipated economic reform front. Impending Investors can invest directly in $920m IPO of state telecom company membership of the EU club has Romania as well as Bulgaria, Croatia, Romtelecom, slated for a dual listing already paid dividends in terms of Serbia and Bosnia if they have a the other market probably being the foreign direct investments as well as security account at the Raiffeisen he London Stock Exchange - later in Zentralbank in Austria or via global the year. investor confidence.

The Romanian government is set to Romania was the main destination depositary receipts (GDRs).

Investors, though, are advised to sell its entire 46% stake in the in the region for overseas investments attracting over 50% of foreign direct exert more caution than usual telecommunication firm within the investment (FDI) flow of South navigating their way around these next six months. Greece’s largest Eastern Europe in 2005. This year emerging market bourses. In the past phone company, the Hellenic analysts expect the country to double couple of months, the BSE as well as telecommunications Organisation, owns the remaining 54%. last year’s FDI figure to about Although not as popular as €10bn on the back of its flat Romania, the Bulgarian 16% income tax and pending Stock Exchange (BSE) has accession to the EU. Bulgaria Michael Massourakis, senior also captured investors’ was the second favourite spot manager of Alpha Bank in Greece imagination, according to with €1.8bn last year and this says, “We are talking about a region Wolfgang Steger, an analyst is predicted to rise to €2.4 bn that has over 60m people, with a with Austria based this year.

Raiffeisen International Michael Massourakis, third of the population in Romania.

Bank-Holding. He points to senior manager of Alpha the success of the recent IPO Bank in Greece says, “We of Bulgarian-American are talking about a region that has over 60m people, with a the rest of the region’s exchanges have Credit Bank (BACB), whereby 30% of third of the population in Romania. all been hit by the same volatility that its shares were sold for $67.5m.

They are also quite different from has impacting on their more International institutional investors Jacob bought 85% of the shares on offer the underdeveloped countries such developed counterparts. as Greece was 20 to 30 years ago. Grapengiesser, fund manager of East while the remainder went to The countries have been quicker to Capital Asset Management based in Bulgarian institutional and retail adapt Western market practices, Sweden, says “I think one of the investors. Fund managers initially state of the art technology, economic problems for these markets in general focused their attention on Bulgarian and legal structures plus they have is that they are small. They need to list companies included in the blue-chip the benefit of advice from one to two more telecommunication Sofix index, which has risen more international organisations. EU companies and large banks to be more than ten-fold since 2000 and in 2004 membership will also mean more developed. Romania will continue to took the first place in growth on a stable economic growth which sets be the favourite because it has the global scale.

However, they have also been lured these countries apart from other largest companies and an active privatisation programme that has by the potential of the broader BG40 emerging market countries.”

For now and most likely in the seen companies listed from a wide index of the most traded stocks which future Romania will remain the most range of sectors including utilities, was launched in early 2005. The 40 most liquid stocks represent a diverse popular hunting ground for telecoms and banks.”

This perhaps explains why the group ranging from Bulgarian institutional investors. The country’s political stability combined with an $245m initial public offering of power Telecommunications Company (BTC) economic growth rate of about 5% grid company Transelectrica in July to Sopharma, DZI Bank, Sofia BT, and a domestic consumer base of was almost six times oversubscribed, Zlatni Pyassatsi, a tourism company Biovet, a veterinarian more than 20m people are some of its with both local and foreign investors and

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Bosnia and Herzegovina is also SASE forged closer ties with the pharmaceuticals firm. For the more adventurous investors, there is Croatia, acting as a magnet for yield hungry Vienna Stock Exchange through a Bosnia and Herzegovina and to a lesser investors with discounted stocks memorandum of understanding. This extent Serbia due to political tensions. whose prices promise double digit is not only expected to boost liquidity Albania, Macedonia and Montenegro, annual growth in the medium term, but market transparency which will which recently won its independence on the back of continual GDP growth, make the market even more attractive from Serbia are still too small and stable domestic currency and an to foreign investors. As for Serbia, last underdeveloped to be on investors’ improving business environment. In year the Belgrade Stock Exchange radar screens. The next crop of EU January, the ex-Yugoslav country introduced a new index, the Belex 15, hopefuls, however, also have economic began talks with the EU on a comprising of the 15 most liquid Stabilisation and Association (SAA) stocks. However, for now there is too and social hurdles to overcome.

Croatia is in the best shape but the agreement, designed to forge closer much uncertainty over the country’s government still needs to push ties with the EU and seen as the first EU future mainly because pre-entry through painful reforms in healthcare step toward eventual EU membership. talks have been suspended due to the and reducing state subsidies to public Although the timeframe is unclear for country’s reluctance to hand over General Ratko Mladic, former companies, according to Bosnian Serb commander, to Martin Stelzeneder, an the U.N. war crimes tribunal. analyst with Raiffeisen Croatia is in the best shape but There are also question marks International. More work the government still needs to push over the future status of also needs to be done in through painful reforms in Kosovo which is currently the privatisation arena being debated and discussed where activity has been healthcare and reducing state in the United Nations. more or less dormant for subsidies to public companies, Stelzeneder, an analyst the past two years. All the according to Martin Stelzeneder, an with Raiffeisen International, big deals were delayed analyst with Raiffeisen International. says, “Serbia’s stock market although there has been More work also needs to be done in has been a strong performer some movement in the the privatisation arena where activity but there is a cloud over the insurance, bank, steel and country. Talks with the EU shipyard sectors to sell off has been more or less dormant for have been put on hold and remaining government the past two years. the Kosovo situation remains stakes. The second IPO unclear. There are also phase of INA, a domestic concerns that nationalistic oil company, is also scheduled for some time this year. possible EU accession – some analysts parties might gain a majority in next The lack of large, headline grabbing point to 2015 - foreign investors are year’s elections and that could create IPOs has not hurt the Zagreb Stock not wasting time buying Bosnian further tension. ”Peter Sanfey, lead Exchange. The market has been equities in anticipation of a so-called economist of the European Bank for booming thanks to the takeover fever convergence play. The country is still Reconstruction and Development circling around domestic drug recovering from the 1992-1995 civil (EBRD) adds, “The country also still producer Pliva. The company is war, in which a significant part of its faces some difficult challenges in road and social terms of restructuring the economy being courted by two suitors, industrial, Icelandic drug maker Actavis and US infrastructure was destroyed. The and moving ahead. It has to catch up rival Barr, both of whom have been government is busily forging ahead after a lost decade in the 1990s where there was no reform. The country was gradually raising their offers in a rebuilding the country and economy.

The country’s two exchanges – the in isolation due to sanctions. $2.3bn bid battle. This has pushed the index to an all time high, with other Sarajevo Stock Exchange and the Although there has been rapid growth blue chip companies such as sugar Banja Luka Stock Exchange – were over the last five years, it is not a manufacturer Viro and shipping established in 2002 to service the simple task to turn a country around. company Tankerska Plovidba basking voucher privatisation programme in We are, however, optimistic about its the country. This past March, the long term future.” in the limelight.

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Regional Review LATIN AMERICA: PRIVATE EQUITY

When Brazil’s TAM Linhas Aéreas airline went public in March, comparisons were made with the 2004 initial public offering (IPO) of its archrival, discounter Gol Linhas Aéreas Inteligentes.

Both were Brazilian, both were airlines, both listed on the Bovespa. The IPOs also had another thing in common. Both were successful and lucrative exits for private equity funds. TAM, for example, raised close to $700m, with most of the monies split between five investment funds.

After an extended period in the doldrums, it looks like private equity in Latin America is beginning to pick up in momentum. John Rumsey reports from São Paulo.

PRIVATE EQUITY IN MOTION HIRTEEN OUT OF the 20 IPOs in the Brazilian market since early 2005 “have been in the portfolios of venture capital or private equity firms at some stage,” according to Marcus Regueira, president of the Association for Brazilian Venture Capital and Private Equity. These are not minnows either, with substantial deals including the likes of Lupatech, the parent company for Valmicro and MNA valves which is located in the industrial southern part of Brazil, and electronic commerce specialist Submarino.

It is a big turn-around. Until recently, Brazilian private equity had faded to grey. The 1999 devaluation began the process of decline. Reverses in global markets with the resultant lack of

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liquidity and concerns over regional political instability— especially with the election of President Luiz Inácio Lula da Silva in 2002—hastened it.

Then also, there were more interesting opportunities in Asia. Those Latin private equity firms that depended on capital markets to exit their positions found they were locked in as the market fell and consequently all parties and partners (both limited and general) fell into near silence.

In 2003, the pendulum of global liquidity began to swing back in favour of Latin markets. To the mix was added increased macroeconomic stability.

That enabled private equity firms to begin selling off their investments through the equity markets. In turn,

For many private equity firms working in Latin America, which take minority shareholdings and seek an exit through capital markets, proving a track record has been hard. The lack is a roadblock for drumming up more business. In particular, track records for private equity funds are poor over the short to medium-term. Photograph

by John Leaver, supplied by Dreamstime.com photography agency, October 2006.

they posted positive results to their investors and began to generate more interest in their asset class.

By 2005 private equity fund raising began to show some brio. Alex Burgess, managing editor of Venture Capital Latin America, explains the rapid transformation of the industry.

In 2004, the value of private equity exits reached $600m throughout Latin America. One year later and the value of exits reached $1.5bn. By the middle of this year, exits have totalled $2bn and Brazil—the largest market by far— has dominated, with $1.25bn worth of IPO exits in the period.

According to Innes Meek, portfolio director for Latin America and China at CDC Group, the UK government-

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owned fund of funds with net assets of $2.9bn,“Valuations are still reasonable in Brazil and are still in single digit multiples of earnings, and exit possibilities have improved, especially with the creation of the Nuovo Mercado.”The market has improved in Mexico as well. Even though Mexico’s capital markets are much thinner than Brazil’s, there have already been two significant offerings in the year to September, says Burgess. Homebuilder Homex, for example, raised $246m and Mexican furniture and household goods retailer Grupo Famsa $230m in Mexico and the United States.

Fund raising opens The improved picture on the exit front has started to feed through to more interest in fund raising, albeit with a time lag. One of the largest private equity firms is sitting up and taking notice. Ernest Lambers of AlpInvest Partners, the Dutch giant with €30bn in private equity investments, is now looking at Latin America closely after being broadly absent.“We are more optimistic on the region now and expect to become more active in the near future. We clearly see positive signs, both in terms of the economies as well as the environment.” And Ernest Bachrach, chief executive of Advent International’s Latin American deal group, which has led $1.5bn of investments in the region over the last 10 years, says that investment track records are now sufficient to attract institutional investors. According to Meek, a notable feature of this particular cycle is the participation of hedge funds, “which has given firms, such as GP Investimentos, a much more substantial pool of funds from which to invest. The problem is that hedge funds tend to have short term horizons and currently their interest is stimulated by the rise in the stock exchange.”

Ernest Bachrach, chief executive of Advent International’s Latin American deal group.

Advent has led $1.5bn of investments in the region over the last 10 years, and Bachrach says that investment track records are now sufficient to attract institutional investors. Still, he sounds a note of caution. Although the $1.3bn in private equity raised for Latin America last year is up considerably from the low of the 2002 to 2003 period, it is still well below the peak reached in 1998 and is miniscule compared to the amount raised in Asia: “This is not a boom, but it is a pick-up in activity.”Photograph kindly supplied by Advent International, October 2006.

Bachrach however sounds an additional note of caution. Although the $1.3bn in private equity raised for Latin America last year is up considerably from the low of the 2002 to 2003 period, it is still well below the peak reached in 1998 and is miniscule compared to the amount raised in Asia: “This is not a boom, but it is a pick-up in activity.”

For many private equity firms working in Latin America, which take minority shareholdings and seek an exit through capital markets, proving a track record has been hard. The lack is a roadblock for drumming up more business. In particular, track records for private equity funds are poor over the short to medium-term. Antonio

FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2006

Gledson de Carvalho, professor of finance at EAESP in São Paulo, explains why. In the early years of the life of a private equity fund, the only investments the firms divest are usually those where the investments have gone sour and need to be written down. “We have a saying. ‘Lemons mature faster than pearls,’” he says.

Successful investments tend to stay in a portfolio for a more orderly exit once the business has been properly prepared for sale, usually several years into the life of the fund.

Advent, whose funds concentrate on majority shareholdings and typically sell to strategic investors, largely escaped the capital markets downturn and has a strong track record in the region, according to Bachrach. He claims the firm has made compound annual returns of 35-40%. That would be more than enough to woo more investors. In comparison, local pension fund PETROS, the pension fund of Petrobras, expects a real return of some 13.5% net of fees from its infrastructure investments, 16% for other private equity investments and 22.5% for venture capital investments, says Ricardo Malavazi, director.

As sentiment improves, private equity funds are getting larger. Giant Conduit Capital Partners raised $400m in July for a power fund and Advent International closed a $375m fund in autumn last year. Still, this is small beer compared to the size of funds in the buoyant late-1990s which produced some funds with an investment value of more than $1bn.

Local participation The participation of stable, local institutional funds in private equity is key for the industry to enjoy sustainable growth. Regueira thinks this local money is critical. Pension funds such as Previ (from the Banco do Brasil), Funcef

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Regional Review LATIN AMERICA: PRIVATE EQUITY

(Caixa Econômica Federal), and funds successful bid for the acquisition of asset class because of the likelihood of run by BNDES are scrutinising or Brasil Telecom (at the time called Tele falling interest rates in Brazil, a low entering the market, he says. The re- Centro-Sul), as well as the mobile exposure to floating rate investments entrance of institutional funds is very telephone companies Tele Amazônia and the rich seam of opportunities, promising as these were the kind of and Telemig Celular, with Citibank and especially in infrastructure.

There are other reasons to be more funds that were responsible for the the Canadian Telesystems International growth of the private equity industry in Wireless. In 2001 a falling out between optimistic about the longer-term the US in the late 1980s. Bachrach partners mired all concerned in lengthy prospects for private equity in the region. agrees. “Private equity in the region is and costly legal battles, with allegations Ther is a strong consensus that private going to remain a volatile source of and counter-allegations of improper equity teams are now stronger and more professional. The famine funds until local investors are a in the early years of this more significant presence,” he decade winnowed out weaker says. Still, the amounts local The quality of teams is especially and less dedicated firms and institutions are investing important this time round, thinks de teams. Burgess believes: needs to be put into Carvalho. The late 1990s saw “There is a commitment to perspective.

Foreigners private equity firms focus on the building strong, high quality continue to dominate, buying private equity teams 68% of the total value of IPOs low hanging fruit: mature nowadays, which are able to on Bovespa since 2001. companies needed help work very closely with the According to CDC’s Innes restructuring as the Brazilian managements of the Meek, Brazil’s local private economy was opened up, he says. companies in which they take equity scene is dominated by a stake. This is now seen as four big investment firms: GP key to the success of private Investimentos, Patria, Dynamo and TMG. “In terms of international influence. The case also highlighted the equity investments and represents a new players, Advent and AIG are the main sometimes blurred distinction between generation of talent in the region.” ones, with Darby also looking at general and limited partners in the Lambers adds a nuance. His funds’ of the investments are focused on growth mezzanine finance. Others come and management telecommunications giant. The issue is capital and buyouts because he does not go, still wary of Latin America.”

By and large, local activity is rising still not resolved and has cast a yet see many quality managers focused and it is likely to prove a growing force. sometime shadow over private equity on venture capital, which is a very The pension fund industry in Brazil, for investment in the country; particularly different business.

The quality of teams is especially instance, is still in its infancy, but likely as the case has involved some of the to grow fast. “We are seeing new country’s leading pension and important this time round, thinks de Carvalho. The late 1990s saw private investments in private equity by investment funds.

For now, Brazilian private equity equity firms focus on the low hanging Brazilian pension funds. Two years ago, they would not have looked at such funds remain circumspect for other fruit: mature companies needed help investments; now they are making reasons as well. Malavazi explains, as a restructuring as the Brazilian economy dedicated allocations,”says de Carvalho. further example, that PETROS started was opened up, he says. Investors One reason for the circumspection is to invest in privatisations at the end of focused on late-stage opportunities, the sometimes blurred relationship the 1990s, in line with many other cases in which the firm already had a between limited and general Brazilian funds. The fund found itself viable, established business model. partnerships in Brazil: an issue that locked in to these private equity Although the opportunities still exist, came to the fore in the long-running investments between 1999 and 2002 many of the more obvious investments dispute over the governance of Brasil and only in 2003 did the situation start have been made. That means more Telecom. Back in 1997, Opportunity to improve. Since then, PETROS has private equity funds are going to Asset Management, together with committed some R$850m (about earlier stage firms. These require much Citibank, through its vehicle in Brazil $396m) to private equity investments, more nurturing and specialised skills CVC/Opportunity, Telecom Italia and of which R$70m is in venture capital, (typically, they might need help in Brazilian pension funds, cast the he says. The fund was attracted to the developing a business model to staff

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hires and product development).

Meek acknowledges that CDC has yet to finalise an investment in Brazil, although it has committed some $20m to Mexican investment firm Nexxus.

“The issue we have with Brazil is the discipline of investment. Because the industry went through a difficult period, you now find that you are dealing with a variegated investment model which can include investment advisory work as well as hedge fund investing.

It makes the overall decision more complex.” CDC has also looked at smaller funds, operating in the north eastern region,“although the issue here is the desire of local pension funds to be represented on managers’ investment committees, which we don’t like”adds Meek.

Marcus Regueira, president of the Association for Brazilian Venture Capital and Private Equity. Thirteen out of the 20 IPOs in the Brazilian market since early 2005 “have been in the portfolios of venture capital or private equity firms at some stage,” he says. These are not minnows either, with substantial deals including the likes of Lupatech, the parent company for Valmicro and MNA valves which is located in the industrious southern part of Brazil, and electronic commerce specialist Submarino. Photograph kindly supplied by the Association for Brazilian Venture Capital and Private Equity, October 2006.

Sectoral Focus The predicted wave of investments, if indeed it comes, arrives at a time when there is keen interest in several microsectors of the Brazilian economy. The most obvious is renewable energy sources, where Brazil is a world leader with its long experience of biomass energy, or energy derived from plants.

“In clean energy and biomass, Brazil is competing with the best of the world,” says Bachrach. Regueira thinks that roughly one third of the planned private equity investment is likely to be in the sector. Renewable energy is a buzzword right now and foreign investors are flocking to the country to learn more about the technologies with Japan and the US likely to be very significant importers of ethanol. Owners of sugarcane, distilleries and hydro energy plants are attracting most interest.

Bachrach argues that “It’s a win-win situation. It’s labour intensive and jobproducing for Brazil, and reduces American oil dependence on countries such as Venezuela and Iran. There is a major initiative to look at this seriously.”The biggest downside risk for

alternative investments is a fall in oil prices. At $70 a barrel, there is a shortterm incentive to turn to biomass fuels.

With recent price decreases, that logic is looking less secure. If prices were to sink back to $50, “investments in alternative fuels such as ethanol would be a lot less interesting,”he reckons.

Infrastructure is popular too. Firms are raising funds to invest in sanitation, roads and logistics. This is a nexus of investment for PETROS, for example.

Malavazi explains that a sound rulebased structure for investment in the sector has encouraged PETROS to participate and its portfolio is concentrated in electricity, including transmission lines, civil construction, transport and ports. Another of the most talked about sectors is utilities.

The sector offers high yields (attractive to long-term funds), is relatively well regulated and has become attractive

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now that inflation and sovereign risk are under control. Biotechnology, agribusiness, with development of pest- and weather-resistant crops and tourism, especially in the North east and north, are likely to benefit too.

Malavazi remains positive on prospects for private equity in Brazil. He sees the return of international investors after years of absence, the consolidation of macroeconomic gains and improvements in regulations, especially within capital markets as Bovespa and the market regulator refine listing requirements, as vital to further growth in private equity in the region.“Frankly, institutional investors are bound to find Latin America more compelling as the other alternative regions become saturated and start to produce more marginal returns,” adds Bachrach. “It is hard to believe that all those funds will produce satisfactory returns.”

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Regional Review LATIN AMERICA: NEW LATIBEX INDEX

Brazil joins Latibex family HE NEW FTSE Latibex Brasil index is the only Eurodenominated tradable index covering Brazilian stocks, and ranks the most liquid Brazilian stocks listed on Latibex. The FTSE Latibex Brasil index will offer investors worldwide a new tool which is specifically designed to support structured products and ETFs. On launch the index comprises 13 stocks, although this number is expected to rise at future index reviews.

Weightings in the index’s constituents is capped at 20%. Index reviews for the new index will take place bi-annually in May and November.

The FTSE Latibex Brasil index is an answer to growing interest by institutional investors in Brazil and meets current demand for an index of Brazilian blue chips listed on Latibex.

Constituents of the index are “liquidityscreened to make the index suitable for the creation of financial products, such as certificates and Exchange Traded Funds (ETFs),”explains Pablo Ybarra, key account manager at Latibex. According to Ybarra the launch of the index will be quickly followed with the issue of ETFs based on FTSE Latibex Brasil, as well as on the FTSE Latibex Top, which will be listed on the ETF market segment of the Spanish Stock Exchange. Other products supported by FTSE Latibex Top

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In spite of short term volatility, interest in Latin American stocks— and in Brazilian stocks in particular— is resurgent. The Mercado de Valores Latinoamericanos en Euros (Latibex) the Euro-denominated market for Latin American stocks, owned by the Bolsas y Mercados Españoles (BME), is an increasingly popular vehicle for foreign investors and investment institutions to access the region’s growth story. In a new development, Latibex and FTSE Group have collaborated on the development of FTSE Latibex Brasil, a new tradable index focused entirely on liquid Brazilian stocks. are available on different markets, such as: Belgium, Czech Republic, Finland, Germany, Italy, Estonia, Lithuania, Norway, Spain and Switzerland.“This is a decisive step forward in the process of bringing Latin American companies closer to new global liquidity pools through Latibex,”says Ybarra.

The FTSE Latibex Brasil index is part of a growing family of FTSE Latibex indices, which includes the FTSE Latibex All Share Index and the FTSE Latibex Top. FTSE Latibex’s All Share Index has achieved a strong correlation with the behaviour of the Latin American markets, which has meant no small degree of volatility.

The shares comprising the FTSE Latibex All Share Index have a total capitalisation of €200bn, equivalent to over one fourth of the entire value of the rest of the Spanish market.

Latibex was established in 1999 as an easier way to channel European investment efficiently towards Latin America and was established by Spain’s four stock exchanges. Latibex lists LatinAmerican companies with capitalisations of more €300m and is open to members of the four exchanges with equal conditions of access as well as to members of certain Latin American exchanges. Shares admitted to Latibex must have previously been accepted by a Latin American exchange; however, the securities listed on Latibex are traded and settled like any other Spanish security. Unlike the way ADRs work, the Latibex trades original shares in euros electronically via SIBE, guaranteeing

speed and transparency. However, under certain circumstances, ADRs may also be eligible to list on Latibex as has been the recent case of La Electricidad de Caracas. It also provides attractive time zone characteristics, allowing investors to continuously trade in Latin American shares over a ten to twelve hour window. This means that increasingly American based investment firms have begun to access exposure to Latin America through Latibex, as well as a rising European consistuency.

Equally, Latibex gives Latin American companies easy and efficient access to the European capital market and the exchange now boasts a broad representation of Latin American stock exchanges. One of the most highly publicised measures has been the creation of the FTSE Latibex Top index, which brings together the 15 most liquid or tradable shares, and comprises mainly Brazilian, Mexican and Chilean companies.

Latibex has succeeded through some testing times, including the eruption of the Argentinian crisis and the subsequent suspension of its foreign debt payments, the global shock generated by the September 11 attached and the 2002 crisis in Brazil.

Those issues have long faded and now Brazil is among the four leading emerging markets (Brazil, Russia, India and China).

Currently, 38 stocks from seven different countries (Mexico, Brazil, Argentina, Chile, Peru, Panama, and Puerto Rico) are quoted on Latibex,

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including some of the largest companies in the continent, such as Telmex, AmĂŠrica MĂłvil, Petrobras,Vale do Rio, and Bradesco and according to Ybarra, 37 of these are now included in the FTSE Latibex All Share. “Getting onto Latibex has allowed these companies to diversify their shareholders and reach both private and institutional investors. As well, it has allowed investors to access a broader range of securities which give them exposure to the Latin American growth storyâ€?, he adds.

Practically before it was created, the index was used to create warrants. These derivatives permit investments at specific prices for a specific period and allow

investors to bet on a specific trend. They can lead to much higher returns on investment, but there are equivalent high risks involved. The warrants on Latibex Top were the first to be launched on a negotiable index in Latin America. The derivatives were also indirectly useful in helping drive liquidity as contract volumes have increased. Ybarra points to firms such as SociĂŠtĂŠ GĂŠnĂŠrale, which has issued certificates and warrants on the Deutsche BĂśrse, Euronext and the Spanish exchanges based on the FTSE Latibex Top Index. Other banks issuing product based on the same index include ABN AMRO, Merrill Lynch, SEB, Nordea, and Goldman Sachs.

Latin American companies have been

strengthening their profitability as a whole while local regulators have been tightening measures to improve corporate governance standards.

Macroeconomic indicators such as the current account, the government budget deficit and inflation are all much better behaved than in the past and, perhaps most importantly, the banking systems in Latin America have never been as sound and as poised to support future credit growth as they are today. As a result, Latin indices such as the FTSE Latibex skyrocketed by more than 80% last year, although this year the overall performance has been more variable, with volatility in the index related to the vagaries of global energy prices.

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Regional Review LATIN AMERICA: MEXICO’S POST-ELECTION OUTLOOK

Mexico’s President-elect Felipe Calderon waves to journalists after arriving at the Air Force Base in Guatemala City, Guatemala, on Monday, October 2nd 2006. Calderon was on a one-day state visit. Photograph taken by Alexandre Meneghini and supplied by EMPICs/Associated Press, October 2006.

Business as Usual Crises often look less critical as they drag on and few recent events dragged on as long as the Mexican elections, with its knife-edge count, legal challenges and street protests. Once the National Action Party’s (PAN) Felipe López Calderón was declared the winner in early September, and the defiant loser, the Democratic Revolution Party’s (PRD’s) Andrés Manuel Obrador, backed down from his threatened insurgent unconstitutional challenge, Mexican business seems to return to normal. Clearly, the drama has not turned into a crisis—at least so far. Ian Williams reports.

EXICAN FINANCE MINISTER Francisco Gil Diaz announced to journalists in Mexico City at the end of August that his country’s economy would grow by 4.2% in 2006 compared with 3% last year. He attributed the good showing to growing oil revenues and increased car exports. His good news however was somewhat overshadowed by the seemingly interminable electoral crisis. Even if

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many Mexicans were clearly not bowled over with his good news, the financial sector (arguably his real constituency) certainly was. “The currency is stable, stocks continue to rise and bond yields are falling. The markets are showing that not only that there’s confidence but also that [the economy] is growing,”he said.

On the face of it, backed by a relatively strong economic story, it was something of a surprise that the PAN

candidate, Felipe Calderón, should have struggled so hard in such a hotly contested election victory. However, there was much at stake. Many Mexicans, for one, have not necessarily felt the benefits of the country’s growth, and it is the incoming administration’s challenge to steer development so that they do. The bruising election campaign will also be difficult for Mexicans to forget. Widely criticised for extravagant spending and mud-slinging in place of serious debate, allegations of vote-peddling, money-laundering, manipulation of voter rolls, intimidation, and even illegal church interference flew fast and furious in newspapers, on the ratio and on television. Moreover, for the first time in decades, a pronounced left-right polarisation in Mexican politics has resurfaced, rekindling long-standing divisions that had been

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submerged during the ousting of the that the President-elect is planning to century and which has vested interests old Institutional Revolutionary Party use a larger proportion of swelling in the state owned oil sector). That government revenues on social assessment now appears optimistic. It (PRI) from power.

Pamela Starr of the Eurasian group spending to help avert some of those seems that the PRI’s local party leaders, anticipating their disastrous defeat in thinks that: “The markets are a bit too potential confrontations. the presidential and Bun-fighting aside, Calderón has both sanguine about how successful Felipe Calderón is going to be in government inherited significant domestic policy congressional elections, had cooked up because they think he has a majority in challenges and a bumpy relationship a deal with Calderón. Indeed Congress. [They] think that López with the United States. The way in Obrador’s supporters accuse local PRI officials, particularly in the Obrador is backing down Northern states, of fixing the because he has decamped vote for PAN and Calderón. from downtown Mexico City.

Observers now want to see serious With the balance of power Both of those are incorrect structural reforms in the economy, in the legislature, Calderón assumptions.” However, Starr particularly in the national oil can only govern in coalition reckons that the other with the PRI. That means extreme—that Mexico is going company PEMEX. That may not that the tough bedrock of to become ungovernable—is necessarily be forthcoming.

Mexican nationalism equally incorrect.“In any case, married with and exploited it is going to be a tough slog,” which he approaches these problems by the PRI-dominated management she concedes.

Starr had been one of those analysts may provide a bellwether for other of PEMEX and the oil sector unions who did not see the sky falling down Latin American leaders. Geography precludes any outright privatisation of if Obrador were elected, and is now may lie on Calderón’s side. The stakes the company, no matter how much equally sanguine about Mexico’s post- in this post election period are high for Wall St may slaver at the prospect.

On the other hand, Starr suggests electoral prospects.“After all, you now the United States as well. A politically have a president elect and the vast and economically stable Mexico is that Obrador’s strategy is not to majority of Mexicans accept him at the critical for finding a solution to the generate social instability or to get legitimate president. It allows him to perennial migration question and people on the streets but to prevent go forward and structure his cabinet.” proper coordination of bi-national Calderón and the PRD implementing its preferred neo-liberal agenda and As for the reforms that so many efforts to combat drug trafficking.

However, at home, Calderón faces “to try to force Calderón to accept a Wall Streeters would like to see implemented in Mexico, Starr issues that are more complex and dramatic reconstruction of Mexico’s suggests that the markets will perhaps even pricklier. Government political institutions. The PRD will use gradually realise that Calderón “is revenues may be rising on the back of its power in the legislature, and among not going to be as strong and windfall oil profits, but this level of various governors and mayors, and effective a president as Mexico needs incoming revenue cannot be relied where required the party will bring at this present economic upon over the long term. Moreover, activists on to the streets, probably led conjunction” Starr thinks that the present dilemma over allowing by the unions and Obrador. On key because Calderón is “unlikely to have foreign investment in Mexico’s oil issues they can make a heck of a lot of a functioning legislative majority, he sector and in particular Petróleos noise and create significant obstacles to legislative reforms.” will have to make a lot of Mexicanos (PEMEX) remains thorny.

“Even so, we will see more results Observers now want to see serious concessions to get reforms, issue by issue [sic], so his reforms will be structural reforms in the economy, from Calderón than we saw from Fox,” particularly in the national oil company predicts Starr. “I think there will be a interesting but not stunning.”

The power of Obrador’s party in PEMEX. That may not necessarily be labour reform, there will be a reform of local and state institutions and his forthcoming. Both Calderón and the state workers pension system, and ability to mobilise millions on the Obrador were considered potential of the administration of Pemex. But streets will certainly have an influence reformers, as they did not have close they will be hard fought and watered on implementation of Calderon’s ties to the PRI (the party that had ruled down, and he is always going to have policies. Already there are indications the country for the best part of the last Obrador nipping at his heels.”

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Regional Review LATIN AMERICA: MEXICO’S POST-ELECTION OUTLOOK

Carlos Moctezuma of Homex, the low cost homebuilder that recently listed in the US foresees the shape of the compromises ahead.“There is room for [a] more efficient structure of PEMEX without breaking the constitutionally mandated state ownership. There is room for private investment in refineries or transportation. That is something he needs to work out.”

Local commentators are more optimistic than the more detached observers, such as Starr.“Calderon will have a better chance of governing than Fox, since there is now more of an environment for coalition governing, and the PRI will agree to more than they did before. On the other hand there will be more moderation from the PRD, because they won a lot, and they won’t want to continue the noise factor if it jeopardizes the gains they’ve made when the mid-term elections come,” says a senior executive of a major Mexican company who prefers to remain anonymous.

He adds,“Everyone agrees the last six years have been a transition and the next six years will be the same. Some things, but not all will be achieved, and maybe not even to the extent that’s required. That’s life; you do not change a body politic that has been around for seventy years overnight. People are looking for stability economic growth, modest prosperity. They are not looking for someone to turn the house upside down.”

In a similar mode of confidence – but in muted expectations, he identifies Calderón’s task for the next six years as, “building consensus between his own party and the PRI, otherwise it will be impossible for him to govern the country, wasting years of time for macroeconomic reform.

Homex’s Moctezuma dismisses some of the doomsayers who feel that Mexico was already heading for an economic fall before the elections.

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Photograph of a refreshment vendor in Xochimilco Lagoon in Mexico City. However, there was much at stake in the recent presidential elections. Many Mexicans, for one, have not necessarily felt the benefits of the country’s growth, and it is the incoming administration’s challenge to steer development so that they do. The bruising election campaign was also criticised for extravagant spending and mud-slinging in place of serious debate, allegations of vote-peddling, money-laundering, manipulation of voter rolls, intimidation, and even illegal church interference flew fast and furious in newspapers, on the ratio and on television. The photograph was taken by Richard Gunion and was supplied by the Dreamstime.com photography agency, October 2006.

“That is a little too pessimistic. We do need structural changes to grow faster.

We are growing at a rate of 3% to 4% when we should be growing at somewhere between 7% and 8% but we are nevertheless growing, although we do need the reforms to accelerate growth to compete externally.”

Furthermore, he believes, “The next step is to tackle the infrastructure. Not many of us accept the fact that we have enjoyed more than ten years of macroeconomic stability after the Tequila Crisis and that is becoming evident in consumer confidence and spending power. Even though we have our problems we do not have yet a social problem, as long as we keep ourselves on the cool side of the equation and keep the macro-economics.”

The combination of remittances from Mexican workers abroad and general

economic growth are reflected in the results for local producers such as Cemex, Mexico’s multinational cement producer and Homex. Moctezuma felt sure that whichever candidate won, he would encourage homebuilding.

Indeed, some economists suggest that the concentration on exports and the external account neglects the growth possible from internal economic development.

There are indeed many poor people in Mexico, but many of them are benefiting, not just from local growth.

They also continue to benefit from continuing growth north of the border, where, despite the noise about immigration, the flood of remittances continues to run at about $20bn and upwards a year. That is “free”money in the sense that the government and the PRI led institutions cannot control it.

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CENTRAL EUROPE: RUSSIAN PENSION FUNDS

Everyone agrees Russian pensions need to rise and access to healthcare facilities and pharmaceuticals should be made easier. Equally, everyone also knows that such policies could also have a negative effect on the economy.

That dichotomy puts the Russian authorities under pressure, particularly in the run up to next year’s parliamentary elections and the presidential election in 2008. What now? Benjamin Seeder reports from Moscow.

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system and provided decent pension benefits, with a replacement ratio up to 75% .By the 1990s however, Russian birth rates fell dramatically and these days the ratio of working individuals to retirees is a ratio of 1.6/1 compared with five to one in the 1970s. According to Vnesheconombank, the specialist state bank supporting the government’s centralised foreign economic operations, which ration will further reduce to one to one by 2020, making it obvious that PAYG has run its course.

It was only when President Putin took office in 2000 that pension reform took centre ITH THE MOST stage. Based on the advice of important elections economy minister German in a decade just Grev, a new retirement pension around the corner, pressure is formula was established, increasing on Russia’s consisting of a basic pension, an government to pay more insured pension, and a funded attention to those left behind pension, collectively comprising by the post-Soviet miracle. a three-pillar system.

“There is compelling pressure The first pillar is financed on the government to spend through social security more on social services, and contributions, the so-called that will have big effects on this Russian president Vladimir Putin speaks at the international Unified Social Tax (UST) made economy,” states Vladimir economic forum opened in the Black Sea resort of Sochi, by employers and first pillar Pantyushin, an economist with southern Russia, September 29th 2006. It was only when pension benefits are Moscow broking firm President Putin took office in 2000 that pension reform took guaranteed by the state and Renaissance Capital. While the centre stage. Based on the advice of economy minister equal approximately $100 per cost of these reforms could German Grev, a new retirement pension formula was month. Benefit payments are have a detrimental impact on established, consisting of a basic pension, an insured pension, made by the State Pension the country’s burgeoning and a funded pension, collectively comprising a three-pillar Fund of Russia. The second economy, in the final analysis, system. Photograph by Dmitry Astakhov, supplied by pillar covers individuals born the government may have no EMPICS/Associated Press/ITAR-TASS. after 1967 and is financed via choice but to implement them.

It is already under pressure, social challenges facing Russia is employer social security contributions. particularly in the run up to next year’s similar to those in other European These second pillar pensions, which parliamentary elections and the countries: burgeoning numbers of affect around 54.6m Russians, are also retirees, falling birth rates and a state transferable to private providers – presidential elections in 2008.

That pressure has its roots in system that cannot afford its future private asset managers or non-state pension funds depending on each various government efforts in the pension liabilities.

The Soviet pension system was individual’s decision. However only 1990s and early 2000s to reform the country’s pension system. The set of based on a pay-as-you-go (PAYG) around 4% of eligible individuals have

ELECTIONS BRING PENSIONS INTO FOCUS

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Regional Review CENTRAL EUROPE: RUSSIAN PENSION FUNDS

Mark van Loon, a broker with MDM Bank in Moscow says the government has been “printing money and managing the exchange rate by buying dollars and selling roubles. But with fiscal policy loosening now, this may not work in the future, which could lead to some tough decision-making.” Photograph kindly supplied by MDM Bank, October 2006.

transferred this part of their labour pension to one of the 98 non-state pension funds or 55 asset management companies allowed to participate in second pillar pension schemes. The third pillar is non-state pension provision for both individuals and corporations. The market for corporate pensions in Russia covers over 65m people.

A peculiar feature of the Russian market is the existence of captive nonstate pension funds, which belong to large industrial corporations and occupy a substantial market share. In fact, the second and third pillars are marked by a high penetration of captive non-state pension funds, which currently enjoy a 25% market share. Even so, there is still potential for new entrants in the small to medium sized enterprise (SME) sector.

Additionally, there is enormous scope for foreign insurance and pension companies to enter the market: though here the potential is limited by Russia’s distribution capacity.

Although the country remains over-banked, by and large outside the specialist capital markets institutions, such as Renaissance

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Capital, the country’s financial system is still relatively unsophisticated and Russia’s retail savers have little in investment choices before them.

Equally, corporate pensions have not been commonly provided by Russian employers due to a combination of factors—the most important of which is lack of understanding of the pension products by employees and continuing developments in Russian taxes and investments. However, the provision of corporate pensions is becoming increasingly widespread, as more companies, mainly foreignowned, are introducing corporate pension plans for their Russian staff.

The provision of corporate pensions by employers becomes an indispensable part of their remuneration packages by 2008-2010, as more and more individuals born in the 1950s and 1960s are coming closer to retirement.

In an effort to cover the deficit of state pension fund liabilities in 2002 the Russian government cut the UST. While the measure was intended to liberalise income, it failed entirely. ‘Grey’ salary schemes

have not been legalised and the budget deficit did not shrink. In fact, it exploded and this year it is expected to exceed $3bn. Then in 2005, the government introduced a law that converted various Sovietera social benefits into cash payments, which created a popular backlash. Putin’s administration hit an all-time low and the reform was widely criticised. It was unfair and its implementation was botched, said critics. Mass protests–some of the largest in Russia’s history—were staged around the country. For the first time, Putin’s and the government’s approval rating began to slip.“So now they are planning to spend their way out of trouble. They want to buy their way through the election cycle,” says Pantyushin.

The recently unveiled draft 2007 budget increases overall spending by 26% and includes a 50% increase in all public sector salaries, which alone will cost Rb127bn. Meanwhile, Rb206bn will be allocated on specific projects, such as boosting access to healthcare and increasing state support to farmers. The budget will also increase defence spending by Rb70bn, not including increases in soldiers’ pay. There’s nothing insignificant about that, says Pantyushin – pork-barrel budgets happen in every democracy.

In Russia’s case though, where the levers of control in the economy are more restricted, the macroeconomic blowback may be bigger and decidedly negative. Combined with increasing calls to use Russia’s windfall oil profits on infrastructure and social services spending, economists fear a massive appreciation of the rouble or (at the very least) spiraling inflation.

Classical economic thinking supposes that increased government spending leads to higher inflation or a

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stronger currency: two outcomes the Russian central bank is keen to avoid.

Either outcome could lead to a decline in domestic industries outside oil and gas production, at a time when Russia needs to diversify away from its energy-exporting habit. “The central bank has been walking a very fine balance in the past few years, it has not been an easy job for them,” says Mark van Loon, a broker with MDM Bank in Moscow. “They have been printing money and managing the exchange rate by buying dollars and selling roubles. But with fiscal policy loosening now, this may not work in the future, which could lead to some tough decision-making.”

The central bank’s official inflation target is around 9% for 2006, though statistics released in August showed that consumer price index prices are already on schedule to surpass this target.

“The thinking now is that the Central Bank is likely to focus more on fighting inflation. It is hated by the population and really defeats the purpose of raising pensions and salaries. And the only way to do that

may be to let the Rouble appreciate,” van Loon says. The Rouble has been rising anyway. It appreciated some 6% against the Central Bank’s own basket of trade-weighted currencies in the first half of the year, and 7.8% (in nominal terms) against the dollar.

Aside from the prospect of increased spending from the budget, analysts are also worried about the growing pressure to spend some of the money accrued in the Stabilisation Fund – a vehicle set up in 2004 to manage excess oil revenues received from oil export taxes. Many of the government’s critics have attacked the policy of spiriting away the windfall oil revenues in the Stabilisation Fund, which is expected to reach some $80bn in value by the end of the year.

Since its establishment, finance minister Kudrin and other liberalist economists in the cabinet have been fighting off calls to spend the money.

One of their main arguments was that the money should be used to pay off foreign debt – an argument that was grudgingly accepted as prudent by even the fiercest critics. The last

$22.6bn of Russia’s Paris Club debt was paid off in August, and while other sovereign debt exists, it will not be possible to pay it off in bulk.

Analysts say this will prompt renewed calls for the Stabilisation Fund to be spent domestically, instead of being invested abroad, as was originally planned.

One proponent of spending the fund domestically is Vladimir Isayev, the director of the Oriental Studies Institute. Asked recently in an interview on Russian radio as to why Russia should sell oil if it was to lock it in a fund and then send the money abroad, Isayev answered: “We export raw materials, receive the money, and put it into a fund - in order to send it back to the same countries that buy our oil and gas ... and this, in a country that has practically no decent roads!”

He went on to say that the money should be invested in roads and infrastructure, which would, in turn, stimulate jobs in construction in the regions, and open up new development opportunities for land alongside the new roads.

KEY ORGANISATIONS IN THE RUSSIAN PENSION FUND SYSTEM The Russian Federation Pension Fund: responsible for forming a funded portion of the labour pension, and for making arrangements to invest pension assets by entering into trust management agreements with trust management companies and with the state trust management company; Non-governmental Pension Funds: responsible for forming a funded portion of the labour pension, and for making arrangements to invest pension assets by entering into trust management agreements with trust management companies; State Trust Management Company (STMC): responsible for investing pension funds of the persons who failed to choose a trust management company and who chose the state trust management company; Trust Management Companies (TMC): responsible for investing pension funds; Special Depository: charged with monitoring whether trust management companies manage pension savings in compliance with applicable legislation, normative documents and investment declaration, to keep records of securities and of the transfer of entitlements to securities purchased through investing pension assets transferred by the Russian Pension Fund to trust management companies.

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COVER STORY: ATON

one/ half

of a perfect

partnership According to Dealogic, the financial services data provider, Russia’s equity capital markets deals have totalled nearly $10bn so far this year, up 47% of the total for the whole of 2005. No wonder then that bulge bracket banks are now looking to Russia for business growth, bringing with them new competitive pressures, which domestic institutions are gradually coming to terms with.

Many foreign banks are looking for appropriate acquisitions opportunities in the country and few investment banks in Russia are as appealing as Aton Capital. Variously courted by Goldman Sachs and other leading houses, and having rejected their advances, Aton knows it has to find the perfect partner to survive and grow in the newly emergent Russia. What will it take for it to become a bride? Or will it always remain a bridesmaid? Francesca Carnevale talks to Aton’s chief executive officer (CEO), Alexander Kandel in Moscow.

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ERIOUSLY, IT WAS on Arbat—a noted local landmark— Russia’s rapidly expanding financial sector. The company when I looked into the eyes of an owl manacled to a pole employs around 500 people and is represented in more than that I began to understand the predicament of Russia’s 30 regions of Russia through a specialised network of dealing leading investment banks. An imposing animal that should centres and subsidiaries. Aton International Ltd represents it have roamed free was instead pinned down for the benefit of in London, its US subsidiary, Aton Securities Inc., has a western tourists paying for a touch of something once wild and NASD licence, and last year Aton opened operations in now (perhaps tragically) tamed. One thing for sure: for that Frankfurt. It is also the only Russian member of the FSE. All in all, it is an attractive package for a foreign investor and particular bird, things will never be the same. With clipped wings, it cannot go back to the hunt. I guess being in Russia for the firm is expected to command a price of somewhere the first time does funny things to your thinking. However, one around $400m to $500m for anything up to a half share. As genuinely felt for the owl and in a lesser, more realistic way, Kandel notes: "We work with more than 5,000 clients. one feels for Russia’s investment banks, which are increasingly Uniquely, we collaborate with more than 400 investment funds in the West, as well as chained to foreign interests. with vast numbers of clients In the scramble for a corner in Russia, including more of Russia’s growth story, Aton In the scramble for a corner of than 3,000 domestic private is potentially a star buy.

Russia’s growth story, Aton is and investment customers.”

Reportedly, Italian bank potentially a star buy. Reportedly, Pragmatic and straightUniCredit’s central European Italian bank UniCredit’s central talking, Kandel also typifies investment banking arm, CA European investment banking arm, the confident, financial elite IB, is working on a deal to buy CA IB, is working on a deal to buy that has redrawn the Aton Capital as this magazine financial landscape in Russia goes to press. It is the latest in the brokerage as this magazine goes over the last fifteen years and a long running saga that has to press. The brokerage has been who have helped rebuild involved a number of leading holding talks with many partners, confidence in the country’s global players. Talks with including UniCredit, and talks have financial market following UniCredit have been been proceeding for some time. the 1998 crisis. A graduate of proceeding for some time, Moscow Engineering Physics though Aton is still playing Institute and earning an coy. Alexander Kandel, Aton’s CEO has variously stressed that it is talking about possible MBA from the Academy of National Economy under the partnership deals with more than one foreign financial Russian Government, Kandel joined Aton in 1994 as a institution.“It would be wrong to say that the deal is closed or portfolio manager, rising quickly and steadily through the that documents are signed. However, we are not denying that ranks to become head of operations in 1997. He became we are holding talks to set up a partnership based on our chief financial officer (CFO) the following year and in early institutional block of business. CA IB is one of those Western 2003 assumed the mantle of chief executive. Kandel is charged with building relationships between Aton Capital companies,”he told local reporters in late September.

Established in 1991, Aton Capital ranks among Russia’s and prominent Russian and international companies, as well leading investment banks, together with Renaissance Capital as bolstering the company’s profile within the local capital and Troika Dialog. The bank’s broking operations by trading markets. As if that was not enough to keep him busy, Kandel volume on both the RTS and MICEX exchanges regularly is a board member of both the National Association of ranks among the top three in Russia. The bank, for instance, Securities Market Participants (NAUFOR: Russia’s equivalent ranked second among the country’s top three Russian brokers to the US NASD) and the Russian Trading System (RTS) in 2005, according to an annual rating compiled by exchange; and is also president of the country’s Depositary RosBusinessConsulting agency, which bases its results on the Clearing Company (DKK).

That level of drive and energy has also been applied turnover of 50 investment companies working on MICEX and RTS. In that year, Aton’s turnover was $20.2bn—equivalent to liberally to the management of Aton Capital. Kandel is around 10.3% of the total volume, compared with $18bn a year credited with pushing through a major restructuring drive, earlier. However, while total volume increased Aton’s which he launched in the autumn of 2004, to define more percentage of the total fell somewhat, down from an 11.6% clearly the firm’s businesses. Three clear business streams market share in 2004. However, says Kandel, the Russian emerged.The first was asset management, which the firm had trading market has seen a much expanded field of players and been trying to spin off for some time. It was a timely move, as crucially, Kandel felt it was imperative to give a clearer total trading volume has escalated dramatically.

More significantly, perhaps, Aton has emerged as one of direction to the firm’s broking operations.

In fact, up to the point when Kandel took over the running Russia’s leading local market makers, particularly in Russian ADRs and GDRs, blue chips and second-tier stocks. Today of the firm in 2003, Aton had been marketed, in the main, as a the company provides a full range of investment banking pure brokerage company. However, the different demands of services, and has consolidated its reputation as a pioneer in Aton’s Russian clients and overseas clients began to impinge

S

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Ivan Tyrishkin. Aton’s net profit from its retail broking business is expected to increase to between $12m and $15m this year, compared with $5m in 2005. Most of the revenue expected to be generated in 2006 will come from brokerage commissions. Additionally, the firm intends to open an office in Kazakhstan before the end of this year and is considering buying some Ukrainian investment firms.

The scramble for market share For the time being, the focus is on whether Aton will take the plunge and sell a portion of its shares to a foreign partner. UniCredit might just be the one. The bank itself is no stranger to Russia.

Historically, Italy has had extensive trading links with the country and the bank already has a controlling stake in Moscow International Bank.

UniCredit’s move is typical of this year’s overarching trend by foreign financial institutions to secure market share through acquisition rather than market accretion in both the retail and wholesale securities sectors.

That scramble has not left Aton’s peers unaffected. Troika Dialog, for instance, another leading independent broker, is reportedly being Kandel is credited with pushing through a major restructuring drive, which he courted by JP Morgan (and, some reports add launched in the autumn of 2004 to define more clearly the firm’s businesses.

Citigroup). Deutsche Bank meantime bought a Three clear business streams emerged. The first was asset management, which controlling 60% share in United Financial Group the firm had been trying to spin out for some years. Equally importantly, Kandel (UFG) at the end of last year. Earlier in 2005, UBS felt it was imperative to give clearer direction to the firm’s broking operations. bought out local broker Brunswick, while Lehman Photograph kindly supplied by Aton Capital, October 2006.

Brothers has established a joint venture with on business and it became increasingly obvious that it required Renaissance Capital, the Russian investment bank.

It has not stopped there. Citigroup already has a Russian a redefinition of the firm’s activities. Aton’s local institutional and high net worth accounts simply wanted it to provide subsidiary; Raffeisen International bought out Impexbank execution services. Its foreign clients, on the other hand, were earlier this year, Sociètè Gènèrale owns SKT Bank and has a increasingly pushing the firm into investment banking 10% stake in Rosbank and hopes to acquire full control by activities. By the end of last year the restructuring was 2008. Germany’s Commerzbank is taking a 15% stake in completed, a move that was essential if the firm was to begin Promsvyasbank and eventually plans to increase its to work in partnership with a foreign financial institution. The shareholding to 50%, while Credit Suisse recently launched a firm had realised early on that any strategic tie-ups could only new wealth management business in Russia and Goldman Sachs (an ex-suitor of Aton) was granted a licence to trade be reached in the firm’s investment banking area.

Kandel is nothing is not thorough and following the securities in August this year.“The bulge bracket banks have restructuring of the holding, then went and restructured been expanding and investing more heavily in the past in the Aton’s subsidiary operations, a process that was completed past two years to capitalise on the country’s natural resources in August this year. ZAO Aton Broker now services boom and burgeoning corporate sector. The market is institutional investors and OOO Aton services retail growing in both size and the number of institutions servicing investors, says Kandel. The upshot is a wide-ranging uptick the market, and it is only the beginning,” says Alexander in revenues. Revenue from the retail business of Russia’s Kandel, Aton’s chief executive officer.“However, on the flip OOO Aton, the flagship company of Aton Capital Group, is side, the foreign banks have introduced strong competitive expected to double on the year to between $22m and $25m pressure into the market.”

Kandel acknowledges that change is in the air. “As a in 2006, although a larger portion of the group’s revenue will come from Aton Broker. In September, the firm announced standalone entity, it is unlikely we will gain access to the that it would merge the operations of OOO Aton with biggest accounts. If we do not act then our client base will internet broker Aton-Line, with the combined operation eventually consist of Russian corporates ignored by big guys working under the moniker OOO Aton-Line; headed by the like Goldman Sachs.” Given that selling shares to a foreign former RTS exchange president and chairman of NAUFOR, player is one way forward, Kandel is precise about the kind of

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deal that Aton is looking for. The model, he says is Deutsche Bank’s deal with UFG: “in other words a two stage deal in which UFG is reaping the benefit of Deutsche Bank’s resources,”explains Kandel.“As you probably know we spent last year discussing possibilities with Goldman Sachs. They wanted 100% straightaway; but would not have allowed us to benefit from any synergies. We are looking for partners.”

Aton has variously signalled that while it understands the requirement for a partnership, it will not accede at any cost.

The firm is also choosy.“Not every single Western bank is fit to be our partner. It is two-way traffic; a marriage of convenience.

Both they and we should agree on our joint strategy. We must share views on the client base, on the kinds of transaction we want to make, we must agree on what we want to focus on jointly and where we want to reap the synergies,”says Kandel.

One of the points of contention with Goldman Sachs was that Aton wanted to focus on mid-size local businesses and not solely on blue chip companies. “We want to offer the middle market our investment banking services, and help them grow. However, global banks often say that they are not interested; they want to service the top ten Russian corporates. There are no synergies that we could offer in such a partnership. A prerequisite for a deal is that potential business partners share our vision of how we should develop the business,”explains Kandel.

There are three sectors that Aton focuses on. Natural resources companies, “small oil plays, which have been offering triple digit returns,”says Kandel. The second area is consumer goods and retail chains,“where we are searching

for companies in the range of $100m to $200m. These are invariably outside of Moscow, in the regions,” he adds. The third focus is Aton’s signature business, which specialises in “gold, silver and zinc,”according to Kandel. “We have closed a number of high profile deals in companies which have interests in Kazakhstan, Armenia.” Last year the house closed 10 deals in the minerals and mining sector.

While mergers and acquisitions within the Russia’s financial sector remains buoyant, for Aton, the bulk of recent business has centred in equity capital markets (ECM). “Ironically, we have seen more ECM deals than M&A, which take longer and are less transparent. I can tell you,”he says laughing,“that it is hard to bring two parties together in agreement.” That aside, Kandel acknowledges that these days it is much easier to get ECM mandates and the firm boasts expertise in bringing small and medium sized firms to market in a range of overseas exchanges, including Toronto, London and Frankfurt.

By the end of this year, it will become clearer whether Aton will be a reluctant bridesmaid, or finally become a bride.

Irrespective, Kandel remains irrepressibly optimistic. “Either way the opportunities are only just beginning in Russia,”he maintains. “As investor requirements become more complex and we move towards full convertibility of the rouble, there is a big upside on the fixed income side and we will see an explosion of rouble denominated issues. I even anticipate a trend: that in a few years foreign companies will bring in foreign exchange and convert it into roubles. We will still be here to leverage whatever comes.” There is one owl, it seems, that still intends to fly free.

Don’t work in the dark, who knows what you might find Emerging Markets Report provides a comprehensive overview of the principal deals, trends, opportunities and challenges in fast-developing markets. For more information on how to order your individual copy of Emerging Markets Report please contact:

Paul Spendiff Tel:44 [0] 20 7680 5153 Fax:44 [0] 20 7680 5155 Email:paul.spendiff@berlinguer.com

FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2006

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UPWARDLY MOBILE Among options on ETFs, the International Securities Exchange (ISE) is making inroads after a federal district court ruled in 2005 that ISE’s unlicensed trading of options on ETFs that track the performance of stock market indices does not infringe the intellectual property rights of the index providers, a ruling unanimously affirmed in 2006 by a federal appeals court. Multiple listings for ETF options have proliferated as a result.

Market participants have many more indexrelated option contracts to choose from these days thanks to the explosive growth in exchange traded funds (ETFs). As ETFs themselves become more numerous, diversified and sophisticated, index option trading is growing in tandem. What next? Neil O’Hara reports.

NDEX OPTION VOLUME has grown by leaps and bounds over the past five years (please refer to Table: Index option volume by exchange). It’s no coincidence that hedge fund assets have shot up in the same period. Index options provide a convenient and inexpensive way to manage risk, a task at which hedge funds excel. Traditional asset managers are playing a bigger role, too. Better liquidity and transparency have attracted institutions, which can now trade in size without disrupting the market, at least in the more liquid contracts.

Market participants have many more index-related option contracts to choose from these days thanks to the explosive growth in exchange traded funds (ETFs).

According to Ashok Shah, chief investment officer at London & Capital, a boutique, UK-based asset manager, which is about to launch its own investment products based around MarketGrader, an algorithmic investment

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tool; “ETFs are a form of indexation in the way the people manage assets and are the quickest way to manage risk in a volatile quarter,” says Shah. The firm currently offers MarketGrader 40, a basket of 40 North American equities selected by computer algorithms, based on fundamental analysis. In the first quarter of 2007, the firm will launch an extended suite of MarketGrader products that will be launched as ETFs. Options on ETFs provide an alternative to options on whatever underlying index the ETF tracks, says Shah. They are not identical, however. ETF options settle in kind, by delivery of shares in the ETF, while traditional index options settle in cash. Contract sizes differ as well. In most cases, the cash settled index options represent a larger notional principal. The SPX contract on the Standard & Poor’s 500 Index (S&P500) represents 10 times the value of options on the SPDR ETF that tracks that index, while the NDX contract on the NASDAQ 100 Index is 40 times bigger that the QQQQ ETF option.

Physical delivery makes ETF options available to retail investors who would not otherwise qualify to trade index options. A portfolio must meet minimum size and diversification standards – in effect, be a plausible proxy for the index – before an investor can write index call options

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THE GROWTH OF INDEX OPTIONS

according to Paul Stephens, without being considered naked director of international and short. ETFs eliminate the problem; institutional business development short calls are covered as long as the at the Chicago Board Options account holds enough ETF shares to Exchange (CBOE). He notes that deliver upon exercise. cash settled options provide greater Even so, while London & certainty if the index goes out close Capital’s Shah believes that ETFs are to the strike price: the options will still in their exponential growth settle for a token cash payment and phase, the best is yet to come, with the portfolio will be long the next significant implications for the index day. A manager short at-theoptions industry.“Actively managed money ETF calls does not know ETFs are definitely the next step and how many will be assigned – if any on the back of that development the – the so-called pin risk. “Some volume of index options trading will people find ETF options’ physical rise accordingly.” settlement easier for them and Lower nominal values and wider others prefer the cash settlement,” availability may explain why volume Stephens says, “It is a case of in ETF options has outstripped the different strokes for different folks. growth in cash settled index Index options tend to be preferred options. “I have long believed that Michael T Bickford, senior vice president of by people doing the bigger clip.”

ETF options are a superior product,” options at the American Stock Exchange (AMEX), Stephens believes hedge funds says Michael T Bickford, senior vice says,“I have long believed that ETF options are a have propelled the growth in president of options at the superior product.” Not for everyone, though. trading volume. Index options give American Stock Exchange (AMEX).

Bickford points out that institutional investors them a cost-effective way to hedge Not for everyone, though. Bickford may prefer the larger size of cash settled options exposures to stocks as well as other points out that institutional because commissions depend on the number of asset classes, such as credit default investors may prefer the larger size contracts traded; the fewer contracts needed to swaps and convertible bonds. He of cash settled options because hedge a fixed dollar amount the lower the sees more traditional institutions commissions depend on the transaction costs will be. Photograph kindly participating, too. “Covered call number of contracts traded; the supplied by AMEX, October 2006. writing is popular now and has fewer contracts needed to hedge a fixed dollar amount the lower the transaction costs will be. been over the last few years because performance has been Traders may lose some of that benefit at expiration however. very good,” Stephens says. CBOE commissioned a study by An in-the-money cash settled option lifts one leg of a hedged Ibbotson that showed a rolling one-month at-the-money buyposition: the day before expiration a portfolio long SPDRs and write strategy delivered returns comparable to the S&P 500 short SPX options has zero delta, but the next day delta is 100. with much lower volatility. The exchange now trades options Institutional investors can manage that risk, of course; they can on proprietary indices that track buy-write returns on the S&P roll the option out to a future month, or settle in cash and 500, NASDAQ 100 and Dow Jones Industrial Average (DJIA).

The CBOE still has by far the largest market share in adjust the portfolio to maintain the desired exposure – but they will incur transaction costs. “You have to trade out and you index options, thanks in part to exclusive licences it holds to trade the most popular contracts: SPX options on the create friction when you do that,”says Bickford.

An in-the-money ETF covered write takes care of itself at S&P 500, OEX on the Standard & Poor’s 100 and DJX on expiration: delta is zero going in and zero coming out, the DJIA. Among options on ETFs, the International

INDEX OPTION VOLUME BY EXCHANGE Year 2005 2004 2003 2002 2001

CBOE 192,536,695 136,679,303 110,822,092 94,383,545 52,009,919

AMEX 46,744,753 42,337,503 37,890,154 40,828,126 37,329,121

PHLX 23,555,581 25,769,498 23,366,215 10,891,670 8,366,266

PCX 17,158,819 14,353,054 15,039,960 14,005,412 6,991,130

ISE 64,674,471 38,085,408 19,149,997 12,060,836 6,152,766

BOX Total 16,883,720 361,554,039 4,284,223 261,508,989 206,268,418 172,169,580 110,849,202

CBOE – Chicago Board Options Exchange, AMEX – American Stock Exchange PHLX – Philadelphia Stock Exchange, PCX – Pacific Exchange ISE – International Stock Exchange, BOX – Boston Options Exchange Source: CBOE Market Statistics 2005

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Srikant Dash, index strategist at Standard & Poor’s. For an index with relatively few components, each of which has a liquid single stock option, investors can calculate the theoretical value of the ETF option. If the market price differs – or disperses – from that value, traders can capture the arbitrage opportunity. “For now dispersion trading is concentrated in proprietary trading desks, hedge funds and options arbitrageurs,” says Dash, adding: “That strategy has not gone retail.” Photograph kindly supplied by Standard & Poor’s, October 2006.

Securities Exchange (ISE) is making inroads after a federal marketplace has come out,” he says, “Institutional investors district court ruled in 2005 that ISE’s unlicensed trading of can get done what they need to get done in the size they options on ETFs that track the performance of stock market want with immediacy and low transaction costs.”

ISE’s success demonstrates that multiple listings boost indices does not infringe the intellectual property rights of the index providers, a ruling unanimously affirmed in 2006 trading volume. Goldberg notes that average daily volume in by a federal appeals court. Multiple listings for ETF options the DIAMONDS ETF that tracks the DJIA has more than doubled to 68,000 in the year since ISE started trading the have proliferated as a result.

ISE’s electronic trading platform lowered costs, contract. Options on the SPDR ETF were introduced on tightened spreads and introduced greater transparency to multiple exchanges in January 2005 and have already become the options market, which attracted more institutional the third most actively traded ETF options. ISE is looking to investors. Most recently, the ISE launched two sets of repeat its success in equity options; in just three years from its index options: a set of cash-settled index options based on inception the ISE displaced the CBOE as the leading market the FTSE 100 Index and a second set that trades the FTSE for those contracts.“Multiple listing is what drove growth in the equity and ETF options 250 through an innovative market,” says Goldberg, ‘Mini’ contract structure.

Upwardly mobile: the growing appeal of index options “You have more liquidity.

The Mini FTSE 100 and 140 The bid-ask spread the Mini FTSE 250 indices 130 narrows.” He believes that represent 1/10th of the 120 cash settled index options value of the full-size FTSE 110 have not grown as fast as 100 and FTSE 250 Indices.

100 ETF options because the Bruce Goldberg, chief 90 most popular contracts are marketing officer at the ISE, 80 listed on a single exchange. believes that institutions 70 Experience suggests now account for about 40% 60 that the addition of ETF of total options trading options may improve volume, up from an liquidity in cash settled estimated 15% to 20% in FTSE USA Index FTSE USA Index Adj for CPI FTSE All-Share Index FTSE All-Share Index Adj for CPI options on the underlying the pre-ISE era.“A lot of the index. Scott Ebner, head of friction that existed in this Source: FTSE Group. Data as at October 2006

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Scott Ebner, head of new product development at the American Stock Exchange (AMEX), cites the Russell 2000 Index as an example. The ETF assets have grown over the last two years, trading volume on the ETF is up, ETF option volume has gone through the roof and the index option is still thriving.“People are able to incorporate strategies that use both instruments,” Ebner says,“With many indices, index options, ETF options and ETFs, futures on those products and options on the futures can succeed – and not necessarily at the expense of one another.” Photograph kindly supplied by AMEX, October 2006.

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new product development at the AMEX cites the Russell 2000 Index as an example. The ETF assets have grown over the last two years, trading volume on the ETF is up, ETF option volume has gone through the roof and the index option is still thriving. “People are able to incorporate strategies that use both instruments,” Ebner says,“With many indices, index options, ETF options and ETFs, futures on those products and options on the futures can succeed, and not necessarily at the expense of one another.”

The number of ETF option listings continues to grow apace at the AMEX, but new index option listings have tapered off over the last two years, according to Ebner. It is a more mature market in which opportunities for innovation are limited and many contracts have established name recognition and followings. AMEX keeps looking, though. The exchange has a pending application to trade options on the Nuveen Municipal Closed End Bond Fund Index and is considering several other new index options.

Although the number of ETF options keeps growing, trading volume remains concentrated in a few big names.

QQQQ (NASDAQ 100), IWM (Russell 2000) and SPY (S&P 500) lead the pack, followed by DIAMONDS (DJIA) and then sector ETFs such as OIH (oil services), XLE (energy) and SMH (technology).

The increasing popularity of dispersion trading is driving growth in the most active sector ETF option volumes, according to Srikant Dash, index strategist at Standard & Poor’s. For an index with relatively few components, each of which has a liquid single stock option, investors can calculate the theoretical value of the ETF option. If the Bruce Goldberg, chief marketing officer at the International Securities market price differs – or disperses – from that value, traders Exchange (ISE), believes that institutions now account for about 40% of can capture the arbitrage opportunity.“For now dispersion total options trading volume, up from an estimated 15% to 20% in the trading is concentrated in proprietary trading desks, hedge pre-ISE era.“A lot of the friction that existed in this marketplace has funds and options arbitrageurs,” Dash says, “That strategy come out,” he says,“Institutional investors can get done what they need has not gone retail.” to get done in the size they want with immediacy and low transaction Retail investors have contributed to the growth in covered costs.” Photograph kindly supplied by the ISE, October 2006. writing, however. Income is becoming more important as the retiree population grows. It is a demographic shift that volatility and equities,” Dash explains, “That is the ideal will continue for years as baby boomers age. Buy-write companion you could have for a cash equity portfolio.”Back programs packaged into structured notes can provide yields tests have shown that a portfolio long 90% cash equities and 10% volatility would of 5% or more compared to have beaten a pure cash a yield of 1.8% on the Do you swop or straddle a butterfly? equity portfolio hands Standard & Poor’s 500 – 103 down over the past 10 to and leave investors with 102 20 years. some of the upside.“That is It will not take Wall what is driving the 101 Street’s financial increased interest,” Dash 100 engineers long to says,“People want yield.”

99 package that concept for Another strategy is 98 the retail market. With so gaining ground in the 97 much energy applied to institutional market.

96 devising new options Volatility tends to creep up strategies and ways to in a rising market, but it exploit them, the index spikes up when the market FTSE MTIRS USD 2yr Swap FTSE MTIRS USD 2x5 Yr Swap Straddle options market looks set falls. “You have negative FTSE MTIRS USD 2x5x10 Yr Swap Butterfly for further growth. correlation between Source: FTSE Group. Data as at October 2006

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CORPORATE PROFILE: INTEL

After fumbles and stumbles that cost it market share, profits and prestige, the dominant maker of semiconductors counterattacks with price cuts, new products, a management shakeup, and widespread layoffs. The ensuing struggle with archrival Advanced Micro Devices will benefit computer users everywhere. Art Detman reports from California.

Intel chief executive officer (CEO) Paul Otellini during his keynote at Intel Developer Forum in San Francisco, August 23rd, 2005. Photograph kindly supplied by Intel Press Relations, October 2006.

FIGHTS O BACK “

NLY THE PARANOID survive” is the catchphrase of the legendary Andrew S. Grove, who built Intel Corporation into the world’s largest and most respected designer and manufacturer of microprocessors— the silicon-based electronic brains of desktop computers, laptops, and servers (used to power corporate computer networks). Before he retired in 1998 (he now has the title of senior advisor), he even wrote a book called Only the Paranoid Survive. If his successors did not take his basic message to heart immediately, and which included such nuggets as: “Business success contains the seeds of its own destruction,” it was because Intel was both extraordinarily successful and seemingly indestructible.

At the peak of the dot-com boom in 2000, Intel stock soared above $75, giving the company a market capitalisation of more than $500bn. On sales of $33.7bn that year, Intel earned after-tax profits of nearly $10.7bn, for a net profit margin of 31.6%. Its closest competitor, Advanced Micro Devices, Inc. (AMD), had revenues of about $4.6bn, net income of $797m, a market capitalisation that peaked at $15.3bn, and a reputation as an Intel imitator, not as an innovator.

Today, all this has changed. At a recent share price of around $21, Intel is valued at $118.6bn. Revenues for 2006 are expected to come in around $37.5bn, and net earnings will likely be under $6bn. Meanwhile, AMD now has a

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market cap of $12.1bn and analysts expect 2006 revenues of $5.3bn with earnings of perhaps $645m. Of course, AMD is still just a fraction as big as Intel, but the story is in the two company’s bottom lines. This year Intel will earn not only far less than what it did during the fantasy world of 2000, it will earn less than it did last year . . . and the year before. Meanwhile, AMD may be on its way to its second most profitable year ever, after only 2000.

Go back to the days of Andy Grove. A charismatic, driven leader, he recognised that Intel could not compete with the Japanese in memory chips, at that time Intel’s main business.

He bet the company on microprocessors just as the personal computer boom began, and he placed unrelenting emphasis on manufacturing efficiency. Soon “Intel Inside”became one of the world’s best-known sales slogans. In 1993, Grove named Craig R Barrett, an accomplished electrical engineer, chief operating officer (COO) and in 1998 handed over the chief executive officer (CEO) title to Barrett as well.

However, Barrett was the antithesis of Grove — at once overly confident and overly cautious. The company drifted for several years and in May 2005 the board named a new

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In June Otellini announced a deal to sell Intel’s CEO, Paul S Otellini, who had led the highly successful launch of the Pentium chip in 1993. Barrett stayed on as non- struggling mobile communications business, which makes XScale chips for cell phone and handheld devices, to executive chairman of the board.

Otellini — not an electrical engineer — had been Marvell Technology Group Ltd. for $600m. Intel had president and COO since 2002, so Intel’s problems were no acquired the technology in 1998 and 1999 through surprise. Sales of desktop computers, Intel’s single biggest licensing and the purchase of DSP Communications Inc. market, were slowing. AMD’s line of Opteron chips for for $1.6bn. However, despite a customer list that included servers, introduced in 2003, were 20% to 30% more energy- Research in Motion (BlackBerry), Palm (Treo) and efficient than Intel’s Itanium chips, a 2001 product launch Motorola, Intel was never able to win sufficient market that never gained traction. Intel’s XScale line of chips for cell share from Texas Instruments and Qualcomm to turn a phones and hand-held computers was losing money, as profit. Security analyst Mark Edelstone of Morgan Stanley was the NOR flash chip business. Texas Instruments, which estimates Intel lost $80m annually on sales of $400m.

In July 1,000 managers got layoff notices, a first in the Intel forced out of the personal computer (PC) chip market in the 1980s, had reinvented itself and pushed Intel out of company’s 38-year history. Later in September, Otellini revealed that he expects job cuts to total 10,500 over the the market for plasma TV semiconductors in 2004.

At AMD, in an audacious undertaking, the company put next two years—through attrition, layoffs and sale of its advertising and sales promotion dollars not into brand advertising but into a “War in the Store”strategy. By increasing its line of products and improving configurations — to gain an advantage over Intel’s Prescott chip in terms of heat reduction, for example — it persuaded computer makers such as Gateway, Hewlett-Packard and Toshiba to offer PCs and laptops with AMD chips. Then it used rebates, in-store promotions, employee training programs and advertising support to get hundreds of retailers to board the AMD bandwagon.

In mid 2005, Intel’s stock Louis J. Burns vice president, general manager, Digital Health Group, (right) places medical monitoring price, around 28, began a long devices to a member of the Intel’s staff during a demonstration of a prototype computer that helps slide. AMD’s stock price, then medical staff to monitor a patient’s medical information. Burns’s keynote dealt with the opportunities around 18, moved up sharply, for information technology products, platforms, and solutions in the healthcare industry. Photograph passing Intel’s at year-end. kindly supplied by Intel Press Relations, October 2006.

The turnabout reflected AMD’s improved share of the total microprocessor market, business units—enough to save $3bn by 2008. Silicon Valley which by mid 2006 had reached 22%, up from 16% a year was stunned, and Wall Street yawned. Intel shares fell 3.4% earlier. Intel’s share meantime slipped to 73%, down from on the news, reflecting both a belief that the cuts were not 82%. An even more dramatic illustration of Intel’s reversal deep enough and scepticism about Otellini’s long-term of fortune was revealed when first quarter results were strategy. Meanwhile, Otellini also reorganised his corps of announced. For the first time ever, AMD’s gross profit senior officers. The number of “two-in-a-box”co-managers margin exceeded Intel’s, 58.5% to 55.1%. One culprit was was reduced, a new business unit was created, two vice Intel’s bloated management corps, which under COO presidents retired, and the number of executives reporting Otellini had grown faster than the number of employees. to Otellini was reduced.

In anticipation of new product introductions, Intel Indeed, even overall employment had gotten out of balance, growing by 17% in 2005 (to 99,900) even though announced price cuts of up to 60% on its existing models.

The cuts became effective in July, which meant that sales rose only 13.5%.

An energised Otellini began taking action. In the spring second quarter sales were hit hard as customers waited he announced a comprehensive review of all the for the new products or the price reductions. AMD was, of company’s operations, with a goal of increasing efficiency, course, forced to match Intel’s price cuts almost to the percentage point. cutting costs and speeding decision-making.

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In June Intel’s formidable product development laboratories began releasing a stream of new chips: a new Xeon 5100 chip for servers, code-named Woodcrest; an improved high-end Itanium chip, also for servers, codenamed Montecito; a new chip for desktop computers, codenamed Conroe; a new chip for laptops, code-named Merom; and — expected just about when you get this magazine — a device for servers that will comprise at least four chips, code-named Tulsa. Code names are very big in Silicon Valley, where new product launches take on the importance of military invasions.

Intel says that, without exception, every one of its newly launched products offers substantial operating improvements and cost advantages over existing models. For example, the Xeon 5100 is 60% faster than AMD’s Opteron and provides a performance per watt advantage of 80%. It is the first Itanium with a dual-processor chip — two electronic brains on a single silicon wafer — and has 1.7bn transistors. The Conroe PC chip is available as either a conventional singleprocessor or dual-processor chip. The latter model is called the Core 2 Duo (hardly as good a name as Pentium) and chips provides the performance of a Pentium 4 chip but has the energy-saving features of Intel’s chip for notebook computers.

A version for the mobile market, also called the Core Duo, will also be introduced.

“This is a pretty exciting time for us,” says Anand Chandrasekher, senior vice president and general manager of Intel’s new business unit focused on the ultra-mobile PC market (i.e., computers you can

Intel CEO Paul Otellini during his keynote at Intel Developer Forum in San Francisco, August 23, 2005. Photograph kindly supplied by Intel Press Relations, October 2006.

Intel’s Pat Gelsinger, senior vice president, general manager, Digital Enterprise Group, shows attendees The Next Generation:Tulsa silicon wafer during the Digital Enterprise keynote at the Fall Intel Developer Forum held at Moscone West on Wednesday, August 24th, 2005 in San Francisco, California. Photograph kindly supplied by Intel Press Relations, October 2006.

lose nearly as easily as cell phones).“We have launched the first three products in our next generation of micro-architecture products.

These include Woodcrest for servers, Core Duo for desktops and Core Duo for the mobile marketplace. Taken together, these are not so much an evolutionary move for us as they are a revolutionary move.

This is as big an event for the company as the original Pentium was because of the kinds of capabilities we will be able to offer.The range of improvements we will be able to see, on a pure performance basis, will be 40%, which is dramatic.”

Chandrasekher is quick to note that pure speed is no longer the primary goal of Intel engineers.“Performance is still a driving metric in the marketplace. All you have to do is visit websites of gaming magazines to see how enthralled they are by performance. What you are seeing us do is shifting not toward pure performance per se but toward performance per watt.”

When Intel introduced the Pentium chip for desktops and servers in 2000 and later the Prescott, it focused on pure speed. “That was what the market demanded at that time,” Chandrasekher says.“We made a different bet in notebooks with our Centrino chip, where we bet that performance coupled with thermal efficiency would yield great results, because battery life and other things make a difference in notebooks. It was a home run.”

It was more than that.

Centrino also provided the basis for both the new Core Duo series of chips for PCs and the Xeon chips for servers.“Back in 2003, when we launched Centrino, we also made a bet that the entire world would move toward energy-efficient performance, and that is the

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architecture that you see us now bringing to market.”

All well and good, but is the era of rapid growth in personal computer sales coming to an end? The year-overyear growth rate has been almost steadily downhill, and in 2006 is expected to come in around 10%. Many people in the high-tech industry — analysts and CEOs alike — believe future growth will do no better than track growth in the overall economy.

“I could not disagree more with that,” Chandrasekher says.“Let me give you some data. The PC was introduced in 1981. In 1999, the PC market hit about 100m units. So it took 18 years to get to 100m units. In 2005, last year, the PC market broke 200m units. So, the first 18 years, 100m units; the next hundred million, six years. Industry forecasts have the PC market growing to 300m units by 2008. Therefore, the time intervals between 100m-unit increments are shrinking as time goes on.

“I do not think that growth engine stops. Why do I say that? A couple of reasons. One, as the PC market grows, a Delegates look at exhibits at the Fall Intel Developer Forum held at replacement cycle factor kicks in. Over the past eight Moscone West on Wednesday, August 24th, 2005 in San Francisco. years, the mature population of microcomputers has been Photo kindly supplied by Intel Press Relations, October 2006. shifting from desktops to notebooks. The replacement Here’s the view of Gus Richard, head of research at First cycle of a notebook is more aggressive than that of a desktop. Therefore, as the installed base of notebooks Albany Capital: “Intel is about to reassert its leadership in the grows, the replacement cycle of the PC market actually microprocessor market.”Richard also believes that Intel has at increases. So you have the compounding effect of an least a year’s lead, maybe two, in manufacturing processes. installed base that continues to grow and an increasing “Moreover, due to Intel’s adoption of proactive process control, portion of that accounted for by notebooks, which have a the company has driven defect densities to new lows.”

Backed by a research and development budget that faster replacement cycle.”

Then there are emerging markets, countries such as nearly matches AMD’s total revenues, Intel remains the China and India. “In the aggregate, PC penetration of Goliath of the semiconductor industry. Almost certainly its emerging markets is around 4%, and it is growing. When new series of chips will win back some market share across the PC’s penetration of any given emerging market reaches the board, in servers, PCs and notebooks. Even so, do not 8% or 9%, you hit a hockey stick. The network effect takes be surprised if Intel falls short of regaining all lost market place, and growth just skyrockets. And we are going to be share. AMD is not the laggard of years past, and with its approaching that 8% to 9% range in emerging markets pending acquisition of ATI Technologies — a controversial deal in which AMD is criticised for over-paying — AMD over the next couple of years.”

As Chandrasekher is quick to note, Intel’s new products will become a major player in the graphics chips business, have received a warm reception by people who have tested with a smaller market share than Intel’s but with the them in actual applications. For example, in the video game potential provided by ATI’s more advanced technology.

Two things are certain. First, computers of all kinds, from industry, where AMD has largely supplanted Intel, a reversal high-end servers to is likely.“We absolutely love pocketsize devices yet to the guys at AMD,” one Intel: a chip off the old block? be invented, will continue maker of gaming PCs told to provide improved The Wall Street Journal 600 performance at ever-lower when the Core 2 Due was 500 prices thanks to the Intelintroduced. “But they are 400 AMD rivalry. Second, going to get hammered 300 although any number of here at the end of July.”The famous names — names firm of Thomas Weisel 200 such as Digital Partners ran extensive tests 100 Equipment, Commodore comparing two Woodcrest 0 Computer, and Wang server chips from Intel Laboratories — have against two Opteron chips disappeared from the and found that “Woodcrest Intel AMD FTSE NASDAQ Large Cap marketplace, Intel won’t has superior performance be among them. to Opteron systems.”

Source: FTSE Group. Data as at October 2006

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Hedge funds, which are always trying to improve their return on capital continue to push for measures that increase the efficiency of their collateral, including firm-wide collateral calculations. Hedge funds are on the cutting edge, of course, but traditional money managers may pose a bigger challenge – and opportunity – for collateral managers, who now see a rapid increase in the use of OTC derivatives by a greater range of players. Neil O’Hara reports.

THE NEW FRONT LINE FOR COLLATERAL MANAGERS Automation took a big step forward in 2005 when JPMorgan introduced its CommanD product, driven by SunGard’s Adaptiv software and designed to handle OTC derivatives through the entire life cycle from settlement to maturity.“It’s a compelling proposition for both existing and target clients,” says Bhatia.“As the first player in the market to do this, we are an outlier.” JPMorgan will not have the market to itself for much longer, however. BNY is developing a similar offering in partnership with another software vendor. Photograph by Scott Maxwell, supplied by Dreamstime.com photography agency, October 2006.

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OLLATERAL MANAGERS FOR OTC derivatives must envy their colleagues who handle securities lending and repo programmes for which public markets determine prices and computers calculate required collateral margins according to standard formulae.

In the OTC derivatives world, securities do not trade publicly so counterparties have to agree on pricing. Each contract has negotiated non-standard margin provisions and, with computerisation in its infancy, collateral management still relies on phone, fax and e-mail.

Traditional securities lending and repo dominate the market for third party collateral management services but OTC derivatives are growing fast.

The International Swaps and Derivatives Association (ISDA) estimates that the notional value of outstanding collateralised contracts reached $1.33trn in 2006, up from $719bn three years ago. Kirit Bhatia, global head of product for collateral management at JPMorgan Worldwide Securities Services, says that technology and operational infrastructures have failed to keep pace not just for collateral management but for the end-to-end process for managing OTC derivatives, including valuations. That growth has brought the headache that always plagues manual processes: human error. Scott Linden, vice president and global product manager for derivatives collateral management at The Bank of New York (BNY), points out that collateral managers have to track contract terms for every trade, value the trade and then step through the margin calculation. “Your technology requirements include a trade capture work flow as well as linkage to settlement to drive this process,”says Linden,“It is rife with operational risk.”

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As Bhatia notes, “The high level of investment spend needed, access to market professionals and the complexities of integrating with existing internal systems present significant barriers and challenges in building infrastructures in-house.” It could be worse. The ISDA Margin Survey 2006 reported that 75% of collateral posted against OTC derivatives contracts is still cash, which leaves no room for disputes over its value and eliminates haircut calculations on collateral securities.

The numbers do not show it yet, but Linden expects the proportion of cash to fall now that interest rates have risen from historic lows. “Counterparties may begin to see other opportunities,” he says, “They may invest cash elsewhere rather than receive the Fed funds rate under an ISDA. Then they can use securities to satisfy their collateral requirements.”

However, Bhatia explains that, “While interest rates are part of the reason cash dominates today, collateral decisions are driven by infrastructure limitations rather than a calculated assessment of the risks involved and opportunity cost of collateral. This is clearly not ideal.”Yet current accounting rules for many sell-side institutions favour the use of cash for collateral, he says.

Operational responsibilities do not stop at valuation and haircuts for securities collateral, either. Linden says rehypothecation (the pledging of securities in customer margin accounts as collateral for a brokerage’s bank loan) is rampant. Therefore collateral managers have to keep track of where posted securities have gone. Managers must check that the securities meet eligibility requirements spelled out in each contract, too; most specify US treasury bonds, US agencies and G7 sovereign debt. If the market moves away from cash collateral, Linden believes counterparties may embrace the broader range of securities already accepted in securities lending and repo programs.

That will not happen in the burgeoning credit default swaps (CDS) market, of course. These contracts guarantee the principal and interest payments on bond issues in exchange for an insurance premium so if the collateral is not cash it has to be the highest quality AAA paper. “We are looking for assets that cannot be credit impinged,”says Lou Lucido, group managing director at TCW Credit Mortgage Group, a leading manager of collateralised debt obligations, “You do not want to have an underlying obligation which is supposed to be credit secure develop credit volatility.”Indeed, if anything happens to impair a collateral credit TCW insists the CDS counterparty replace that bond with top rated paper.

Unlike securities lending and repos, market price changes do not trigger collateral movements in the CDS world.

Prepayments do, however; if the outstanding principal embedded in a CDS based on asset-backed or mortgagebacked securities drops more than a threshold amount the parties agree to reduce the amount of collateral to match the remaining balance outstanding.“You are not trying to create an arbitrage,”Lucido says,“The collateral is supposed to be right-sized to the notional.”It is a manual process that will probably stay that way because unpredictable prepayments do not trigger adjustments every day.

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Kirit Bhatia, global head of product for collateral management at JPMorgan Worldwide Securities Services, says that technology and operational infrastructures have failed to keep pace not just for collateral management but for the end-to-end process for managing OTC derivatives, including valuations. Photograph kindly supplied by JP Morgan Chase, October 2006.

Collateral use continues to grow due to the forthcoming implementation of the Basel II capital adequacy framework.

Although the Bank for International Settlements has delayed the effective date for another year, the prospect gives banks a powerful incentive to favour secured lending.

Under Basel II, banks must set aside more capital against unsecured commitments; its risk-based approach links capital charges to the type of collateral, too. Government bonds require less capital than asset-backed securities, for example. “Collateral managers will have to monitor concentration limits and sort through highly-rated paper versus unrated paper,”says Jim Malgieri, managing director and product manager for global collateral management at BNY. The purpose of collateral is to mitigate credit risk, of course. Counterparties have to value each derivative contract and aggregate the margin requirements under each credit support annex to an ISDA master agreement before they arrange to move collateral as necessary.

Although the 14 major swaps dealers either have their own sophisticated tracking systems or employ third party collateral managers, many smaller organisations use spreadsheets.

Malgieri reckons spreadsheets do not cut it for more than about 25 ISDA contracts.“You begin to look to outsource those duties,”he says,“That is the service we are trying to offer.”It’s a function for which the big custodian banks are well-suited even though economies of scale do not yet play a major role

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in what remains a labour intensive process. As BNY rolled out its OTC derivatives collateral management product, it found a ready market among custody clients.“It is not a technology scale as much as it is a people and an expertise advantage the custodian banks have,” Malgieri says,“We have the contacts within these organisations already. We can lever up our expertise and experience in handling collateral.”

Elsewhere in the market, JPMorgan has for over a year been offering an integrated service that includes custody, derivatives processing, valuation and collateral management.

The service enables asset managers to include complex instruments like derivatives into the same portfolio as more standard instruments, making it seamless for clients as they develop more diversified portfolios. This capability was instrumental in Threadneedle Asset Management earlier this year choosing JPMorgan as its outsourcing partner.

BNY manages over $1trn in collateral for repo and securities lending programmes, primarily for clients who do not use the bank’s custody services: the funding desks of bulge bracket securities houses that provide equity finance and fixed income repo to their customers.“OTC derivatives dovetail in with corporate treasury, corporations that have interest rate swaps contracts on their books, pension funds that are in the interest rate swaps game and mutual funds,” says Malgieri,“The opportunities are presenting themselves through the custodian relationship.”

Jim Malgieri, managing director and product manager for global collateral management at BNY thinks that government bonds require less capital than asset-backed securities, for example.“Collateral managers will have to monitor concentration limits and sort through highly-rated paper versus unrated paper,” he says.

Photograph kindly supplied by Bank of New York, October 2006.

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That has opened the market to new entrants. Nobody likes to change their custody relationship — it’s an administrative nightmare — so clients are pressing their existing custodians to seize the opportunity. As the use of OTC derivatives spreads through the investment universe, money managers want their custodians to shoulder the administrative burden by providing third party collateral management. That is one reason why, in August, Chicagobased Northern Trust hired Stephen Andress as global head of derivatives operations (he previously fulfilled a similar role at Commerzbank). Northern Trust has seen 30% compound annual growth in OTC derivatives volume among custody clients for the last three years, but growth is accelerating: the bank processed as many contracts in the first quarter of 2006 as in all 2005.

Northern Trust is building a complete collateral management platform and expects to tap existing custody clients in the first instance. “We have their trade details.

Now we can take this process out of their back office and deliver it more cost effectively,”Andress says,“I think that is going to be attractive to a lot of people, that they won’t have to deal with these issues.”Once the infrastructure is in place, the marginal cost of adding new clients will be low — as it is for most custodian bank services.

Collateral managers either have or are developing systems to track trade details and contract administration.

The Depository Trust and Clearing Corporation (DTCC) is compiling a trade data warehouse for CDS and has plans to extend the project to other OTC derivatives. Although collateral managers applaud the initiative, it will not help them much until the warehouse covers the whole suite of derivatives and includes a valuation service.

Even then it will only help if both parties trade through DTCC – and at the moment market participants use DTCC mainly for CDS, according to Andress.“The portfolio you are collateralising usually includes all types of trades so you are only getting part of it from the trade warehouse,” he says.

The ISDA master agreement governs collateral between two counterparties, so automating one class of contracts won’t save much time if people still have to get on the phone every day to resolve valuation discrepancies in other parts of the portfolio. Differences arise not only from pricing but also populations: the contracts each counterparty is tracking under the ISDA master agreement may not match – a problem that has bedevilled the industry’s efforts to work off the confirmation backlog in OTC derivatives. Andress says ISDA is working on an electronic protocol to facilitate portfolio matching between counterparties.

Singing from the same hymn sheet would not eliminate valuation disputes, however. Accepted pricing algorithms exist for plain vanilla derivatives contracts, but valuing newer contracts like structured products is complicated.

“It’s like flying blind. If they do not know the exactly what the price might be, the brokers over-collateralise,” says Dushyant Shahrawat, a senior analyst at Tower Group, consultants to the financial services industry based in Needham, Mass.

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Shahrawat does not expect a big push to automate collateral management for OTC derivatives for another two to three years. Volumes are still modest compared to securities lending and repo and while margins for OTC derivatives remain high dealers have less incentive to automate an already profitable business. A lack of software hampers the effort, too; relatively few vendors have developed products for what is still a young market.

That is starting to change, however. Automation took a big step forward in 2005 when JPMorgan introduced its CommanD product, driven by SunGard’s Adaptiv software and designed to handle OTC derivatives through the entire life cycle from settlement to maturity.

“It’s a compelling proposition for both existing and target clients,” says Bhatia. “As the first player in the market to do this, we are an outlier.”JPMorgan will not have the market to itself for much longer, however. BNY is developing a similar offering in partnership with another software vendor.

Bhatia expects automation will improve collateral utilisation as well.

Once the people, technology and data are in place, collateral managers can focus on calculating the thresholds, haircuts and triggers that address credit and counterparty risk. “Without such infrastructure, participants may make decisions based on limitations on their ability to manage a diverse collateral set rather than risk based parameters,” Bhatia says.

Automated systems would facilitate collateral calculations across asset classes, although neither JPMorgan nor BNY has seen a demand for that service yet. Bhatia believes the market will move in that direction as firms seek to optimise their collateral and free up capital to deploy in other investments.

For now, prime brokers offer cross-asset class collateralisation only to their largest hedge fund clients. At most dealers, repo,

Lou Lucido, group managing director, TCW Credit Mortgage Group, a leading manager of collateralised debt obligations, says,“We are looking for assets that cannot be credit impinged …You do not want to have an underlying obligation which is supposed to be credit secure develop credit volatility.” Indeed, if anything happens to impair a collateral credit TCW insists the CDS counterparty replace that bond with top rated paper. Photograph kindly supplied by TCW Credit Mortgage Group, October 2006.

Stephen Andress, global head of derivatives operations at Northern Trust, has seen 30% compound annual growth in OTC derivatives volume among custody clients for the last three years, but growth is accelerating: the bank processed as many contracts in the first quarter of 2006 as in all 2005. Photograph kindly supplied

by Northern Trust, October 2006.

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designed to handle OTC derivatives through the entire life cycle from settlement to maturity.

“It’s a compelling proposition for both existing and target clients,” adds Bhatia. “As the first player in the market to do this, we are an outlier.”JPMorgan will not have the market to itself for much longer, however. BNY is developing a similar offering in partnership with another software vendor,”he adds.

Equally, at most dealers, repo, securities lending, futures and OTC derivatives are separate business units, according to BNY’s Malgieri.

“Even internally the organisations have difficult time moving collateral around among those internal units,” he says,“It’s almost viewed as standalone.” Linden points out that the industry has no umbrella agreement for cross collateralisation, either, so dealers who do offer the service have to develop their own legal documents and negotiate the terms with each client.

Brad Bailey, a senior analyst at Aite Group, a research firm based in Boston, Mass., expects hedge funds, which are always trying to improve their return on capital, will continue to push for measures that increase the efficiency of their collateral, including firm-wide collateral calculations. He sees more talk than action so far, but believes collateral managers could gain a competitive advantage if they develop the capability.

Hedge funds are on the cutting edge, of course, but traditional money managers may pose a bigger challenge – and opportunity – for collateral managers. “What has suddenly come upon us is the rapid increase in the use of OTC derivatives by a greater range of players,”Bailey says.

The day may come when custodians who develop OTC derivatives collateral management platforms to serve money managers apply their newfound skills to encroach on the traditional securities lending and repo turf long dominated by JPMorgan and BNY.

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CORPORATE-ACTIONS

Over the past several years, the volume of corporate-actions messaging on a global scale has increased significantly. At the same time it has created a completely new set of challenges for custodians and others entrusted with relaying crucial information to the end user on time and error-free. While technological solutions continue to be bandied about, experts underscore the need for greater harmonisation and increased commitment from all parties involved. Dave Simons reports from Boston.

The power of

technology With corporate-actions volume doubling since 2003, key players have championed continued investments in automation technology aimed at reducing the manual transmission of news feeds via fax and other hardcopy components, while eliminating redundant sources of information.

And with good reason. Photograph by Kokkinis Konstantinos, supplied

by Dreamstime.com photography agency, October 2006.

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Yet, despite efforts to address inefficiencies and achieve a S UNIT DIRECTOR of global corporate-actions for Boston-based Investors Bank & Trust, Tom satisfactory level of straight-through processing (STP), Broderick has been at the forefront of a growing corporate-actions remains a manually intensive practice, movement to streamline the manner in which corporate- with operational issues exacerbated by regional variations actions news — including stock splits, buybacks, and a lack of a universally accepted set of standards.“There reorganizations, mergers and the like — is disseminated. is an obvious interest among global custodians in reducing “We like to believe that one day we will all be able to come the time and expense associated with providing corporateto work, just push some buttons and everything will be actions information to clients and processing corporatetaken care of,”says Broderick with a casualness that belies actions related transactions,” says Amy G Harkins, senior the challenges that lay ahead.“It is wishful thinking, but we vice president and director of global asset servicing for Mellon Financial. “The parties with the most at stake are are making strides toward that goal.”

The inception of the International Standard ISO 15022 the owners of the securities associated with corporatecorporate-actions event types six years ago provided the actions, so it is hardly surprising that broker dealers and industry with a globally recognised mechanism to begin to asset managers are playing a primary role in pushing the automate the various links in the corporate-actions chain. industry toward better solutions.”

To date, the industry primarily utilises only two of the five message types — MT564 (notification) and MT566 Automation campaign (confirmation). Moreover, in an effort to increase Responding to the demand for innovative technologies, awareness as well as encourage greater use of the SWIFT leading companies such as TCS and Xcitek have been network, the corporate-actions division of the Securities joined by a growing list of upstart vendors that include Market Practice Groups (SMPG) recently finalised its Event CheckFree, SmartStream, GoldenSource and Information Interpretation Grid, which provides definition and adds Mosaic. They all now provide third-party software clarification for all 15022applications covering the message types. entire spectrum of With corporate-actions corporate-actions volume doubling since processes. “We subscribe 2003, key players such as to seven or eight Broderick champion electronic vendors, with continued investments in the idea that the more automation technology providers of that aimed at reducing the information you have, manual transmission of the less chance that news feeds via fax and something is going to be other hard-copy missed,” says Broderick. components, while “Of course, the Internet eliminating redundant has also been incredibly sources of information. helpful, just in terms of And with good reason. being able to access the While actual loss estimates website of a company, vary, among global depository or stockcustodians, corporateexchange to sometimes actions related operational to second source that risk remains a major data. Our philosophy is source of concern. that we are not going to Additionally, a new report send out a notice to our

by British consulting group clients unless it has been Oxera, in conjunction with properly validated by at the Depository Trust & least two commercially Clearing Corporation recognised vendors.”

(DTCC), found that even At Mellon, the use of the most seemingly imaging allows clients to innocuous corporatenot only receive Justin Chapman, senior vice president, process management worldwide action events can have a notification of a operations at Northern Trust says,“Historically corporate-actions has been a significant impact on corporate-action event very manual process. Because of the number of variants within the major trading, as reflected but also the supporting regions—including all of the different event types requiring all sorts of paper in share price, volume documentation.

This disclaimers and so forth—the cost of achieving automation is very high.” and volatility. allows them to act with Photograph kindly supplied by Northern Trust, October 2006.

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working group for the Industry Standardisation for Institutional Trade Communication (ISITC), says that developing industry wide standards is a crucial part of the automation initiative. “We are working directly with the clients in order to educate them and help them incorporate SWIFT messaging or use their proprietary solutions, which gives them risk reductions in their own operations as well as giving us a level of STP for things such as decision capture.”

Even if standardisation were to be achieved, idiosyncrasies may still exist that most likely would have to be dealt with on a caseby-case basis, says Broderick.“On message notification type 564, for instance, there may be some differences among the various players regarding the treatment of options. Right there, you have the potential for all that automation to go right down the drain. It may just be that when you have some natural differences and can’t reach a mutual agreement, that event just gets marked with an asterisk.”

At last summer’s Managing Tom Broderick, unit director of global corporate-actions for Boston-based Investors Bank & Trust, Global Corporate-Actions Processing has been at the forefront of a growing movement to streamline the manner in which corporateconference, Harkins, who served as actions news—including stock splits, buybacks, reorganizations, mergers and the like—is chairperson, addressed the issue disseminated.“We like to believe that one day we will all be able to come to work, just push some directly. “We all need to decide buttons and everything will be taken care of,” he says. Photograph kindly supplied by Investors what we are going to call Bank & Trust, October 2006. something, and then call it that,”he the best information possible. “We see these kinds of said. “Event names differ; issuers give something one enhancements as an extension of our commitment to client name, and then it is held as something else. Let us all just service, and as an important part of executing on our call it the same thing.” strategy of differentiating ourselves on the basis of our technology,”says Harkins.

The issuer’s issue Experts agree that a significant infusion of investment At present, the job of sanitising the fundamental data capital aimed at boosting automation services will be elements in corporate-actions communications is primarily required in order to address fundamental weaknesses up to organisations such as Northern Trust and other large within the corporate-actions chain. A report by consulting global custodians, says Chapman, who must act as group Celent estimates that automation related spending consolidators of information, taking multiple data feeds could approach $1bn by the end of the decade.“Historically and creating a “prime record” of information of the corporate-actions has been a very manual process,” corporate action event. While the investment manager is, says Justin Chapman, senior vice president, process to some degree, responsible for making the right decision management worldwide operations at Northern Trust.“And should the client not properly understand or misinterprets because of the number of variants within the major the corporate-actions instructions. “The liability model regions—including all of the different event types requiring tends to sit in the middle of the equation, not at either all sorts of paper disclaimers and so forth—the cost of end,”says Chapman. achieving automation is very high.”

Accordingly, many believe that the push for corporate Chapman, who chairs the European corporate-actions action efficiency should begin at the top of the corporate-

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actions ladder—beginning with the issuer. “The single broader spectrum of the market,”he says.“It is going to be greatest obstacle in the way of improving the handling of tough, but I think we need to make the effort. Because corporate-actions in the US continues to be the reluctance everyone realises that this is the point where it all begins.”

Clearly it is in the issuing company’s best interest to of issuers to establish a standardized, ISO-compliant format for reporting corporate-actions,”maintains Harkins. address any potential breakdown in information transfer “We need to be mindful of the law of unintended from the point of origin, adds Chapman.“By streamlining consequences in looking at third-party solutions—none of this part of the process hopefully sometime in the near us wants to see the industry take one step forward in terms future, it will really be a win for everyone else.” of a standardized format for corporate-action messages, only to take two steps back in terms of adapting that format Europe takes the lead to a myriad of competing solutions.”

Unlike in Europe, where multiple-market variants have To that end, proponents have been pushing for issuer accelerated the need for modernisation in order to reduce guidelines that might include setting time limits on event the level of actuarial risk, the relative stability within the US notifications, or establishing a minimum data requirement for has made the move towards automation and tender offers. Still, without the presence of a governing body, standardisation a much tougher sell. Despite the potential issuers cannot be held accountable from a punitive for incurring catastrophic losses, a report recently issued by standpoint, leaving sub-custodians and others along the consulting firm TowerGroup asserts that regulatory communications chain bearing the brunt of the risk.“As they intervention may be required before a definitive set of are not party to the actual process, and without any current standards is adopted within the industry. regulation, it is true that there is minimal incentive for issuers “One of the ironies surrounding the search for more to get on board at this efficient ways to handle point,” says Chapman. corporate-actions is the Attacking the problem great success we have on a global scale is achieved as an industry, daunting, to say the least. handling corporateHowever, Chapman sees actions issued by progress being made companies registered on region by region. “In international exchanges, Europe, we are using the compared with the slow essence of the progress the industry is Giovannini G30 reports making with companies in order to promote registered with US consistency of messaging exchanges,” remarks from the issuer to an Mellon’s Harkins. To investor and back to the some degree a reflection issuer, using an industry on the more pervasive use standard for messaging.” of SWIFT messaging If the industry cannot outside of the US, says move sufficiently Harkins is required. says Chapman, some “Attributing the lack of form of pan-European progress here in the US to legislation may need to resistance on the part of be adopted. issuers to buy into SWIFT Broderick believes it begs the question as to will be something of a why we cannot come up challenge to get all the with a better solution,”she issuers on board. says. “It is clearly in the “Unless you can interest of all parties to establish greater have corporate-actions harmonisation that handled more quickly and makes it possible for efficiently. As the efficiency multiple markets to variance between the US Amy Harkins, senior vice president and director of global asset servicing for trade together and and global markets Mellon Financial thinks that “the parties with the most at stake are the some level of continues grow, the owners of the securities associated with corporate-actions, so it is hardly consistency is created, pressure to find a better surprising that broker dealers and asset managers are playing a primary you won’t have the solution here in the US is role in pushing the industry toward better solutions.” Photograph kindly ability to govern a sure to intensify.” supplied by Mellon Financial, October 2006.

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HEINZ: SHAREHOLDER ACTIVISM

HJ Heinz chief executive officer William R. Johnson gestures in his office in Pittsburgh, Monday, July 25, 2006.

Johnson has consistently defended his company’s restructuring efforts in recent years and dismissed as unrealistic profit demands by a group led by billionaire investor Nelson Peltz. Photograph taken by Gene J. Puskar, supplied by EMPICS/Associated Press, October 2006.

THE BATTLE FOR Until recently, HJ Heinz had been a source of frustration for its shareholders; its stock movement as stubborn as a full bottle of its famous ketchup. That is until one highly ambitious dissident investor decided to take on the board of directors — and at long last, things are looking up for the condiment company. Coincidence? From Boston, Dave Simons reports.

HEINZ OR OVER A century, the name Heinz has been a fixture at roadside bistros and ballpark concession stands, its ubiquitous “57 Varieties” logo as American as cheeseburgers and fries. But in Pittsburgh, where Henry John Heinz Company first set up shop 134 years ago, Heinz has come to mean much more than beans, ketchup, or tater tots. During football season, Steelers fans take in the action from Heinz Field, while a few blocks away the world-class Pittsburgh Symphony Orchestra performs in the acoustically superior Heinz Hall. In a city still reeling from the demise of the once-powerful steel industry, Heinz remains an integral part of the region’s economic vitality, and is regarded as one of the last great vestiges of good old-fashioned business loyalty.

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Earlier this year however, that traditionalism came faceto-face with 21st-century shareholder activism when a group of dissident investors, led by billionaire Nelson Peltz of Trian Fund Management LP, squared off against Heinz’s board of directors in an effort to revamp Heinz’s ailing business model. Following a rancorous proxy battle, Trian, which is Heinz’s second-largest shareholder, succeeded in ousting incumbent directors Peter Coors, vice-chairman of Molson Coors Brewing, and Mary Choksi, managing director of Strategic Investment Partners, in favour of Peltz’s colleague Michael Weinstein, a former executive with beverage maker Snapple, and Peltz himself. Trian members received backing from such influential proxy advisory firms as Institutional Shareholder Services (ISS) and Glass Lewis.

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It is not the first time that Peltz, a noted turnaround had all intentions of making their business plan work.“We expert, has been down this road. In 1997, Peltz snapped up are confident that we have the brands and the people to Snapple for $300m, and then sold the company three years build on our business momentum and create a strong and later for a cool $1.5bn. In recent years, restaurant chains that prosperous future for Heinz,” said Johnson. In the three years leading up to Peltz include Cracker Barrel, Arby’s arrival, Johnson noted that and Wendy’s have been party management had to Peltz’s singular brand of “dramatically transformed” “operational activism.”

To underscore [the] message, a the company, which had The battle for Heinz is the letter was issued to Heinz exceeded the performance of latest in a series of initiatives shareholders, stating, “The sad the S&P Packaged Foods by mega-investors such as peer-group through the Carl C Icahn and Kirk reality is you would have been better period with an 18.9% total Kerkorian, who, like Peltz, off financially keeping your money in shareholder return.

In have secured large positions a piggybank than investing it in anticipation of August’s in public companies in order Heinz stock.” proxy vote, Heinz initiated a to influence board members no-holds-barred public and make their mark on relations campaign that fiscal policy. While their included a $14m advertising aggressive strategies—which often include massive labour cuts and reductions in capital blitz dubbed“Project Steelers,”aimed at shoring up support expenditures—can yield positive results and boost among company shareholders.

Had Heinz been more assertive in years past, the shareholder value, critics see a significant downside, including, in the case of Heinz, the potential displacement encounter with Trian could have been avoided altogether, argues Dominic Jones, principal of Clarity of a regional icon.

Communications of Canada Inc. and the founder of IR Web Report. According to Jones, such proxy fights are a Seeing red After trading near $60 during the high-flying late 1990s, prime example of what can happen when companies do over the next several years Heinz’s stock began its ketchup- not properly convey their business intentions to like descent, losing nearly half its value as the company investors. “They become sitting ducks, easy targets for struggled to find its feet. Although its shares had recovered people who know how to exploit situations where slightly by the start of this year, David Nelson, food analyst companies have failed to earn the support and for Credit Suisse, noted that Heinz still ranked below every understanding of their shareholders,” says Jones. In a large-cap US-based packaged foods company except Sara recent review of Heinz’s online investor-relations Lee in terms of sales per employee and sales per communications conducted by Jones’ firm, Heinz ranked manufacturing facility.“This is still an inefficient company, a poor 44th out of 51 consumer-staples sector firms.

“While the company was probably complying with every in our view,”added Nelson.

Enter Peltz, longtime partner Peter W May and various securities law it was required to,” observes Jones, “it just other confidantes from Peltz’s Trian Group, an investment- was not communicating.”

Although most observers believed Heinz’s business plan management firm that seeks to revamp under-performing companies through aggressive hands-on involvement. In was in need of repair, not everyone agrees that Peltz is the early 2006, Trian took up a 5.5% position in Heinz, and right man for the job. Nell Minow, editor of the Corporate then began its dissident campaign in earnest. Using a series Library, a research company that promotes shareholder of meticulously crafted white papers, Peltz laid out his plan rights, cautions against casting Peltz as“the lone ranger, the to address Heinz’s listless shares and lacklustre financials: guy who is going to come to town and make everything buy back stock, cut spending by $575m, sell assets, and better,’’ and instead calls the Trian Group a case where “the raise dividend payments. At the same time, Peltz proposed cure is worse than the disease.” Noting Peltz’s history of boosting the visibility of core products such as Heinz buying, fixing and then flipping companies for a substantial Ketchup and A1 Steak Sauce while cutting allowances to profit, Minow concurs, “He’s been better at taking care of himself instead of other shareholders.” retailers by $300m.

Peltz’s choice of nominees, which included son-in-law To underscore his message, a letter was issued to Heinz shareholders, stating, “The sad reality is you would have Ed Garden, another Trian partner, as well as close friend been better off financially keeping your money in a golfer Greg Norman to the board of directors at Heinz, raised more than a few eyebrows within the industry. In a piggybank than investing it in Heinz stock.”

Taking understandable umbrage, Heinz CEO William letter to shareholders, CEO Johnson and presiding director Johnson argued that Peltz’s plan went too far, too fast and Thomas Usher called Peltz’s group “a self-interested voting revealed a distinct lack of understanding of the company’s bloc” that “cannot be expected to fairly represent the principles and history. Johnson maintained that his board interests of all Heinz shareholders.”

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HEINZ: SHAREHOLDER ACTIVISM

speak in Peltz’s favour. In the three months since Trian secured its stake in the company, Heinz’s stock has moved up an astonishing 35%. It is not an isolated case, say observers, who note that while proxy contests often fail to seat any dissidents at all, on balance share prices usually jump a good 10 percent during the proceedings.

Meanwhile, the company reported 2006 first quarter earnings of 58 cents a share, some five cents ahead of expectations, with profit totaling $194.1m (versus 45 cents and $157.3m, respectively, for the year-ago period). The company is confident it will achieve 10% earnings growth for the full year, according to Heinz spokesman Michael Mullen.

“Behind all the name-calling and finger-pointing, something positive is going on,” notes columnist Rachel Nelson Peltz of Trian Fund Management LP, Beck. “Heinz is being forced to rethink the way it does Heinz’s second-largest investor, sits among business — its operations and its accountability. That shareholders before the annual meeting in could make it a better company in the long run.”By forcing Pittsburgh on Wednesday, August 16th, 2006. management to come up with a plan of action that Photograph by Keith Srakocic, supplied by enables the business to operate more efficiently,“Peltz has EMPICS/Associate Press, October 2006. made it nearly impossible for Heinz’s executives or board to hide behind promises of change that then fail to materialize,” says Beck, adding that Heinz is in a much different position now than it was just months ago.“All of that is good news for investors, who have suffered while Yet it appears that Peltz has been at least partially the company’s previous restructuring moves fell flat.”

While he disagrees with Peltz’s strong-arm tactics, successful in selling his bill of goods to Heinz management. Though not nearly as deep as Peltz had Credit Suisse’s Nelson gives kudos to Trian for accelerating proposed, in June Heinz management announced it would the company’s containment campaign, which, said cut 2,700 jobs over the coming year, or roughly 8% of its Nelson, “has boosted share price and called attention to total workforce, resulting in savings of over $355m over a company weaknesses.”

The dissident-investor trend underscores the belief that all two-year period, and will close several plants in 2008. At the same time, Johnson announced a 17% increase in boards should have independent members, maintains Heinz’s dividend payment, along with a $1bn increase to Capital Source Partners’ Di Stefano, who can act as the eyes and ears for the average stockholder. Di Stefano cites recent its existing buyback program.

“If we lived in a vacuum, we probably would side with Peltz’s studies that show that corporations with strong independent interests,”notes Ted di Stefano of Rhode Island-based Capital directors typically fare better than those without independent Source Partners.“The fact is that other issues are involved, such representation in terms of profits and corporate governance.

“The days of the directorship as sinecure — a tradition that as the possible number of employees who would be laid off, and the reduction of pension benefits to retirees. Also, allowed directors to sit back and collect fat fees for minimal community interests may not be well served.” Besides, says services — are gone,”notes Di Stefano in a recent commentary analyst Christopher Growe of AG Edwards, “Firing every in E-Commerce Times.“Directors must be vigilant and active. salaried employee still would not produce the $400m in SG&A There is simply no other way.The bottom line, as I see it, is that dissident directors, savings that stood as the assuming that they are central theme of the Trian Does Heinz need more beanz? acting in a professional plan, casting some doubt on 140 manner and are not simply its legitimacy.”

130 being gadflies or 120 malcontents, are much Peltz spells results 110 needed on today’s boards In the aftermath of the 100 and in today’s regulatory Heinz proxy vote, analysts 90 environment. Therefore, I say the issue is not so much 80 look at dissidence as a about how many seats Peltz 70 positive thing that helps and company secured, but 60 protect the shareholders of a the overall impact on the company. Hopefully, the company as a result of the shareholders will be all the initiative. At least for the HJ Heinz FTSE US Food Producers Index better for it.” time being, the charts Source: FTSE Group. Data as at October 2006

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PRIME BROKERAGE

Like merchants of yore in gold rush towns who made their fortunes selling shovels and pickaxes to aspiring miners, prime brokers provide essential services to hedge funds – and make more money than all but their most successful clients.

The growth in hedge fund assets has brought new players into a business long dominated by three firms in the United States, namely Morgan Stanley, Goldman Sachs and Bear Stearns. The good times just keep on rolling as the ever evolving requirements of hedge funds as they push into new markets becomes ever more complex and despite growing pressure on margins.

Bangles, Baubles and Prime Brokers PRIME BROKER USED to be what the name implies: a central custodian of a hedge fund’s assets that processed all its trades, financed positions, arranged stock loans and provided reports tracking the entire portfolio. Hedge funds had only a little leverage over their chosen broker and paid the freight as a cost of doing business.

Not these days. The bigger funds today have multiple prime broker relationships, sometimes playing firms against one another to get better terms. Adam Sussman, a senior analyst at TABB Group, suggests funds typically branch out when assets reach about $500m.“Managers do not want to be completely dependent on one service provider,” he says,“They use the secondary relationship as leverage and as backup in case the communication link with the original firm fails.”

Prime broker relationships tend to proliferate as funds grow larger and move into additional strategies, asset classes or geographic regions. Sussman says a manager may end up using five or six firms for a while, but once the fund matures the number starts to drop.“They want to pick best of breed,” he says, “They consolidate most of their prime broker business back down with three or four firms.”

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The switch to multiple prime brokers opens the door to new entrants, of course. Credit Suisse has made inroads by offering a full range of services to a select group of funds that are either already well established, or which the firm believes are poised for rapid growth. For the last three years, its prime broker assets have increased at triple the rate for hedge funds overall, according to Philip Vasan, head of prime services at Credit Suisse. At a time when hedge funds have extended their reach into international markets, a global footprint has helped Credit Suisse, Deutsche Bank, and UBS build market share.

With only 400 managers in its stable by design—less than a third the number at the big three, estimates Vasan— Credit Suisse aims to provide its clients high focus and know their evolving needs well. The bank takes a creative approach to financing, too, an important competitive edge as hedge funds move into less liquid asset classes.

Although the three leaders have lost market share, Edward Hawthorne, a partner at Capco, a financial services research and consulting firm, estimates that Morgan Stanley, Goldman Sachs and Bear Stearns still control about 60% of prime brokerage revenues and assets. He believes that new players have muscled in by focusing on

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particular niches. Deutsche Bank and Credit Suisse have specialised in synthetics, for example; while Société Générale and BNP Paribas in structured products. These firms have leveraged their existing capital markets expertise to win prime broker mandates.

San Francisco-based Merlin Securities has focused instead on its multi-prime performance attribution reporting capability. “When we created the company (in 2004) we thought we could add value by providing the most advanced reporting technology in the business,” says Stephan P Vermut, Merlin Securities’ chief executive officer (CEO). Merlin has reporting capability including “attribution reporting,” explains Vermut, which allows the hedge fund to attribute exactly where it made excess returns.

Not only that. Hedge funds will be able to determine exemplary performance relative to underlying market dynamics. Merlin Securities’ platform can handle any asset class and is multi-currency, says Vermut.

The icing on the cake however, according to Vermut, is that its proprietary systems allows multiprime hedge funds to calculate exactly how much risk they took in implementing a buy strategy. “Being able to calculate the beta and excess return of a particular portfolio versus an index such as the Russell can help firms better manage both their portfolio as well as operational issues.” As a prime of primes Merlin’s system gives the portfolio manager full transparency, on an aggregated level, and by account, across all of a fund’s multi-prime broker relationships.

Market acceptance may hinge in part on whether hedge funds will be able to cross-margin positions held at different prime brokers. Hawthorne acknowledges that some prime brokers are still struggling to integrate margin and netting across different asset classes, a capability clients have long sought. “Crossmargining creates a stronger argument for consolidating with a

Adam Sussman, a senior analyst at TABB Group, suggests funds typically branch out when assets reach about $500m.“Managers do not want to be completely dependent on one service provider,” he says,“They use the secondary relationship as leverage and as backup in case the communication link with the original firm fails.” Photograph kindly supplied by TABB Group, August 2006.

Brad Bailey a senior analyst at Aite Group, a research firm based in Boston, Massachusetts says that: “As you get to multiple prime brokers it becomes hard to see where exactly the exposure is and get a global picture of the risk.” Regulators may take some persuading, too; a complex hedge may survive a volatile market unscathed overall but a losing leg could leave a particular prime broker undercollateralised. Photograph kindly supplied by Aite Group, August 2006.

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single player,” he says. If a prime broker combines its margin calculation – including OTC derivatives and structured products as well as equities and fixed income – clients need less capital to support complex hedged positions.

Getting multiple prime brokers to accept margin based on positions held elsewhere will be a tall order, however. “These OTC derivatives present risk and credit issues with a single prime broker,”says Brad Bailey a senior analyst at Aite Group, a research firm based in Boston, Massachusetts, “As you get to multiple prime brokers it becomes hard to see where exactly the exposure is and get a global picture of the risk.” Regulators may take some persuading, too; a complex hedge may survive a volatile market unscathed overall but a losing leg could leave a particular prime broker under-collateralised.

Prime brokers traditionally lend against assets held in custody. They run daily “what if” scenarios to measure how client portfolios would perform in a volatile market. For risk management purposes, prime brokers want to be sure a forced liquidation under adverse market conditions will cover any outstanding loans. As competition heats up, though, credit standards may be slipping. A source at Morgan Stanley complains that some new entrants will lend against illiquid assets and demand less collateral against traditional asset classes, too. He suggests the upstarts are providing credit-driven unsecured loans rather than conservative assetbased financing.

That may be just sour grapes from a leader feeling threatened. Jon Hitchon, global head of prime services at Deutsche Bank, believes that hedge funds’ move into exotic assets and international markets plays to the strength of global banks like Deutsche. Clients who seek financing for new asset types recognise that a single transaction that stays on the books for three months does not justify the work a bank has to do on research, valuation

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is starker.“I do not think that and obtaining a valid these days you should get into security interest. “Clients the capital introductions will reward us by shipping game. You cannot have 500 in easier financing business hedge funds and promise as a quid pro quo for the them all you will raise money value we have added,” for them,” he says. Merlin Hitchon explains.

Securities, explains Vermut is He finds client priorities concentrating on two key vary by strategy. Statistical levels of service: “helping arbitrage players focus on hedge funds grow their cost, speed of latency in business and providing direct market access, them with top flight securities lending and analytics.” Merlin Securities confidentiality, while multiraises money for its hedge strategy managers want fund clients through leverage, cross-margining, “working with a number of letters of credit and strategic, independent synthetic access to markets. partners,” says Vermut. “It Deutsche Bank keeps it clean and they get accommodates them all. In paid only if they succeed.” effect, banks are using their Most hedge fund strategies balance sheet muscle to Stephan P Vermut, Merlin Securities’ chief executive officer (CEO). employ short selling so the grab prime broker assets Merlin has reporting capability including “attribution reporting,” choice of prime broker often away from the brokerexplains Vermut, which allows a hedge fund to attribute exactly depends on its securities dealers. Hitchon estimates where it made excess returns. Not only that. Hedge funds will be lending prowess. Although that Deutsche Bank, UBS able to determine exemplary performance relative to underlying prime brokers continue to and Bear Stearns now have market dynamics. Merlin Securities’ platform can handle any asset unearth new sources of roughly equal market class and is multi-currency, says Vermut. Photograph kindly supply, the growth in hedge shares. US-oriented firms supplied by Merlin Securities, October 2006. fund demand has driven up with a weak international presence have proved vulnerable as hedge funds allocate a the cost of “specials” – securities that are hard to borrow. greater percentage of their trading assets outside the US “Specials have become very expensive for the hedge funds Deutsche Bank’s multi-asset cross-margin capability and and quite profitable for prime brokers that have that stock to relatively simple corporate structure give the bank’s lend,” says Bailey. Higher margins on stock lending partly offset pricing pressure in other parts of the business. financing package a competitive edge, Hitchon says.

It is neither hard nor expensive to hedge market risk, of Financing long and short positions still delivers the lion’s share of prime broker revenues, but firms have broadened their course. Index futures, ETFs, options, swaps or even a services in less profitable areas to keep pace. Execution services shorting a portfolio of securities from the general now extend beyond US equities and bonds to international collateral pool will do that. Most hedge funds generate a markets and derivatives. Prime brokers provide risk significant part of their excess return from individual shorts, however. If funds management software and cannot borrow securities other technology support to that they either identify as help hedge funds meet overvalued, or which they demands for greater If you want to compete with the need to hedge merger or transparency from big boys you have to have global convertible arbitrage institutional investors. They reach and provide execution positions, the bottom line organise meet-and-greet services, financing and securities will suffer.

Worse, events at which hedge funds lending for a variety of different institutional investors will and potential investors not tolerate the fees hedge mingle, too. “You are seeing asset classes,” says Sussman. Of funds charge for market more wrapped-around the second tier full service prime short positions they could services from prime brokers brokers, he sees UBS gaining replicate at lower cost. as a means of differentiating market share based on its Securities lending is so themselves,” Bailey says. extensive international network and important that Sussman Vermut, who in fact, investment in technology. believes it contributes to the introduced the first cap intro concentration of hedge fund programme, thinks the choice

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assets at the largest firms. (A recent Alpha magazine survey found that the top 100 hedge funds account for two-thirds of industry assets.)“If you want access to shorts you are not going to go to a small prime broker that doesn’t have the custodial assets or the same pull at the larger custodian firms,” Sussman says, “That is why the big keep winning.”

Even so, the big three are not resting on their laurels. They have invested heavily in information technology to accommodate the proliferation of asset types and geographic exposure. “If you want to compete with the big boys you have to have global reach and provide execution services, financing and securities lending for a variety of different asset classes,”says Sussman. Of the second tier full service prime brokers, he sees UBS gaining market share based on its extensive international network and investment in technology.

Although – or perhaps because – prime brokers make little money from the reports they provide to clients, quality Philip Vasan, head of prime services at Credit Suisse says that for the last three years, the varies dramatically from one firm to bank’s prime broker assets have increased at triple the rate for hedge funds overall. At a another. Among the hedge funds TABB time when hedge funds have extended their reach into international markets, a global interviewed, satisfaction with prime footprint has helped Credit Suisse, Deutsche Bank, and UBS build market share. brokers’ technology and reporting varied Photograph kindly supplied by Credit Suisse, August 2006. far more than for custody or clearing services.“Some have been investing a lot of money in their we think are going to be game-changers, where we feel we can make some jumps ahead,”he says. reporting capabilities and others have not,”Sussman says.

The enormous and increasing IT infrastructure required in The quick and easy solution to hedge fund reporting merely adds short positions to an existing system designed prime brokerage raises the barriers to entry and tilts the for long-only portfolios. One telltale sign: a jerry-rigged long- playing field in favor of the established firms. Although only system thinks a long put is a long position. A report like pricing has come under pressure from new entrants and that is no help to a hedge fund trying to track its net market third parties that offer some services traditionally the exposure. In a true long/short portfolio accounting system – preserve of prime brokers – eSecLending in securities such as the system Morgan Stanley built from scratch 10 lending, for example – profit margins remain robust.“There years ago – long puts show up where they belong, with the is not some bogey out there ready to take it down,”Sussman other shorts. Morgan Stanley’s reports can also handle says,“Prime brokerage is not coming under the same kind of pressure as the equity multiple currencies, an trading model.” important feature as hedge There’s gold in them thar hedge funds!

Prime brokers have it funds expand their trading 320 even better than those on major European and 280 old-time gold rush Asian bourses and in 240 merchants. When a gold emerging markets.

200 vein ran out, the Thanks to its integrated prospectors left town and approach, Credit Suisse can 160 the merchants’ business deliver long/short portfolio 120 vanished. Asset flows into reports consolidated across 80 hedge funds show no sign multiple asset classes and 40 of abating, however – and currencies, too. Vasan views if net inflows were to stop, integration and innovation prime brokers would coin as weapons to gain market Credit Suisse Deutsche Bank UBS ‘R’ Morgan Stanley Goldman Sachs Bear Stearns FTSE Developed General Financial Index money for years to come share.

“We have off the existing assets. concentrated in areas that Source: FTSE Group. Data as at October 2006

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CORPORATE PROFILE: MATTEL

Most of us could do with a makeover.

Surprisingly, so too did the perennialy beautiful Barbie. Blonde, beautiful and according to the marketing blurb, brainy enough to run for president, Barbie’s future seemed full of promise. However, looks aren’t everything.

Barbie and Mattel’s shareholders have not enjoyed the best of days over the last eight years. Now, after a long overdue reorganisation and a key acquisition, Mattel and Barbie appear to be on the brink of a strong comeback. Art Detman reports.

TOY

TURNAROUND Mattel’s chief financial officer Kevin M. Farr says.“We have not connected with consumers as well as we could have.” But he is encouraged by early reaction to this season’s product, Barbie & the 12 Dancing Princesses, a $24.99 product that “is off to a great start.” And do not forget the matching horse and carriage set at an additional $32.99! Photograph kindly supplied by Mattel, October 2006.

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one estimate. Despite an HANCES ARE BOB aggressive stock buy-back Eckert never thought program, earnings per that running a toy share fell two years company would be so running, from $1.25 in 2003 hard—especially one with to $1.18 in 2005. For iconic brands such as shareholders, the worst Barbie, American Girl, news lies in the stock price.

Tickle-Me-Elmo, Hot From a high of $45.625 in Wheels and Matchbox.

1998, shares dropped below After a 23-year career at $9 in 2000 and recently Kraft Foods, where he rose traded at under $20. to chief executive, he joined “We have been Mattel, Inc., as chief challenged in the past executive officer (CEO) in couple of years,”concedes 2000. At the time, the Mattel’s chief financial company was something of officer Kevin M. Farr. a shambles. It had suffered “Our goal this year is to from two years of declining make progress against earnings capped by a that challenge.” somewhat ill starred Mattel’s shareholders can acquisition, in 1999, of take heart in Barbie’s US Learning Company, a sales, which rose slightly in consumer-oriented software both the first and second publisher second in size quarter. What is more only to Microsoft. important is the Despite its hefty $3.4bn Bob Eckert, Mattel’s chief executive officer (CEO. Chances are that reorganisation that Eckert price tag—equivalent to Eckert never thought that running a toy company would be so hard— effected in October of 2005.

4.5 times revenues at the especially one with iconic brands such as Barbie, American Girl, He consolidated the US time of purchase— Tickle-Me-Elmo, Hot Wheels and Matchbox. After a 23-year career at operations of Mattel Girls Learning Company was a Kraft Foods, where he rose to chief executive. He joined Mattel, Inc., in & Boys Brands and the predog, an agglomeration of 2000. Photograph kindly supplied by Mattel Inc., October 2006. school Fisher-Price Brands various companies that produced aging educational and entertainment CD-ROMs. into a single unit under Neil B. Friedman. As head of Tyco As consumer interest shifted to DVDs and free Internet Toys, Friedman launched the fabulously successful Ticklegames, Learning Company’s $30 titles ended up in Me-Elmo plush stuffed bear in 1996. Mattel bought Tyco the retailers’ $5.99 bargain bins. Barely a year later Mattel following year, folded it into Fisher-Price, and made practically gave away Learning Company to a turnaround Friedman president of Fisher-Price.

Last year’s consolidation reduced headcount by more firm for $21.3m and a share of future profits.

This was not Eckert’s only problem. Barbie had come than 200 and cut annual overhead by $10m. Perhaps more under attack by Bratz, a line of edgy, ethnically conflated and important, it also allows Friedman—one of the industry’s controversial dolls from privately held MGA Entertainment. most respected executives—to work his magic on the Like Mattel, MGA Entertainment is a Los Angeles area toy entire Mattel line, especially Barbie.

At the ripe age of 47, Barbie remains by far the maker but in 2000, it appeared to be more hip and far hungrier. “That was the first doll that was able to take on company’s most important and most profitable product. If Mattel,”says Richard Gottlieb, a New York-based consultant. Mattel is to recover next year, the next edition of Barbie— Mattel took 14 months to respond to Bratz, an eternity in created on Friedman’s watch and to be shipped in early the toy business. Mattel’s My Scene line of dolls, which ‘07—must be successful. Barbie was introduced in 1959 by have various skin tones and whose facial expressions can Mattel’s co-founder, Ruth Handler, who adapted it from a be altered to show different emotions, are successful—but collectible doll she had seen in Europe. With her adult at best have only halted the advance of Bratz. In America, curves and super model proportions, Barbie made many which is becoming more ethnically diverse by the day, parents uneasy at first. “What made her successful was, Barbie remains not only tall and slim but also white and when you looked past her measurements, that she really did empower little girls,” says Tim Walsh, a Florida-based blonde.“That is where her struggle is,”says Gottlieb.

Mattel’s numbers tell a sad tale. Revenues peaked in 1999 consultant and game designer. “She has run for president at $5.5bn, recovering weakly to $5.2bn last year. Net earnings twice, been a NASA scientist, an astronaut, a NASCAR topped out at $553m in 2003, then fell in 2004 and in 2005 driver — just about any career you can imagine. She really and are expected to decline yet again in 2006, to $465m by has allowed girls to envision themselves’ being anything.”

C

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MATTEL’S COMEBACK

Mattel’s chief financial officer Kevin M. Farr.“We have lost market share,” admits Farr.“But we are in business to gain market share. Barbie is the most successful toy brand in history. The Number One brand in the toy industry today is Barbie. That is true globally, and it is true for every retailer—Wal-Mart, Target, Toys R Us. Moreover, it is the Number One Website for girls, with 54m hits per month on Barbie.com. So it is a very strong brand.” Photograph kindly supplied by Mattel Inc., October 2006.

A decade or so ago, Barbie accounted for 30% of Mattel’s sales and 35% to 40% of earnings. However, says analyst Timothy A Conder of AG Edwards & Sons,“Barbie’s sales have been declining while a lot of other products in the company have been growing. Therefore, as a percentage of revenues, Barbie has been coming down in recent years. We estimate that Barbie accounts for somewhere in the low to mid 20s as a percent of revenues and a little bit more as a percent [sic] of profits.”

Even in her weakened condition, Barbie remains formidable, accounting for well over $1bn in sales each year.“We have lost market share,”admits CFO Farr.“But we are in business to gain market share. Barbie is the most successful toy brand in history. The Number One brand in the toy industry today is Barbie. That is true globally, and it is true for every retailer—Wal-Mart, Target, Toys R Us. Moreover, it is the Number One Website for girls, with 54m hits per month on Barbie.com. So it is a very strong brand.”

Consultants such as Gottlieb and Walsh say Barbie lost her way in recent years because Mattel failed to create compelling stories to go along with each year’s costume change; stories that would make the doll fun. Farr agrees.

“We have not connected with consumers as well as we could have.” Nevertheless, he is encouraged by early reaction to this season’s product, Barbie & the 12 Dancing Princesses, a $24.99 product that “is off to a great start.”And do not forget the matching horse and carriage set at an additional $32.99!

Farr is even more upbeat about the tenth iteration of Elmo, named TMX for Tickle Me Extreme. In response to a belly rub, the doll not only laughs but also stands up, sits down, rolls over, and stands up again. “The product is blowing off retailers’ shelves,” says Jim Silver, co-publisher of Toy Wishes, an influential trade publication.“I know that

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some stores are already sold out. It is going to be a tough toy to find during this holiday season.”

TMX Elmo has a suggested retail price of $39.99; ten dollars more than last year’s far simpler Shout model. Because TMX is so complex, Silver believes Mattel may be able to manufacture only 700,000 or so instead of the 1.5m units it has produced in past years.“If you can sell another 800,000 pieces, you do not leave that kind of volume of the table,”Silver says.“So Mattel is making as many TMXs as it possibly can.”

Both Barbie & the 12 Dancing Princesses and Elmo TMX are on this year’s Toy Wishes list of the industry’s dozen hottest toys, along with Fisher-Price’s Kid-Tough Digital Camera and Digi Makeover from Radica, a maker of electronic toys that Mattel is acquiring. Mattel is the only company with four products on the list, evidence that it still has product magic. Alas for Mattel, MGA’s latest set of Bratz dolls, Forever Diamondz, has also made the same list.

The Kid-Tough Digital Camera and Digi Makeover well illustrates two relentless and evidently unstoppable trends that affect all toy makers. First, children’s toys are becoming increasingly high tech. “Kids consider cell phones toys,” says one analyst. The Kid-Tough camera, with a 1.3-inch liquid crystal display screen, is a real digital camera designed for the eager but clumsy hands of young children.

The Digi Makeover product allows a young girl to take a photo of her face, display it on her home TV and then alter it with more than 50 hairstyles.

Second, age compression has steadily shrunk the window for traditional children’s toys.“Kids grow up faster than they used to,”says Walsh, a father of two young girls.

“Girls of 12, 13 and 14 years old used to play with Barbie.

But as the years have gone by, kids have gravitated to more high-tech toys, and now many girls are done with Barbie by the time they are only seven or eight years old.”

Walsh cites the example of Fisher-Price’s View-Master.

“When it first came out in 1939, View-Master was a gadget for adults to look at the Grand Canyon and other places they could not afford to visit in person. Over time, it evolved into an item for teenagers—the lunar landings and all those 1960s TV shows that teenagers loved. As years went on, the View-Master’s audience got younger and younger. It started as an adult product and now is almost a preschool item. So, it is pretty amazing how age compression can affect toys.”

Mattel has responded by acquiring Radica, a relatively small ($163m in annual sales) but highly regarded maker of hightech toys for both boys and girls.“The fastest-growing category in the toy industry is electronic games,”says Farr,“and Radica has done very well in creating innovative electronic games.

They are one of the leading players in this area. Strategically, this acquisition makes a lot of sense for Mattel and from a financial perspective, I think we have made a great deal.”

Net of Radica’s cash on hand, Mattel is paying $180m or $11.55 per share, a relatively modest 12% premium over market price. Citigroup’s senior leisure time analyst, Elizabeth Osur, was surprised by the deal but likes it.“This acquisition will not make Mattel dominant in this market because of Radica’s fairly small size. I think this is indicative of a greater

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willingness on Mattel’s part to acquire companies in order to enter market segments they are not now in [sic]. So, yes, I think we could see other similar acquisitions. I think electronic toys will become a more significant part of Mattel’s business.”

Osur and others expect that Mattel will be able to effect cost savings in terms of freight and other charges and also accelerate Radica’s growth in many foreign markets where Mattel has established distribution channels.

Meanwhile, one of Mattel’s earlier acquisitions—the 1998 purchase of Pleasant Company, a Wisconsin maker of the high-end American Girl line of dolls—continues to grow, approaching the half-billion-dollar mark in sales.The unit sells direct to consumers by mail order, over the Internet, and at three elaborate American Girl retail stores, in New York, Chicago and Los Angeles.There are two lines of American Girl dolls. Dolls in the historical group represent specific ethnic groups and time periods, while the Here and Now dolls are contemporary. At the retail stores, girls can buy not only dolls, doll clothes and doll furniture but also matching children’s clothes and books. Plus, each of the stores has a doll hospital, a theater for doll-related musical shows, and a restaurant where girls and their parents can enjoy a meal—with, of course, the doll sitting on a special chair at the table.

It can be a pricey visit, easily topping $200.“You get what you pay for,” says Walsh, who has treated his daughters to a visit to the Chicago store.“The dolls are very high quality, and parents will spend the money for them because they are so well made and have such a rich play pattern.”

Not many markets can support a full-fledged American Girl Place, so the company is considering opening up to 20 boutique stores over the next several years. Eckert is mum on how big these stores will be (the flagship stores are 40,000 square feet) or where they will be located. An even more promising avenue is expanding overseas sales.“Some 97% of the world’s kids live outside the United States, and currently only about 44% of our sales are outside the United States,” says Farr.“And that is up from 2000, when we were at about 31%. So there is a great opportunity for this company to grow globally.”

Despite the reorganisation and Radica acquisition, Wall Street is taking a wait-and-see attitude generally. The toy business is, after all, highly volatile. The benefits from falling gasoline prices may be more than offset by America’s rapidly cooling housing market. The just-in-time delivery schedules of major retailers leave little cushion for bad weather or other problems. Even so, it appears that finally Mattel has gotten past most of its recent problems, and in years to come perhaps shareholders can be as happy as TMX Elmo.

A selection of Mattel toys. The Kid-Tough Digital Camera and Digi Makeover well illustrates two relentless and evidently unstoppable trends that affect all toy makers. First, children’s toys are becoming increasingly high tech.“Kids consider cell phones toys,” says one analyst.

The Kid-Tough camera, with a 1.3-inch liquid crystal display screen, is a real digital camera designed for the eager but clumsy hands of young children. The Digi Makeover product allows a young girl to take a photo of her face, display it on her home TV and then alter it with more than 50 hairstyles. Photographs kindly supplied by Mattel, October 2006.

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ASIAN SUB-CUSTODY

It is all change in the geography of Asian sub-custody—partly because global players are changing the rules of the game. Increasingly, clients are also selecting providers based on credit ratings, where global players also have an advantage. In most cases, the choice of provider is not determined by price, although service quality and range of products influence prices. Consequently, these days it is more difficult for single market sub-custodians to make the required investment in overheads as the need to invest in services and people is immense. Rekha Menon reports.

GLOBAL PLAYERS I LINE UP TO DOMINATE ASIAN SUB-CUSTODY

N AUGUST THIS year, Westpac Banking Corporation, Australia’s fourth largest bank, announced its decision to sell its sub-custody and clearing business to HSBC. With assets under custody of over $300bn, Westpac was regarded as a premier provider of sub-custody services in Australia and New Zealand.

According to David Morgan, Westpac’s chief executive officer, the bank’s decision to exit out of a business which it had been operating for over six decades was prompted by the desire to focus only on areas where it could achieve a sustainable comparative advantage. Custody, this indicates, is not a business where the bank thought it could remain competitive. “We believe that custody is increasingly an international business and that natural owners require global scale,”says Morgan. Global scale is something that the new owner certainly does not lack. HSBC operates in 37 markets globally in the sub-custody arena, and is responsible for

In Asia, apart from a few countries where there are strong local sub-custodian banks, such as Mizuho in Japan, DBS Bank in Singapore and Maybank in Indonesia, it is the global providers with a multi-market presence in the region that hold sway.

Photograph by Michele Goglio, provided by Dreamstime.com, September 2006.

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servicing client sub-custody assets of over $1trn.

The HSBC-Westpac deal is interesting, not only because it makes HSBC the leading sub-custody and clearing player in Australia and New Zealand, but also because it captures in a nutshell the key trends in the subcustody business – the need for scale in order to survive and the growing dominance of global players. These trends are well evident in the neighbouring countries of Asia as well, where HSBC ranks among the largest sub-custodians along with other international players such as Standard Chartered and Citigroup.

Among them, HSBC leads the rolls in terms of geographic reach in Asia, with a presence in over 20 countries, followed by the other two that have a presence in 17 and 15 countries respectively. Deutsche Bank, which retained its Asian sub-custody business after selling parts of its global securities services business to State Street in 2002, too is another leading player in the Asian sub-custody arena, and has its footprint across 13 countries in the region.

Mike Sleightholme, head of direct custody and clearing, Asia Pacific at Citigroup global transactions services, Rajan Raju, managing director and head of South and South East Asia, and head of global says that the sub custody business transaction services at DBS Bank, says,“As the markets in Asia grow deeper, there is a requires scale, which is why multigrowing need for regional sub-custody services. We aim to provide a single point of contact to country, multi-region; sub-custody global custodians and fund managers for domestic and cross-border custody services across providers are much better placed to the region.” Photograph kindly supplied by DBS Bank, October 2006. compete than others.

Citigroup’s own efforts to increase its reach in Asia Singapore, where it is the leading sub-custodian. Now, received a significant boost two years back when through taking a leaf from the global players, the bank is pursuing the acquisition of ABN AMRO’s direct custody units in an ambitious strategy of building a pan-Asian sub-custody Europe and Asia, the global giant gained access to key presence on the back of the regional retail and commercial countries such as India, Indonesia, South Korea and banking network that the bank is building. Rajan Raju, Taiwan.“There are not too many single market providers of managing director and head of South and South East Asia, sub-custody in Asia any more,”notes James Hogan, global and head of global transaction services at DBS Bank, says, head of custody and clearing at HSBC. “Earlier, several “As the markets in Asia grow deeper, there is a growing banks offered sub-custody in a single market. But now, if need for regional sub-custody services. We aim to provide you do not provide sub-custody in more than one market, a single point of contact to global custodians and fund managers for domestic and cross-border custody services it is very difficult to effectively compete.”

In Asia, apart from a few countries where there are across the region.”

Notably, DBS hopes to carve a unique identify for itself strong local sub-custodian banks, such as Mizuho in Japan, DBS Bank in Singapore and Maybank in Indonesia, it is the among other pan-Asian sub-custody service providers. global providers with a multi-market presence in the Unlike the global players, it is positioning itself as an Asian bank that understands the Asian market and its region that hold sway.

One indigenous Asian sub-custodian that is hoping to unique requirements.

The biggest challenge in Asia says Raju, is that the equity break the mould is DBS Bank. DBS currently provides subcustody and clearing services in Hong Kong and markets are fragmented and there is no consistent

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ASIAN SUB-CUSTODY

Asian context and will help give DBS a critical edge by helping create a robust custody product suited to the Asian market. Along with the right technology, Raju thinks that it is essential to have the right presence on the ground. To that end, DBS has identified five other key markets over and above Singapore and Hong Kong, where it plans to expand its operations. These markets are China, India, Indonesia, Korea and Taiwan. In the first phase, DBS is targeting China, India and Indonesia where it has already applied for regulatory clearances and is investing in people and technology on the field to begin operations by the end of this year. The other two markets will be targeted later.

Like DBS, other pan-regional sub-custody providers are also focusing their efforts on creating on-the-ground presence in the main markets. Citigroup for instance, opened its office in Vietnam early this year.

Sleightholme of Citigroup describes Vietnam as an exciting, fast growing market. “The fundamentals of the Vietnam market are very strong, just like China and India. The three markets Citigroup is very bullish about are China, India and Vietnam.” Interestingly, opinions about the potential of individual Mike Sleightholme, head of direct custody and clearing, Asia Pacific at Citigroup different markets among the key players global transactions services, says that the sub custody business requires scale, which might vary, HSBC’s Hogan for instance, is why multi-country, multi-region, sub-custody providers are much better placed to mentions Korea and Taiwan too as markets compete than others. Photograph kindly supplied by Citigroup, October 2006. to watch out for, but all players are infrastructure and standards.This is a common refrain across unanimous in their focus on China and India.

However, despite promising exciting growth all the multi-market players. Hogan of HSBC says,“One of the biggest challenges of doing business in Asia is the opportunities, both China and India offer radically different fragmented infrastructure and the different stages of experiences. While India presents a more straightforward evolution of market maturity. Unlike Europe, there is no growth story with its booming stock market, a solid base of similarity between the markets.”The key from a sub-custody domestic retail and institutional investors, steady growth in provider, he suggests, is therefore to provide a standardised foreign investments and improving payment and set of services and to have a single platform that provides settlement infrastructure, the reality in China is very products and reports that look and feel the same irrespective different. Much of the focus on China is pinned on the hope of an open financial of the location. market – in the future. The Raju concurs, Global custodians make it big in Asia Qualified Foreign “Technology is the main 300 Institutional Investor competitive weapon to (QFII) programme, which manage the different 250 allows foreign investors market conventions and 200 access to the Chinese deliver a consistent domestic A-share market, service across all 150 is still very restrictive while markets.”

DBS has 100 the Qualified Domestic invested in a custody Institutional Investor platform which was 50 (QDII) program, which launched early this year. allows Chinese investors This technology solution access to foreign markets is from Tata Consultancy Deutsche Bank HSBC Holdings Standard Chartered yet to properly take off.

State Street ABN AMRO FTSE Developed General Financial Index Services, Raju adds, is The domestic subuniquely designed to the Source: FTSE Group. Data as at October 2006

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custody space is dominated by the so called ‘Big Four’ state owned Chinese banks, including the Bank of China (BOC), the China Construction Bank (CCB), the Agricultural Bank of China (ABC), and the Industrial and Commercial Bank of China (ICBC). Furthermore, the crossborder sub-custody space has seen very limited activity — to say the very least. In such an environment, much of the effort of global players is targeted at developing relationships, interacting with regulatory bodies and providing consulting services on best practices.

“China poses an interesting challenge for global subcustodians today,” says Pauline Banks, head of network management for Asia at JP Morgan, which provides subcustody services only in Taiwan and Australia. “Despite the presence of the usual set of leading sub-custodians, foreign fund managers investing in China often select local banks for sub-custody in order to distribute their funds through them. Local banks have huge branch networks such as 25,000 branches or even more which the foreign players cannot hope to compete with,”she says.

Sleightholme of Citigroup acknowledges that some global institutions go with domestic Chinese banks for custody services.

However, but Sleightholme would have it that they cannot match the quality of service offered by the larger providers. “These banks do not have our kinds of experience nor do they have the advantage of being able to deploy global practices like we do.” China, he adds, has a huge potential but it has not been properly opened yet. Nonetheless, Citigroup is offering a full range of services in China from domestic and global custody to securities lending and fund administration.

James Hogan, global head of custody and clearing at HSBC.“Earlier, several banks offered sub-custody in a single market. But now, if you do not provide subcustody in more than one market, it is very difficult to effectively compete,” he says. Photograph kindly supplied

by HSBC, October 2006.

Thibaud de Maintenant, head of product and client management for domestic custody in Asia Pacific at Deustche Bank. Photograph kindly supplied by Deutsche Bank, October 2006.

FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2006

The strategy of offering a wide range of services beyond plain vanilla custody and clearing is the hallmark of Citigroup’s subcustody product offering in the region. Recently the bank launched a comprehensive suite of automated clearing and settlement of exchange traded derivatives in India, and launched third party clearing services in Australia which enables its broker dealer clients to trade securities listed on the Australian Stock Exchange (ASX) from offshore locations.

“In order to grow and stay ahead of competition, it is important to innovate and have a diversified portfolio,”says Sleightholme.

A product diversification strategy has been adopted in varying degrees by most leading sub-custody players. In addition, given the growth in the domestic mutual fund industry in various countries, the leading banks are seriously looking at the increasingly attractive domestic custody business. Deustche Bank, which for long has focused on the domestic custody market, has been steadily coming out with new services. For instance, in Indonesia the bank is certified to be a custodian and an administrator of funds that are compliant with the Islamic Shariah law and in India, it is launching a transfer agency service by the end of the year, becoming the first custodian to do so.“We are continuously refining our services to meet the requirements of the domestic markets,” says Thibaud de Maintenant, head of product and client management for domestic custody in Asia Pacific at Deustche Bank.

“Given the margin pressures, sub-custody on its own is no longer enough,” states Banks of JP Morgan. Sub-custodians need to offer a wider range of services not only to gain additional revenue from existing clients but to gain a wider clientele as well.

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Stock Performance Best Performing FTSE All-World Index Stocks (USD/%) Great Wall Motor Company (H) CHN 154.0 Shenzhen Investment (Red Chip) HK 153.4 Yantai Changyu Pioneer Wine (B) CHN 139.2 SWED 132.2 Boliden Samsung Techwin KOR 129.6

Overall Index Return (USD) 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/%) ITV PCL THAI -72.0 Mills Corp USA -60.2 Optimax Technology Corp TWN -60.8 Privee Investment Holdings JA -59.1 Yukos RUS -69.7

No. of Consts

Value

3 M (%)

8,077 1,198 1,731 5,148 2,929 1,804 209 115 1,705 210 2,657 1,377

367.90 341.87 440.49 440.51 219.76 452.56 788.80 746.37 415.46 509.48 324.89 391.17

3.9 4.5 3.3 1.5 4.3 5.2 5.7 2.4 5.3 -1.8 4.1 -1.6

6 M (%) 12 M (%)

2.3 3.4 0.8 -2.3 2.9 4.1 0.8 -2.5 6.6 -17.3 1.9 -6.6

13.2 12.8 15.1 13.0 13.2 17.0 21.1 21.9 20.8 3.3 8.9 10.8

YTD (%) Actual DIv Yld (%)

9.8 9.8 10.0 9.4 9.9 12.3 16.1 15.8 18.6 -6.4 7.0 -1.2

2.08 2.22 1.77 1.63 2.14 2.81 3.12 1.64 2.72 2.90 1.74 1.02

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

FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2006

87

il

O

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88

S e il & rv G ic as es P & ro Di du st ce r r In C ibu s d Co us he tion ns tr mi i c al a tr u M ls El Ae ctio et ec a ro n tr sp & Mi ls on ac M nin ic a & Ge e & te g El ne D ria 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 & s Fo Be Pa He Ho od ver rts Pr ag al u t se od es Ph h C Pe hol uce ar are r s d G rs m E on o ac q al od eu uip Go s tic m o a e Fo ls & nt Tob ds od B & ac S i & ot er co Dr ec vic u h e Ge ug no s Fi ne R log xe ra eta y d l R ile Li et rs M ne T ai ob Te ra le ile lec ve M rs Te om l & ed le m Le ia co u is m nic ur Te So Gas m a e c h f tw , W un tio no ar a ic ns lo e te gy & r & E atio Ha Co M lect ns rd mp ult ric w ut iu ity ar e til e r S iti & e es Eq rvi ui ce No pm s nl e ife B nt I Li n an Eq f s k e ui In ura s ty su nc In ve Ge Re rra e st ne al nc m ra E e en l st t I Fin ate ns an tr ci um al en ts

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MARKET REPORTS BY FTSE RESEARCH

O

MARKET REPORTS 16.qxd Page 88

FTSE Global Equity Index Series – Developed ex US

30 December 2005 to 29 September 2006

FTSE Developed Regional Indices – Large/Mid Cap (USD) 130 130

125 125

FTSE Developed (LC/MC)

120 120

FTSE Developed Europe (LC/MC)

115 115

FTSE Developed Asia Pacific (LC/MC)

110 110

FTSE All-Emerging (LC/MC)

105 105

100 100

FTSE Developed ex US (LC/MC)

95

FTSE US (LC/MC)

90

15

5

FTSE Developed Asia Pacific ex Japan (LC/MC)

FTSE Developed Regional Indices – Capital Returns YTD (USD) 20

15

% 10

5

0

F

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

35

30

25

20

10

Capital

Total Return

0

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

NOVEMBER/DECEMBER 2006 • FTSE GLOBAL MARKETS

MARKET REPORTS 16.qxd

13/10/06

17:31

Page 89

Stock Performance Best Performing FTSE Developed ex US Index Stocks Shenzhen Investment (Red Chip) HK Boliden SWED CNPC Hong Kong (Red Chip) HK AU Minara Resources Tencent Holdings HK

Overall Index Return (USD)

(USD/%) 153.4 132.2 129.3 119.0 115.1

Worst Performing FTSE Developed ex US Index Stocks (USD/%) Privee Investment Holdings JA -59.1 Invoice Inc JA -57.0 GMO Internet JA -54.6 Aiful JA -53.6 Softbank JA -50.9

No. of Consts

Value

3 M (%)

FTSE Developed ex US Index (LC/MC) 1,351 FTSE USA Index (LC/MC) 708 FTSE Developed Index (LC/MC) 2,059 FTSE All-Emerging Index (LC/MC) 870 516 FTSE Developed Europe Index (LC/MC) FTSE Developed Asia Pacific Index (LC/MC) 773 FTSE Developed Asia Pacific ex Japan Index (LC/MC) 286 FTSE Developed ex US AC Index 3,922 FTSE Developed ex US LC Index 574 FTSE Developed ex US MC Index 1,731 FTSE Developed ex US SC Index 5,148

248.01 553.50 213.38 381.57 248.35 228.04 366.32 417.80 386.63 502.58 532.05

3.6 5.0 4.3 4.3 5.3 0.3 3.9 3.5 3.4 4.7 2.6

6 M (%) 12 M (%)

3.5 3.0 3.3 -0.9 6.7 -2.5 6.0 3.2 3.6 3.3 0.7

16.9 8.9 12.8 19.5 20.1 11.6 11.4 17.1 15.8 22.2 18.8

YTD (%) Actual Div Yld (%)

12.9 6.9 9.8 10.7 17.9 3.7 12.8 13.0 12.4 15.4 13.5

2.44 1.80 2.12 2.45 2.83 1.72 3.44 2.37 2.54 1.77 1.63

FTSE Global Equity Index Series – Asia Pacific 30 December 2005 to 29 September 2006

FTSE Asia Pacific All-Cap (AC) Regional Indices (USD) 125

FTSE Global AC

120

FTSE Developed Asia Pacific (LC/MC)

115 110

FTSE Developed Asia Pacific ex Japan (LC/MC)

105

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

100

FTSE Japan (LC/MC)

95

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

FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2006

89

MARKET REPORTS 16.qxd

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14 12 10 8

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6 4 2 0

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%

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20 10

Total Return

0 -10

O S e il & rv G ice as s Pr & o Di du st ce r In C ibu rs du h tio Co st em n ns r ia ica tru l M ls El Ae ctio et ec a r n o tro sp & Min ls ni ac M in c & Ge e & ate g El ne D ria e In ctr ral efe ls In du ica Ins nce du str l E ut 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 & s Fo Be Pa He Ho od ver rts Pr ag al u t se od es Ph h C Pe hol uce ar are r s d G rs m on o ac Eq al od eu uip G s tic m al en T ood Fo s & t ob s & od B ac S & iot er co Dr ec vic h Ge uug no es Fi ne Re log xe ra ta y d l R ile Li et rs M ne ai ob Te Tra le ile lec ve M rs Te om l & ed le m Le ia co u is m nic ur Te So Gas m a e ch ftw , W un tio no ar a ica ns lo e ter gy & & E tio Ha Co M lect ns rd mp ult ric w ut iu ity ar e til e r S iti & e es Eq rvi ui ce No pm s nl ife B ent Li In an Eq f s e u ks ui In ra ty su nc In ve Ge Re rra e st ne al nc m ra E e en l st t I Fin ate ns an tru ci m al en ts

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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/%) Great Wall Motor Company (H) CHN 154.0 Shenzhen Investment (Red Chip) HK 153.4 Yantai Changyu Pioneer Wine (B) CHN 139.2 Samsung Techwin KOR 129.6 HK 129.3 CNPC Hong Kong (Red Chip)

Worst Performing FTSE Asia Pacific Index Stocks (USD/%) ITV PCL THAI -72.0 Optimax Technology Corp TWN -60.8 Privee Investment Holdings JA -59.1 Invoice Inc JA -57.0 TPI Polene Co THAI -55.0

Overall Index Return (USD) No. of Consts

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)

8077 3181 1302 523 779 1879 286 773 529 487

Value

3 M (%)

367.90 416.92 237.58 402.32 459.57 460.48 366.32 228.04 277.78 146.59

3.9 1.5 1.6 1.7 1.4 0.5 3.9 0.3 6.2 -1.2%

6 M (%) 12 M (%)

2.3 -1.9 -1.2 -0.6 -3.9 -7.2 6.0 -2.5 3.4 -5.7

13.2 13.6 14.1 14.1 13.9 10.2 11.4 11.6 22.9 11.7

YTD (%) Actual DIv Yld (%)

9.8 4.7 5.6 6.4 1.6 -1.7 12.8 3.6 12.3 0.2

2.08 1.86 1.86 1.87 1.76 1.87 3.44 1.72 2.29 1.01

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

90

NOVEMBER/DECEMBER 2006 • FTSE GLOBAL MARKETS

il

O

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MARKET REPORTS 16.qxd Page 91

FTSE Global Equity Index Series – Europe

30 December 2005 to 29 September 2006

FTSE European Regional Indices Performance (EUR)

115

FTSE Global AC

110

FTSE Developed Europe ex UK LC/MC

105

FTSEurofirst 300

100

FTSE Developed Europe AC

FTSEurofirst 100

95

FTSE Eurobloc AC

90

FTSEurofirst 80

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

14

12

% 10

8

6

4

2

0

F

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

50

40

% 30

20

Capital

Total Return

10

0

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

91

MARKET REPORTS 16.qxd

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MARKET REPORTS BY FTSE RESEARCH

Stock Performance Best Performing FTSE Developed Europe Index Stocks (EUR/%) Boliden SWED 132.2 FRA 112.4 Vallourec SP 99.2 Metrovacesa Euronext FRA 95.7 Sacyr-Vallehermoso SP 93.8

Overall Index Return (EUR)

Worst Performing FTSE Developed Europe Index Stocks (EUR/%) Thomson SA FRA -24.8 EADS FRA -23.7 Tietoenator Oyj FIN -19.3 Emporiki Bank of Greece GRC -17.5 A P Moller - Maersk B DEN -17.0

No. of Consts

Value

3 M (%)

8077 1820 246 334 1240 1705 115 873 1214 300 80 100

334.43 381.38 350.45 467.51 516.89 377.66 678.47 396.66 401.69 1396.45 4910.08 4484.83

4.9 6.2 5.8 7.8 6.4 6.3 3.4 7.1 7.1 6.3 7.0 4.9

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 (%)

-2.3 1.6 1.6 2.2 1.0 1.8 -6.8 1.0 1.2 1.9 1.4 1.5

YTD (%) Actual Div Yld (%)

7.7 15.0 12.7 22.3 20.5 14.9 16.0 16.3 16.8 13.7 14.7 10.1

2.3 10.4 8.7 15.0 15.7 10.5 7.8 12.0 11.5 9.5 10.0 7.3

2.08 2.69 2.90 2.22 1.92 2.72 1.64 2.71 2.53 2.84 3.09 3.17

FTSE UK Index Series 30 December 2005 to 29 September 2006

FTSE UK Index Series (GBP) FTSE 100

125 120

FTSE 250

115 110

FTSE 350

105

FTSE SmallCap

100

FTSE All-Share 95

Se p06 30 -

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FTSE Fledgling 5

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FTSE techMARK

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

30

20

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10

Total Return 0

F

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-10

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

92

NOVEMBER/DECEMBER 2006 • FTSE GLOBAL MARKETS

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FTSE UK Indices – Capital Return YTD (GBP) 14 12 10 8 6 4 2 0 -2

te

ch M AR F K TS 10 E 0

FT Al S E l-S A ha IM re

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Sm FT SE

FT SE

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25 0 FT SE

FT SE

10 0

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Stock Performance Best Performing FTSE All-Share Index Stocks (GBP/%) Ashley (Laura) Holdings Chemring Group London Stock Exchange Group Soco International Lookers

Overall Index Return (GBP)

No. of Consts

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

Worst Performing FTSE All-Share Index Stocks (GBP/%) Stanelco -88.8 iSOFT Group -87.1 Plasmon -64.7 Instore -51.1 SkyePharma -50.8

116.7 106.5 100.6 89.3 89.2

Value 3 M (%) 6 M (%) 12 M (%)

100 250 350 333 683 256 1180 100

5960.81 9996.78 3103.74 3541.89 3050.44 3978.00 1016.40 1418.14

2.2 6.1 2.7 4.4 2.8 6.1 -5.9 4.9

-0.1 1.5 0.2 -2.0 0.1 -2.4 -15.2 -4.7

YTD (%)

8.8 25.7 11.1 12.1 11.1 10.6 -7.1 10.7

6.1 13.7 7.1 7.2 7.1 6.1 -2.8 -0.9

Actual Div Yld (%)

3.24 2.29 3.10 1.88 3.06 1.81 0.55 1.44

Net Cover

2.54 2.38 2.52 1.36 2.50 -1.26 -0.35 -

P/E Ratio

12.17 18.31 12.8 39.13 13.09 0 0 -

FTSE Xinhua Index Series 30 December 2005 to 29 September 2006

FTSE Xinhua Index Series (CNY/HKD) 150

FTSE/Xinhua China 25 (HKD)

140

FTSE Xinhua All-Share (CNY)

130

FTSE Xinhua Small Cap (CNY) 120

FTSE/Xinhua China A50 (CNY) 110

FTSE Xinhua 600 (CNY)

100

FTSE Xinhua China Government Bond Total Return Index (CNY)

90

6 -S 30

31 -A

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6

6 l-0 -Ju 31

30 -Ju

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6

6 ar -0

06 b-Fe 28

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31

-D

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5

06

80

FTSE Xinhua Index Series Index Name

Consts

FTSE/Xinhua 25 Index (HKD) FTSE/Xinhua China 50 Index (CNY) FTSE Xinhua All-Share Index (CNY) FTSE Xinhua 600 Index (CNY) FTSE Xinhua Small Cap Index (CNY) FTSE Xinhua China Bond Total Return Index (CNY)

25 50 966 600 366 33

Value 3 M (%) 6 M (%) 12 M (%) YTD (%)

12012.99 5506.57 3398.02 3621.78 2609.56 97.30

6.2 2.8 2.1 1.4 6.2 1.6

8.5 25.8 39.8 37.4 55.6 1.1

27.7 43.1 60.1 58.6 70.2 2.4

30.5 41.0 61.2 59.0 75.2 2.0

Actual Div Yld (%)

2.44 2.05 1.63 1.77 0.70 2.94

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

FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2006

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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

p06 Se

ar -0 6 M

Se

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05

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60

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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 on daily indicative values

Index Level

3M (%)

6M (%)

12 M (%)

5362.63 3198.52 2239.48 2032.49 1975.80 3389.66 2188.83 2326.16 3113.02 2068.35 2110.49 2056.80

0.8 0.5 1.5 -2.3 0.1 2.2 2.6 1.9 0.8 2.5 -0.1 0.2

0.2 -2.0 -2.0 -1.6 -1.3 2.9 4.4 1.8 1.6 4.0 1.9 0.7

5.3 4.5 4.0 5.1 6.3 7.4 7.5 7.5 4.8 6.9 7.4 2.3

YTD 5-Year Ann 3-Year (%) Return (%) Volatility (%)

3.9 2.5 2.9 0.9 2.3 6.8 8.0 6.0 4.3 7.2 6.2 1.9

4.9 6.2 6.7 6.1 5.0 4.2 2.0 6.2 3.2 6.7 3.6 1.2

3.2 5.4 4.9 11.7 6.3 3.0 2.2 4.6 1.4 3.1 2.3 1.4

FTSE EPRA/NAREIT Global Real Estate Index Series FTSE EPRA/NAREIT Global Real Estate Indices (Total Return Basis) 130

EPRA/NAREIT Global Total Return Index (USD)

125

EPRA/NAREIT North America Total Return Index (USD)

120

EPRA/NAREIT Europe Total Return Index (EUR)

115 110

EPRA/NAREIT Eurozone Total Return Index (EUR)

105

EPRA/NAREIT Asia Total Return Index (USD)

100

p06 -S e 30

31

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

94

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Page 95

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

Consts

Value

3 M (%)

328 FTSE EPRA/NAREIT Global Index (USD) FTSE EPRA/NAREIT North America Index Index (USD) 142 FTSE EPRA/NAREIT Europe Index (EUR) 97 FTSE EPRA/NAREIT Euro Zone Index (EUR) 41 FTSE EPRA/NAREIT Asia Index (USD) 89

3146.86 3797.64 3297.04 3538.65 2272.91

9.9 9.9 12.8 13.8 8.7

6 M (%) 12 M (%)

9.5 9.2 8.5 8.8 7.6

30.6 27.8 31.0 26.4 31.1

YTD (%)

Actual Div Yld (%)

24.8 24.8 27.7 32.1 17.6

3.32 3.89 2.31 2.71 3.10

FTSE Bond Indices FTSE Bond Indices (Total Return Basis)

FTSE Eurozone Government Bond Index (EUR) FTSE Euro Corporate Bond Index (EUR) FTSE US Goverment Bond Index (USD) FTSE Pfandbriefe Index (EUR) FTSE Gilts Index Linked All Stocks (GBP) FTSE Japan Government Bond Index (JPY)

104 103 102 101 100 99 98 97

6

FTSE Euro Emerging Markets Bond Index (EUR) FTSE Gilts Fixed All-Stocks (GBP)

30 -S

ep

-0

06 31 -A

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6 31 -Ju l-0

31 -

30

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06

6

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5

96

FTSE Bond Indices (Total Return) Index Name

FTSE Eurozone Government Bond Index (EUR) FTSE Pfandbrief Index (EUR) FTSE Euro Emerging Markets Bond Index (EUR) FTSE Euro Corporate Bond Index (EUR) FTSE Gilts Index Linked All Stocks Index (GBP) FTSE Gilts Fixed All-Stocks Index (GBP) FTSE US Government Bond Index (USD) FTSE Japan Government Bond Index (JPY) FTSE China Government Bond Index (CNY)

Consts

Value

3 M (%)

244 361 40 306 11 29 123 242 33

155.30 177.78 211.68 144.33 2065.52 1953.77 150.40 110.40 97.30

3.0 2.4 3.7 2.6 4.0 2.7 3.9 1.8 1.6

6 M (%) 12 M (%)

2.2 1.9 1.4 2.0 3.3 1.6 3.5 1.4 1.1

-0.1 -0.2 1.3 -0.3 6.2 3.7 2.9 0.2 2.4

YTD (%)

Actual Div Yld (%)

0.0 0.3 1.4 0.3 2.7 0.9 2.0 0.0 2.0

3.85 3.90 4.82 4.34 1.39* 4.30 4.79 1.51 2.94

* 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 Executive 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

FTSE GLOBAL MARKETS â&#x20AC;˘ NOVEMBER/DECEMBER 2006

95

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Page 96

CALENDAR

Index Reviews November – December 2006 Date

Index Series

Review Type

Effective Data Cut-off (Close of business)

Oct/Nov

FTSE/ ATHEX 20

Semi-annual review

30-Nov

29-Sep

10-Nov

Hang Seng

Quarterly review

8-Dec

29-Sep

16-Nov

MSCI

Quarterly review

30-Nov

31-Oct

Early Dec

CAC 40

Quarterly review

15-Dec

30-Nov

Early Dec

ATX

Quarterly review

15-Dec

30-Nov

Early Dec

IBEX 35

Semi-annual review

1-Jan

Early Dec

OBX

Semi-annual review

15-Dec

30-Nov

1-Dec

OMX C20

Semi-annual review

16-Dec

30-Nov

4-Dec

DAX

Quarterly review

15-Dec

30-Nov

6-Dec

FTSE JSE Africa Index Series

Quarterly review

15-Dec

1-Dec

6-Dec

FTSE All-Share

Annual review

15-Dec

5-Dec

6-Dec

FTSE UK Index Series

Quarterly review

15-Dec

5-Dec

6-Dec

FTSE techMARK 100

Quarterly review

15-Dec

30-Nov

6-Dec

FTSE Euromid

Quarterly review

15-Dec

1-Dec

6-Dec

FTSEurofirst 300

Quarterly review

15-Dec

1-Dec

6-Dec

FTSE eTX

Quarterly review

15-Dec

1-Dec

6-Dec

FTSE Global Equity Index Series Annual review / North America

15-Dec

30-Sep

(incl. FTSE All-World) 8-Dec

NASDAQ 100

Annual review

15-Dec

30-Nov

11-Dec

NZSX 50

Quarterly review

29-Dec

30-Nov

11-Dec

Russell US Indices

Quarterly review / Additions

15-Dec

30-Nov

12-Dec

S&P MIB

Quarterly review - shares & IWF

15-Dec

13-Dec

S&P US Indices

Quarterly review

15-Dec

13-Dec

S&P Europe 350/ S&P Euro

Quarterly review

15-Dec

13-Dec

S&P/ ASX 200

Quarterly review

15-Dec

13-Dec

S&P/ TSX

Quarterly review

15-Dec

13-Dec

S&P 500

Quarterly review

15-Dec

13-Dec

S&P Midcap 400

Quarterly review

15-Dec

13-Dec

DJ STOXX

Quarterly review

15-Dec

14-Nov

15-Dec

PSI 20

Semi-annual review

2-Jan

30-Nov

Mid Dec

Norex All-Share

Semi-annual review

31-Dec

30-Nov

15-Dec

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

96

MARCH/APRIL 2006 • FTSE GLOBAL MARKETS

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Page IBC1

Unlock China.

At FTSE Xinhua Index we believe in developing the products that can unlock China for you.

The FTSE/Xinhua China 25 and FTSE/Xinhua China A50 are the leading tradable indices for the world’s fastest growing market. They are part of the most comprehensive index data set available, giving you access to the market using the internationally recognised standards you understand and rely upon.

If you are entering the Chinese market, we hold the key.

To find out more about the FTSE Xinhua Index Series, visit www.ftsexinhua.com email info@ftse.com or call.

FOR FURTHER INFORMATION VISIT WWW.FTSE.COM, E-MAIL INFO@FTSE.COM OR CALL YOUR LOCAL FTSE OFFICE: BEIJING +86 10 6515 9265 BOSTON +(1) 888 747 FTSE (3873) FRANKFURT +49 (0) 69 156 85 143 HONG KONG +852 2230 5800 L O N D O N + 4 4 ( 0 ) 2 0 7 8 6 6 1 8 1 0 M A D R I D + 3 4 9 1 4 1 1 3 7 8 7 N E W YO R K + ( 1 ) 8 8 8 7 4 7 F T S E ( 3 8 7 3 ) PARIS +33 (0) 1 53 76 82 88 SAN FRANCISCO +(1) 888 747 FTSE (3873) SHANGHAI +86 21 3401 5526 TOKYO +81 3 3581 2840 “FTSE™” is a trade mark of the London Stock Exchange Plc and The Financial Times Limited and is used by FTSE under licence. “Xinhua” is a trade mark of Xinhua Finance (“XFN”) and is used by FTSE under licence. The FTSE/Xinhua Indices are calculated by FTSE in conjunction with FXI and XFN in accordance with a standard set of ground rules. The FTSE/Xinhua Indices are the proprietary interest of FTSE, FXI and/or its licensors. Neither FTSE, XFN or FXI shall be responsible for any error or omission in the FTSE Xinhua Indices. Distribution of FTSE/Xinhua Indices index values and the use of the FTSE/Xinhua Indices to create financial products requires a licence with FXI.

GM EDITORIAL 16

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Page OBC1

understanding

2

Getting you there.

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