FTSE Global Markets by FTSE Global Markets

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THE ATTRACTION OF PRIVATE EQUITY INVESTING ISSUE SIX • MARCH/APRIL 2005

Candover – Up Front and Personal Airbus Ascendant WSE Builds Volume

Northern Trust’s

High High strategy DERIVATIVES REPORT: CHICAGO’S BOARDS BRANCH OUT

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Outlook EDITORIAL DIRECTOR:

Francesca Carnevale, Tel + 44 [0] 20 7074 0008, email: francesca@berlinguer.com CONTRIBUTING EDITORS:

Karen Jones, Neil O’Hara, David Simons. SPECIAL CORRESPONDENTS:

Andrew Cavenagh, Rekha Menon, Tim Steele, Bill Stoneman, Angela May Ward, Paul Whitfield, Ian Williams, Michele Carnevale FTSE EDITORIAL BOARD:

Mark Makepeace [CEO], Carl Beckley, Graham Colbourne, Peter de Graaf, Paul Hoff, Marianne Huve-Allard, Stuart Ives, Paul McLean, Jerry Moskowitz, Gareth Parker, Jamie Perret, Claire Spraggett, Sandra Steel PUBLISHING & SALES DIRECTOR:

Paul Spendiff OVERSEAS REPRESENTATION:

Adil Jilla [Middle East and North Africa], Faredoon Kuka, Ronni Mystry Associates Pvt [India], Ferda Akyürek [Turkey], Harold Leddy & Associates [United States] PUBLISHED BY:

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Mailcom plc, Snowdon Drive, Winterhill, Milton Keynes MK6 1HQ FTSE Global Markets is published six times a year. No part of this publication may be reproduced or used in any form of advertising without prior permission of FTSE International Limited or Berlinguer Ltd. FTSE Global Markets is published by Berlinguer Ltd on behalf of FTSE International Limited. [Copyright © Berlinguer Ltd 2004. All rights reserved.] FTSE™ is a trade mark of the London Stock Exchange plc and the Financial Times Limited and is used by FTSE International Limited under licence. FTSE International Limited would like to stress that the contents, opinions and sentiments expressed in the articles and features contained in FTSE Global Markets do not represent FTSE International Limited’s ideas and opinions. The articles are commissioned independently from FTSE International Limited and represent only the ideas and opinions of the contributing writers and editors. All information is provided for information purposes only. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by FTSE International Limited for any errors or omissions or for any loss arising from use of this publication. All copyright and database rights in the FTSE Indices belong to FTSE International Limited or its licensors. Redistribution of the data comprising the FTSE Indices is not permitted. You agree to comply with any restrictions or conditions imposed upon the use, access, or storage of the data as may be notified to you by FTSE International Limited or Berlinguer Ltd and you may be required to enter into a separate agreement with FTSE International Limited or Berlinguer Ltd. ISSN: 1742-6650 Journalistic code set by the Munich Declaration.

he announcement that Apax Partners, the UK private equity firm, had placed a bid for high street chain Woolworths did two things. It highlighted the resurgence of mergers and acquisitions activity in the buyout space and, at the same time, put a new spotlight on the performance of private equity as an investment class. Our own coverage includes an exclusive profile of Candover Investments, a rising star among Europe’s mid-market buyout firms, as well as an exhortation by Watson Wyatt’s market specialist Stephen Breban on the opportunity costs of investing in private equity. In the first of a series of reports on the global derivatives markets, we kick off with a profile of the derivatives boards in Chicago. We look at the challenges to their dominance in their respective fields, especially from European exchanges looking to garner new business share in the North American markets and the rise of new, specialist, electronic exchanges. In spite of a more competitive marketplace, the confidence of Chicago’s houses positively bristles as they talk of opportunities opening up for them, including regional growth plans, strategic alliances and new product development. Banking features strongly in this issue. The cover story highlights Northern Trust, which is redefining approaches to customer service and support to both the high net worth and institutional investment markets. Europe and Asia figure prominently in the bank’s new business development plans and we look at the innovative ways in which Northern is winning new mandates. In the area of custody, we examine the impact of years of market consolidation on the provision of services to the domestic market in the United States. Dave Simons asks whether there is room still for smaller, specialist providers as the market is increasingly dominated and defined by an ever-decreasing number of global institutions. Separately, Bill Stoneman looks at the US retail market and tests the value added assumptions that lay behind the acquisition of FleetBoston Corporation by Bank of America. New Pfandbrief legislation will redefine the parameters of a German issuance market that is over 230 years old. Andrew Cavenagh looks at the immediate impact of the forthcoming Pfandbrief Bill on issuance volume and structures through 2005, while Dr Louis Hagen of the Association of German Mortgage Banks explains the salient features of the new law. Our regional specialists have focused on exchanges. Highlights include Karen Jones’ article on incoming chief executive Richard Nesbitt’s plans for the Toronto Stock Exchange and Angela Ward’s review of the Warsaw Stock Exchange prior to its privatisation. Ian Williams meanwhile looks at the impact Sarbanes Oxley legislation continues to exert on Chinese companies wanting to list in the United States.

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Francesca Carnevale, Editorial Director March 2005

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FTSE GLOBAL MARKETS • MARCH/APRIL 2005

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Contents COVER STORY NORTHERN TRUST

..........................................................................................Page 32 Northern Trust is making waves of new business at home and abroad. It is achieving it its own sweet way. Northern’s diffident and obliging façade overlays a focused and aggressive drive for market share in both the high net worth and institutional investment markets. It is succeeding beyond expectation. How does it do it?

REGULARS ABSOLUTE RETURNS ARE ALL RELATIVE ..............................Page 6 MARKET LEADER

Karen Jones explains the dynamics of a new generation of hedge funds.

SECTOR TRENDS PUSH GLOBAL BENCHMARKS ............Page 9 Why global benchmarks are coming back into fashion.

SAUDI BANKS ON ISLAMIC FINANCE

IN THE MARKETS

......................................Page 12 Middle East banks report higher profits on rising Islamic financing volumes.

REGIONAL REVIEW

Nesbitt sets a new pace at TSX ....................................................................................Page 16 SEC to streamline shelf registration ............................................................................Page 20 Tech stocks ......................................................................................................................Page 23 How SOX works on Chinese IPOs ..............................................................................Page 25 Warsaw builds on optimism ........................................................................................Page 29

EQUITY REPORT

..................................................................Page 73 Neil O’Hara explains why investors should consider their voting rights.

THE POWER OF THE VOTE PFANDBRIEF ISSUANCE

DEBT REPORT

..........................................................................Page 50 Andrew Cavenagh examines the impact of the new Pfandbrief Bill.

THE PFANDBRIEF BILL: A NEW START

....................................Page 55 Dr Louis Hagen of the Association of German Mortgage Banks explains the new law.

UPFRONT AND PERSONAL

ALTERNATIVES

..................................................................Page 76 Francesca Carnevale reports on the growing prestige of Candover.

INVESTING IN PRIVATE EQUITY

....................................................Page 82 Watson Wyatt’s Stephen Breban explains the attraction of private equity.

THE ENDURING APPEAL OF SMALL CAPS ..........................Page 85 INDEX REVIEW

Why Small Caps continue sweet Market Reports by FTSE Research ................................................................................Page 88 Companies in this issue ..................................................................................................Page 87 Calendar ............................................................................................................................Page 96

MARCH/APRIL 2005 • FTSE GLOBAL MARKETS

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INTEREST RATES

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CBOT

Last: Change: Time:

Gold

EQUITIES

METALS

BUY ORDERS QTY PRICE 36 66 115 124 6 1 5 2 1 1

CBOT

ZGG5

100 oz

AGRICULTURAL

MARKET DATA

12/2/05

422.0 421.9 421.8 421.7 421.6 420.5 420.0 418.1 418.0 417.7

mini-sized

422.1 -1.3 10:05:00

BUY ORDERS QTY PRICE

422.2 422.3 422.4 422.5 422.6 422.7 422.8 423.2 423.5 423.9

Jan 20, 2005 10:05:00 AM

Last: Change: Time:

Gold

SELL ORDERS PRICE QTY 10 2 7 68 115 100 10 1 2 1

YGG5

110 121 103 203 3 2 9 3 2 3

422.0 421.9 421.8 421.7 421.5 421.4 421.3 421.0 420.6 420.5

422.1 - 1.3 10:05:00

SELL ORDERS PRICE QTY 9 112 113 115 200 1 4 3 1 8

422.3 422.4 422.5 422.6 422.7 422.9 423.0 423.4 423.8 424.0

Jan 20, 2005 10:05:00 AM

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Contents FEATURES HOW FAR CONSOLIDATION?

..........................................................Page 37 Mergers continue to shape the asset servicing industry. In the United States, custody is increasingly dominated by only a handful of banks. Is there any room left for the smaller, specialist providers? Dave Simons reports from Boston.

AIRBUS ASCENDANT

................................................................................Page 42 Paul Whitfield explains how Airbus managed to overtake Boeing as the world’s leading supplier of aircraft. What now for America’s flagship manufacturer? And what lessons can be learned from Airbus’ tactics?

OFFSHORE ATTRACTIONS

....................................................................Page 46 Exchanges in low tax regimes have opportunity ahead of them, if they can only grasp it. More restrictive reporting requirements in the EU could discourage Eurobond issuers to list in London, Dublin or Luxembourg. But some of them are also fighting back with their own initiatives.

SPECIAL REPORT: DERIVATIVES THE FIGHT BEGINS FOR NEW MARKET SHARE

................Page 57 Francesca Carnevale travelled to Chicago to test the temper and drive of the Windy City’s leading exchanges and came away with a sense of a battle for business beginning to pick up fire.

BEATING THE ODDS

....................................................................................Page 62 Futures contracts start of at a disadvantage to traditional investments. Futures trading is, largely, a zero-sum game, writes Neil O’Hara. Even so, unprecedented amounts of money are poured into managed futures.

AUTOMATING DERIVATIVES PROCESSING

............................Page 67 Peter Axilrod, of the DTCC on the need to automate in order for the OTC market not to be overwhelmed by it’s own success.

BofA MAKES HAY FROM FleetBoston PURCHASE

........Page 70 Futures contracts start of at a disadvantage to traditional investments. Futures trading is, largely, a zero-sum game, writes Neil O’Hara. Even so, unprecedented amounts of money are poured into managed futures.

MARCH/APRIL 2005 • FTSE GLOBAL MARKETS

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A NEW TRADE ROUTE TO CHINA IS HERE. Introducing the iShares FTSE/Xinhua China 25 fund (ticker symbol: FXC), the first European ETF to offer exposure to an index comprised solely of Chinese stocks. This is an unprecedented opportunity to invest in the largest emerging market in the world in one transparent and cost-effective trade. Mainland China has never been so open to European business. And there has never been a better time to capitalise on the advantages of iShares.

WWW. i S HARES.NET

+44 (0)20 7668 8007 Barclays Global Investors Limited (“BGI”), authorised and regulated by the Financial Services Authority (“FSA”), has issued this document for access in the United Kingdom only. The iShares FTSE/Xinhua China 25 fund is a sub-fund of iShares plc which is an investment company with variable capital incorporated in Ireland and authorised by the Irish Financial Services Regulatory Authority. Shares in any iShares fund may not be offered or sold to persons or in jurisdictions where such offering or sale is prohibited. Barclays Global Investors Limited does not guarantee the performance of the shares or the fund. Affiliated companies of BGI may make markets in the securities mentioned in this publication. Further, BGI and/or its affiliated companies and/or their employees, from time to time, may hold shares in the underlying shares of, or options on, any security included in this publication and may as principle or agent buy or sell securities. The price of the investment (which may trade in limited markets) may go up or down and the investor may not get back the amount invested. Your income is not fixed and may fluctuate. The value of investment, involving exposure to foreign currencies can be affected by exchange rate movements. Any application for shares in the iShares fund is on the terms of the iShares plc prospectus, copies of which can be obtained from: www.iShares.net or by calling +44 (0)20 7668 8007. None of the shares has been or will be registered under the United States Securities Act of 1933, or as an investment company under the 1940 Act, or the laws of any of the states of the United States, and, therefore, may not be offered or sold, directly or indirectly, in the United States or to or for the account of any U.S. Person, as defined by the 1933 Act, except pursuant to an exemption form, or in a transaction not subject to, the regulatory requirements of the 1933 Act, the 1940 Act and any applicable state security laws. The iShares FTSE/Xinhua China 25 is not in any way sponsored, endorsed, sold or promoted by FTSE/Xinhua Index Limited (“FXI”), FTSE International Limited (“FTSE”) or Xinhua Financial Network Limited (“Xinhua”) or by the London Stock Exchange PLC (the “Exchange”) or by The Financial Times Limited (“FT”) and neither FXI, FTSE, Xinhua nor Exchange nor FT makes any warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE/Xinhua China 25 Index (the “Index”) and/or the figure at which the said Index stands at any particular time on any particular day or otherwise. The Index is compiled and calculated by or on behalf of FXI. However, neither FXI or FTSE or Xinhua or Exchange or FT shall be liable (whether in negligence or otherwise) to any person for any error in the Index and neither FXI, FTS, Xinhua or Exchange or FT shall be under any obligation to advise any person of any error therein. “FTSE™” is a trade mark jointly owned by the London Stock Exchange PLC and the Financial Times Limited. Xinhua is a service mark of Xinhua Financial News Networks Limited. All trademarks are licensed for use by FTSE/Xinhua Index Limited. “iShares” is a trademark owned by Barclays Global Investors N.A. © 2005 Barclays Global Investors Limited. All rights reserved.

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Market Leader MARKET LEADER

Absolute returns are all relative really Although many hedge funds underperformed in 2004, assets under management reached nearly $1trn US dollars, up 17% on the previous year, with fund of funds representing 24% of overall capital, according to Hennessee Group LLC, an advisor to hedge fund investors. With increased interest from institutional investors, more transparency due to United States’ Securities and Exchange Commission (SEC) regulations plus proposed mergers and consolidation, the next generation of fund of funds may be different than the first. Karen Jones reports. also feels that high net worth investors “will migrate from fund of funds towards direct investing.” Although hedge funds underperformed on a relative basis in 2004,“they did so with 70% less risk,” says Gradante. “When we talk about hedge funds we talk about risk relative to returns.”He describes the results as “typical” for coming out of a bear market and cautions that it is positively misleading to use the term absolute returns when discussing hedge funds because it suggests they

HARLES GRADANTE, MANAGING principal at Hennessee, says that as the market becomes more “rational” in picking stocks in 2005, both winners and losers, hedge funds will “pick up steam and out perform the S&P.” He also predicts that smaller fund of funds will lose capital to larger, more established fund of funds and the industry will see “more growth”at the institutional level. “Larger fund of funds will see more capital from foundations and endowments,” He

Hedge Fund Assets vs. Number of Hedge Funds January 2005 $1,000

$934

$900

8,050 7,000

$800

$795 Assets in Billions

$700 5,500 $600

4,800 4,000

$500 $400

2,800 3,000

$300

2,080

140 $3

30 $2

100 $20

880

1,100 $50

$99

$76

3,200 $210

1,640

$200 $100

5,700

$97

3,500

$564

$592

$408

$324

$221

$130

$35 $ 0 .1 $ 0 .8 $0 Jan -50 Jan -60 Jan -71 Jan -74 Jan -87 Jan -92 Jan -93 Jan -94 Jan -95 Jan -96 Jan -97 Jan -98 Jan -99 Jan -00 Jan -01 Jan -02 Jan -03 Jan -05 Jan A s s et in Billio n s

# o f Hed g e Fu n d s

are not affected by what is happening in the equity and bond markets.“This is not true. It implies never having a negative year and hedge funds can have negative returns. The term absolute was intended to mean low correlation to the markets, it does not mean you will not affected by the fact that the markets are doing poorly.” A recent research report from the Hennessee Group predicts that in 2005, most market participants expect relative performance for long/short equity strategies to improve. Most managers anticipate improved returns in convertible arbitrage and merger arbitrage in 2005, although Hennessee says they are expecting lower returns in distressed and credit related strategies in comparison to 2004. Andrew Schneider, principal at HedgeCo. Networks, the leading free online hedge fund information portal, says that fund of funds started becoming popular a few years ago because “they diversify and spread out the risk, therefore investors prefer this type of investment over single strategies…their growth has been tremendous.” He adds that institutions have been attracted to fund of funds due to “lacklustre”returns in the equity markets and what he calls a mutual funds industry “going up in shambles.” Schneider also sees the fund of fund industry changing to accommodate the institutions.“To keep investors or attract new ones, fund of funds have been using leverage in some cases as high as

Source: Hennessee Group LLC

MARCH/APRIL 2005 • FTSE GLOBAL MARKETS

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Investa tab be

Investa s ble e

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FTSE Hedge FTSE Hedge gives investors confidence by opening the door to the complex world of hedge fund investing. It is a new, fully investable index that combines complete clarity and accessibility with the proven quality and discipline of all FTSE Group’s index products and services. For daily index values and history information or to obtain an information pack on FTSE Hedge please visit www.ftse.com/hedge © FTSE International Limited 2004. All rights in and to the FTSE Hedge Index Series and the FTSE Hedge Index Series Classification System are vested in FTSE International Limited. "FTSE®", "FT-SE®" and "Footsie®" are trade marks of the London Stock Exchange Plc and The Financial Times Limited and are used by FTSE International Limited under licence.

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Market Leader of fund instrument.” He cites the number of US pension funds employing a fund of fund strategy in 2004 at 14% compared to 16% employing a single fund. However the growth he sees in 2005 is “mainly fund of funds.” A recent Greenwich report on hedge funds suggests they are “moving out of the realm of the alternative and into the maistream.” Because institutions are trying to help offset their problems in the equity and bond markets, with hedge funds and other alternatives, hedge funds that want institutional money are “having to become more professional in the way they do their business, more open, more due diligence, and more user-friendly,” says Webster. He adds that pending SEC regulation will add an extra layer of costs “not present two to three years ago”. Once shrouded in secrecy, hedge fund advisors managing over $25m in assets will be required to register with the SEC by February 1, 2006. “I see a trend towards more transparency and investors are asking for it,” says Schneider. “50% of hedge funds are registered and the hedge funds that

are going after pension money will have to register.” James Waters, general partner of Sonata Funds, which manages $40m of assets regards mergers and consolidations as a major industry trend in the next few years.“Those who run a fund of funds for less than $200m to $300m are considered small and might have to exchange independence for distribution and a new infrastructure.” He lists the rising costs of investing in technology, marketing support, key personnel and SEC compliance as contributing factors towards mergers with larger firms. “It used to be you could work your numbers and a fund of fund of $20m could make money. If you could have good performance all the time, it could work. If you do not and all you are living on is your management fees, it can not be done.” On the other hand Waters feels that large funds “typically become dinosaurs and need to get out of a rut.”He suggests that the pooling of key resources between both small and large funds will be the wave of the future. “Institutions are looking for something exciting, research driven and emerging and you

From periods of lacklustre returns to the possibility of absolute returns – FTSE Hedge Index Series vs. FTSE Global All Cap Index 300 250 200 150 100

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TSE Hedge is an investable hedge fund index that combines complete transparency and accessibility with the proven quality and discipline of FTSE Group's index products and services. The index provides a broad asset class representation of trading strategies and reflects the aggregate risk and return characteristics of the open, investable hedge fund universe. Each eligible fund must have a minimum of $50m of unleveraged assets under management, independent audited financial statements, a minimum two-year track record and monthly reporting with a minimum of quarterly liquidity screening. The index comprises three Management Style Indices and eight Trading Strategy Indices with Net Asset Value (NAV) and Gross Asset Value (GAV) for each. For more information visit www.ftse.com/hedge

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ABOUT FTSE HEDGE

MARKET LEADER

four to one to enhance returns. Typically, almost all funds offer different types of products, leveraged, unleveraged and principal guaranteed. As large institutions get involved, they want their money, the principal, to be guaranteed.” For 2005, he sees most of the fund of funds growth with leveraged and principal guaranteed products. Schneider says the growing popularity of fund of funds is based, in part, on the fact that most investors do not know how to find good, single strategy hedge fund managers. John Webster, managing director at Greenwich Associates, concurs. “The early adopters in the hedge fund business such as the Harvard and Yale endowments had the internal staff and the wit and wisdom to interrogate these hedge funds, find out what they were doing, due their own due diligence and see whether this was good for the pension fund or endowment.” He adds that there are a lot of people today who want the benefits from hedge funds, but because they lack the necessary infrastructure, “rely on another layer of advice through the fund

FTSE Hedge Index

FTSE Hedge Convertible Arbitrage Index

FTSE Hedge Distressed & Opportunities Index

FTSE Hedge Merger Arbitrage Index

FTSE Hedge Equity Hedge Index

FTSE Global All Cap Index

Data as at 31 January 2005. Source: FTSE Group

MARCH/APRIL 2005 • FTSE GLOBAL MARKETS

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are not getting that from $1bn funds.” Larger funds can tap smaller funds for “good management and a unique approach.”He predicts a “huge transfer of wealth” as billion dollar firms form satellite groups of smaller funds that are “giving institutions what they want.” The larger funds can “seed them, buy the general partnership out and walk hand and hand…“It is where we are all going to end up. Diversification is the key to success.” Webster offers that the initial view of hedge funds and fund of funds was that they were high performance generators that could “get a lot of people out of their problems.” What he sees now is potentially more people saying there is still the opportunity to get real value added, but also an opportunity to “do something different.” Regardless of upcoming changes to hedge funds and fund of funds, institutional interest will remain, but

Hedge Fund Sources of Capital January 2005 $411 Billion

4 4% 45 % 4 0% 3 5%

$224 Billion

3 0%

24%

$140 Billion

25%

15%

20%

$84 Billion

15 %

$75 Billion

10% 5% 0% Individuals / Family Offic es

Fund of Funds

Corporations / Ins titutions

Pens ion (Public & Endow ments & Foundations Private) Source: Hennessee Group LLC

with a decided reality check. After the 2004 returns, Gradante says he heard investors and endowments asking, “I thought hedge funds do well in all markets, a constant 10%. I tell them to

some degree the returns are relative to what the markets can give. Institutions are starting to understand it is not an absolute but more a relative return vehicle.”

Global benchmarks: A new investment lever The internationalisation of many industry sectors is revitalising interest in global benchmarking. The usefulness of these benchmarks is now moving from being utilised as a comparative tool, to being actively managed as a performance lever. Investors are more focused on investment opportunities that arise from mispricing among sectors than mispricing among markets. S THE INTEGRATION of the world’s capital markets proceeds at a quickening pace, “global industrial classification becomes a more important element of asset allocation strategies and returns,” explains Carl Beckley, director, FTSE Group. “Sector allocation strategies are in any case

increasingly regarded as more relevant these days.”This is, in part, a result of the erosion of differences between markets as activities such as accounting, regulation, information, corporate governance are increasingly harmonised and markets become more liquid. Traditionalist concerns about country or regionally

FTSE GLOBAL MARKETS • MARCH/APRIL 2005

partitioned portfolios are fading.“The quant guys in investment banks are leading the charge,” says Beckley, “as they forget country based approaches and look more at the valuation of stocks. It is a conscious breaking down of the old investment matrix and supplanting it with a regional or global, sector oriented methodology.”

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Market Leader MARKET LEADER 10

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“Whether in active management or as the basis for an index fund,” continues Beckley. “Looking at liquidity it is a logical step to move from regional sectors to global sectors. For example, many Eurozone sectors can be illiquid, so adding the United Kingdom and Switzerland helps increase liquidity and sector coverage.” In the same vein, continues Beckley, “including the United States and Japan makes the sectors highly tradable. This philosophy can then be used to compare global sector performance and the next step is to look at individual stocks within the sectors chosen. When you are looking at being overweight or underweight you are looking at companies in a sector, it can make more sense to do this on a global basis.” If sector elements have overtaken country based considerations, then global sector approaches will offer more diversification potential and Carl Beckley, director, FTSE Group. therefore opportunity. Whether sector superiority will be a permanent stocks on a discrete basis or as part of May/June 2004, p. 5), which allocates fixture, however, it is too early to say, a broader benchmark.” FTSE GEIS is companies to one of ten economic thinks Beckley – nevertheless, he is backed by FTSE’s specialist Global groups encompassing 36 industrial noting a significant shift in thinking Classification System (please refer to sectors and 102 industry sub-sectors. on the part of consultants and FTSE Global Markets, Issue 1, “It gives investors and consultants access to a comprehensive investment managers. sector allocation and FTSE’s own FTSE Diversification on a global scale – The FTSE Global attribution tool, which Global Equity Index Sector Index Series 750 dovetails nicely into the series (GEIS), which is 650 current trend,” he adds. reviewed annually, is GEIS is also broken down made up of 48 countries 550 into 24 developed, 6 allocated into three 450 advanced emerging and 18 country classification 350 emerging markets. segments “that are used 250 “Uniquely, FTSE GEIS is to incorporate investor 150 reviewed on a regional sensitivity to country 50 basis,” he says, adding: risks,” explains Beckley. “When we approached Each stock is broken asset owners and down into large, medium FTSE Global Energy Index FTSE Global Pharmaceuticals Index FTSE Global Telecoms Index FTSE Global Utilities Index consultants with this idea, and small cap, “thereby FTSE Global Media Index FTSE Global Tech Index they could see the logic of allowing investors Data as at 31 January 2005. Source: FTSE Group reviewing the world in this flexibility to manage

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Regional Review MARKET LEADER

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way – literally the review is carried out a significant lever in the efforts of indices, he says, including lower investors to achieve “their own portfolio turnover and thereby lower on an investment mandate basis.” Reviewing on a regional basis also efficient frontier,” explains Beckley: in costs. Pension plans quite rightly see better return and lower leads to an improved costs as a contribution rate distribution of large, mid Small Caps on the rise – the FTSE Global Equity benefit. Over the life of the cap and small cap Index Series fund this can be very constituents and by 260 240 significant. covering some 98% of 220 An array of overlays, the investable universe. 200 such as value, growth and The result is better 180 currency hedging, and net coverage in terms of 160 total returns are available, both constituent and 140 which allow investors to market capitalisation. 120 screen any index “An index is there to 100 80 component to create their represent an opportunity index of choice.“This is the set, it should therefore next step,” suggests look to include all Large Cap Mid Cap Small Cap All Cap Beckley. “The interest in opportunities,” says customised indices is Beckley, “then how you Data as at 31 January 2005. Source: FTSE Group soaring”. He thinks slice the component managers will increasingly elements makes it an effective representation of the other words, how to contain risk and use fundamental attributes such as enhance return. There are several book value and return on equity to mandate you are trying to achieve.” These days, global benchmarks are other benefits of utilising global “value stocks in sector. ”

Banking profits rise on rising Islamic business Firm oil prices and high local oil production, resulting in higher than budgeted oil revenues, good government fiscal performance and a continued rise in Islamic issuance volumes has underpinned another good year for banks in the Middle East. HE BENCHMARK BRENT crude oil price has averaged $38.5 per barrel throughout 2004 and consequently buoyed the performance of the Saudi economy. The surge in oil prices through last year, coupled with an increase in the kingdom’s oil output, has generated a surplus totalling SR98bn over the

year. Of that a little under half has been allocated for various development projects, while the balance of SR57bn has been used to amortise public debt. The Saudi economy grew 5.3% in 2004 thanks to record-high oil prices and strong performance in non-oil sectors. The financial group SAMBA is forecasting

growth of 4.25%this year. SAMBA's figures showed that the real gross domestic product (GDP) grew by 5.3%reaching $248.4bn, while nominal GDP increased by 16.9%. "The Saudi economy ... earned $106 bn dollars in oil export revenues in 2004, the highest in its history, and well above the average of $69bn

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dollars for the previous five years, the report said. The Saudi stock market also benefited with the Tawadul All-Share Index posting a massive 84% gain by the end of last year; more than comparable to the 76% rise in the 2003 financial year. Share issuance also rose on the back of a new Capital Market Law that encouraged domestic firms to list on the national stock exchange. Against this background, banks in Saudi Arabia, and in fact throughout the Middle East, have reported good profits for the year. National Commercial Bank (NCB), noted in 2004 for arranging the R8.8bn Murabaha financing for the Etisalat consortium (the largest Shariah compliant transaction to date), reported that profits rose 16% year on year to SR3.5bn in its 2004 financial year. Arab National Bank’s (ANB’s) profits meanwhile saw an increase of 52% to SR1.1bn. According to Nemeh Sabbagh, ANB’s managing director and chief executive officer, the commercial bank’s “record results came thanks to buoyant economic conditions in the local markets as well as a focused strategy”that allowed the bank to take advantage “of this favourable environment.” Net profit at the bank has tripled over the last five years and return on equity (ROE) more than doubled from 12.7% in 2000 to a tad shy of 27% in 2004. Until now, domestic banks have it all to play for in the domestic market. But increasing competition from foreign banks, will begin to bite. The structure of the Middle Eastern banking market is also in flux. “Smaller banks in the Gulf will increasingly have to deal with the dilemma of differentiation,” reported Standard and Poor’s credit analyst Anour Hassoune, in a recent report on Islamic banking.

Increasingly Islamic banking is seen as a logical option as a new business development strategy and one that is being adopted by more Western banks based in the Gulf countries. There are there ways to gain access to the Islamic market: by offering discrete Islamic products through the establishment of separate Islamic branches or account facilities; by becoming a fully Shariah compliant financing institution or by establishing a fully Islamic subsidiary from scratch. ANB has preferred to adopt a multi-faceted strategy. It played a leading role in financing the newly established Ittihad Ittisalat Company and has been involved in launching an innovative Tawarruq Islamic financing scheme in the country. The scheme covers consumer loans and allow clients to own specified commodities. As well, three of ANB’s branches are now Islamic and provide only Shariah compliant services. Hassoune expects however that even in the Gulf itself, Islamic banking will remain a complement to and not a substitute for more traditional western style financing. A noticeable exception to the tendency of banks to offer discrete Islamic services through “Islamic windows” has been NCB, the largest commercial bank in the country. NCB took the decision to convert its entire retail banking operations into an Islamic facility. European banks are particularly keen to enter the Saudi market. Deutsche Bank was granted a licence back in 2003, the first foray into the Saudi Arabian market by a foreign bank. It now provides Islamic financing services to both Middle East and Asian issuers. HSBC had been present through its 40% holding in Saudi British Bank, while BNP Paribas was awarded a universal banking licence in June of last year.

NASDAQ IS ADDED TO FTSE MV EXCHANGE INDEX

n early February the NASDAQ stock market debuted on its own market, using the ticker NADQ. NASDAQ unloaded more than 17m shares to the public and marked a further step by the Exchange towards being a more independent company. The National Association of Securities Dealers (NASD), which launched the NASDAQ back in 1971, was reported to be selling around a third of the Association’s shares in the Exchange. NASDAQ shares, which had previously traded on the OTC Bulletin Board, rose 64 cents in early first day trading to reach $10.35. At the close of that day’s trading the market capitalisation of NASDAQ was some $841m, with a free float weighting of 30%. The listing means the Exchange is now eligible to be added to the FTSE/MV Exchanges Index, which is jointly produced by FTSE Group and publisher Mondo Visione. The FTSE/MV Index was launched in September 2001 to track the performance of exchanges and other trading venues and currently includes the London Stock Exchange, Euronext, Deutsche Börse and the Australian Stock Exchange. John Jacobs, NASDAQ’s vice president and the chief executive officer of NASDAQ Global Funds says: “We hope this development will provide observers with an enhanced view of international market performance and result in a continuing representation of their investment interests.”

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Nesbitt sets a new tone at TSX Richard Nesbitt, chief executive officer of the TSX Group.

HE TSX GROUP is considered a cornerstone of Canada’s financial system. In addition to the Toronto Stock Exchange, which serves the senior equity market, they own and operate TSX Venture Exchange, serving the public venture equity market and the NGX Canada, a Calgary-based exchange for the trading and clearing of natural gas and electricity contracts. Appointed from inside the TSX Group, Nesbitt, 49, served as President of TSK Markets from 2001 to 2004 and is credited with a number of key changes to the trading and markets divisions.“What I am most proud of is changing the interaction with the customer. It is not a product but a service. Coming out of the utility days of the Exchange and converting it to a customer service organisation was a dramatic transformation. When I first got there, there was some hostility with the member firms. Basically we were able to find ways to bridge that gap and making sure they feel we are trying to service all their needs.” Nesbitt’s credentials include more than 20 years’ experience in the securities industry. Prior to joining TSX,

In December 2004 Richard Nesbitt was appointed chief executive officer (CEO) of the TSX Group, owners and operators of the Toronto Stock Exchange. Though a consummate insider with a proven record of innovation and success, he has a tough act to follow. Former TSX Group CEO Barbara Stymiest had overseen the successful transition of an antiquated broker-owned exchange into a publicly traded company. Karen Jones reports. he was President and chief operating officer (COO) of BayStreetDirect Inc., an Internet-based investment dealer and also served as president and CEO of HSBC Securities Canada. In a concentrated effort at modernisation that began as far back as 1997, the TSX closed its trading floor to become entirely electronic, while bumping its market makers “upstairs to trade from computer screens providing hyper efficiency to the exchange,” says Thomas Caldwell, chairman of Caldwell Financial Ltd and subsidiaries Caldwell Securities Ltd., Caldwell Investment Management Ltd. (Toronto) and Caldwell Asset Management Inc. (NY). Subsequent changes included becoming demutualised and a forprofit corporation in 2000, plus moving the self-regulatory organisation (SRO) functions to Regulations Services, now 50% owned by TSX and 50% by the Investment Dealers Association (IDA). “These were tectonic changes,” says Caldwell adding that the exchange is “no longer the utility for the exclusive use of one constituency, the dealers.” While on the Board of TSX Caldwell

watched the exchange transform from what he terms a “monopoly regulated utility and national icon” to providing “the three essentials ingredients of an exchange: price discovery, liquidity and information/data flow.” He feels Nesbitt is an ideal candidate to lead the Exchange forward. “I am very encouraged that he was chosen as the next CEO because he understands the game, understands the business and comes from a dealer environment.” In his new role of CEO, Nesbitt is responsible for the long-term strategic development of the TSX Group as well as daily operations of all facets. He says their publicly stated goal is “to grow earnings per share on a long term basis by 10-12%. We are a very shareholder value driven organisation. We take that to heart and it dictates the bulk of our decisions.” Nesbitt has a three-tiered strategy for growing revenues. The first he says is to enhance core business “by building our listings, trading and data businesses”which have been growing over the last three years. The second is to move into “adjacent” areas that utilise existing skill sets such as the acquisition of the NGX last year.“It is

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-0

Toronto focused on the our re-entry into the Serving up the right ingredients for growth – TSX Group vs. US market. derivative space. NGX is FTSE MV Exchanges Index and FTSE GEIS All Cap Index Caldwell, who also both letting us provide 400 owns several seats on the additional services to the 350 New York Stock Exchange energy companies that list 300 (NYSE), advises that an on our Exchange but gives 250 aggressive line of attack is us derivative capabilities.” 200 necessary. “He is in a His third goal is 150 business that is brutally geographic expansion.“We competitive. He has to haven’t bought anything 100 fight for listings, fight for outside of Canada yet, not 50 market share of listings to say we wouldn’t. We trading in Toronto vis-à-vis have decided to sell a lot TSX Group New York. Toronto has to more products outside of FTSE MV Exchanges Index FTSE GEIS All Cap Index compete because some of Canada and the United Data as at 31 January 2005. Source: FTSE Group/Factset their biggest companies, States (US) remains our biggest market potential.” He adds team” in New York dedicated to the such as Nortel and International that last year they placed both a “data US markets and a trading team in Nickel, are co-listed on the NYSE.”

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Inextricably linked to the US, particularly by the North America Free Trade Association (NAFTA), Nesbitt says that as the US is such a large part of the North American market, “we are captive to what happens to her to some degree.”He adds that as the US dollar depreciates, “we have had to absorb currency losses.” He is also carefully watching proposed Securities and Exchange Commission (SEC) initiatives, in particular Regulation NMS and the tradethrough rule. The SEC’s latest proposed NMS ruling states it would “affirm the fundamental principle of price priority by limiting trade-throughs of protected quotations for all NMS stocks.”A “trade through”is a trade at a worse than a quoted price. To qualify for protection, a quotation would be required to be automated. Manual quotations will not be protected – a problem for Exchanges such as the NYSE.“We are very much

in favour of trade through protection,” says Nesbitt. “However, we understand the dilemma when you have a market such as the NYSE that can hold up or delay orders. We are an electronic marketplace. We don’t hold up anything, every order is immediately executable.” The US is not the only marketplace in Nesbitt's geographical expansion plan. He has been proposing more “open markets on trading of securities” between Canada and NAFTA partner Mexico plus, like everyone else, making concentrated efforts in China. “It is very significant to bring good quality Chinese companies to list on the TSX,”he says, adding that the exchange has some 18 companies listed to date and that he wants to convince Chinese companies that the TSX is the “proper window”in North America, as opposed to NASDAQ or the NYSE. “We start by pushing our strong suits, mining, energy and biotech, but there are a lot

of other companies that would be interested.” He adds that they welcome not only large but medium sized companies as well. As far as the question of due diligence with Chinese firms, Nesbitt confirms, “They have to meet our standards. We are not over there alone. We are there with Canadian law firms and Canadian broker dealers to work together as an industry.” He adds that they are not “so desperate” for listings that they would take firms who would reflect badly on the exchange. So far, it has been good at TSX. Full year 2004 revenues were up 26% from 2003 to $295.6m while new listings on the two exchanges were up 70% from 204 in 2003 to 346 in 2004. Its share price has tripled since going public two years ago and TSX Group just declared a 40-cent dividend (up from 33 cents) and proposed the shareholders split the stock 2 to 1. This should give Nesbitt a cushion to pursue his strategies.

Toronto Stock Exchange: Key Statistics 2003-2004 Comparison (figures rounded up to nearest C$m) Value Volume Transactions New Issuers Listed Number of IPOs IPO financings raised Secondary financings raised* Total financings raised Market Cap Listed Issues Domestic Market Cap

2004

2003

% Change

$833,906.5m 61,277,965,139 40,267,012 204 115 58 $15,633m $38,380.8m 1,546,928,389,765 $1,387,010.6m

$648,654m 55,562,931,370 30,893,995 128 67 47 $11,271.5m $29,144m $1,287,684,755,832 $1,155,252m

28 10.3 30.3 59.4 71.6 23.4 38.7 27.3 20.1 20.1

$3,302.6m 242.7m shares 159,473

$2,579.1m 220.9m shares 122,839

28.1 9.9 29.8

Daily Averages Value Volume Transactions

Source: TSG Group, January 2005 Notes: *Secondary financings include prospectus offerings on both a treasury and secondary basis but do not include supplementary listings. The total value of shares at listing is obtained by multiplying the opening trade price times the issued and outstanding shares at the opening of trading. Alternately, if the issue did not trade during the month the offering price will be used.

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Not so quietly does it The gag is coming off. Securities laws in the United States (US) today prohibit any written marketing materials for securities offerings except the statutory prospectus, and prevent underwriters from distributing research while an offering is in progress. That will change if the Securities and Exchange Commission (SEC) adopts proposed reforms intended to streamline shelf registration offering procedures. Neil A. O’Hara reports. HE SEC DECLARED war on ranked on corporate and selective disclosure back in transactions 2000 when it adopted corporate governance Regulation FD, which requires by a poll of Fortune companies to make investor 250 law departments. The SEC has communications freely available to large and small investors alike. Web struggled to regulate broadcasts of earnings and other Internet road shows. important events are now available to These are currently everyone and companies may not governed under a disclose any material information not statute that, which already in the public domain at never had to take into electronic private meetings with large investors. acount Bradley Kulman, a partner at Stroock & Stroock & Lavan That rule governs financial communications. In disclosures. It does not address moves that were “inconsistent with explains, “The reform proposal is a communications during securities the SEC’s directive against selective complete reversal. These days, in offerings, when companies must disclosure,”according to Truesdell, the order to avoid having to file an observe a “quiet period”. The only agency had insisted on live Internet road show, you have to make it available to everyone.” permitted written material is Comments filed at the the prospectus, although the SEC suggest some investors SEC does not restrict oral Investor reactions have been muted, fear the rule will deter communications at road though Kulman thinks ending the quiet companies from using shows. “The rubber chicken period will find favour. “They can Internet road shows if they lunch, where people made have to file presentation statements and put slides up continue to get research on the materials. Bradley Kulman, a on the wall but nobody could companies they are invested in even if partner at New York’s touch or feel them. That the banks are in the process of doing specialist corporate finance was all oral and, except for deals,” he says and real estate law firm, the anti-fraud provisions, Stroock & Stroock & Lavan, unregulated,” explains dismisses such concerns. Richard Truesdell, a partner at Davis, Polk and Wardwell, the presentations, not staged events, and “One of the lynchpins will be the audience to universal access to electronic road Lexington Avenue, New York-based confined law firm, which was recently top sophisticated investors. Now he shows, which undoubtedly issuers will

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be taking advantage of to reach out to term sheet for a particular security to convertible securities. Today, debt issuers can access the market a potentially unlimited audience for determine whether there's demand.” Whether issuers and underwriters immediately, even without a shelf, their offerings,”he says. The proposed rule creates a new class will use free-writing prospectuses through a private placement under of well-known seasoned issuers remains to be seen.“It sounds great in rule 144A followed by an exchange offer for registered debt (WKSIs) who will receive securities.“That does not work preferential treatment. To The proposed rule creates a new class for common stock or qualify, an issuer must either of well-known seasoned issuers (WKSIs) mandatory convertibles have at least $700m equity because they can’t be done on market capitalisation or have who will receive preferential treatment. raised at least $1bn in To qualify, an issuer must either have at a 144A basis,” explains Truesdell at Davis, Polk and registered debt offerings in the least $700m equity market Wardwell. preceding three years. The SEC capitalisation or have raised at least The SEC tried to speed the estimates that only 30% of US $1bn in registered debt offerings in the equity offering process when it issuers will qualify, but those introduced universal shelf companies account for 95% of preceding three years. registration statements that equity market capitalisation can include debt, equity and and 87% of the total debt issued in registered offerings over the concept. You can blast out faxes, you convertible securities. It did not work. can send out all these supplemental “All the bankers told the issuers: if past seven years. For WKSIs, the proposals knock the pieces of information,” says Michael you put equity up everyone is going statutory prospectus off its hallowed Littenberg, a partner at New York full to ask ‘when are you selling?’ and perch. The SEC will permit “free- service law firm Schulte, Roth and ‘what are your plans?’” continues Furthermore, most writing prospectuses” that describe Zabel, “But because of liability Truesdell. offered securities but need not include concerns I am not sure where the companies do not have universal complete information about the issuer. market is going to come out on this shelf registration statements. In future, WKSIs will be able to add “Issuers will be able to test the market stuff.” His investment bank clients for a particular security without have expressed serious reservations. equity or convertible securities to their jumping through a lot of hoops,” says “They do not see this as some great debt shelf registration and sell them Kulman, “You could use a two-page big bone that has been thrown to immediately. “There is no signalling. There is no overhang until it is too them,”he adds. Investment banks will welcome the late,”adds Truesdell. Issuers and underwriters, administrative changes that simplify access to the capital markets for well- meanwhile, have hailed the proposals. known, seasoned issuers. In a “Everyone is very excited about not significant departure, WKSIs will no having to deliver physical final longer run the risk that the SEC may prospectuses,” says Kulman, “That is review their financial disclosure just a huge cost that nobody sees a whenever they file a securities offering. benefit for.”Electronic delivery not only Under “automatic registration,” a lowers costs but also facilitates shorter WKSI's offering documents will be settlement.“This is the Holy Grail,”says effective as soon as they are filed.“That Littenberg,“If you want to move to T+1 would allow an issuer to file and go,” you have to have electronic delivery.” Investor reactions have been muted, says Littenberg, “You go effective automatically, instead of filing and not but Kulman thinks ending the quiet knowing whether the staff are going to period will find favour. “They can continue to get research on the review you or not.” However, the changes will not companies they are invested in even if Richard Truesdell, a partner at Davis, Polk accelerate the time to market for the banks are in the process of doing deals,”he says. and Wardwell WKSIs except for equity or mandatory

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Tech Stocks still tread water At the end of the year, NASDAQ’s star seemed to be rising, but in the early New Year, the market sent a warning that investors should not be too quick to forget the crash from which Tech stocks had been recovering. It may be that this time they wanted to get off the bus before it crashed through the irrational exuberance barrier. Ian Williams reports from New York on the outlook for tech stocks through 2005. N SPITE OF a generally Investments attributes the early year and had a good run, but it is due for acknowledged consensus that doldrums to investors taking profits a breather.” He adds,“It is also partly that there current valuations of the tech for the end of the tax year, a tilt was a bit of a speculative stocks that make up much of nature to the rise, so people the NASDAQ were realistic are quick to take profits and (notwithstanding some Tech stocks may also be hit by the run. But overall we are individual exceptions) it now impending move to expense options positive on some technology appears that whatever value which will certainly diminish earnings, stocks, so we take the path of there had been earlier in an and may well reveal how well least resistance. Over the under-priced sector had long term especially in the already been extracted. managements have been paying smaller stocks there may be At their peak, techs were themselves, which a cynic may think is some speculative excess, but about 31% of the US stock the major reason why they have been we can name some areas like market, and now they are lobbying so furiously against the wireless, information storage down to less than 13%. A proposals in Washington. . and companies such as year ago even, they had Qualcom and Motorola, amounted to just over 17% Internet Security, and we of the market. But while the broader market has been recovering, accentuated by the mixed earnings think they are on a solid foundation techs have been treading water. reports. He adds “It has had a big and happy to hold them.” As he says, the individual ups and Shannon Reid of Evergreen rally but not to the bubble levels,

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The Highs... 1200 1000 800 600 400 200

-9 9 De c-9 9

Ju n

-9 8 De c-9 8

Ju n

7 De c-9

-9 Ju n

6 -9 Ju n

De c-9

5 De c-9

-9 Ju n

De c-9

-9 Ju n

De c-9

...and the Lows... 1200 1000 800 600 400 200

02 pSe

ar -0

1 ar -0

pSe

ar -0

...of the FTSE US Information Technology All Cap Index 1200 1000 800

600 400 200

5 t-0 Oc

5 r-0 Ap

4 t-0 Oc

4 r-0 Ap

t-0

3 r-0 Ap

t-0

pay outs for shareholders. Atypically, the NASDAQ 100 actually had a yield last year. It was less than one percent, but it was a sign. Driehaus confirms, “I think people are more interested in dividends now, domestically because of the changes in the tax rate. We started a dividend recovery fund that went up by 29% last year, which exceeded even our expectations since we only aimed to be Morgan Stanley composite by one and half times!” Tech stocks may also be hit by the impending move to expense options which will certainly diminish earnings, and may well reveal how well managements have been paying themselves, which a cynic may think is the major reason why they have been lobbying so furiously against the proposals in Washington. On the other hand, that has been looming so long that any investor who has not priced it in deserves to be caned. Reid comments, “I personally do not think this is a big deal, but it may be a shock to some folks, initially when we see the earnings reports. I think the market can weather that. Companies will adjust on how they compensate employees, and in the long term the market will adjust,”says Driehaus. The other lingering factor is, of course, the events that led to the Sarbanes Oxley/Spitzer syndrome – not to mention investor confidence melt-down. Driehaus thinks that that has mostly worked its way through the system, but does allow that “Investor perceptions are probably lingering. People are very scared of the markets, and there’s a tremendous urge to hedge themselves, with a trillion or so dollars in the hedge funds, but they could be missing the real world wide growth. People are too defensive.” That impinges not only NASDAQ’s

NORTH AMERICA

downs from the companies pretty much cancelled each other out and kept techs as a sector static. Advances by Apple balanced by falls from Sun, and in a volatile market, which is what NASDAQ so often is, small differences between results and expectations can and do end up in much bigger movements. So, for example, EBay still carried on making lots of money, but because its results were not quite as good as Wall St had predicted, Wall St punished it. Richard Driehaus of Driehaus Capital agrees lugubriously,“The tech sector is still not the most vibrant area to be in.” NASDAQ was, he admits, “on a rebound at the end of 2004, and then it was hit with a heavy volume of selling. A lot of what you look at depends on your time perspective. There was the March blow off in 2000, then it made a bottom in March 2002, before making a reasonable recovery in 2003. For most of last year however it was pretty static. Now it has taken a hit again and it will probably go lower.” His conclusion is that any serious growth prospects depend on the long term. “The NASDAQ stocks ricocheted from being hopelessly over-valued to hopelessly undervalued. But it gets bit more selective now, since there is not as much value as there was a year ago. It is not going be easy to make money in tech, so we are concentrating on sub sectors like online retailers, playing on the I-pod or sectors such as wireless.” Accentuating the grin-and-bearish nature of the technology stocks that make up much of NASDAQ are some external influences. Investors are moving to want dividends, encouraged by the favourable US tax regime – and most tech stocks do not traditionally pay them, although Microsoft converted last year to bigger

Source: FTSE Group

history of bubble stocks, but also the urge of investors for safety. Even the plummeting dollar may factor in, since NASDAQ mostly lists smaller companies without the foreign currency earnings of the bigger and older listings on NYSE. Evergreen Investments’ Reid ends on a slightly bullish note, “On the positive side, the economic backdrop is sound with inflation under control the new issues have gone up, NASDAQ has had its shakeout, it is just that it is unlikely to have a quick up-side Some of the NASDAQ and small caps have gone to extremes and at the very least should take a rest.”

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Chinese IPOs in the US keep SOX in mind In 2004, Chinese companies issued some $22bn in equity overseas – much of that in the United States (US). Four Chinese companies issued American Depository Receipts (ADRs) in the US last year. As Chinese companies come to prominence in the markets, so do their accounts. The requirement of corporate reporting legislation following the passage of Sarbanes Oxley beginning to bite foreign firms wanting to list in the US – or does it? Ian Williams reports from New York. ITH SOME 17 Chinese firms listed on the New York Stock Exchange (NYSE) and a further 16 on the NASDAQ, demand for shares in Chinese companies reflects growth prospects for China, increasing transparency in company reporting and improved corporate governance. Indeed the Beijing government has been encouraging Chinese companies to list on the NYSE and NASDAQ not only to raise foreign capital for investment, but also as a means of importing corporate standards and techniques from the US. “The Chinese like us, they like what we do:” suggests one NYSE official. During the first 7 months of 2004, the total average dollar value of trading in all NYSE-listed mainland Chinese companies was $137.3m per day. The NYSE is now opening an office in China to attract more companies, despite problems with the increased costs of compliance with the US’s Securities and Exchange Commission (SEC), NYSE regulations, and above all Sarbanes Oxley (SOX) in its latest 404 phase.

NASDAQ also plans to move its office from Shanghai to Beijing soon and will shortly announce the appointment of its director there. The looming shadow of costly SOX compliance“has not proved that much of a deterrent,”comments NASDAQ’s international marketing managing director, Peter Yandle. He points out that the number of mainland companies listing with his exchange has doubled recently. Yandle maintains that the extra valuations available from exposure to the world’s largest capital markets “are clearly worth the additional labour and expense of compliance. Certainly the companies listed on our market have seen their share prices benefit.” He adds “by the time the Sarbanes Oxley timetable is completed, some 48% of the world companies will be applying the world’s toughest corporate government standards.” But has listing in New York really impelled Chinese companies to improve their standards? One blip is the announcement that Air China had diverted its planned listing from

FTSE GLOBAL MARKETS • MARCH/APRIL 2005

New York to London and Hong Kong, citing the costs of compliance with SOX. Interestingly this passed virtually without comment. It would not have done two years ago when marketers were more concerned about corporate governance standards in Chinese companies. David Webb, the Hong Kong-based scourge of inscrutable corporate governance points out “you might be thinking that Air China is dual listed in London and Hong Kong, but it is not. The London trading facility is a secondary listing so the United Kingdom Listing Rules do not have any real effect.”This must imply that the cost of SOX is a convenient excuse. However, even then he holds firm, “I do not think that US listings have improved corporate governance standards in the People’s Republic of China (PRC). Rather, those mainland issuers that are not willing to face the risk of class action law suits if they screw up, simply will not list in the US. They come to Hong Kong instead, where we do not require quarterly reporting (unlike Shanghai and Shenzhen) and where we do not have class action rights for investors.” Webb is the founder of Webbsite.com, an independent website focusing on economic and corporate governance as well as investment and regulatory affairs. Run on a non-profit basis, Webb-site is the scourge of analysts, brokers and companies in equal measure.

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The overseas holders at the end of shareholding from voting on the And even for companies that are on US exchanges, Webb points out November voted down a proposal to issue. However, the intense scrutiny of overseas investors was that “listing in the US did crucial to the process. not prevent the China Capturing the performance of China – So how do the Chinese National Offshore Oil FTSE Xinhua China 25 Index and FTSE Xinhua All-Share feel about it? Chen Corporation [CNOOC] Index vs. FTSE Global All Cap Index 8000 Wei Dong, company from passing a resolution secretary of COSI and an in January to lend money 7000 Investor Relations to a finance company 6000 pioneer in the mainland, controlled by its parent. 5000 considers that the process Indeed, the fact that ADR of listing has helped holders are an extra layer 4000 Chinese management removed meant that many 3000 understand what the of them did not hear about 2000 stock markets want and the vote until it was over, to adjust to it. However, and so the turnout was low he is urbane and not and the proposal was FTSE Xinhua China 25 Index FTSE Xinhua All-Share Index totally impressed with passed.” On the other FTSE Global All Cap Index American standards, hand, he notes that “we Data as at 31 January 2005. Source: FTSE Group pointing ironically at Jack managed to stop the deal at COSI China Oil Field Services. It lend money to the parent company Welch “No one would have known has the same controlling shareholder, CNOC, using Beijing regulations how much he was being paid if it were which excluded the majority not for the divorce case!” but which is not listed in the US.”

Upcoming Chinese IPOs Company

Aiming for listing in

China Construction Bank Bank of Communications Bank of China Huadian Power International PC Online ChinaByte Orsus Tencent Shanda Baidu Shanghai Automaker Industry Corporation Huatai Automobile Co Ltd

Mid 2005 Mid 2005 Mid 2005 2005 2005 2006 2005 2005 2005 Mid 2005 Second half of 2005 Early 2005

Market

NYSE or NASDAQ Hong Kong Hong Kong

Company

Listed on

Market Cap

Ping An Insurance China Netcom Semiconductor Manufacturing International Corporation 8 Telecom International Holdings Beijing Media Group

Hong Hong Hong SGX Hong

$27.4m $380m

Domestic Hong Kong or Nasdaq NASDAQ/Amex

Leading Chinese IPOs 2004

Kong Kong Kong Kong

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So, while he had not heard of any He explains: “There is no perfect something on that scale?” Chen is equally sceptical about companies delisting in New York, he did form of corporate governance. There is always a balance somewhere Sarbanes Oxley.“In a way,”he says,“it consider that Sarbanes Oxley will make between managers enriching reminds me of the scare over the it more likely that in future Chinese companies are more likely to themselves out of the go to Hong Kong, where there company’s assets, on the Overall, Steve Davis sees some progress, are still regulations, but less one hand, and on the other and points to PetroChina, which he says bureaucracy and still access to hand, not having enough of foreign capital. Heretically he a stake in it to drive them to offers some evidence that it is a better suggests, “Chinese Statemake the company more company for its listing – and it benefited owned companies are already prosperous.” from its previous ties to BP. under close scrutiny both from Such experiences make the party and the government him dubious of the efficacy of American panaceas like Millennium time bomb when billions so the managements there are much independent directors. “They are not of dollars were spent fixing a problem better controlled!” Lending some very measured experts in the company, and they will that was not there.” He recalls that always be at a disadvantage compared CNOC recently had a meeting to support to that view, Steve Davies of with management inside the company, consider the costs of implementation US based Governance Metrics, points who are insiders, who control it and and they estimated that it would take out that the China Securities know much more about it. Look at 100,000 hours of staff time to comply, Regulatory Commission (CSRC), the Exxon Mobil and Microsoft – they are before taking into account the official regulatory body, “has really bigger than some countries’ GDP, how amounts necessary to pay outside gone out of its way to adopt really ambitious standards – the problem is can an independent director monitor agents like lawyers.

Advisors/Underwriters Arrangers

Notes

China International Corporation

Already listed in HK

Goldman Sachs Goldman Sachs Goldman Sachs and CSFB

Advisors/Underwriters Arrangers

Filed with SEC: Value approx $120m Unconfirmed Unconfirmed Looking for around $200m. Baidu is China's largest web search engine A downturn in China's auto sector may affect IPO value (approx $1bn) Privately owned utility vehicle maker, based in Beijing

Notes

Telecommunications company: Issued 120m shares BNP Paribas

FTSE GLOBAL MARKETS • MARCH/APRIL 2005

Source: Various new items through June 2004 to Jan 2005.

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that they are so ambitious that they are generally felt to be unrealistic.” Neither the companies nor other government agencies, which often own the companies, will implement the standards. The People’s Liberation Army is a major investor, and when its leaders think about the Long March – it is not the one to demand transparency. “But where in China do you get independent directors?”he asks. It is a valid point. China is still a one party state and a trawl through the web sites of many of the major companies openly lists the Party organisation in the enterprise – which seems remarkably parallel to the managerial hierarchy. For example Richard Driehaus of Driehaus Capital lists three Chinese companies that his growth fund had put money into: 51Jobs Inc, a recruitment and human resources company, CTrip, a consolidator for the travel and airline markets, and Shanda Interactive, an online games company. He points out that these companies, apart from having great growth and expectations have something in common. They do not have large amounts of capital and infrastructure that can be held hostage by local officials or managements. “We are looking for independents, new management and start ups,” he explains, where there is no old-style management resistant to reeducation.“I think the listings here are certainly making them aware of it. But it is not perfect. You remember China

Yandle maintains that the extra valuations available from exposure to the world’s largest capital markets “are clearly worth the additional labour and expense of compliance.

Life went public – and they had some problems, but in general there is more transparency, and these companies in particular are Internet start ups.” Overall, Steve Davis sees some progress, and points to PetroChina, which he says offers some evidence that it is a better company for its listing – and it benefited from its previous ties to BP. However, he does suggest that the current costs of Sarbanes Oxley“do

offer a good excuse for those who want one,” among mainland companies. Overall, returning to the metaphor from PRC history that everyone seems to use, he sees the Chinese corporate world as “just at the beginning of a Long March to transparency and modern corporate governance standards.” US listings may be one of first steps on that road, but there are many more needed.

CHINA’S DOMESTIC IPO PIPELINE BUILDS UP

hina announced in mid-January that it will resume approvals for issuing domestic initial public offerings (IPOs), which were suspended in the autumn of 2004, according to a China Securities Regulatory Commission (CSRC) release. Initial public offerings have been suspended in China since last August. Possibly, as a result of the suspension, as 2004 drew to a close China’s stock market has been among Asia's worst performers, with the benchmark FTSE Xinhua All-Share Index hovering around the 2,3002,400 mark in recent weeks. Huadian Power International Company, owned by the China Huadian Group Corporation, the state-owned energy provider with assets estimated at $10.8bn, is expected to be the first out of the block. The IPO, which is being underwritten by China International Capital Corporation, will be issued under new pricing enquiry guidelines and greater transparency in financial reporting rules, which came into force at the beginning of the year. The rules replace earlier guidelines which imposed an unofficial price limit of 20 times per-share earnings on first-time share sales. The rules were issued back in August of last year in the hope of strengthening the country’s securities issuance regime by making the pricing of shares in a domestic IPO more transparent. The new rules are aimed at making the share-sale process more market-driven and bringing China's stock markets in line with international standards. Starting in January, domestic companies seeking to go public must solicit advice from at least 20 institutions under new rules on book-building before pricing their stock. The CSRC published the draft of the pricing inquiry regulations in August 2004 following complaints that many Chinese IPOs were overpriced and that company financials were opaque. Around one third of Chinese IPOs in the domestic market in 2004 saw their firm’s share price fall below IPO prices, as some companies were found to have inflated valuations. The new rules will likely dampen the price of stock shares for some time. Hang Seng Bank estimates that mainland Chinese companies raised HK$59bn between January and October 2004, with Hong Kong still the channel of choice for mainland issuers. Mainland companies have raised some $100bn in Hong Kong between 1994 and 2004.

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Jaroslaw Grzesiak, managing partner of the Warsaw office of Dewey Ballatine Grzesiak

EUROPE

Warsaw builds on optimism In a year when Poland joined the European Union, the Warsaw Stock Exchange (WSE) celebrated what was arguably its best year ever with numerous public offerings and a significant increase in turnover. During the year, 36 companies made their debut on the WSE – with the total number of listed companies rising from 203 to 230. And the year ended on a high note, with the WIG index closing on December 31 at 26,636.19 points – a new all-time high. Angela Ward reports

HE TWO MAIN drivers of the regional financial capital – an idea that Commission (SEC). “The main factor success the WSE has enjoyed in was presented by the Ministry of behind this upward trend is the recent years have been Poland’s Finance in its strategy ‘Agenda Warsaw growing attraction of the WSE among accession to the EU, along with the City 2010’. Basically, it sees the WSE individual investors. The more country’s strong economic growth,” becoming the key trading platform for individuals are involved, the more says Dr Janusz Fiszer, partner at law securities listed in the Central and benefits for all of us.” The first stock exchange firm White & Case, Warsaw, opened in Warsaw on May 12 and assistant professor a the Warsaw University School of “The future of the WSE is certainly bright. 1817 and, at that time traded mainly bonds and other debt Management.“There has also It’s got a strong track record and great instruments. Trading in been a pronounced increase prospects and there’s no reason why it equities developed in the in the demand for good shouldn’t become one of the major second half of the 20th quality securities from exchanges in the region.” century and, before the institutional investors – Second World War, there were primarily Polish and foreign seven stock exchanges pension funds. In addition, operating in Poland – with Warsaw the increase in trading activity on the Eastern Europe (CEE) region. “Poland is one of the fastest accounting for more than 90% of the WSE has motivated a large number of small and medium-sized issuers to growing economies in Europe and we total trading. In 1938, there were 130 enter the public market, where they are by far the biggest country that securities traded in the city but, due to had previously been hesitant to do so.” entered the EU in 2004. No wonder the changing political and economic The Polish government has also put our stock exchange is booming,” says systems after the war, the capital its full weight behind the WSE with its Lukasz Dajnowicz, spokesman of the markets could not be recreated in the plans to transform Warsaw into a Polish Securities and Exchange Communist run regime.

“

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ar -0

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“The privatisation of Jaroslaw Grzesiak, Reaping the benefits of accession into the EU PZU has been highly managing partner of the FTSE Poland All Cap Index vs. FTSE Europe ex Poland All politicised since the Warsaw office of Dewey Cap Index beginning and a special Ballatine Grzesiak, puts 160 investigation commission the success of the WSE 150 was recently set up by the down to the efforts that 140 Polish Sejm (the lower were put into establishing 130 chamber of the Polish the Exchange in the early120 parliament) to examine the 1990s. The creation of the 110 privatisation process,” WSE began in 1989, when 100 explains Dr Janusz Fiszer. the new non-communist 90 “The findings of this government began 80 commission may well have creating a capital markets an impact on any future structure. The new legal FTSE Poland All Cap Index (EUR) FTSE Europe ex Poland All Cap Index (EUR) listing of the company.” framework, the Act on Data as at 31 January 2005. Source: FTSE Group Other privatisations are Public Trading in Securities expected to include 30% of and Trust Funds, was adopted in March 1991, and the WSE the stock market in style on the shares in the Polish natural gas November 10 last year, climbing monopoly PGNiG, as well as the IPO of was established the following month. “The working party that was behind 19.5% on its first day of trading. The the country’s second-largest oil creating the WSE – which included previous month, thousands of Poles company Grupa Lotus. “We are also the Polish SEC, lawyers, economists had spent days queuing in the streets expecting that we may see privatisations and professors – built it from scratch for the opportunity to buy shares and in the Polish coal mining sector for the and they did a great job,” Grzesiak the demand was so high – from first time,”says Jaroslaw Grzesiak. Poland is also anticipating its largest explains.“It is well regulated, well run, domestic and foreign investors, as well as the public – that the State non-privatisation IPO. The ceramic transparent and sophisticated.” He adds that another reason for the Treasury increased the amount it was tile producer Opoczno is due to debut on the WSE midway through the year WSE’s success was pension fund selling from 30% to 38.5% At the time of the IPO, Jacek Socha, – and the listing will mean an exit for reform in Poland during the late1990s, which means that there is a Minister of the Treasury commented: huge hunger from private pension “The IPO of PKO BP’s stock is a success on the capital market. It is a funds to invest on the Exchange. The success of the WSE is signal that privatisation via the stock highlighted by the interest of foreign exchange is the right direction and I companies to gain a listing on the advocate further transactions of this Exchange.The first of these was Bank of kind.” As Mr Socha indicated, the Austria Creditanstalt in October 2003 Polish government is fully behind and, during 2004, four further foreign privatisations and there is another companies listed – BorsodChem, a bumper year planned for 2005, with Hungarian chemical company; IVAX, a plans on the table that affect more US pharmaceutical company; BMP, a than 100 companies. Privatisations via German computer company; and the the WSE are likely to include the longawaited listing of PZU. However, this Hungarian oil company MOL. Of all the debuts on the WSE during is conditional upon the Polish 2004, the initial public offering (IPO) government and PZU’s strategic of Poland’s largest bank PKO BP investor, the European insurance stands out as being the largest and consortium, EUREKO, ending their Dr Janusz Fiszer, partner at law firm White most successful – in fact, it was the current dispute and reaching a & Case, Warsaw, and assistant professor a over EUREKO’s biggest IPO in Europe during the settlement the Warsaw University School of fourth quarter of last year. It entered investment in the company. Management

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its two financial investors, Credit thinks that there might be some US Fiszer. “Access to EU funding will Suisse First Boston Private Equity and interest in the exchange – possibly create the conditions for the necessary because of how successful the listing investment and we fully expect to see Enterprise Investors. But, one of the most eagerly awaited of US firm IVAX was - as well as a surge in the number of construction privatisations in Poland this year is interest from exchanges within the and infrastructure development that of the WSE itself. The Ministry of region, such as Vienna or Stockholm. contracts awarded in Poland during Treasury is currently on the verge of Vienna has already take substantial 2005. In almost all cases, EU-funded choosing which of two consortiums equity in the Budapest Stock Exchange projects also require funding from private investors and it’s will advise on the likely that these investors privatisation – a third one, a One of the most eagerly awaited will look to borrow these syndicate composed of privatisations in Poland this year is that of funds, meaning that the Citigroup Global Markets banking sector will also Polska and DM Bank the WSE itself. The Ministry of Treasury is Handlowy, has already pulled currently on the verge of choosing which of benefit.” Jaroslaw Grzesiak says out. The two remaining are two consortiums will advise on the that it is not just banks and Rothschild Polska; and a privatisation. building companies that are consortium composed of doing well in Poland McKinsey & Company Poland, CDM Pekao, a brokerage (please refer to FTSE Global Markets, currently, explaining that companies across the WIG20 – the Exchange’s 20 July/August 2004, Issue 2, page 16). house, and Ernst & Young Audit. “The privatisation of the WSE will ‘golden’ companies – are all doing “Privatisation will make the WSE more competitive in the region and see it better able to cope with well. “I see a bright future for the transform it from a local player into a international competition, particularly WSE,” says Lukasz Dajnowicz. regional one. It may also create on a European level,” says Lukasz “Warsaw has a unique opportunity to conditions for closer integration with Dajnowicz.“It is a golden opportunity.” become a financial services centre of Market commentators predict that central Europe. Certainly there are other stock exchanges,”says Dr Janusz Fiszer. “Depending upon the banks and large building companies some dangers involved as well – for privatisation model adopted by the will outshine players in other industrial example, the growing competition of Polish government and the exchange sectors on the WSE during 2005. alternative trading systems and other itself, such a link with another stock Poland’s accession to the EU is stock exchanges will force the WSE to exchange could become a significant resulting in large infrastructure become even more efficient.” Adds Dr Janusz Fiszer: “The future growth factor through, for example, development, which is having a knockdual listings or the introduction of on effect on construction businesses, as of the WSE is certainly bright. It’s got a strong track record and great well as the banking sector. new financial instruments.” “Much of Poland’s infrastructure prospects and there’s no reason why it The law firm Dewey Ballantine Grzesiak is part of the McKinsey requires urgent investment and shouldn’t become one of the major consortium and Jaroslaw Grzesiak improvement,” explains Dr Janusz exchanges in the region.”

The Warsaw Stock Exchange – Equities: Basic Indicators Item/Year Number of all listed companies (year end) Number of newly listed companies Domestic companies market capitalisation (PLNm) Total Market Capitalisation (PLNm) Turnover value - Cash market (PLNm) Turover value - off-session trades (PLNm) Average turnover value per session (PLNm)

2004

2003

% change

230 36 214,313 291,697 109,775 430 17,500

203 6 140,001 167,717 66,443 265 16,459

13.3 500 53.1 73.1 65.2 62.6 6.3

Source: Warsaw Stock Exchange, February 2005

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Northern Trust is enjoying a sustained period of high octane growth. Like its rival fee-based investment services providers, Northern has sparked a new business push at home and abroad. Its particular focus however is driven by two engines – superior execution through single platform technology and the elevation of client service into an art form. But will that be enough in the increasingly competitive global investment services market? Francesca Carnevale went to Chicago to find out.

HERE IS A point in the lifetime of any firm when it comes up to the bar and is measured. If it is found wanting then, like a baseball team spent of good hitters, it will gradually fade away. If, on the other hand, it can confidently meet all the batting criteria that matter, it will cross into another, more prominent, league. Northern Trust reached its own crossing in 2003. Coming to the bar that year as an already heavyweight provider of asset management and administration services for institutions and highend, high net-worth individuals, Northern left it with all the appearance of having appreciably stepped up its game (please refer to Charts 1,2 and 3). As a consequence,“I feel better about our business now than I have for several years,” says William Osborn, chairman and chief executive officer. So he should. The Chicago firm has been firing on all cylinders in recent times, with business volumes in the three areas that matter to it on an impressive upward trajectory. In 2003, assets under management (through Northern Trust Global Investors [NTGI]) grew by 58% to $479bn on the previous year – only to rise again by another 19.4% in 2004 to $572bn. In a rising market this statistic would be impressive. But in a still falling market, the performance is staggering (even factoring in the purchase of Deutsche Bank’s passive equity asset management business). In the firm’s custody business assets under custody meanwhile reached $751bn in 2003, up 59% on the previous year and increased by another 33% in 2004 to just a tip over a watershed $1trn. In the area of wealth management, a clear cut forte of the bank, the story repeats, with assets under custody rising 30% in 2003 and up 23% last year. Recently released results for 2004, show combined assets under administration rising by 23% to $2.65 trn from $2.16trn in 2003, reflecting new business and improved equity markets. Custody fees also increased 12% to $69m in the last quarter of the year. For the full year, Northern Trust reported income of $505.6m, on revenue of $2.33bn

Photo courtesy of Northern Trust 2005.

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(equivalent to $2.27 per share), up from $404.8m on $2.14bn in 2003. Trust fees represented 57% of total revenue, while feerelated income represented 74% of revenue. “Of our total $2.6trn in assets under administration in our corporate and institutional services operations, global custody assets account for well over 40% of the total,” explains Steven L. Fradkin, executive vice president and chief financial officer. “Compare that with the situation back in 1993, when global custody represented only 11% of total assets under administration. From 1993 through the present, global custody assets at Northern Trust have grown at a compound annual rate of 30%,” says Osborn. “At year end our PE was 19 times earnings. Citigroup’s was 11.” Among a spate of developments which brought Northern to the bar, say observers, the most notable was the purchase in 2003 of Deutsche Bank’s (DB) global passive equity, enhanced equity and passive fixed income businesses. The business represented total assets under management of approximately $75bn at conversion. The acquisition immediately pushed up Northern’s global investment management business to some $447bn, up from the $327bn under management in June 2002. It was an inspired move, as the acquisition dovetailed neatly into Northern’s quantitative management platform. “The additional product mix,”says Osborn,“allowed us to expand our international and enhanced index offerings.”At the time of the acquisition, Northern announced in an official statement that,“The enhanced product line also provides a natural bridge between our index capabilities and our highly competitive line of active equity and fixed income products.”Terry Toth, president of NTGI, is up front about the value-added in the deal.“Going in we really didn’t have the scale to compete, we were lounging around in 8th place. Now we are one of the three largest providers in the world.” The purchase of a portion of DB asset management business inspired Northern as a whole. In the direct NTGI space, in particular, however there was a noticeable up-swell of confidence and new market building. In addition to offering the traditional array of both passive and active investment and investment management strategies, Toth and his team are now pushing hard in the ‘manager of managers’ space, “where we are third largest with approximately $26bn under management,” he says. That business is being accrued on a number of fronts. For institutional players that “want to outsource, we will determine asset allocation and hire management,” he explains.“Others will want to outsource the entire pension fund. This is often the case with smaller funds governed by an oversight committee that act as plan sponsors. It is a good market for us.” The challenge for Toth and his team now is to roll out NTGI’s formula across the globe. “Although we

FTSE GLOBAL MARKETS • MARCH/APRIL 2005

William Osborn, chairman and chief executive officer

have a large and diversified product offering in this space, we are perhaps best known as an investment manager in the US; outside that perimeter we are largely known for our prominence as a global custody provider. But it is not the whole story, not by a long way.” Asia is an opportunity landscape for the bank,“It is very important,”acknowledges Osborn.“We are already in Tokyo and Hong Kong since 1995 and in Singapore since 1996. This year we will open an office in Beijing. Japan for us has seen great growth,”adds Toth. That spread of upside can be jolting for even the largest global financing institutions and while the market has noted Northern’s recent performance with envy or admiration, there are even bets as to how sustainable these rates of growth will be.The thought is never far from Osborn’s mind. “These days there are so many factors out of the control of management. We have seen all the trust banks impacted by these changes. We have to acknowledge that things can’t always move from better to better. On the work side, we remain focused on the job. But we also need to be prepared: never spending too much on fixed costs,”he says. Northern’s success has been achieved in some measure as a result of its intense focus on selected business lines. It is not a bank for all businesses.“As a firm,”explains Osborn, “we focus on what we do well. We simply do not do what we don’t know.” What Northern does know well is the provision of investment management and asset services for both wealthy individuals and institutions. The firm’s method in this regard is simple, yet effective. According to Tim Theriault, president and chief technology officer of the bank’s worldwide operations and technology division, “There are two fundamentals: sophisticated technology coupled with an intense commitment to client service, whoever the client.” In other words, Northern treats both

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COVER STORY: NORTHERN TRUST

individual and institutional investors in a similar way and the US’s largest personal trust bank in terms of assets under works with all of them on a single technology, internet- management. Here the bank’s business performance is based platform. “We have worked hard to develop the expected to continue to excel. Says RBC’s Cassidy, this is blended architecture that supports this approach,” states due in some part to the “demographics of the US chairman Osborn. That architecture is a combination of population, as the baby boomer generation enters proprietary and off-the-shelf technology to provide single retirement”. Northern has already developed strategic platform delivery.“The key advantage for our clients is one market strongholds in Florida, California, Texas, Arizona, ID and one password to access all systems, globally,” says New York, Boston “and more latterly Minneapolis, where there are concentrations of Theriault and “the most high net worth individuals,” enduring thing about it is “Laser-like precision in targeting explains Osborn. It is “going that there are no architectural incredibly well,” he constraints,”he adds. specific groups of high net worth maintains, “backed by our The backbone of investors allows Northern to offer broad capability in asset Northern’s product delivery services that are among the best in the management and asset is Passport, a refined online country. One important target segment, services, Northern is well reporting, news and database for instance, starts at $75m. At that placed to capitalise on these facility available to clients demographics.” To date and employees, with access level of personal wealth, you simply don’t Northern has enjoyed a permissions available on an play around.” wealth management clientele individual basis. Already 10 to die for. “There are just years old, the platform is now “used by clients in 39 countries,” expands Theriault. under 300 families with an average 350m in assets with us,” “Passport sources data from inside and outside the firm, says Fradkin. Northern also claims at least 24% of the utilising some 65 different data sources.” According to personal wealth among the Forbes top 400 in the US. Northern executives, Passport is highly cost effective. A According to RBC’s Cassidy, “Laser-like precision in further advantage is that development of the system is that targeting specific groups of high net worth investors allows it is iterative, constantly upgraded both on a predictive and Northern to offer services that are among the best in the on need basis. “The intimacy of our client relationships country. One important target segment, for instance, starts gives us a valuable feedback loop,” says Theriault. at $75m. At that level of personal wealth, you simply do not Anticipation, however, counts for much in the investment play around.” That expertise is now being leveraged abroad and mixed services business these days, so “like Wayne Gretsky [the noted but now-retired NHL ice hockey all-time leading with larger applications in custody and asset management. scorer],”smiles Theriault,“We have to know where the puck Northern has timed its expansion well. Variously valued at $55trn (roughly equal to the total value of equity and debt is going all the time.” One direction is obviously wealth management. Founded securities in the G25 countries) the worldwide market for in 1889 in Chicago by Byron Laflin Smith, Northern is now custody services, for example, is still up for grabs. Only 60%

Chart 1: Northern Trust: International & Global Fund Services Global Custody Assets 1994-2004 [in $ billions] Year 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Assets under Custody 66 85 108 149 200 312 385 452 472 751 1006

Chart 2: Northern Trust Global Investments: 1998-2004 Growth in Assets under Management [in $ billions] Year 1998 1999 2000 2001 2002 2003 2004

Assets under Management

YOY% Growth

233 292 326 320 303 479 572

25.32 10.43 -1.84 -5.31 58.09 19.42

Chart 3: Northern Trust: Wealth Management Assets Under Custody 1994-2004 [in $ billions] Year 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Assets under Custody 13 16 23 28 38 52 61 65 65 85 105 Source: Northern Trust 2005

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or so is held by the world’s top 15 global custodians; a league table in which Northern is generally ranked a rising ninth. “Put another way, 37% of the marketplace – approximately $20trn – is in the hands of second tier or regional providers. There are significant opportunities to become provider of choice,”says chief financial officer Fradkin. Grist to the mill then for a bank that is never wanton with a client relationship opportunity. Client relationship management is a quality that Northern executives rank highly and which, they say, marks it apart from its competitors. It has not gone unnoticed. The Pension Fund Partnership, in August 2004, for instance, ranked Northern number one in 12 out of 17 categories in the custody appraisal section of their annual survey of the UK fund market. Northern currently enjoys an estimated 18% share of the top 200 UK pension funds and a 25% share of the UK local authority or public fund market. Frederick H. Waddell, president, corporate and institutional services But global custodians do not live by client relationship management alone. “Cross-border and emerging market benefit from reduced investment risk and economies of investing are two trends that fit perfectly with the scale from being able to participate in the larger pool and sophisticated product set of a global custodian,” says the corporate headquarters to benefit from enhanced Frederick H. Waddell, president, corporate and institutional oversight. These pools are also tax-efficient for all the services. “The local custodian is becoming less and less a underlying pension plans. It is fair to say that Northern factor in the global market. Add to that the privatisation of Trust is ahead of the game here.” An additional strength is in-country expertise.“We can pension funds worldwide and we see continued support both Dublin and Luxembourg domiciles – our opportunity in this sector.” “It should also be remembered that some of the top 15 clients can choose the jurisdiction which suits them best. custodians have not invested in the technology necessary We have proprietary language in the trust agreement to serve this complex business, which also leaves designed to support tax transparency,” expands CFO substantial opportunities for takeaway business from that Fradkin. Furthermore, he adds.“An anomaly in local law – $35 trillion held by competitors,” says Timothy J. Theriault, the subscription tax – put Luxembourg at a disadvantage to president, chief technology officer, worldwide operations Dublin when it came to attracting multi-nationals that wished to establish investment vehicles to pool their crossand technology. Northern also has other claims. Osborn, Fradkin and border pension assets. Northern Trust lobbied the government for change and Waddell cite trenchant worked extremely closely reasons for the bank’s Anticipation, however, counts for much with them to remove this growth trajectory in the obstacle. We were in the international markets in in the global investment services room as the ink dried on the support of its clients. Not business these days, so “like Wayne statute book!” least is the bank itself.“We’re Gretsky [the noted but now-retired NHL Northern’s ability to get in Midwestern,” says Fradkin. ice hockey all-time leading scorer],” and mix at local level is “We are strongly capitalised smiles Theriault, “We have to know equally illustrated by and conservative with a small Northern’s “Nordic mutual ‘c’. We are always putting where the puck is going all the time.” fund solution,”says Waddell. quarters in the piggy bank. Northern Trust worked Sounds facetious, but it is not. Clients appreciate it: for focus and stability. Wherever closely with local regulators to alter Sweden’s mutual fund we are in the financial cycle we benefit: when markets rise act to accommodate the new servicing model being clients come to us for our conservatism and in bad times pioneered with local investment major Folksam. Northern was selected by the Swedish insurance giant as sole global they come to us in a flight to quality.” Market drivers are also a key fact. “An important custodian for all of Folksam’s $17bn in insurance assets and development is the emergence of multinational pension mutual funds. In addition, Northern Trust will provide pooling,”explains Waddell. He is referring to relatively new trustee services to Folksam via a brand new agreement vehicles recently approved by regulators in both Ireland with Swedish trustee Svenska Handelsbanken. It was the and Luxembourg that provide opportunities for first time that a non-Swedish bank provided custody and multinational pension plans to co-mingle their assets in a related services to a Swedish mutual fund. While it was a major coup, Northern had undertaken single fund.“This allows all the individual country plans to

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intensive groundwork in the Nordic market which,“from a standing start, has been ongoing for over a decade. The firm now has over $87bn worth of assets under custody in the market [equivalent to around an approximate 10% market share],”adds Waddell. “We have developed a template that can now be applied to other key markets,”expands Osborn. “We can also demonstrate tangible success in growing relationships with our global clients,”continues Fradkin. He cites the example of Schlumberger, a large, multinational client “with a number of highly complex and customised needs that we have been able to effectively serve over many years,”he explains.“Consistent with other global corporations, our growth with this type of client can be exponential. It might begin, as did this relationship, with a US custody mandate, which in turn grows through the addition of more product offerings such as securities lending and index management,”continues Waddell. “The exponential opportunity comes from adding non-US plans and providing a broad range of value-added services to each of those plans,”concludes Fradkin. Osborn is frank about the value of this approach: “Half of our international business is now doing more with existing clients.” Northern has however continued to add to its international capabilities. In November of last year, Northern announced it will purchase Baring Asset Management’s Financial Services Group. When that deal closes later this year, it will add product, clients and new locations in Guernsey, Jersey, and the Isle of Man. It will also add depth of expertise and experience with 770 FSG employees.“The scope of FSG’s business will significantly enhance and expand our global fund administration capabilities, as well as our growing hedge fund, private equity, and property administration capabilities,” said Osborn at the time of the announcement. The acquisition continues Northern’s philosophy of capability driven expansion, “and it fits strategically with our commitment to the fast-growing global fund manager segment,”adds Osborn. Although these instances highlight the way Northern leverages its regional expertise, Osborn is keen to stress that “we are a now a truly global franchise with a premium clientele located all around the world, as opposed to a business that provides international services to its domestic client base.” Northern now delivers product through nine foreign offices and its headquarters in Chicago. Around one third of the bank’s “bottom line, is driven by international business,”he explains. Put in context, in a recent investor presentation, Fradkin reported that in 2003, international activities represented approximately one quarter of the bank’s net income. “We have close to 900 staff members located in our foreign offices and the vast majority of these individuals are locals – giving the business a true global feel dominated by local expertise,”he adds. By whatever measurement then Northern is walking taller, both at home and abroad. But that growth won’t come without cost of a kind. Unlike Lampedusa’s Leopard, who saw the motor of history changing little in the essential

Steven L. Fradkin, executive vice president and chief financial officer

things of life, growth at Northern will invariably mean change of a high order. The possibility appears to weigh somewhat on Osborn and his team, caught as they are between the promise of tomorrow and the knowledge that adoption of a global mantle will put the comity that is a touchstone of the bank at risk. The same consonant attention that it offers clients is also applied in large measure to its staff. “I spend a lot of time thinking about people. Our people are aware that we need to make changes and broaden horizons,” says Osborn thoughtfully. He “travels an immense amount,”says Fradkin,“if he is not visiting clients, he is trying to understand and work through the needs of our staff.” That sensibility is not a façade.“We regard staff as culture carriers,”conceded Fradkin, who has worked at Northern for some 20 years and “I am at the mid to low end of the leadership team in terms of tenure,” he smiles.“We are a unique construct in today’s age.” Osborn agrees. “Our attention to detail around people is phenomenal,” he says, pointing out the mid-western approach to ownership, which is unique among large financial service companies. Between the founding Smith family, explains Fradkin, and the employees, retirees, and directors, 24-25% of the company’s stock is in friendly hands. So far so good then. However Northern’s distinction for client service not withstanding, its approach does not always work. After a twenty year relationship, in September 2004, for example, the Illinois State Board of Investment chose not to retain Northern Trust as its custodian. It says much about the bank’s integrity that it cared enough about the loss to announce it via a press release rather than wash it under the carpet. Even if recent enviable growth rates and benchmarks may be hard to sustain over the medium term, Northern has a future of powerful consolation ahead of it. So says Royal Bank of Canada’s (RBC’s) specialist banking analyst Gerard Cassidy. The firm, he maintains,“is one of the best managed fee based banks in the United States (US). I expect the bank’s growth to continue in low double digits, or at least high single digits for some time to come.”

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THE BATTLE FOR

INVESTMENT SERVICES: US CUSTODY

HIRTY YEARS AGO last autumn United States (US) President Gerald R. Ford signed into law the Employee Retirement Income Securities Act (ERISA), which established for the first time a set of standards governing private-sector pension plans. Among other things, ERISA required that fund management and custody services – the processing of trades, the safekeeping of assets and the management of affiliated portfolios – be divided into separate entities. With that, the era of the independent custodian was born. Domestic and global custody providers prospered through the 1980s. As the field of custodians became more crowded, causing transactional revenue to shrink, custodians gradually turned to service bundling in an effort to stay solvent. But as it became more and more challenging to make a buck in the custody business, many US institutions ceded their share of the market altogether. As was often the case during the 1990s, eroding margins began to favour a climate of big volume over customised service. Not surprisingly, the biggest beneficiaries have been the largest banks – including the likes of Bank of New York, Citigroup and State Street Bank, whose assets under custody have risen sharply since the start of the current decade. As the top-tier players joined forces through mergers and acquisitions predictably, the number of major US custodians began to dwindle. According to leading observers, further consolidation seems likely.

CUSTODY Mark Pepper, senior vice president of marketing, sales and CRM for SASI

FTSE GLOBAL MARKETS • MARCH/APRIL 2005

While consolidation continues to shape the asset-servicing industry, custodians continue to diversify and deepen their product range. In the United States in particular, the industry is increasingly dominated by a handful of institutions that continually threaten to take more market share as product offerings become more sophisticated. Is there room left for the smaller, more specialised houses? David Simons reports from Boston.

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Importance of value-added services

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particularly those with multiple lines of business to contend with – can maintain this. Clients understand this too – they do not want to go to a service provider that might exit the business in a couple of years, or one that cannot effectively service them with a full suite of products, globally.”

As has been the case for many years, custodians looking to maintain their competitive edge have developed a packed menu of value-added services that include fund-accounting, fund-administration, transfer-agency and performanceevaluation services.“One of the drivers for demand for this integrated suite of capabilities is the emergence of multiple and complex products across geographies,” notes Greene. Increased competition and further “Securities lending, enhanced performance evaluation and consolidation Consolidation will continue to shape the asset-servicing analytics and full-service trading capabilities are also areas of industry, particularly investment management firms as well growing importance for customers.” At Northern Trust, where securities lending, foreignas vendors who provide niche technology and product capabilities “Particularly among the custody only exchange trading, and transition management services are providers,”says Steven J. Appell, senior vice president, head all part of the custodial package, new product ideas are of North American Sales for Chicago-based Northern Trust continually assessed based on client need, says Appell, Company. Going forward, Appell stresses that custodians particularly with respect to regulatory requirements and cost containment. must stay diversified in “Northern Trust was the order to stay on top. Voting independence – which side of the fence do you first custodian, for “In order to compete, a sit on? Hewlett-Packard vs. Compaq example, to develop firm needs to have a full 160 automated complianceand broad range of global 140 monitoring alert tools,” capabilities and enough 120 says Appell. “We are also scale to continuously 100 the first custodian to invest in the technology 80 implement a true pooling necessary to innovate 60 vehicle for multinational around ever changing 40 companies that provides client needs and regulatory tax efficient investment demands,”he adds. 20 capabilities for their global As the tightening pension liabilities. It is market continues to drive Hewlett-Packard Compaq FTSE US IT Hardware All Cap Index important for a custodian costs downward, US Data as at 3 May 2002. Source: FTSE Group/FactSet to have enough scale to custodians will need to continuously invest in a find alternative ways to stay competitive – and profitable – while delivering a global technology platform to not only stay ahead of the greater number of advanced services to their clients, says competition with innovative products, but also to remain Appell. “From a client perspective, this is a good thing as extremely cost competitive.” customers are benefiting from pricing pressures. But at the end of the day, they also value stability. So they are looking A niche for smaller custodians for a custodian that is committed to the industry for the With consolidation resulting in a smaller field of larger long term and has the resources to evolve and invest in the custodians, the industry as a whole has undergone radical technology necessary to remain competitive.” changes in just a few short years, observes Ed Anselmin, Alan Greene, executive vice president of State Street senior vice-president of operations for Swiss American Corporation in Boston, sees a clear advantage for custodians Securities Inc. (SASI) in New York.“Unfortunately there has who have demonstrated a willingness to invest in emerging been a lot of pressure brought to bear on fees, and custody techniques and technologies.“To be a leader in this business services have really been commoditised,” says Anselmin. you need focus, commitment and the ability to provide a “Larger banks can often sell their services as loss-leaders in complete and integrated array of solutions to customers,”says many instances, on bigger relationships – on volume. That’s Greene.“You also need to be able to keep pace with market really put the market into the position that it is in now – there developments – such as the trend toward daily pricing in just aren’t that many US custodial providers any more.” Europe – and technology requirements. This necessitates To some observers, the lower-fee, larger-scale trend that continual investment in the business and not everyone – has driven the market of late represents a significant threat 9

INVESTMENT SERVICES: US CUSTODY

By the late 1990s, financial-service firms had begun to job out their custodial duties; in the years that followed, stiff competition within the mutual fund industry, coupled with a tough new era of vigilance under Sarbanes-Oxley, quickened the pace of back-office outsourcing, with the largest custodians reaping the lion’s share of the extra business. But while the prevailing climate appears to favour those at the top, by no means does this signal the demise of the middle-market custodians. Despite failing prices and a stubborn equities market, these smaller players have hung tough and tenaciously carved out a niche for themselves in the custody sector.

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many ways, is something that can really benefit a company such as ours – particularly as we continue to improve the internal processes through faster executions, improved technology, and so forth.”

Impact of alternative investments

Alan Greene, executive vice president of State Street Corporation in Boston

to the long-term viability of the smaller custodian. Anselmin, however, takes an opposing viewpoint. With fewer custodians to choose from, Anselmin sees a growing demand for a more client-friendly and customised form of custodial operations among the middle-market providers. “Increased competition has not changed our basic approach, which is to basically add value where we can,” says Anselmin, whose client base includes private and retail banks, broker-dealers and other small institutional investors.“What it amounts to for us is that if you have a specific requirement, depending on what is important to you as a client – be it someone who has a clientrelationship management team that will service you from a total perspective, including customising the point-ofaccess and reporting mechanisms, to people who have a long-standing relationship with their clients, as well as someone who can implement your solutions in very timely manner – then you look to an organisation like ours. If you have a bigger infrastructure and you do not mind being one of many, than perhaps you consider a larger player. “Not being the large conglomerate where our clients are only one of many allows us to customise our offerings to our clients’ requirements, rather than the other way around,” says Anselmin. “Recently we have seen more of the big-name custodial providers coming into the middlemarket space and actually offering a level of customisation. Because once they’re in that market, they have committed themselves to a lot of the points required to work within that market. Even though many people may claim they offer a contractual custody product, that’s not necessarily the case across all levels.” According to Mark Pepper, senior vice president of marketing, sales and customer relationship management for SASI, the larger the custodian, the less likely that the client’s individual needs will be met.“Not to mention the difficulties each merger places on the client,” adds Pepper. “This, in

The increased popularity of hedge funds, managed accounts and other alternative assets have placed a unique set of demands on custodians in recent times. “The investment product offerings we need to bundle for our clients, the back office needs of investment management firms for which we provide outsourcing services and the information reporting needs of plan sponsors who are increasingly using these vehicles are all impacted by these types of investments,” says Northern Trust’s Appell. “And providing services for hedge funds and other alternative assets is not just an issue of fund administration and record-keeping, but it is also an issue of having the systems and expertise to manage and execute efficient settlements of these assets, and an issue of having the intellectual capital and expertise in-house to work with clients with these investments.” Robust performance and analytics services and online, customised reporting capabilities are key components for any service provider, particularly with regard to hedge funds and managed accounts, suggests State Street’s Greene.“Risk reporting is an important element for these two market segments,” he says. “With transparency growing in importance, especially as it relates to hedge funds, service providers need to offer state of the art risk capabilities that truly add value to investment managers’ investment strategies. Reporting for managed accounts needs to be sophisticated enough for use by the investment manager overseeing the assets, but also clear enough for the end consumer to understand as well. “In both of these market segments, a true partnership with the service provider is crucial,” says Greene. “Hedge fund and managed accounts are relationship intensive businesses and service providers need to be flexible enough to provide solutions that allow the client to focus on their own client relationships.”

Importance of technology The events of September 11, 2001, which temporarily disabled the transaction services of several prominent New York-based custodians, underscored the need for a technologically advanced communications system with redundant backups. Not surprisingly, in the years that followed the industry shifted its primary focus away from a T+1 global settlement system, and instead moved toward the establishment of a higher level of straight through processing (STP) in an effort to ensure the fail-safe transfer of electronic data between financial agents. Naturally, the implementation of such leading-edge systems doesn’t come cheap, and has been a leading factor in the rush towards consolidation. Nevertheless, even smaller custodians are committed to staying in step with the ongoing

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have traditionally played a technological revolution. Beneficiaries in the battle for global custody key role in helping their Many, in fact, have led by A selection of global custodians vs. FTSE US Financials clients meet their reporting example. All Cap Index needs,” says Appell. “Any “We have had a 1000 change in the regulatory remarkably strong STP 800 environment creates an process for many years,” opportunity for custodians maintains SASI’s Anselmin, 600 to innovate around the new “the same process that the 400 needs of the client. It is world has only recently important for custodians to begun moving towards, and 200 continue to invest in the at an unprecedented pace.” 0 technology and people to To help bolster its STP not only understand these infrastructure, in 2003 SASI new regulations, but to also began offering RadianzNet, Bank of New York Citigroup Northern Trust understand how to assist the global financial extranet State Street Corp. FTSE US Financials All Cap Index clients in meeting these new of network provider Radianz, Data as at 31 Jan 2005. Source: FTSE Group requirements.” giving SASI clients secure While compliance has always been a key component of network access to the company’s international trading and custody services.“Because of the niche position we’re in, and as any investment strategy, says Greene, service providers are part of our effort to try to provide a comprehensive service at a now being asked for more transparency and robust cost-efficient price, technology has become an integral reporting within this realm.“What has changed is the level component,”says Anselmin.“Not only does our affiliation with of scrutiny that our customers devote to compliance Radianz allow our clients to have network connectivity to us, it issues,” he adds. “Clients want to know that their service providers can act as their ‘eyes and ears’ on issues such as also allows us to have a larger outbound connectivity.” corporate actions, and how changing regulations will impact their business.” Looking ahead At State Street, for example, clients are offered education Despite the overall sluggishness of US equities since the start of the decade, stingy interest rates have kept sessions and workshops on proposed rules and regulations Americans from abdicating their pension positions, changes, and are provided with a forum to discuss how college-savings plans and other privatised investments, service providers can address these needs. “The type of scrutiny the industry is now under, and the which has proved beneficial for the custodian market. Additionally, financial institutions are expected to continue liability that comes from that from a service provider to outsource in an effort to cut costs, improve efficiency perspective, really underlines the case for outsourcing to the and, of greater significance, comply with Sarbanes-Oxley. right third party,” says Greene.“As the mutual fund industry For many service providers, the potentially huge flow of has recognised the benefits of outsourcing, and the more back-office business could have an enormous impact on complex it becomes to do business from an operational, compliance and reporting standpoint, the more those benefits custodial revenue over the long haul. “Regulatory demands are always changing, and custodians will assert themselves. This is a huge opportunity for us.”

The world’s leading global custodians, ranked by total reported assets under custody Ranking

Provider

Worldwide assets [billions $]

Reference Date

1 2 3 4 5 6 7 8 9 10

The Bank of New York State Street JP Morgan Citigroup Mellon Group* BNP Paribas Securities Services Northern Trust UBS AG HSBC Securities Services Société Générale

9657 9100 8014 6640 3198 2958 2600 2436 1572 1352

December 31 2004 June 30 2004 March 31 2004 March 31 2004 December 31 2004 September 30 2005 December 31 2004 September 30 2005 May 31 2004 September 30 2005

Source: globalcustody.net 2005. The table is based on data supplied to globalcustody.net. Assets held on Mellon Group's network includes ABN AMRO Mellon, Mellon and Mellon Global Securities Services

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COMPANY PROFILE: AIRBUS

Airbus ascendant In an industry with just two players, one company’s joy is another’s misery. Little wonder then that executives at Boeing are unhappy. These are, after all, heady times for European aircraft manufacturer Airbus. In January the company said it had delivered more aircraft than Boeing, for the second year running (and only the second time ever). Furthermore, it expects to repeat the trick this year. Paul Whitfield reports from Paris. IRBUS’ SUCCESS IS not merely galling to Boeing, it is also somewhat embarrassing. The speed with which the Washington State based company has been knocked off the top perch is remarkable. As recently as 1995 Boeing had an 80% share of new orders in the civilian aircraft market. Four years later it was second to Airbus in terms of new orders and by 2003 was smaller in terms of both new orders and deliveries. To rub salt into the wound, the European operator has enjoyed a flurry of positive headlines following the January launch of its A380, the world’s largest civilian aircraft. Boeing, by comparison, was left red-faced when its high-profile Sonic Cruiser, a plane that would fly near the speed of sound, was shelved after airlines rejected the idea that wealthy but time conscious passengers would pay a premium for speed. The United States (US) administration is understandably worried. The civil aviation industry is an important source of both jobs and foreign income; some $62bn worth of planes was delivered last year. However, it is not just Boeing’s fall from grace that is concerning the US government, Airbus’ success is also worrying. Europe’s aircraft manufacturer is being heralded as a victory for the European Union (EU), and a model of how Europe can compete against established US trial giants. European heads of state have clamoured to attach themselves to Airbus’ success. The January launch of the A380, for example, an event with all the glitz and kitsch

of an Olympic opening ceremony, was attended by Messrs Blair, Schröder, Zapatero and Chirac. They all had something to celebrate - parts of the A380 were made in Britain, Germany and Spain and it was assembled in France. What is the secret of Airbus’ success? Unfair subsidies, says the US administration and in October of 2004 it lodged a complaint with the World Trade Organisation (WTO) accusing EU governments of breaking a 1992 agreement, by lending $15bn to Airbus. The EU responded forcibly to the charges. Peter Mandelson, the recently appointed EU trade commissioner said: “Just because Airbus is a formidable competitor does not mean that it is unfairly subsidised.”A day after the US complaint the EU filed a counterclaim with the WTO which asserted that Boeing had received some $23bn in government aid since 1992. Tit-for-tat accusations are a tradition in the civil aviation industry. This however was the first time that either party had threatened to take a dispute to the WTO – a move that would have likely seen both parties sanctioned. In the end it didn’t get that far. On January 11 this year the EU and the US governments agreed to 90 days of negotiations aimed at drawing up a new deal on acceptable subsidies. Dr Konstantinos Adamantopoulos, a trade specialist and a partner in the Brussels office of Hammonds, the law firm, says: “This is a church where everyone is a worshipper and a sinner. A negotiated settlement was the only logical solution.” The decision to by-pass the WTO was widely interpreted as a victory for Mandelson, who had strongly opposed the idea of a WTO hearing. The reasons are perhaps more arcane however and tangled with an increasing desire by the US administration to adopt a more conciliatory approach to Europe after relationships with a number of EU countries were strained over the issue of war in Iraq. Some cynical observers even suggested that the Bush administration never planned to take the dispute to the WTO, but were happy to present a politically expedient

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hard-line while facing a tricky election in the closing head because Boeing feels that it is being disadvantaged months of 2004. Whatever the motive, the offer of an olive and blames this for its recent inability to compete with its branch was timely, particularly given that the US President European competitor. Airbus receives a third of its R&D costs from sponsor was scheduled to visit Europe in February. Since the announcement of the negotiations much of the governments in the form of “launch-aid”. These are talk, particularly that emanating from the US, has been effectively loans that are repayable only if a project becomes about removing all aid to the industry. Robert (Bob) profitable. The Europeans claim that these are not subsidies Zoellick, the US trade representative who, with but investments. Repayments, they say, include interest and Mandelson, brokered the talks, says: “For the first time in a share of royalties from the aircraft. The US administration, this longstanding dispute, both the US and EU agree that meanwhile, has typically provided indirect support to Boeing the goal should be to end subsidies.” Adamantopoulos through tax breaks and research contracts from NASA and the US Department of though is sceptical. He Defence. The problem is says: “It is impossible. It is Unfairly Subsidised? Boeing vs. FTSE Aerospace & that this is neither as not going to happen. By Defence Indices 180 directly supportive of new definition, entering into aircraft nor, in the case of negotiations means they 160 the soft-contracts, so are not going to give up 140 assured. All the more so their support, rather they 120 given recent calls for cut are looking for definitions 100 backs to NASA’s budget that are workable.” 80 and the drain on defence Neither manufacturer 60 finances of the “war would likely welcome an 40 against terror”. end to subsidies. What role an imbalance Development costs are a in subsidies has played in key issue. The research and Boeing FTSE World Aerospace Index FTSE World Defence Index Airbus’ success is a matter development (R&D) Data as at 31 January 2005. Source: FTSE Group/FactSet of conjecture. As indeed is budget for the A380 alone the fact that there is an is expected to top $12bn and the risk involved in financing such a large outlay prior to imbalance, or that the imbalance has not favoured Boeing. securing any returns is considerable. Subsidies lower this risk There is little doubt that without loans the European by sharing the burden, most often with unwitting tax payers. manufacturer would have been swamped by its much Without subsidies the rate of development in the industry larger competitor during its earlier years. The US administration openly acknowledges this position. For this would slow considerably. The US position is finely tuned. The problem is not reason the Americans accepted the loan-system at first. subsidies but the balance of subsidies, they say. The US However now that Airbus is established they now think the administration, under pressure from Boeing chief executive loans give the European company an unfair advantage. Airbus, not surprisingly, denies the suggestion. David officer (CEO) Harry Stonecipher, is bringing the issue to a

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advantage in terms of better fuel efficiency, the attraction of the planes to passengers and reliability. The Boeing 777 is really the only modern aircraft that we compete against.” Boeing would disagree, citing significant improvements to many of the planes in its fleet, but the fact remains that in the past decade Airbus has launched six totally new products, while Boeing has rolled out just one in almost twenty years. It is here that the line between good management and advantageous subsidies blurs. According to Boeing the reason its competitor has been able to keep up this rapid pace of development is because of its subsidised launch cost. Airbus, inevitably, disagrees: Noël Forgeard, chief “Boeing quite simply lost focus over executive officer, Airbus the last few years and has not invested in producing modern planes,”says Vellupillai. Both arguments have merit. The ease with which Airbus has been able to tap government money has given it the confidence to be ambitious in its development schedule. For example, Forgeard has said that he expects Airbus will receive launch aid for the development of a new plane, Vellupillai, a spokesman for the Airbus Central Entity, says: dubbed the A350, which will go head-to-head with “There is government support on both sides of the Atlantic, Boeing’s newest offering, the 250-seater 7E7. It is highly unlikely that without government money Airbus could have to claim that it is one-sided beggars credibility.” Noël Forgeard, who will leave his post as CEO of Airbus responded so quickly to the 7E7, particularly had it been in the summer to become joint chief executive at Airbus forced to pay for the entire A350 project. Yet, say market watchers, some of the responsibility for owner European Aeronautics Defence & Space Co., maintains that Airbus’ success is a result of good Boeing’s circumstance rests with management. The management. He says: “There is no mystery. If there is any company is perhaps paying the price for staying with a magic, it is the uncanny ability of the company to basic design (that of its biggest selling aircraft, the 747) which was developed in the 1960s. To some extent Boeing acknowledge problems, face them and fix them.” Under Forgeard, Airbus has made big improvements to has been a victim of the 747’s success. Management’s efficiency (in 2004, for instance, the firm’s average unit cost understandable reluctance to introduce a model that might fell 7%). It has also improved customer service, had the edge cannibalise its cash-cow’s market has, inadvertently, led in sales and regularly made predictions with regards to the firm to its current listlessness. Boeing recently proposed market trends. This has translated into better profit margins. a half-way house of a radically updated version of the 747, The earnings before interest and tax (EBITA) margin at but it appears the market was not interested. Boeing’s focus hasn’t been helped by a number of other Airbus and Boeing in 2003 was 7.1% and 3.2% respectively. The final figures for 2004 are expected to be about 10% and issues either. In 1997 it was forced to temporarily close a 5.8%. Forgeard says: “Our audited accounts show Airbus to number of factories, at a cost of $1.6bn, while it waited for be almost twice as profitable as its competitor and our profit bottle necks in its production to clear. The $13bn takeover margin has grown this year in spite of our huge R&D costs.” of McDonnell Douglas, in the same year, has also proven to However, the key advantage that Airbus has developed be a distraction as Boeing’s management has struggled to and exploited in overhauling Boeing is the modernity of its realise the expected synergies. There is one last significant factor working against fleet. Vellupillai says, “We have built a complete family of modern aircraft from 100 seats up to 555 seats in the past Boeing – its owners. Boeing is listed on the New York 15 years. This more modern family has given us the Stock Exchange (NYSE) and is subject to all the short-

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term pressures that come with market ownership. The pressure to maximise returns in the short to medium term may be a welcome discipline in terms of controlling costs but it is fundamentally at odds with the long-term investment required to update a fleet of aircraft. Airbus is sheltered from much of this pressure by its corporate ownership. EADS, a business/government conglomerate, owns 80% of the manufacturer while the UK’s BAE Systems owns the balance. None of this should suggest that Airbus’ lead is unassailable, in fact, it looks some what precarious. Falls in the dollar have handed Boeing a significant price advantage. Airbus’ response has been to try to switch supply contracts into dollars where possible. But with much of its parts and manufacturing coming from within the EU it will struggle to match Boeing’s dollar advantage. Airbus has also taken a risk in launching the A350. The plane will undoubtedly hurt sales of Boeing’s 7E7, but could also damage sales of Airbus’ A330, one of its best selling models. Randy Baesler, Boeing’s vice president for marketing, says: “By offering the A350, they have thrown their 20-year product strategy out the window.” The A380 project still represents a significant risk as well. Sales of the enormous jet are premised on growth in demand for travel between major airports, so called, hubto-hub traffic. Boeing believes that customers will increasingly demand direct flights to their destination, meaning that smaller jets will prove more popular. If Airbus has picked the market incorrectly the A380 could yet prove

a turning point in the two company’s fortunes. Finally, Boeing evidently feels that its chance of regaining lost ground will improve if the US can negotiate an agreement that reduces the size of government assistance. If the current subsidy-regime changes then it is not inconceivable that the long-term balance of power in the market could shift too. One thing is certain, no matter what the outcome of the subsidy negotiations the civil aviation industry is not about to enter a new era of amicable competition. Even as the subsidies conflict rumbles a new ethically questionable battle ground is developing with both Boeing and Airbus outsourcing production, and political leverage, to key foreign markets. Boeing has awarded contracts for the construction of its 7E7’s wings and fuselage wing box to Japanese firms Fuji, Kawasaki and Mitsubishi. Not only has this put political pressure to purchase the plane on Japan’s airlines, the biggest buyers of long haul planes, but it has also netted Boeing a $1.5 billion subsidy from the Japanese government. Airbus meanwhile has announced the creation of a partnership with the Chinese manufacturers that will see the latter take a stake of up to 5% in the A380 project. Forgeard says, “We would also like to see Russia play a growing role in that respect.” The involvement of foreign national partners, particularly those outside the EU, will add further complexity to market dynamics and almost inevitably lead to future disputes. The WTO may yet have a role to play in this battle.

AIRBUS ASCENDANT Boeing & Airbus: Comparative Deliveries: 1999 – 2005(f). Year: 1999 2000 2001 Boeing: Airbus:

620 294

489 311

527 325

2002

2003

2004

2005 (f)

381 303

281 305

285 320

320 350-360

IRBUS DELIVERED 320 planes during 2004; 35 more than Boeing and expects to maintain that lead in 2005, when it has forecast deliveries of 350 to 360 planes against Boeing’s estimate of 320. Airbus has also opened up a significant gap in a number of key markets. In 2004 it won some 87% of orders from the fast growing low-cost airliner market, where its single aisle A320 competes with Boeing’s 737. In the mid-sized market, Airbus’s A330-200 has effectively won the battle against Boeing’s 767, which has only 25 deliveries to make. It is in this market however that Boeing has stolen a march on its rival with the development of the mid-sized Boeing 7E7, which will enter service in 2008. The 7E7 has attracted 126 orders, of which 56 are firm. That success is qualified by the fact that the figure is well short of 2004’s firm-order target of 200 aircraft. Airbus’s A350, which will compete with the 7E7, has only a handful of orders though that is unsurprising given that the project was only confirmed in mid-December. The aircraft won’t come into service until 2010. In the larger 300 to 375 seat market, which was long-dominated by Boeing’s 747, the Airbus A330 and A340500/600 captured 57% of the orders in 2004. And finally, as of the end of January Airbus’s A380, for which Boeing has no rival, had 154 orders, over half way to its break even point of 250. The stakes are getting higher for both companies as the market grows. International airline traffic increased 11% in 2004 and is expected to grow 6% per year on average from 2004 to 2008, according to estimates by the International Air Transport Association. Airbus predicts strong demand for new aircraft during the next 20 years. It estimates total sales of some 17,328 new passenger and freight aircraft by 2023, equivalent to 866 aircraft per year. Boeing sees even greater demand, predicting total sales in the region of 20,000 aircraft over the same period.

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Offshore attractions Exchanges in lower rate tax regimes are, rightfully, in these days of intensive market globalisation, becoming part of the mainstream. The boards have it all to play for, particularly as new European Union (EU) directives which tighten up disclosure and reporting requirements for issuers of Eurobonds could alter the market balance more in favour of offshore exchanges. Francesca Carnevale reports. HESE DAYS, IT is becoming harder to distinguish offshore exchanges from the mainstream. As leading stock markets are driven by consolidation and the development of regional hubs, so-called offshore institutions are under greater pressure to compete directly with the mainstream boards and diversify their services. These days, they compete on both an operational and regulatory perspective. Added to that, many reside in lower tax countries. In future though, further growth will depend more on strategic initiatives and new product. But perhaps, “most important, the ability to provide internationally acceptable levels of market support (regulatory and operational) while keeping in mind the needs of domestic and international clients,” says Greg Wojciechowski, president and chief executive officer (CEO) of the Bermuda Stock Exchange (BSX). Opportunities for exchanges such as BSX remain strong, he says. BSX “was established to ensure that all investors using the Bermuda capital market, whether domestic or international, were afforded the same regulatory protections as one would expect in the world’s mature financial centres. We then leveraged the opportunities that arose from the success of our jurisdiction and the innovation of its product range,” he adds.“We continue to experience growth and success as we are very mindful of the needs of our clients and ensure that our regulatory infrastructure and oversight responsibilities keep pace with changing trends in the global regulatory environment.” BSX reports growth from two key business lines: hedge funds and BSX’s Mezzanine market – a pre-initial public offering (IPO) market listing for start up companies with high growth potential. BSX allows development stage companies to list on a recognised stock exchange without having to commit to a full IPO, with all the regulatory and reporting requirements associated with a full listing. Derivatives,“though not on offer yet, is an area of potential interest, with adoption based on demand,” continues Wojciechowski. But, he notes, significant opportunity in the immediate term resides in the Eurobond market, which: “We are all watching with interest,” he says.“Being bound

by neither EU nor US regulation, BSX is well positioned to attract issuers as Europe tightens up on listing requirements,”says Wojciechowski. Kick starting this optimism is the anticipated impact of a number of EU directives issued under the European Commission’s Financial Services Action Plan. The first, the so-called Prospectus Directive, gives European and nonEU issuers a simplified approval procedure – essentially a European ‘passport’. Once approval for a prospectus is obtained in one member state, it can be used throughout the EU. The Transparency Directive 2004/19/EC, sets out periodic and ongoing information disclosure requirements for securities listed on markets, regulated or operating in a member state. The directive has not yet been implemented by the Commission, though it is understood that it must be in national law by the end of January 2007. It requires, among other items, the publication of annual and semiannual financial statements which must be prepared in line with International Financial Reporting Standards (IFRS). Since January, this obligation has applied to publicly traded issuers incorporated in the EU, under an already extant International Accounting Standards (IAS) regulation. During a transitional period that stretches up to the end of 2006 however, member states may permit other accounting standards for certain issuers. The framework is expected to impact on the public offering and admission to trading of Eurobonds for two reasons. First, the scope of disclosure obligations before and after the issuance of securities will become more onerous. The requirements, say market analysts, will particularly affect convertibles and wholesale bonds. Second, issuers whose securities are admitted to trading on a regulated market will be required to meet IFRS reporting standards. Luxembourg’s success as a financial centre developed in line with the growth of the Euromarkets from the 1960s onwards. Over 20,000 bonds now list on the Luxembourg stock exchange, equivalent to around 60% of the global total issued. Current issuance and listing procedures were laid down in a 1990 Grand-Ducal regulation, which conform to European Union listing requirements. If any market were to feel the effects of the directives, this is it. So far, the exchange does not appear overly concerned. The value of bonds listed in Luxembourg continues to rise at a steady pace,“practically 20% to 25% growth every year, in line with the market,” says Axel Forster, member of the executive committee of the Luxembourg stock exchange. But also (like the Swiss Stock Exchange [SWX]) it has taken steps to position itself to minimise the impact of the legislation, at least in the short term. Luxembourg recently gained approval to create a temporary un-regulated or

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U n i q u e l y

Established in 1971 the Bermuda Stock Exchange (BSX) is today the worldâ&#x20AC;&#x2122;s fastest growing offshore securities market.

p o s i t i o n e d

The BSX is internationally recognised as an attractive venue for the listing of: Hedge Funds Investment Fund Structures Equities Fixed Income Structures Derivative Warrants

Advantage Bermuda

www.bsx.com e-mail: info@bsx.com 22 Church Street, Hamilton HM 11, Bermuda Tel: 1-441-292-7212 â&#x20AC;˘ Fax: 1-441-296-1875

The BSX is a full member of the World Federation of Exchanges. Bermuda is a British Overseas Dependent Territory and is part of the UK for the purpose of OECD membership.

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LOW TAX RATE REGIMES

‘alternative’ market, says Forster in response to the EU transparency and prospectus directives, thereby nullifying to a degree its potentially damaging impact over the short term. The market will “attract and encourage issuers that cannot comply with the accounting standards requirements laid down by the EU Directives, but which comply with the standards of the exchange itself,” adds Forster. The new rulings will also encourage the listing of asset backed securities and credit-linked products. The operating rules of the alternative market will be defined by the rules and regulations of the Luxembourg Stock Exchange and will be almost identical with those already specified by Luxembourg law and supervised by, the Commission de Surveillance du Secteur Financier, and governed by public policy rules. As far as its regulated market is concerned, the Luxembourg Stock Exchange is taking all the necessary measures to meet the legal challenges created by the implementation of the prospectus directive and its transposition into national law.“It therefore offers a solution which is consistent with the current set of rules,”says Forster. He does not think that the un-regulated market will be a long term solution however. “Over the years we anticipate the need for such a market to diminish. EU issuers, for instance, still face the same choice of markets they have always done, between London, Dublin and Luxembourg and we anticipate no change there at all,”he explains. Forster says that the market will best suit non-EU issuers,“for example, issuers that might not, over the short term, be able to comply with the more onerous reporting requirements lain down by the EU. But, over time, this will change also, as non-EU issuers’ work to more exacting

Greg Wojciechowski, president and chief executive officer (CEO) of the Bermuda Stock Exchange (BSX)

reporting standards.” But questions arise. “Why list on an unregulated market when you have the opportunity to list on a regulated exchange,” says BSX’s Wojciechowski. “We offer a recognised, modern, electronic exchange with proximity to the largest capital market in the world, while eliminating the confusion of having to cope with regulated versus non-regulated markets and which accounting standards must be followed,”he adds. New rules issued by the Admissions Board of the SWX came into force at the beginning of February, essentially de-regulating the market. SWX wants to offer a convenient listing venue, given the more onerous requirements in neighbouring markets which might push issuers elsewhere. SWX’s new listing rules permit foreign issuers to list Eurobonds, medium term notes, convertible bonds and other debt securities. SWX no longer requires bonds to be subject to Swiss law. Instead they will be governed by OECD requirements. This builds substantially on earlier exemptions covering bonds issued under foreign issuance programmes, public issuers, Pfandbriefe, or bond issues tied to regulatory capital requirements. It’s a significant move, from a significant market maker. By turnover SWX is the third largest exchange in Europe and the world’s sixth largest securities trading centre. The Channel Islands Stock Exchange (CISX) is also prepared for the opportunity. CISX has gone to well-trod lengths to secure acknowledgement and approval from mainstream regulators, as a long term survival and enhancement strategy. CISX recently received approval from the United Kingdom’s (UK’s) Financial Services Authority (FSA) as a Designated Investment Exchange. Authorised firms now treat transactions on the CISX in much the same way as if they were trading on the London Stock Exchange. As a consequence, investments by an FSA firm in CISX listed securities now incurs a significantly lower position risk requirement and reducing overall transaction costs. The move follows the UK’s Inland Revenue having designated the CISX as a Recognised Stock Exchange under the Income and Corporation Taxes Act 1988 (please refer to FTSE Global Markets, May/June 2004, Issue 1. p.36). “We serve our local community and have adopted an approach and policy in keeping with the way business is done in the Channel Islands,” says Tammy Menteshvili, chief executive officer (CEO) at CISX.“This is not only a personal service and a personal approach to doing business, but also being innovative in our thinking and working with issuers and professional advisors to list and trade securities which are, at times, at the cutting edge of product development.” Shares listed on the CISX are now deemed qualifying investments for a number of UK retail investment products, such as PEPs, which has encouraged the listing of a growing number of closed end funds on the exchange. But the exchange also offers additional incentives for issuers looking

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for alternative markets to list Eurobonds. The tax treatment of Eurobonds in Guernsey is boosted by the CISXâ&#x20AC;&#x2122;s status as a Recognised Stock Exchange under ICTA. Interest paid on a qualifying quoted Eurobond does not have to be withheld for tax purposes if it is listed on the CISX. Similar accreditation from the US Securities and Exchange Commission (SEC) has awarded it Designated Offshore Securities Market and the US Internal Revenue Service has also recognised Guernsey as a Qualified Intermediary and a Designated Investment Exchange. This means that firms can take advantage of the US Commodity Futures Trading Commissionâ&#x20AC;&#x2122;s exemptions that allow FSA authorised firms to sell investments listed on the CISX to investors in the US. Furthermore, listing rules on the CISX will not be restricted by the â&#x20AC;&#x153;maximum harmonisationâ&#x20AC;? which the EU Directives will impose. As a result the CISX will still be able to make appropriate changes to its own listing rules, while EU stock exchanges will have to rely on changes being made and approved at the European level, if at all. Compliance costs and risks are therefore much less than listing in the EU. In particular, the CISX is not obliged to 0AGE PDF PM implement the EU Transparency Obligations Directive.

It is unlikely Eurobond listings market will drift en masse out of Luxembourg, thinks Forster. It is also unlikely that the future of the offshore exchanges will be tied to this outflow. While the outflow will be a welcome fillip, â&#x20AC;&#x153;there are other new business opportunities presenting themselves,â&#x20AC;? says Wojciechowski. For Bermuda, its position both as a transatlantic hub (taking advantage of marketing opportunities on the US East Coast and in Latin America) and as a market for alternative products, such as its Mezzanine market, seem to offer unique and prosperous consolation. Eurobonds remain a temptation however. â&#x20AC;&#x153;International investment firms have expressed an interest in using Bermuda for Eurobond listings. Our listing regulations contemplate the listing of these structures,â&#x20AC;? he adds, â&#x20AC;&#x153;Our location and time zone complement both the European and US structures and our electronic, regulatory and operational platform make us a serious contender for this business.â&#x20AC;? CISX agrees.â&#x20AC;&#x153;If exchanges continue to meet international standards,â&#x20AC;? says CISXâ&#x20AC;&#x2122;s Menteshvili, â&#x20AC;&#x153;then we look at the service end and the ability to give people a choice. The work we have done on the regulatory side, gives us the immense credibility with which to attract quality names.â&#x20AC;?

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FTSE GLOBAL MARKETS â&#x20AC;˘ MARCH/APRIL 2005

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A broader attracts franchise new issuers

After a stagnant year in 2004, Europe’s largest bond market – that for German covered bonds or Pfandbriefe – should receive a significant boost from the changes to the country’s banking laws. The Pfandbrief Act, which will supplant all the existing legislation that governs the €1,100bn market, promises to increase Pfandbrief issuance for two reasons. It will enable institutions other than the 18 private mortgage banks (Hypothekenbanks) and 11 publicly owned state Landesbanks to issue Pfandbriefe and will also remove the state guarantees from the Landesbanks (to comply with European Union law on state aid). Andrew Cavenagh reports.

IDENING THE FRANCHISE of Pfandbrief issuers will open up at least another third of the €1,000bn German residential mortgage market to the financing technique, as the local savings banks (Sparkassen) and the country’s big three commercial banks – Deutsche, Dresdner and Commerzbank – will be able to use it to finance or re-finance their portfolios for the first time. The Association of German Mortgage Banks (Verband Deutscher Hypothekenbanken) reports that the Sparkassen account for €296bn of the outstanding residential mortgage loans in Germany, while the big three commercial banks hold a further €56bn of the loans. Meanwhile, the loss of the guarantees will mean that the Landesbanks – which currently account for about 20% of the mortgage (hypotheken) Pfandbrief market and 50% of the (offentliche) Pfandbrief market backed by public-sector loans – will inevitably become more reliant on the covered bonds to provide them with an economic cost of funding. The certainty that the German taxpayer would ultimately meet all their obligations has enabled the Landesbanks up to now to borrow on triple-A ratings in the capital markets around the world.“They were global players everywhere – because of that non-existent risk of losing their triple-A rating,”explained a senior former executive at one. But without the guarantees they will not be able to secure such cheap funding in the senior unsecured markets – none would currently achieve a stand-alone triple-A rating – and will need to look to alternatives for cheap funding. “If you lose your state guarantee, you simply fall back on your Pfandbriefe,”suggests Holger Dohra, head of business and relations management on the treasury side at DG Hypothekenbank. Thomas Cohrs, the head of origination for international financial institutions at Hypovereinsbank (HVB), says the extent of the Landesbanks’ funding difficulties postguarantees will vary. Two factors will be decisive – their access to a good retail banking network and the extent to which they have developed business models that did not rely on the guarantee. Nevertheless, he concluded that “you probably have two that have severely worsening problems”. But while this pressure on the Landesbanks and the emergence of new issuers will undoubtedly produce a big surge in future issuance, it will not happen overnight. Bankers and analysts do not expect dramatic growth over

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investing large sums in the the next 12-18 months. necessary systems and Last month Dresdner personnel. However, the Kleinwort Wasserstein's state governments are asset-backed research team lobbying the upper forecast total Pfandbrief chamber of the German issuance of €130bn this parliament to amend the year – up from the €116bn Pfandbrief Act to allow of last year and 2003, but Landesbanks to use not massively so – and existing cover pools for an others support this view. interim period. “You might have a 5% Cohrs pointed out that on or an 8% growth here,” top of the costs involved in suggests Drew Patrick, head segregating, monitoring and of treasury at SEB reporting on the assets, new Hypothekenbank.“It’s going issuers would also have to to take about a year and a meet the Act’s demanding – half before you see any real if as yet unspecified – changes.” Markus Nitsche, requirement to maintain a who is head of marketing at regular market presence. Deutsche Hypothekenbank, “The general consensus is also agrees that the market that you will have to bring at will not really accelerate least one deal a year,” he until late next year. “From says. Again, the vast majority 2006 on, the total amount of of the savings banks do not Pfandbriefe outstanding will have the volume of business probably be much bigger Holger Dohra, head of investor relations on the treasury side at DG to contemplate making such than this year or last year.” Hypothekenbank. a commitment on their own. One reason for the delay Even the big three is that the potential new It is no longer only the Pfandbrief commercial banks are entrants will need time to presently debating whether assess how best to access market that offers the opportunity to or not it will be worth their the market. The directly fund German mortgage lending while to acquire a licence or requirements of the in the capital markets. The True Sale find another route to access Pfandbrief Act are more Initiative, developed by Kreditanstalt fur the market.“The question is stringent than those of the Wiederaufbau (KfW) and 13 commercial whether they will incur the legislation they supercede banks, has created a platform that will costs required to obtain a (with the aim of enhancing licence or will they use one the quality for investors), enable fully funded securitisation of of the existing Pfandbrief and they would require a mortgage portfolios. issuers,”says Cohrs. new issuer to make a There seems certain to be considerable investment. A bank with no previous experience of issuing the bonds, a significant consolidation across the German banking for example, would have to set up the systems and procedures sector to put together groups with portfolios large enough to meet the required standards of risk management and the to meet the demands of the future market. Most expect the rules on reporting and disclosure. It is highly improbable that number of Landesbanks, for instance, to at least halve over a small savings bank could justify the expense. “There are the next two years, while Patrick at SEB believes the certainly barriers to entry into this market,” observes Patrick. reduction will be even more drastic.“I think you’re going to see a concentration down to three, four or five.” “For the majority of them, it's simply not worthwhile.” Many of the savings banks will also conglomerate into “The whole thing is not going to be cheap, that is, putting the technical infrastructure in place,” agrees Cohrs groups to form the necessary critical mass. “There will be at HVB. Some of the Landesbanks are facing a potential lots of merging and consolidation going on in Germany problem in this respect, because they do not have systems over the next two years – and not just among the in place to monitor collateral performance to the required Landesbanks,“comments Peter Hansen, managing director standard – their guarantees meant that in the words of one of the European Securitisation Forum. A second reason why the surge in issuance will not come banker they “didn’t need a very closely meshed legal framework”for their Pfandbriefe. They could consequently for another two years is that the Landesbanks have made be unable to acquire a licence under the new act, without full use of their guarantees since they learned in 2003 that

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c-0 4

c-0 3

c-0 2

c-0 1

c-0 0

c-9 9

they were to lose them and have borrowed heavily in the issue of financing themselves without the benefits of the senior unsecured markets in the meantime (all transactions guarantees. Meanwhile, the established Pfandbrief issuers do not expect the completed ahead of the broadening of the July deadline are on The FTSE German Pfandbrief Index Series franchise for the covered grand-fathered terms). 170 bonds to have any “A lot of them have 160 immediate impact on their issued a lot of debt to 150 modus operandi. “From make use of the interim 140 our point of view there is period,” commented 130 no change at all – we still Markus Sgouridis, legal 120 issue triple-A product counsel at the Bond 110 backed by excellent Marketing Association. 100 collateral pools and Most seem to think that 90 constant contact with the this borrowing binge will rating agencies,” have covered the FTSE German Pfandbrief Index 1-3 years FTSE German Pfandbrief Index 3-5 years maintained Dohra at DG Landesbanks’ liquidity FTSE German Pfandbrief Index 5-7 years FTSE German Pfandbrief Index 7-10 years Hypothekenbank. needs through this year FTSE German Pfandbrief Index >10 years FTSE German Pfandbrief Total Index The gradual increase in and 2006.“At the moment Data as at 31 January 2005. Source: FTSE Group competition in the they are so cash rich, my domestic market is feeling is they have enough to last two years,“ says Richard Leib, the head of expected to lead the mortgage banks to broaden their horizons, however, for commercial lending. “As mortgage treasury at Munchener Hypothekenbank. Patrick at SEB suggests it would be three or four years banks, we’re going to have to start looking further afield,” before the remaining Landesbanks really had to address the acknowledged Patrick at SEB. Leib at Munchener also says

What all bond investors should know about Pfandbriefe www.pfandbrief.org

Pearls in the asset market are hard to find. Good, that fixed-income investors can quickly access essential information at the official Pfandbrief website. For example about its outstanding SAFETY, YIELD AND LIQUIDITY. The German Pfandbrief – Europe’s biggest bond market. An asset class well worth looking into. Association of German Mortgage Banks (VDH) Berlin, Germany Fax +49-30 2 09 15- 419 • info@pfandbrief.org

The Pfandbrief ISSUED BY GERMANY’S MORTGAGE BANKS

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“maybe we will look a little bit more outside Germany in the commercial market,” while stressing that the bank would “stay on its core business”. An increase in German sovereign borrowing could also put a check on the growth of Pfandbrief issuance this year, if the Government decides to ramp up issuance of bunds ahead of expected increases in interest rates over the next 6-12 months. There seems to be no lack of investor appetite for bunds at present, despite the seven-month rally that drove 10-year yields on the instruments in January to their lowest point since mid-2003. Pacific Investment Management, the world’s largest bond investor in California, recently identified bunds as a “better alternative” to US Treasury issues this year. Bill Gross, the fund’s manager, noted in his monthly outlook in January that Merrill Lynch, Deutsche Bank and Lehman Brothers had also made this recommendation in recent months. And there is already anecdotal evidence that some investors are buying bunds in preference to Pfandbriefe, as the yield pick-up on the latter has narrowed. Leib at Munchener says he had met one investor recently who had told him bluntly: “Sorry gentlemen, investing in Pfandbrief is not attractive for me at the moment compared with bunds because the [negligible] additional spread is not worth it.” It is no longer only the Pfandbrief market that offers the opportunity to directly fund German mortgage lending in the capital markets. The True Sale Initiative developed by Kreditanstalt fur Wiederaufbau (KfW) and 13 commercial banks, has created a platform that will enable fully funded securitisation of mortgage portfolios. However, to date, the only transaction launched under the TSI trademark to date was the €1,042m securitisation of a pool of Volkswagen auto loans in November. Dohra at DG Hypothekenbank says there was “a substantial market” for mortgage-backed securities under the TSI, using collateral that had higher loan-to-value percentages (up to 80%) than were acceptable for Pfandbrief issues. There are also a large number of mortgage lenders in Germany, such as life insurers, that cannot access the Pfandbrief market.“They have mortgage loans on their books that they would like to put into the securitisation market,” added Dohra. The reason this market has not taken off to date is an outstanding legal problem with the transfer of mortgage rights. Because the vast majority of mortgages in Germany are registered rather than certified, the transfer of the rights to a portfolio currently requires the re-registration of each individual loan to the special purpose vehicle. However, a change in the law – that should also come into effect in July – would enable banks to effect the transfer of a pool of loans on an internal register. Stefan Bund, managing director for structured finance at Fitch Ratings in Frankfurt, says the legal change would be the key to unlocking a market that could easily grow to tens of billions of euros within the next two years.“That’s going to be the catalyst.” There is also massive scope for

securitisation in Germany outside the residential mortgage sector, as the country’s medium-sized commercial and industrial companies – or Mittelstand – begins to move away from its almost total reliance on bank funding. The second issue out the Preferred Pools Share (PREPs) programme in December, raised €616m of mezzanine finance for 67 Mittelstand companies through a collateralised debt obligation (CDO) – virtually matching the €650m of such debt that Mittelstand companies raised from banks throughout the entire previous year. The PREPS programme is limited to the top 2,500 companies in the Mittelstand, which are considered to be investmentgrade on the basis of Moody’s and Fitch models for privately held companies, and the second PREPS 2004-2 transaction delivered mezzanine finance debt at a cost of 7.5% compared with 12-18% interest rates that the banks typically charge for such debt. JP Morgan, one of the lead managers on PREPS 2004-2, has estimated that this market – for just the mezzanine debt of the top 25% of Mittelstand companies – could be worth more than €15bn over the next three-five years. This market could grow by an order of magnitude if the programme – or others like it – can break into the unsecured lending market for these companies. Bank lending would only need to become 1-2% more expensive to make the PREPS pricing competitive. This is not out of the question – once the Landesbanks lose their guarantees and the Basel II Capital Accords increase the regulatory capital cost of loans with low or sub-investment grades. “SME securitisation will definitely become an issue in Germany, I think,” says Hansen at the European Securitisation Forum. “I think what we have now is more alternatives in the German market.” Yet another growth market for securitisation is big banks refinancing syndicated loans. “What they’re doing is buying back the loans, putting them into a securitisation vehicle and selling them on in the secondary market – it’s cheaper for the banks to do it that way,” says Nitsche at Deutsche Hypothekenbank. The 50 basis over Libor/Euribor pricing achievable on triple-A commercial mortgage backed securities (CMBS) represents a worthwhile saving on the 80bp average for bank debt with the same security. European Covered Bonds outstandings (Dec. 2003)

Spain 42 bn €(3%) Schweden 60 bn €(4%)

Switzerland 31 bn €(2%)

Luxemburg 16 bn €(1%)

Ireland 13 bn €(1%)

UK 11 bn €(1%)

France 87 bn €(6%)

Danmark 231 bn €(15%)

Germany 1056 bn €(67% Total: 1.554 bn €

Source: European Mortgage Federation

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Pfandbrief bill – a new start The German Pfandbrief, first issued some 235 years ago, is a bond collateralised by long-term assets. The creation of the Mortgage Bank Act in 1899 uniformly regulated the issuance of Pfandbriefe through mortgage banks for the first time. Since 1927 public sector credit institutions have issued Pfandbriefe on the basis of the “Act governing Pfandbriefe and similar debt instruments issued by public sector credit institutions”, or the Public Pfandbrief Act (ÖPG). In 1933, an Act governing Shippfandbrief banks (SchBG) expanded the remit of governing legislation and created the legal basis for the issuance of ship Pfandbriefe by banks. Now the Pfandbrief faces a new era, as a general Pfandbrief Act takes shape that will encompass all issuers of Pfandbriefe. It is expected to become effective in July 2005. Dr. Louis Hagen, executive director of the Association of German Mortgage Banks explains the implications of the new legislation. N JULY THIS year the German state guarantee mechanisms for public sector banks – the maintenance obligation and the guarantee obligation – will be abolished in order to create a level playing field between all banking groups competing in the same business. With it, the justification for differing legal bases for different banking groups will become obsolete in the Pfandbrief market. The draft bill for the Pfandbrief Act currently being debated in the German Parliament clearly bears the hallmark of the Mortgage Bank Act. A large part of the new Act will be familiar to investors and issuers. This is intentional, as legislators are anxious not to undermine investors’ confidence in the new law. The 2002 and 2004 amendments to the Mortgage Bank Act (which covered net present value calculation of cover pools, mandatory overcollateralisation, regulations in the event of issuer

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insolvency) have been taken over virtually unchanged. Other traditional core elements are included. This covers, for instance, components such as the calculation of the mortgage lending value, compliance with the 60% loan to mortgage lending value ratio, the cover pool monitor function, special supervision by the German Federal Financial Supervisory Authority (BaFin), and the limit on cover assets for which Pfandbrief holders’preferential claim (in cases of insolvency) is not safeguarded.

DEBT REPORT: PFANDBRIEFE

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Dr. Louis Hagen, executive director of the Association of German Mortgage Banks

Abolition of the specialist bank principle For public sector credit institutions, however, the major obstacle in bringing the Public Pfandbrief Act in line with the Mortgage Bank Act is the specialist bank principle that is a cornerstone of the current Mortgage Bank Act. Quality assurance measures will make up for the abolition of mortgage banks’ specialist bank principle and public sector banks’ loss of state guarantees Such quality assurance measures are meant to safeguard the cover assets and the issuers, namely the joint commitment of the mortgage banks to the quality of the Pfandbrief through both voluntary measures and continuing development of the legal framework. These measures will achieve effects similar to the specialist bank principle. A high degree of homogeneity of issuers, for instance, as a prerequisite for a transparent and liquid market and improved safety of the Pfandbrief is also protected under the new legislation by the measures. The specialist bank principle also ensures that specialist institutions have the specific expertise for their business fields and the management of the various risks, from which the cover assets are generated. This refers not just to the requirements on the system side, but also to the qualifications of the issuer’s staff. With the abolition of the specialist bank principle, this requirement will be expressly stipulated in the Act as a prerequisite to obtaining a Pfandbrief license. Only fully chartered domestic financial institutions with equity capital of at least €25m are to be licensed to issue Pfandbriefe. This is a necessary condition of any legislation, as only German institutions are subject to the national supervision that is a requirement of the Act. Further, the required insolvency provisions can only be regulated by the German legislator for financial institutions that fall within the scope of German insolvency legislation. However, banks will not be entitled to issue Pfandbriefe automatically. They will need to apply for a licence and will need to prove that they are in a position to meet the

requirements of a Pfandbrief issuer on a sustainable basis. An issuing licence can and will be revoked however if the requirements are not met and will automatically expire if the bank does not issue Pfandbrief on a regular basis. A major component of the Pfandbrief’s high-quality reputation derives from the special supervision by BaFin, the regulator, to which mortgage banks are subject today. This fact in particular has been highlighted in the new legislation. The supervision also comprises cover audits at least every two years, which have not to date been expressly stipulated in the Act. The importance of special supervision will also be reflected in the options available to the supervisory authorities. To date the Mortgage Bank Act has only provided for cover assets and Pfandbriefe to be transferred in the event of an issuer’s insolvency. As mentioned above BaFin will be allowed to revoke the issuing license. If this happens BaFin will be entitled to appoint a cover pool administrator, who has the same rights as any administrator has in instances of issuer insolvency, to protect Pfandbrief creditors. The main characteristic of Pfandbrief is the fact that Pfandbrief holders have a priority claim on the cover pools in case of insolvency of the bank. Cover pools therefore have to be managed in a way to enable them to meet the Pfandbrief holders’ claims should insolvency occur. Credit quality of the Pfandbrief is therefore based to a great extent on the fact that the risks intrinsic to cover pools (that is, the credit, concentration, market and liquidity risks, are actively managed to ensure that the probability of such risks occurring is kept as low as possible). It is therefore a prerequisite that a bank issuing Pfandbriefe must have suitable risk management systems in place to measure and manage the above specific risks of the cover pools. By the same token, this methodology ensures that Pfandbrief issuers have a long-term nonopportunistic approach towards issuance in order to amortise the necessary investments. A necessary and complementary measure to the professional management of risk is to provide a high level of transparency. That way, the market itself has the opportunity to freely assess or measure the quality of the cover assets in terms of credit quality, regional breakdown and loan size. Standards governing transparency are already met vis-à-vis the external rating agencies. The new regulations in the Pfandbrief Act therefore are modelled closely upon these international standards. Although issues such as the eligibility of mortgage loans from USA, Canada or Japan, are putting pressure for additional changes to be made to the draft bill, it appears to meet the necessary high standards required in this regard. As long as the provisions on quality assurance measures are not diluted as the bill passes through the legislative process, investors’ confidence in the Pfandbrief will be sustained. It would then also prove positive for the Pfandbrief market if the Pfandbrief were used to fund assets of banks that have not previously issued Pfandbriefe. The dawning of a new era for the Pfandbrief promises to be a continuation of the success story of the past 235 years.

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Chicago’s new age challenge

DERIVATIVES REPORT

Chicago’s exchanges positively bristle with confidence. In 2004 new business volumes across the city’s various boards accrued at a staggering pace. 2005 could be even more rewarding for the exchanges – judging by the comprehensive range of initiatives now underway at the exchanges. These are heady days for the Chicagoans, who are taking a much more imaginative approach to the ways they are building new business. Francesca Carnevale reports.

IRED BY MASSIVE increases in derivatives trading in the United States (US) and rapid growth in individual equity options trading, all three of Chicago’s leading exchanges enjoyed rapid increases in derivatives volume last year. Not all exchanges were as lucky. Trading actually declined at the Korea Futures Exchange, as its Kospi 200 index option failed to keep pace with previous year performance. Options trading globally also grew 18% in 2004. US interest rate futures dominated the world’s top 20 contracts during most of last year. The world’s largest futures contract, the Chicago Mercantile Exchange’s (CME’s) Eurodollar, rose by over 42% to 297.5m contracts in 2004, while the Chicago Board of Trade’s (CBOT’s) 10year Treasury futures increased by almost 33.6% to over 196.1m contracts, and 5-year Treasury futures leapt by 43% to 105.5m contracts over the same period. The future certainly looks bright then for Chicago’s derivatives exchanges. With growing diversity of product, a supportive regulatory environment, attractive opportunities for growth both at home and abroad and a cache of demand in the over-the-counter (OTC) and cash markets, all Chicago’s derivatives exchanges are bang in a trading volume and earnings up-swell. “In any sense, we are one of the world’s largest organised marketplaces,”says Craig Donohue, the CME’s chief executive officer (CEO). The CME, for one, handled some $464trn worth of transactions on behalf of institutional clients last year. Their dominance in today’s market is amplified by other benchmarks as well. Eurex, for instance, one of Europe’s leading derivative markets, traded some €86trn by comparison. Donohue also, casually lobs another comparison on the table. “We traded more volume in the first two weeks in January than the New York Stock Exchange will handle in an entire year.”

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DERIVATIVES REPORT

A similar story is also writ large on the Chicago Board In fact, trading volumes at all Chicago’s exchanges are well up on previous years. The CME, for example, reported Options Exchange (CBOE). The exchange kept its lead as record revenues and earnings for 2004, driven by strong the largest US options board in overall volume in 2004, volume growth in the exchange’s interest rate and foreign trading over 361m contracts, a new all-time volume record exchange products. The rise in volume also included a 71% at the exchange, and an increase of 27% over the previous year. The rolling out of a increase in electronic revolutionary trading trading. The exchange’s net system and the launch of revenues in 2004 climbed “In any sense, we are one of the world’s innovative products 37% to reach $734m, through the CBOE’s new compared with $536m in largest organised marketplaces,” says Craig futures exchange (the 2003. CEO Donohue, Donohue, the CME’s chief executive officer CFE) has expanded points to two components (CEO). The CME, for one, handled some CBOE’s products and of the exchange’s uptick. $464trn worth of transactions on behalf of services for its clients. First is “a significant institutional clients last year.” While there are contribution generated by significant differences the exchange’s clearing between the CBOT, the activities on behalf of the CBOT, which is our biggest customer,”he explains.“Rising CME and the CBOE (Please see Box: 1: How Chicago’s business volumes are good for them and by extension, exchanges compare), they share some marked characteristics. good for us,” he adds. Second, but more significantly, he For one, the rise of electronic trading is increasingly a points to the efforts the exchange has made in“building the feature of all three markets. The CME brings together financial strength and critical mass necessary for executing buyers and sellers on CME Globex electronic trading our long term strategy of expanding our core business and platform while the CBOT’s platform is e-cbot. “In January 2004 we acquired and implemented the technology that broadening our product range.”

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allowed us to offer Eurodollar options on the floor to the screen in just a few short months,” says CME’s Donohue, although the majority of the options are still traded on the floor of the exchange. Within this, however, an important sub-trend emerged in 2004 that is likely to continue into 2005, namely the migration of the benchmark fixed income products to electronic trading; applicable to both the CME and the CBOT. The job has already been done with Eurodollar futures. In January last year, the number of Eurodollar contracts traded on the CME Globex was less than 10% of the exchange’s total volume in that product. By December of that year that ratio had reached 72%. The CBOT faces the same challenge in 2005. While almost all of its Treasury futures trading is now on the e-cbot platform, virtually all of its Treasury futures options are floor traded. For all exchanges, the migration to electronic trading has had a huge effect on efficiency. Migration is a big driver for earnings growth and provides more room to compete with other exchanges on price. “There has been a significant impact on the rate per trade. Add to that the ease of access to our CME Globex platform through a proprietary front end system and the benefits of the system on both sides of the equation keep on building,”acknowledges Donohue. The CBOE meanwhile launched its Hybrid Trading System back in June 2003. Differing from the CME and CBOT’s side-by-side trading of choosing either floor or screen based trading, the CBOE’s offering combines a “best of both worlds” approach; mixing open outcry among the exchange’s pool of market makers working in its ‘pits’ with the ability to stream live quotes and expedite order execution on an instantaneous basis electronically. Hybrid 2.0, an iterative upgrade of the initial system, introduced last July, has enabled a wider range of market participants, referred to as electronic-Designated Primary Market Makers (e-DPMs), to enter the system through remote location access. Further upgrades enable Remote Market Making membership, allowing individuals and firms to work off-floor (in other words, remotely). The Hybrid “offers transparency, liquidity and opportunities for price movement and more complex transactions,” explains CBOE Chairman William Brodsky. Chicago’s exchanges are also thinking more globally than ever before. With an eye on international users, the CBOE launched its proprietary equity Volatility Index (VIX) product in the spring of 2004, which enjoyed immediate pick up from hedge funds and, in particular, European users. According to Brodsky,“the majority of trading in VIX options comes out of Europe. Europeans have an obvious penchant for equity derivatives, so they were early adopters of the product.” The continent is of growing interest to the CBOE, and Brodsky explains that he visits every other month. The marketing of the exchange is undertaken through three outlets: one on one visits to both the buy and sell side; attendance and presentations at key market conferences, and discrete presentations at CBOE-run events in London and Paris. There are no immediate plans to open physical operations there: “quite honestly it brings you into a

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Bernard Dan, CBOT president and CEO

Craig Donohue, the CME’s chief executive officer .

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c-0 4

c-0 3

DERIVATIVES REPORT

different regulatory regime, with greater restrictions. At this fees by 75% prior to Eurex US opening. Both sides have since cut prices further. point there is no need for it,”says Brodsky. Seasoned market watchers say Eurex US’s market share Both CME and CBOT began campaigns last year to extend their distribution networks into Europe, targeting continues in the low single digits. One year on Eurex US is languishing, but it is not proprietary traders in out. Eurex US is utilising particular. According to When volumes speak louder than words – Chicago the clearing and settlement Donohue, “2005 should Mercantile Exchange vs. Deutsche Bourse and Euronext services of Clearing Corp., see a continuation of that 550 (which at one time also effort.” CME faces rising serviced CBOT, before the competition from 450 business moved to CME) Euronext.liffe, which 350 and has also set up a began listing Eurodollar transatlantic link to Eurex futures on its electronic 250 Clearing in Frankfurt. trading platform in 150 Eurex customers can clear March. By October 2004 both their US and it was reporting volume 50 European in America of 60,500 contracts per through Clearing Corp. It day. That was still less Chicago Mercantile Exchange Deutsche Bourse AG means that its customers than a tenth of the Euronext FTSE MV Exchanges Index benefit from a single Eurodollar volume at margin payment, use a CME. Nonetheless, it Data as at 31 January 2005. Source: FTSE Group/FactSet smaller amount of remains a pointer to regulatory capital and growing competition in this space and the timely importance of CME’s European enjoy tax advantages under the 60/40 rule. European traders using Eurex US, however, still require regulatory approval expansion strategy. The strategy will also be extended to Asia, where again, from the CFTC. An equal consideration for all three of Chicago’s both exchanges have recently announced partnerships with Asian exchanges and “targeted those parts of Asia exchanges is the issue of consolidation, in other words were business volumes will emerge,”adds CBOT president expansions through acquisition. CME has been the most and CEO Bernard Dan.“We have executed five memos of explicit about this, telling analysts and shareholders that it understanding, in markets such as Dalian in China and the is actively looking for opportunities both within the Taiwan Futures Exchange, all areas where we see sources of exchange business as well as across the derivatives capital and activity.” China is of particular interest to the landscape. CME’s Donohue will not identify any targets CBOT and its commodity franchise. Dan’s eyes light up at publicly, but the exchange is sitting on a large cash pile, the mention of the fact that “more than 30% of global variously estimated at $500m – money itching to be used soybean imports flow into China. Given our market on the acquisition trail. The CBOT is not in this position, simply because it has leadership in soybean product and that China has to come to the global export market to meet that need, that fact other fish to fry and now appears to be on track for demutualisation. This could pave the way for an initial alone is significantly important to our future.” It has not gone unnoticed and the CBOT in particular is public offering of shares. Dan says the exchange’s facing stiff competition overseas from other US specialist conversion to a for-profit organisation will provide exchanges anxious to cash in on the commodity based “enhanced operational flexibility. A number of options are bonanza that is following the re-emergence of rising open to us, including an initial public offering, a merger or demand in the emerging markets. Nymex, for instance, has even strategic sale.” Dan thinks that the US exchange global pretensions and has plans to establish subsidiary landscape will evolve in the same direction as Europe,“with exchanges in the Middle East and Asia, as a means to grow exchanges consolidating into multi-asset platforms that combine stocks, options and futures.” market share in the energy futures business. For the time being, the CBOT mergers and acquisitions The going has not been entirely smooth at home either. Eurex (which is owned by Germany’s Deutsche Börse and are not the only route to consolidation, however. CBOT is Switzerland's SWX) made a play for US market share in taking on the Nymex in gold and silver futures. CBOE’s early 2004, shortly after the failure of a joint venture alliance Brodsky, meantime, contends that the key for exchanges to with the CBOT. Eurex US started trading American Treasury adding value in a fiercely competitive marketplace is through continued innovation and diversification. “We futures, thereby directly competing with the CBOT. The fight back from the CBOT and the CME came hard believe that innovation in its many forms – products, and fast. Once enjoined, the battle between the exchanges technologies and services is the lifeblood of our business. became heated. CBOT took a competitive leaf out of This has been the impetus behind much of what CBOE has Eurex’s book and announced that it had slashed its trading done over the last three decades,”he says. c-0 2

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DERIVATIVES: MANAGED FUTURES

that CME is in the A key market CBOE Chairman William Brodsky enviable position that any development is the acquisition strategy would convergence of futures and not necessarily be limited securities. Historically, to other similar futures and securities exchanges. “There are exchanges are difficult to huge non-organic combine in the US, mainly opportunities across the because they operate derivatives world,” he within different and smiles. “The conventional separate regulatory wisdom is that the regimes. The CBOE and exchanges of the future the other US securities will be multi-asset class,” exchanges, such as the he added. “Let’s see.” New York Stock Exchange, The CBOT meanwhile are regulated by the US has been looking further Securities and Exchange afield, despite its Commission, while the demutualisation plans – CME and CBOT are perhaps in a pointer to its regulated by the forward strategy. The Commodity Futures CBOT is hosting three Trading Commission smaller agricultural (CFTC). One reason that futures exchanges which the CME might want to now list their products on acquire an options the e-cbot system, exchange would be to beginning in December surmount the regulatory 2004, with the idea that a hurdle that requires a common infrastructure special operating licence will lower costs and from the SEC. These are attract more business, hard to come by it appears, Hedge funds, in particular, which are very especially during as the International comfortable with strategies that combine overnight hours when Securities Exchange (ISE) options and futures are increasingly blurring Asian traders are active. appears to be the only one the lines in the usage of both options and “The opportunities to have received a licence futures as diverse hedging and arbitrage provided by the in the last thirty years. The consolidation of CFTC is positively wanton strategies between the two products flourish. Winnipeg, Minneapolis by comparison, having and Kansas City onto a agreed eight new common platform are immense,”says Dan,“allowing both exchanges and several clearing houses in the past five years. Market developments may force the issue. Hedge funds, in Asian and European users access. We are currently particular, which are very comfortable with strategies that evaluating the transition and whether the concept can be combine options and futures are increasingly blurring the expanded.” While in theory the CBOT could simply list lines in the usage of both options and futures as diverse variants of these contracts on its system and compete with hedging and arbitrage strategies between the two products these exchanges head-on, the exchange instead wants flourish. The options exchanges seem most eager to pursue consolidation to occur on friendly terms, with the three this course, starting with the CBOE’s seminal listing of VIX smaller exchanges controlling the pace of their integration futures in March last year and subsequent rollouts of unique into the CBOT fold. For the time being, the markets are all playing into the products such as Variance futures and futures on the CBOE China Index. The Philadelphia Stock Exchange looks to be hands of Chicago’s exchanges. Regulatory issues aside, any the next exchange to move in this direction, having revived cap on their growth trajectories will depend on the ability the Philadelphia Board of Trade, a licensed futures exchange of competitive exchanges to effectively muscle in on the last year. The exchange is exploring equity index futures territory and expertise of the Chicagoans. Euronext.liffe based on specific sectors of the stock market and a series of aside, few pretenders will find the princely crowns worn in “event” futures based on economic indicators. The CME the Windy City easy to dislodge in the near term. The battle meanwhile reportedly approached the ISE, suggesting an for business will undoubtedly assume all the richness of acquisition, but the ISE decided to stay on course with plans medieval drama replete with moves, countermoves and for an initial public offering instead. Donohue emphasises alliances. A space worth watching then.

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DERIVATIVES: MANAGED FUTURES

Futures contracts start off at a disadvantage to traditional investments. While bonds and equities offer positive expected returns, futures trading is a zero-sum game. Yet investors have ploughed unprecedented amounts of money into managed futures over the past three years, lured by high returns uncorrelated to other asset classes. Neil A. O'Hara explains how and why an arcane investment strategy is gaining respect.

HIP

NSTITUTIONAL INVESTORS LOST faith in equities during the bear market that started in March 2000. Their quest for alternative investments continues to this day. That quest, in turn, has revived interest in the modern portfolio theory prediction that, over the long term, a portfolio of uncorrelated asset classes will generate higher risk-adjusted returns than any individual class. This approach has opened new doors to managed futures firms. “If people were to look at managed futures as a standalone they would not be attracted because they see it as something they do not understand,” says Mark Fitzsimmons, a partner at Millburn Ridgefield Corporation, which directs in excess of $1.1bn in managed futures and currency overlay programs. Many investors recoil from commodities, leverage and active trading, all of which contribute to success in managed futures.“It has a lot of the buzz words that people get afraid of,”he says. Established firms, such as Millburn Ridgefield, founded in 1971, have proven that managers can overcome the statistical disadvantage to deliver high returns that have no correlation to anything else. “We make our money at different times and for different reasons than other things you may have in your portfolio,”Fitzsimmons explains,“As a result it is a good diversifier.”

Barclay CTA Index (Jan 1987 – Dec 2003) Compound Annual Return Sharpe Ratio Worst Drawdown Correlation vs. S&P 500 Correlation vs. US Bonds Correlation vs. World Bonds

13.58% 0.44 15.66% 0.00 0.05 0.16 Source: Barclay Trading Group

to the Beat

Managed futures returns appear to defy modern portfolio theory.“Many of them have zero beta,”says Hans Stoll, professor of finance at Vanderbilt University’s Owen Graduate School of Management, “If it is a zero beta investment then it is diversifiable and you do not expect a positive rate of return.” The only return an investor can anticipate is interest at the risk-free rate on the cash deposited as collateral. “The returns are not high in equilibrium; they can only be high if you are a superior manager,” he says, “So you ask, can all these people be superior managers?” Put another way, if successful managed futures programmes make money against the odds, who is losing it and why do they continue to play the game? “I think much of it is simply the true hedgers, as opposed to the true speculators,”says Jim Hedges, president of LJH Investments, “Hedgers are happy to lose.” Markets that transfer risk depend on willing losers. Futures are like insurance; everyone who buys an insurance policy hopes never to make a claim. Protection against disaster comes at a price willingly paid – from which the insurer makes a profit. Sol Waksman, president of Barclay Trading Group, points out that while the stock markets facilitate capital formation the futures markets do not.“Futures are there entirely for the purpose of risk transfer,” he says, “Transferring the risk of excessive price volatility from one class of investor, a commercial interest, to another class of investor, the speculator.”He believes that markets driven by different forces are unlikely to generate correlated returns – and the statistics bear him out. The Barclay CTA Index, which measures the performance of commodity trading advisers, has zero correlation to the S & P 500 Index or US bonds (please refer to Table 1: Barclay CTA Index Jan 1987 to December 2003). The low correlation between managed futures and other asset classes extends even to the instruments that underlie the

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financials such as energy, futures contracts.“A normal metals and agricultural bond fund is a buy and hold commodities. Financial fund, and it usually does not futures – on interest rates, use leverage at all or it is a currencies and stock indices small amount,” says – dominate most portfolios. Fitzsimmons, “Managed “You can find people who futures programs are not would shade a little bit buy and hold. We can be more to the non-financial long or short any of the but for diversified portfolios instruments in our portfolio, it is at least 50% financial,” and we do utilise leverage.” he says, “The most liquid An executive at another markets in the world are successful managed the financial markets.” futures firm – so successful As funds under it wishes to remain management grows the anonymous while it pressure to focus on digests recent inflows – financial futures increases. agrees. “Our S&P trading Hans Stoll, professor of finance at Vanderbilt University’s Owen “It is one thing if you are has no correlation to the Graduate School of Management trading a total asset base S&P. Our bond trading has no correlation with bonds. Why? Because we can be short at the manager level of $10m or $20m to have a lot of money in the commodity markets,” says Waksman,“But if as well as long,”he says. Managed futures players divide into two camps. you multiply that by a factor of 10 all of a sudden you're Discretionary traders rely on fundamental analysis to spot not able to put the same percentage bets in corn or future price trends, while systematic traders such as Millburn soybeans or cotton as you can in the financial markets.” Stoll believes the currency markets may be fertile ground Ridgefield use technical analysis to search for trends already reflected in historical and current prices. Most firms, however, for managed futures traders despite his theoretical are systematic traders. “The managed futures industry is a reservations. “It is hard to believe that trend-following momentum based industry, it is trend-following,” says would be consistently profitable,” he says, “Unless, in Waksman,“No one is trying to predict the price. When the markets such as currencies, governments do not allow their price starts moving, whether they are using a moving average currencies to adjust to free market prices and there is a crossover or a breakout methodology, as prices go up people trend as governments reluctantly accommodate the pressures of the market.” are buying, and as prices go down they are selling.” Systematic traders seldom rely on a single indicator. Liquidity is especially important to systematic traders. “If you are searching for trends, you are looking for liquid Millburn Ridgefield uses eight different models to trade the markets because you want to be a trend-follower not a trend- €/$ exchange rate.“All of them are searching for trends, but setter,”says Fitzsimmons, whose flagship diversified portfolio they will search for trends in different ways,” Fitzsimmons has 70-75% in the financial markets and 25-30% in non- says, “We might be looking at daily prices; we might be

Table 2: Returns: Barclay BTOP 50 Index

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec YTD

2004

2003

2002

2001

2000

1999

1998

0.71% 3.92% -0.83% -4.28% -1.37% -2.72% -1.01% -1.20% 0.30% 3.05% 4.10% 0.35% 0.65%

5.22% 5.61% -5.80% 1.61% 5.53% -2.42% -1.81% 1.99% -0.49% 2.36% -0.43% 3.84% 15.55%

-0.50% -2.87% 0.21% -1.72% 2.91% 7.29% 3.58% 2.17% 3.39% -4.06% -2.57% 5.76% 13.68%

0.64% 0.13% 5.16% -4.20% 0.50% -0.85% -0.48% 2.05% 2.52% 3.84% -6.96% 2.05% 3.83%

0.71% -1.90% -2.51% -2.55% 0.24% -1.74% -1.31% 0.40% -2.84% 2.05% 6.87% 9.83% 6.60%

-2.01% 2.41% -0.66% 2.52% -0.93% 3.05% -1.63% 0.99% -0.01% -3.71% 1.55% 0.28% 1.64%

0.82% -1.11% 1.53% -3.55% 2.00% 0.05% -0.36% 5.80% 4.86% 2.42% -2.68% 2.38% 12.38%

Source: Barclay Trading Group

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De c-0 3

De c-0 0

De c-9 5

De c-9 0

De c-8 5

De c-8 0

US Dollar (billions)

systematic traders have looking at minute by Growth in managed futures assets under management – much bigger profits on minute prices. The time 1980 to 2003 their good trades than period you’re looking at 100 86.5 they have losses on their can differ.” If the models 80 bad trades.” all agree, the firm makes a Portfolio risk full allocation but scales 60 management works only back when they diverge. 37.9 40 if firms make sure each The strength of 22.8 trader adheres to position identified trends 20 10.5 limits, Stoll explains. determines the degree of 1.5 0.3 “What is he doing? How leverage in the portfolio. 0 much has he lost today? “If we had trends in all 80 When is he out? When do positions we trade, if Data as at December 2003. Source: Barclay Trading Group you knock him out? How those trends were very well defined and if the volatility in the markets was quick are you to observe a trader who’s over-extended?” relatively low we might have leverage on the order of he asks,“You can do all the fancy delta hedging stuff but eight or nine times underlying assets,” Fitzsimmons if you're not controlling the guys who are responsible for explains. In less favourable conditions, the firm pares the trading then you’ve got a big problem.” Systematic traders generate high portfolio turnover. leverage but it remains integral to the strategy. Managed futures firms need robust risk management The industry measures activity by the number of “round because leverage accentuates the volatility of returns (see turns per $1m” – how many in and out trades the firm makes per annum per $1m invested. “In our flagship Table 2). Investors should focus on a firm’s risk management programme that tends to be about 1,400 round turns per rather than its performance record, according to Waksman. $1m,” says Fitzsimmons. Futures commissions and clearing charges are low, so the “The place to look when evaluating managers is, ‘How do they do in the worst of times?’” he says. “When that frenetic trading costs no more than 1%-2% of assets per year. From its inception in the 1970s, assets under inevitable day comes and they’re going to take losses, how do they size the bet and diversify the portfolio so that they management in managed futures grew steadily through the early 1990s. Assets stagnated as the equity bull will not take a mortal hit?” Besides diversification across markets and trading market gathered steam; returns on managed futures systems, Millburn Ridgefield backs into its position limits paled beside the S&P 500 and failed to match earlier from a disaster scenario. “Suppose our portfolio is fully results. Growth in assets picked up after strong relative allocated. We’re trading every market, volatility in every performance in 2001 followed by double digit returns in market is relatively low and the trends are very well- 2002 and 2003. Assets swelled to almost $120bn in 2004, which may defined so we have our maximum leverage,” Fitzsimmons says, “Tomorrow, all those positions move against us by prove a watershed year for managed futures. For the first three standard deviations. How much could we lose?” The time, assets continued to flow into the industry through a firm derives limits from its threshold of pain: a maximum sustained drawdown, six consecutive months from March through August when the industry lost money.“In the past, potential loss target. Managed futures traders let their winners run but are when we’ve been in draw-downs like that you have seen quick to cut losses. “One can control risk by the assets drop by 25% or so,”says Fitzsimmons, who believes disciplined use of stop orders, simply getting out when it a new generation of investors is more sophisticated. Patience paid off as performance bounced back in the starts to go wrong,” says the anonymous executive,“Most

Table 3: Managed Futures Assets Under Management $ billions on Dec. 31 1980 1981 1982 1983 1984 1985 1986 1987

0.31 0.38 0.56 0.63 0.77 1.49 1.96 3.90

$ billions on Dec. 31 1988 1989 1990 1991 1992 1993 1994 1995

5.51 7.00 10.54 14.50 18.50 26.00 24.90 22.80

$ billions on Dec. 31 1996 1997 1998 1999 2000 2001 2002 2003

23.98 33.10 36.00 41.30 37.90 41.30 50.94 86.50 Source: Barclay Trading Group

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different styles or strategies. fourth quarter. “People But obviously trees do not who have been in the grow to the sky.” industry for a while know In contrast, Waksman that during the drawdown recalls that investors periods when everyone blame capacity constraints else is pulling the plug is whenever performance the best opportunity to slips. “In all the years I add to the investment,” have been in the business, says Waksman. every time there was a bad Liquidity concerns will year they’d say there’s too force this new money much money,” he says, “I into financial futures, do not think anyone where a skeleton lurks in knows how much the the closet. Portfolio Sol Waksman, president of Barclay industry can handle.” insurance, a dynamic Trading Group Fitzsimmons believes hedging strategy that technology may constrain followed trends, performance, too. “The contributed to the 1987 stock market crash when the volume of stock index information comes to the market quicker so these trends futures selling exceeded available buying power. Could do not last as long as they used to,” he says, “I do not trend-followers disrupt the markets again? “I do not think you can get as far away from equilibrium because think that is reasonable because these markets are the the market has too much information.” Investors show no concern about diminishing returns. deepest, most liquid markets out there: bonds and Money is flowing into managed futures from individuals, currencies,” says Hedges. A larger asset base may put pressure on returns without institutions and hedge funds, according to Hedges.“Right roiling the markets. “There is a finite limit as to how much or wrong, I think it is clearly a directional move across the money can be run through these markets in any specific industry, a strong sentiment for everybody to participate in strategy,”says the anonymous executive,“Some of the bigger this field,” he says. The Cinderella of alternative players are expanding capacity by trading markets using investments is now being invited to the ball.

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automating derivatives processing The imperative of

The over-the-counter (OTC) derivatives market is on a roll of its own. Worth some $173trn (in notional value) according to the International Swaps and Derivatives Association (ISDA), deal volume is up by $30trn over 2003 and the market is expected to continue at a double-digit pace for some time to come. This growth trajectory has, however, simultaneously raised both the level of operational risk and the costs of manually processing this magnitude of contracts. The market must automate in order not to be overwhelmed by its own success. Peter Axilrod, managing director of new business development for The Depository Trust & Clearing Corporation (DTCC) writes from New York.

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HE FASTEST GROWING area of over-the-counter derivatives is credit default swaps. These instruments have proved to be an essential part of controlling credit exposure for major dealers and the financial system as a whole. “The market for credit derivatives has grown in prominence not only because of its ability to disperse risk, but also because of the information it contributes to enhanced risk management by banks and other financial intermediaries” noted Alan Greenspan, chairman of the United States’ (US’s) Federal Reserve Board (the Fed), back in 2003 in referring to financial derivatives. “As the market for credit default swaps expands and deepens, the collective knowledge held by market participants is exactly reflected in the prices of these derivative instruments. They offer significant supplementary information about credit risk to a bank’s loan officer, for example, who heretofore [sic] had to rely mainly on in-house credit analysis,” he concluded.

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Until a few years ago, the low volume and high degree of customised terms in credit default swaps and other OTC derivatives almost necessitated manual post-trade processing in a paper-based environment. Trading and confirmation were done via phone calls and faxes. It was not particularly burdensome as volumes were (generally) low. In the first half of 2000, the ISDA estimated there were about $60trn (in notional value) in interest rate and currency swaps outstanding, with little or no measured activity in credit default swaps or equity derivatives. By the first half of 2002, the same survey shows about $82.7trn notional value in interest rate Peter Axilrod, managing director of derivatives, some $1.5trn in credit default new business development for The swaps, and $2.3trn in equity derivatives. It Depository Trust & Clearing is a very different picture these days. In Corporation (DTCC) the latest survey for the first half of 2004, interest rate derivatives stands at $164.5trn notional value, credit default swaps were at products. [Intelligent defaults are values that are not fixed for all contracts, but rather are fixed depending upon values of $5.4trn and equity derivatives at $3.8trn outstanding. As the market for these instruments has exploded in the basic business terms.] The existence of these sorts of standard past few years, there has been an increasing need to industry practices has facilitated the automated confirmation develop an electronic, automated system for matching and and matching of interest rate derivatives as well. confirmation. Prior to the advent of automated confirmation systems, it averaged over four weeks to Addressing Industry Concerns confirm a credit default swap – a situation that was Recognising the need for automation, ISDA, in a report absolutely incompatible with the explosive market growth issued late in 2003, set an aggressive timetable for we have recently seen. automating the OTC derivatives marketplace, calling for With the advent of master confirmations for credit the automated matching and confirmation of most default swaps, which standardised most terms of any derivatives trading by the end of 2005, and the related cash contract, buyers and sellers could complete legally binding flow payments reconciliation and netting by 2006. credit default swaps on Fortunately, the industry short-form transaction had already begun supplements by agreeing to responding with solutions The automated flow of information, as little as 20 or so elements before the report was beginning with trade capture and flowing of transaction data. That issued, and it appears that made automated matching directly through to a central matching utility, there will be service will eliminate the risk that a market and confirmation of trades in offerings available to permit these instruments feasible. participant can legally confirm a trade that the ISDA goals to be met. Recently, ISDA has also While different solution does not comport their understanding as established master providers have taken recorded at the time of trade. confirmation agreements for different approaches to equity options and variance automation, the key goals swaps, with master are the same: to provide confirmation agreements for equity swaps nearing ways for firms to match and confirm trades through the completion as well. Automated matching of trades in these use of real-time systems, and if there are mismatches, to products can be expected to increase as master find quick and easy ways to correct those mismatches, confirmations are adopted by ever-expanding groups of while providing firms with the maximum transparency industry participants. throughout the confirmation process. Although there are no master confirmations for interest A key way to achieve this is to provide a way that both rate derivatives, industry practice has given rise to generally counterparties are required to submit their transaction accepted “intelligent default” values for most of the items to details for matching. be specified in the standard ISDA confirmations for these One of the major advantages of having a two-sided

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automated matching process is that it allows individual firms, the software development is something that must firms to operate in a very high control, post-trade still be undertaken in-house. One of the accommodations that some central environment. The automated flow of information, beginning with trade capture and flowing directly through confirmation utilities have made to increase the level of to a central matching utility, will eliminate the risk that a automation and confirmation is to provide a way for firms, especially buy-side firms market participant can legally such as hedge funds that confirm a trade that does not may be small or be limited in comport their understanding Although there are no master the level of automation they as recorded at the time of confirmations for interest rate have available, to connect to trade. This sort of automated derivatives, industry practice has given the service using the Internet trade matching not only rise to generally accepted “intelligent and a browser over a secure reduces risk by reducing the default” values for most of the items to connection. time to confirmation, but be specified in the standard ISDA The most rudimentary use also reduces error by of a browser connection is to virtually eliminating confirmations for these products. permit firms to review and mistaken confirmation. affirm on-line trades However, any automation, even using a one-sided submission and affirmation by the submitted to an automated confirmation facility by their contra-party, provides a much more rapid review and counterparties. More importantly, however, some correction of the confirm process than paper-based manual providers have adapted the browser connection to allow systems. As noted above, such paper-based confirms could lower volume firms to obtain most of the benefits of twoliterally take weeks to complete – a huge risk, given the size sided trade matching without making very expensive technology investments. They do this by permitting the and complexity of some of these transactions. Using automated real-time matching systems, firms can safe and secure upload of a properly formatted quickly and efficiently match and confirm OTC derivatives spreadsheet containing all of the transaction data by having both parties to the contract input details about necessary to perform matching. Such uploaded the transaction to a service provider. In turn, the service spreadsheet data is then processed through the matching provider, at a minimum, identifies any unmatched entries system, with results able to be reviewed in real-time. In its most rudimentary form, use of such browser-based and automatically notifies both parties of the mismatches. Some systems can even suggest the best possible matches connections essentially means there is no requirement for programming internally in order to use these automated for the mismatches. This has helped to spur a wave of new services by a host confirmation services. A connection can be completed even of different organisations, each initially focused on offering via low-cost dial-up Internet service. In the case of DTCC’s a confirmation service for a different OTC derivative, OTC derivatives matching service, while virtually all of the although many of these services are now being broadened 20 major dealers who use the matching and confirmation to include a wide range of OTC derivative transactions. The service use a mainframe-to-mainframe connection, the 40 leading providers of these automated confirmation services or so (as of mid-January) hedge funds and other buy-side are DTCC, SwapsWire and SWIFT, but there are others. firms use a mix of mainframe-to-mainframe, spreadsheet Some also offer cash flow reconciliation or settlement uploads and affirmation of trades using the individual browser fields. systems as well. As the trading in OTC derivatives grows, these These services have only come into widespread use over the last year or so (despite some having been available for automated matching and confirmation services can provide much longer). Nonetheless, they have already significantly the essential connectivity between trading parties that, improved the confirmation and back office operations of with standardisation approved by the ISDA, such as FpML, major market participants. Nowhere has the improvement will make it far easier to match, confirm and make been more dramatic than in the credit default swaps area, payments on a global basis for these complex, but where, prior to the advent of automated confirmation of increasingly essential instruments. Firms themselves will these transactions, the average time to confirmation among have to decide what level of automation they need to monitor and control the use of these derivatives in their major dealers exceeded four weeks. While these services can and are helping, the biggest businesses, but that need will surely grow in the future as problem may be getting firms to use them, giving up their well, because these instruments have significant risk manual ways. And much of the required automation that connected to them as an inherent part of their nature. By automating the infrastructure, these new services must take place is within the firms who trade in these instruments. Increasingly, a number of vendors are have the potential to spur greater productivity, greatly beginning to develop and offer off-the-shelf middleware reduce and manage both operating and credit risk and that provides the control and monitoring necessary, and increase trading volumes in an increasingly important connect to automated matching services, but for many arena set for greater expansion.

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What was Bank of America (BofA) thinking of when it bought FleetBoston Corp.? Although the bank bought its way into the slowest growing part of the US with the Fleet deal, the Northeast, the acquisition could pay off if BofA drums up significantly more business in the region. But it also depends on BoA’s ability to continue to cut costs. Working in the deal’s favour are concentrations of wealth that are among the greatest in the US in the old Fleet territory writes Bill Stoneman.

Checks and balances prop BoA/Fleet merger

ANAGERS OF SOME 5,900 BofA branches station themselves near the front door of their offices as often as they can and greet customers as they walk in. Sending its managers out into the middle of its branches is called “Leading from the Lobby’”, says Diane Wagnor, a spokeswoman for BofA’s retail business. The thinking is that consumers will do more business where they feel appreciated. Indeed, people visiting the 1,460 branches that Bank of America Corp. picked up with its acquisition last year of FleetBoston Financial Corp., which cemented BofA’s lead as the largest retail bank in the US, just might be responding to that personal touch. BofA said in its year-end financial report that it gained 184,000 new checking accounts and 196,000 new savings accounts in former Fleet territory last year. Although the lobby work is an obvious product of the merged entity, BofA launched the initiative about a year before it acquired Fleet, adds Wagnor. “It is a little too early to be declaring victory yet,” says Denis Laplante, a bank stock analyst with Keefe, Bruyette & Woods Inc., a New Yorkbased investment bank that specialises in financial companies. Moving the Fleet offices onto BofA’s computer systems, for example, still

lies ahead. And that is when problems that alienate customers often arise. But like other analysts who expressed doubts when the deal was announced, Laplante said early signs about the $47bn transaction are mostly positive. Many analysts stated out loud that BofA appeared to have bought its way into the slowest growing part of the US with the Fleet deal. However the acquirer could have the last laugh in that Northeast US segment. The deal could pay off if BofA drums up more business than Fleet ever managed to and, at the same time, continue to slash costs. In the deal’s favour are concentrations of wealth that are among the greatest in the US in the old Fleet territory. Whether the volume of new accounts being opened that BofA has reported adds up to taking market share from competitors, however, is far from clear. The view from the outside is mixed. “Everyone rolls out the metric that looks best for any given quarter,” says Craig Woker, an analyst with Morningstar Inc., an independent research company based in Chicago. Executives with Webster Financial Corp., for example, a far smaller banking company based in Waterbury, Connecticut, hold up figures seeming to show that they picked up business last year at BofA’s

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expense. Webster, which has $17bn in assets and which does business in a portion of the region that Fleet served, gained 50,000 new retail banking customers last year, according to Bill Samuelson, director of business and professional banking. “You can not accomplish that without taking some of that market share from your largest competitor,”Samuelson says. And so just what the Fleet deal will contribute to BofA shareholders is even more difficult to discern – at least so far. Still, it is hard to argue that the early customer response to a new name in town looks a whole lot better than it often does after big US bank mergers – including a host of mergers that for BofA and its Charlotte, North Carolinabased forerunner, NationsBank Corp., engineered. As BofA spokeswoman Eloise Hale posited,“When you do a merger, you typically lose customers.”BofA did not make company executives available for an interview before press time. Bank stock analysts mostly panned the Fleet acquisition when it was announced in October 2003. The deal, which was completed in April 2004, made BofA the closest thing to a truly national retail bank in the US. It now does retail business in 29 states and is virtually precluded from making any further retail banking acquisitions by a law that limits banks to holding 10% of the nation’s deposits. From its roots in the Southeast, it had previously acquired its way into Texas, California and other western states. With $196bn in assets and based in Boston, Fleet was easily the largest bank New England and a mid-ranking competitor in New York. The combination of BofA and Fleet created an institution with about $1trn in assets, keeping BofA close in size to Citigroup Inc., and briefly moving it ahead of JP Morgan Chase & Co. (before it completed its takeover of Bank One Corp.) and rendering it unlikely that another bank will ever vie for the title of the largest in the US Problem was, analysts said, it would take an awful lot of earnings growth to justify the price BofA paid. Many analysts are far more positive about BofA now, if not because of its acquisition of Fleet, than at least without objections based on Fleet. Keefe, Bruyette & Woods’ Laplante, for example, rated BofA an outperform in midJanuary, meaning he recommends purchasing its stock, but as much because it was trading at a lower price-to-earnings (PE) ratio than other large banks. It was not out of any great enthusiasm for the Fleet business itself. Analysts say, however, that BofA appears to be delivering on its promise to cut an annualised $1.8bn from Fleet’s cost base without causing any major disruptions. And though evidence is a bit shakier, many say it appears likely to squeeze more revenue out of the Fleet franchise than Fleet did. Rolling Fleet into BofA involves melding operations across a host of business lines, including corporate lending, investment banking and asset management. The combination of BofA’s Nations Funds with Fleet’s Columbia Management Group creates the largest bank-owned mutual fund company and the ninth largest overall in the US, when measured by long-term assets under management, according to Financial Research Corp., a Boston-based mutual fund research and consulting firm. The combined organisation

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manages approximately $80bn in long-term assets. Consumer and small business banking loom largest, however. The segment, which includes branch banking, mortgage lending and credit cards, accounted for 46% of total earnings last year, more than twice as much as any other business area. Retail customer service has deteriorated pretty badly at many of the biggest US banks, certainly including BofA and Fleet, by many accounts, as they lurched from one big acquisition to the next through the 1990s. Smaller banks actually gained market share in many parts of the country, if acquisitions are excluded from calculations, according to some analysts. Those very same analysts have led the questioning on the value of big banking mergers. BofA, however, by many accounts, has made sharp improvements in its customer service, starting perhaps four or five years ago. Those improvements were vital to the bank if it was to position itself to attract new customers and win more business from existing customers. “Fleet didn’t have the best reputation for service,” says Morningstar’s Woker. He expands by saying that that as a result consumers in its markets were not too upset about the arrival of an out-of-towner, such as BofA. That may even explain, in part, the apparent success BofA has had in opening new accounts, he adds. BofA was well aware of the requirements. The bank has implemented a number of specific changes in the former Fleet branches, including sending branch managers out to schmooze with customers. The same managers now expedite simple transactions when tellers are all tied up. With that degree of effort, its prospects for winning new business probably boil down to how well it executes on its customer service plans. More tangible changes include introducing a new service tier, for people who aren’t rich enough for private banking services but who are significantly more affluent than average customers. In addition, it has revamped branch staffing, replacing many full-timers with part-time employees, partly to cut costs and partly to make sure that more people are working when customer traffic is heaviest. BofA also has a much stronger mortgage offering than Fleet did, providing home loans through its mortgage subsidiary, rather than through a third-party lender. BofA (more than Fleet did) takes the time to pitch its credit card business though its branches. This is considerably cheaper than constantly dropping millions of card offers in the mail, said Kenneth D. Lewis, BofA’s president and chief executive officer, at a Smith Barney conference in New York in early February. Most significantly, perhaps, BofA has brought “free checking” to the former Fleet branches – a checking account configuration that has grown popular in US banks during the last few years. The account is credited with generating big increases in deposits at some banks, but mostly through large numbers of very low-balance accounts, making its management rather tricky. BofA’s year-end financial report, in which it said that net

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income rose 41% from the previous year, gave little recommitting to leaving several business units in Boston. Then indication of what the Fleet deal will deliver to shareholders. BofA gave up in December, after months of negotiations, on That will become clearer only after the company finishes getting its name on biggest and most prominent billboard in taking any charges related to the merger, such as one for New England, the Fleet Center basketball arena in Boston. The $181m, or four cents a share, taken in the fourth quarter, company that owns the building sold naming rights to suggests Woker. Full-year earnings per share rose 3.4% last Shawmut National Corp., with the stipulation that it could only be renamed once, which year over 2003 or 4.5% if happened when Fleet took charges related to the Fleet Clash of the Titans - Bank of America vs. Citigroup, Shawmut over in 1996. acquisition are excluded JPMorgan Chase and the FTSE US Banks All Cap Index from calculations. Analysts following the 200 Earnings growth would banking industry say that 180 have looked significantly consumers do not 160 140 better last year, if not for necessarily pay much 120 how good it was a year attention to a dust-up 100 earlier – largely due to a between a bank and local 80 tremendous year in politicians, such as an 60 40 mortgage banking, says earlier skirmish over 20 Anthony Polini, an analyst employment levels. And 0 with FTM Midwest so it is doubtful that Research. Laplante, allegations of broken Bank of America Citigroup however, says 2004 results promises had much JP Morgan Chase & Co. FTSE US Banks All Cap Index got a lift that won’t impact on business. Data as at 31 January 2005. Source: FTSE Group/FactSet necessarily be repeated At the same time, from venture capital analysts caution against investments. Either way, as big an acquisition as Fleet was, reading too much into any company’s claims about new it fairly disappears in BofA’s financial reports. business. Whether 184,000 new checking accounts and BofA chief Ken Lewis and his predecessor, Hugh L. McColl 196,000 new savings accounts, compared with 5.5m household Jr., have about as long a record of big bank mergers as anyone relationships that Fleet said it had shortly before it was sold, in the US, stretching back to the 1980s. NationsBank took the represents a shift in market share will take time to determine. Bank of America name when it bought the San FranciscoLaplante, for example, says he counts himself as one of based BofA in 1998. Their combined performance over time the new checking account customers, but is hardly handily beats all broad US stock market indexes, but leaves committed to doing much of his personal business with some critics saying it would have been better if they worked BofA. He says he took a home equity loan from Fleet just as hard at running banks as they did buying them. Total about the time the deal was completed. He was offered a return to shareholders, combining improvements in stock better interest rate on the loan, he says if he opened a price and dividends paid out, grew at a compound annual checking account, from which loan payments would be rate of about 19% over the past 10 years. Earnings per share automatically drafted. “It is not my primary checking growth, however, averaged a more modest 9.8% over the account,” he said, suggesting that selling him additional same period, rising from $1.52 per share in 1994 to $3.86 last services isn’t especially likely. year, according to Second Curve Capital, a New York-based Thomas K. Brown, the head of Second Curve Capital, is hedged fund that invests primarily in financial stocks. particularly doubtful about business drawn in by pitching If by most measures, BofA’s integration of Fleet into its free checking accounts. “We know that churn on free organisation has gone fairly smoothly, there have been checking accounts with no minimum balance is 40% to some stumbles. Massachusetts politicians, reacting to 50% higher than it is on a regular checking account,” rounds of staff layoffs and relocation of business units in Brown said, adding that he believed that staffing cuts were the first few months after the deal closed, charged BofA last going to hurt customer service before long. August with reneging on promises it made in the course of One other measure, however, suggests that the getting regulatory approval for the acquisition to retain combination of BofA and Fleet is safely on track. existing staffing levels and to keep several businesses Notwithstanding statements by Webster Financial headquartered in Boston. The state treasurer briefly executives and occasional other competitors, bank threatened to pull about $120m in state deposits from the executives in Fleet’s former territory have been bank. The Boston Globe, the region’s largest newspaper, uncharacteristically quiet. Their counterparts are often only spared no ink in reporting on the clamor, ensuring that too happy to talk about the disaffected customers they’ve BofA’s new customers knew all about the dispute. picked up after bank mergers happen in their markets. But Lewis travelled to Boston within days of the first headlines when they talk to analysts about the new competitor from and apparently soothed hurt feelings, explaining that as many North Carolina, Polini, the Midwest Research analyst, they part-timers would be hired as full-timers were let go and say,“They are a lot tougher than we thought.” c-9

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voting THIS way AY BACK IN 1988, the United States’s Department of Labor (DoL) ruled that voting rights are plan assets under the Employee Retirement Income Security Act (ERISA) subject to sponsors' fiduciary duty to manage assets in the best interests of beneficiaries. That requires plan sponsors to vote shares unless the cost is prohibitive, an obligation most sponsors delegate. “Proxy voting is actually ceded to the investment manager that has been retained by the plan sponsor,” explains Bruce Kosakowski, a senior consultant at Mercer Investment Consulting, Inc.,“The sponsor’s guidance is to comply with the spirit and the letter of enhancing the value of the securities,”he says. Investment managers provide voting policies to plan sponsors for review.“You get a booklet that says we will typically vote with management in these circumstances, we will oppose management in others,” says Kosakowski. “At least annually, plan sponsors request a summary of what proxy votes managers were faced with and how they voted, and to affirm that they were in compliance with the guidelines,” he adds. Handing off responsibility insulates sponsors from pressure to direct votes but does not diminish their liability as fiduciaries. Managers’ voting policies have evolved as the scrutiny of votes has intensified. “We see a much greater emphasis on issues that could be perceived as conflicts of interest,” Kosakowski continues, outlining

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EQUITY REPORT: VOTING RIGHTS

Some fifteen years ago, most institutional investors suffered "the slings and arrows of outrageous fortune" in sometimes supine indifference to the power of the vote. If a company performed poorly institutions sold their shares and moved on. During the 1990s, investors began to vote for improved corporate governance and often times management changes at underperforming companies. Institutional investors must balance a duty to maximise investment returns against a responsibility to exercise voting rights – and the cost. Neil A. O'Hara reports from New York.

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examples such as “the composition of boards, outside directors’ qualifications, the number of outside directors, things like that.” Although plan sponsors must monitor votes, they have no legal obligation to disclose voting information to beneficiaries. Michael Garland, corporate transactions coordinator at the American Federation of Labour-Congress of Industrial Organisation’s (AFL-CIO's) Office of Investment notes that multi-employer union pension funds and public funds – that are not subject to ERISA but operate under similar rules – often post proxy votes on their web sites, but corporate plans do not.“I don’t know of any single-employer plan that discloses their proxy votes in any way,”he says. A recent General Accounting Office (GAO) report, initiated by Senator Edward Kennedy, a long-time ‘Big Labour’ ally and leading Democrat, recommended that Congress amend ERISA to give plan participants access to proxy votes cast on their behalf. It is unlikely however that the GAO will get its way. Allegedly, the DoL has disavowed the proposal – though it has not given any official reason why. In any case, the Republican-controlled Congress is unlikely to pursue the idea. Corporate pension plans may escape voting disclosure for now, but mutual funds are already in the spotlight. In April 2003, the US’s Securities and Exchange Commission (SEC) adopted a rule that requires mutual funds to disclose both how they make voting decisions and the proxy votes they cast. Peter Clapman, senior vice president and chief counsel, corporate governance at TIAA-CREF, the New York based financial services group with $325bn in combined assets under management, blames a convoluted US regulatory structure for the inconsistency. “I strongly believe it is proper public policy for voting disclosure to happen,”he says,“The SEC regulates mutual funds. It does not regulate administrators of pension funds. It is a question of the authority of the SEC to do it.” Mercer Investment Consulting’s Kosakowski believes investment managers oppose voting disclosure more than plan sponsors. Suppose a firm manages pension funds for two companies, A and B, B’s pension fund owns shares in A. If governance issue comes up at A the firm votes a proxy against A’s management. B releases the proxy vote to participants, who make it public.“All of a sudden company A looks at the manager and says, “you voted against us? Well, you’re not going to manage money for our pension plan,’”he says. Money managers may skirt conflicts by hiring third parties such as the Rocksville Maryland-based Institutional Shareholder Services (ISS), a leading provider of corporate governance and proxy voting services, to provide independent voting advice. The Investment Responsibility Research Center (IRRC) takes a different approach: its software allows managers to automate voting after they select criteria to drive the decision.“As long as they stick to their policy and don’t change the vote for some particular event then there's no possibility of being accused of having made the vote with a conflict,”says Carol Bowie, director of

Bruce Kosakowski, a senior consultant at Mercer Investment Consulting, Inc.

IRRC’s Governance Research Service. Shareholder organisations concerned about conflicts of interest pressed for voting disclosure for years before the SEC acted.“When it comes to proxy voting by investment managers, we believe it is important that the voting is truly independent and free from pressure from the marketing, investment banking and client management sides of the business,”says Ann Yerger, deputy director at the Council of Institutional Investors (CII), “The Hewlett-Packard vote highlighted the need for independence. It also highlighted the fact that optics do matter. No matter what Deutsche said, it simply looked bad.” A last minute switch by Deutsche Asset Management tipped the balance in favour of the merger between Compaq and Hewlett-Packard – after Deutsche’s investment bankers, who were advising Hewlett-Packard, called a meeting with asset management personnel to discuss the proposed merger. Activist shareholders face a dilemma: they bear all the costs but must share the benefits with others. Institutional investors may bear a cost for supporting activists, too. Most large institutions enhance their investment returns through stock lending programs, but cannot vote shares lent out. The voting right passes to whoever buys shares from the short seller who borrowed them. If the stock lender wants to vote, it must call the shares back over the record date and forgo the incremental income. “Securities lending is a very lucrative sideline for these big institutions and they're not about to give it up,”says Bowie. TIAA-CREF applies a cost-benefit analysis to its lending program.“If we have lent stock in a company where there are serious shareholder issues that come up for a vote then we will recall the shares,”says Clapman,“We will weigh the governance potential that our votes could produce against the economic benefits of the stock lending.” The opportunity cost may be high for controversial votes on share exchange mergers like Compaq and Hewlett-Packard because arbitrageurs bid up the price for borrowing stock when the supply gets tight.“We would never abandon our vote in a situation like that,”he says,“We would feel it more

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important to weigh the merger for its economic terms and investment merits.” Clapman also worries about arbitrageurs gaming the system to claim votes. Perry Corp.’s recent manoeuvre in the proposed merger between King Pharmaceuticals and Mylan Laboratories illustrates his concern. Perry owned a large position in King, hedged by a short position in Mylan designed to match the shares it would receive if the merger went through. Faced with opposition from Carl Icahn (the noted corporate raider of the 1980s and now shareholder activist), Perry entered into derivative transactions that gave it the right to vote 10% of Mylan in favour of the merger without any continuing economic interest in the shares. “That hypothetical would be quite alarming to us,” says Clapman, who declined to comment on the Mylan case, “People who are not motivated in the best interests of the shareholders of either company are seeking to have a role in determining the fate of the merger. I think that raises very significant regulatory concerns. It is the integrity of the system that is at stake.” Although proxy votes seldom carry so much weight, shareholder-sponsored resolutions must pass a costbenefit test before they attract support from institutions bound by a fiduciary duty to maximise returns. “Shareholder resolutions where the issue is purely social or may have a political overtone might not qualify,” says Clapman, “But practically all of the corporate governance issues do – annual election of directors, poison pills, expensing of stock options, independence of the board, the main focus issues on corporate proxy statements. Corporate governance has a direct relationship to long term investment returns, taking the portfolio as a whole.” Nell Minow, editor at The Corporate Library, points out that social activists have learned to couch resolutions in cost-benefit terms. “You can only vote in favour of things like that if they are quantifiable and will be in the best interests of investors in the long term,” she says,“It is not that outlandish to do that. I don't make a bright line distinction between social responsibility and shareholder returns. I think they are intertwined.” The business community often portrays shareholder activists as a monolithic anti-management bloc, a view Garland disputes.“People in the social investing community are frustrated by the fact that we have permission under our guidelines to be active with social issues,” he says,“Unions are more concerned with making sure the corporations are around down the road to pay.” If social proposals impose significant costs, companies in financial distress may cut benefits or close pension plans to new employees. The growing popularity of indexed investments has created another activist class: shareholders who cannot sell.“Our average CII member indexes 50% of its domestic equity portfolio, which means you’re in these stocks whether you like it or not,” explains Yerger, “So then the question is can you effect change other ways through your ownership?” Institutions can use the voting power in indexed portfolios to make common cause with unions and

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socially responsible groups on corporate governance without supporting agendas dedicated to organised labour, human rights or the environment. The SEC’s much-criticised proposals to give shareholders access to management's proxy in certain circumstances could empower investors with indexed portfolios. Only shareholders who have held shares for two years qualify to nominate directors, so would-be activists may have to co-opt passive holders. “The corporate side was saying, ‘if this goes through, everyone is going to be casting votes willy-nilly against the directors’,” says Yerger, “Our attitude was that people may be even more careful with those votes because they realise there are real consequences.” A vote withheld today is an easy protest. The director nominee will be elected to the board as long as one shareholder votes one share in favour. Bowie does not think activism will let up even if the SEC drops proxy access altogether.“In 2005, we expect to see a lot more of a shareholder proposal that’s been suggested as an alternative to proxy access, what's called majority vote director elections,” she says, “It is standard practice in the United Kingdom. Directors are elected by a majority. If they don’t get a majority they're not seated.” A vote withheld becomes equivalent to a vote against the candidate in a majority election. If Bowie is right, institutions awash in a sea of troubles will not lay down their arms – or votes – any time soon.

Peter Clapman, senior vice president and chief counsel, corporate governance at TIAA-CREF

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FUND PROFILE: CANDOVER

Limited partners prefer consistent performance from their private equity investments and the European mid-market sector has tended to deliver and deliver again. Perhaps few midmarket private equity houses have delivered more consistently than the United Kingdom’s (UK’s) Candover Investments, which has given back some €2bn to investors since January 2003 alone. Francesca Carnevale details the key drivers and deals behind the buyout firm’s success and looks at how the firm might fare in the newly changing European buyouts sector.

Upfront&personal Marek Gumienny, Candover’s managing director

NUSUALLY, AMONG THE UK’s sometimes reclusive buyouts community, there is a strong element of amity at Candover Investments plc. In fact, it is elemental to the firm’s business method. Scratch Marek Gumienny, Candover’s managing director, and he says that in 25 years of working in the European buyout market, his favourite deal was the €393m acquisition of Swissport in February 2002. It is a signal choice and typifies Candover’s consonant approach, even in the face of adversity. Swissport was the ground handling division of Swissair. Candover had been asked by the carrier to come up with a fully financed bid over a long August bank holiday weekend the previous year. “The due diligence was ongoing with September 11. At the time, the aviation business was simply the worst place to be. If we had walked away then from the deal, no one would have blamed us,” explains Gumienny. Three weeks later, Swissair went bust as its banks pulled the plug. “Again, no one would have criticised us for walking away. But we stayed. We really liked the team, we had met

them back in July 2001, and we wanted to back them. So we gave it our best shot.” Candover’s is very much a personal involvement. Neatly encapsulating the firm’s particular approach, Gumienny explains:“We back management, we don’t buy businesses.” Even so, there was more than forbearance in Candover’s method with Swissport. As the century turned, market watchers predicted that ground handling would eventually be dominated by only a handful of global companies. Among them Swissport loomed large. Other trends were also in line. The market was increasingly described by a bustle of takeovers. Europe, in particular, was a hub of acquisition activity and deal flow progressed at a sometimes incestuous but always staggering rate. France’s Penauille Polyservices, for example, acquired Lufthansa’s baggage handling arm Globeground only to merge it the following year with Servisair. American Airlines’ AMR Handling Services became Worldwide Flight Services (WFS), which then was merged with cargo handling

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company SFS. SFS was then, in turn, purchased by the Partners, JP Morgan Private Equity and 3i. Highly focused, French Vinci Group. Elsewhere the UK’s Menzies Aviation these pan-European players dominate the larger end of the had bought the US’s Ogden Aviation Services and KLM’s buyout market yet still work at the lower end of the buyout cargo handling arm, Cargo Service Center (CSC), was chain. Sometimes in competition, sometimes in tandem, acquired by Germany's D-Logistics. The German firm was they continue to redefine a sector that is in constant transition. Together, for instance, they have stretched the then sold to Swissport in 2002. Most carriers still buy ground handling on a station by definition of the mid-market from a deal value range of station basis and often times use the same handler for £10m to £200m five years ago to £15m to $1bn today. more than one airport. Extended relationships, it seems, According to Gumienny, “you need a broad footprint to count for much in the ground handling business. In August make it in the mid-market these days.” Candover was established in 1980 (structured as an 2003, Swissport took over the entire worldwide ground handling work of Swiss International Airlines on a three- investment trust) by Roger Brooke, variously described as year contract, and in April of the same year it signed a 60 the founding father of buyouts in the UK, who was joined station, five-year deal with KLM. Historical relationships soon after by now chairman Stephen Curran, Doug underpinned each agreement. Swissport had been owned Fairservice (until recently deputy chairman) and managing by Swissair and, remember, Swissport had also bought directors Marek Gumienny and Colin Buffin. The firm listed on the London Stock Exchange four years later. CSC from KLM via D-Logistics. Investing in businesses worth an aggregate enterprise Swissport now handles cargo at some 169 airports (in comparison WFS handles cargo in more than 100 stations). value of approximately £9bn throughout 2003 and 2004 Other firms are spread around in the ground handling Candover is one of the most acquisitive of the UK-based sector’s own version of market globalisation. Swissport and, mid-market buyout firms. “We’ve been around for a long time,” acknowledges by default, Candover, were Gumienny, “and we soon on a roll. Upsides, consistently punch above our unfortunately, are neither weight. I think we have a ubiquitous nor everlasting. In In bad times as well as good Candover has straight-talking and honest mid November last year, shown remarkable resilience, a sure-fire (open) approach. Our Swissport shocked the component in its success. Gumienny says it reputation is everything and industry by closing its passenger handling is all down to the quality of people that the we, frankly, guard it jealously. operation at London’s firm selects as business partners. “You see It is not immodest, I think, to Heathrow airport after it time after time, the difference between an state that we feature in most of the market’s leading several years of reported owner manager and an employee. It transactions.” losses. The company supplied reinvigorates everything.” Investments in buyouts check-in services to a number are provided by Candover of airlines at Heathrow Investments plc and from including Aer Lingus, El Al, third party funds raised and Cyprus Airways, Air China and Hellas Jet. Swissport’s cargo handling operations at managed by Candover Partners Limited, a wholly owned subsidiary of Candover Investments plc. Typically, the firm Heathrow, however, survived unscathed. In bad times as well as good Candover has shown works with a financing structure that keeps to a ratio of remarkable resilience, a sure-fire component in its success. 70/30 split between debt and equity, “sometimes 65/35,” Gumienny says it is all down to the quality of people that says Gumienny. “In periods where liquidity is tight, then the firm selects as business partners.“You see it time after the equity sometimes goes as high as 50%, but this is time, the difference between an owner manager and an refinanced to a safer 70/30 as soon as it is possible to do employee. It reinvigorates everything.” In the case of so,” he adds. Since its inception, Candover has raised and Swissport Gumienny says: “We just kept going. We had to managed eight funds, with aggregate capital commitments deal with Swiss bankruptcy courts and, at the same time, over €5bn. To date, Candover reports having invested in back a bottom-up business plan in a business area that was over 123 buyouts, worth an aggregate €25bn. Although the effectively in a downturn. It gave us a level of confidence in firm will hold an acquisition in its portfolio for a period the business. Ironic, isn’t it, after six months of difficult anywhere between three to seven years, it has exited from circumstances? Now the business is doing very well almost 90% of these investments.“The ability to exit a deal (despite SARS) and we are on track for an initial public is a paramount sign of success,” he notes. There are also other benchmarks. Candover has realised a gross internal offering some time in 2005.” In the dynamic that is the European buyout sector rate of return (IRR) of 33% over 24 years. “Our optimum Candover has come to prominence amid an upper mid- area is the €200m to €2bn deal. With a fund size of €2.7bn, market crowd that includes names such as Apax Partners, we are limited to a degree. We tend work with investments Permira, Cinven, Barclays Private Equity, Bridgepoint that are between 13 and 17 times our equity investment. In

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Candover: Some key acquisitions in 2003/4 Date

Target

Nov-04 Bureau van Dijk Electronic Publishing

Advisors/Arrangers/Price

Not known. Reported in the region of €370m

Sector

Media Electronic Publishing team holding 40%. NOTE: Candover bought it because of its specialised products that had strong brand definition. Nov-04 ALControl, which was owned by BNP Paribas for Environment UK buyout firm Bridgepoint Bridgepoint; while the & Food Partners that had bought the debt portion was provided company for €112m in 2000 from by Dresdner Kleinwort Kelda. Wasserstein and Bank of Scotland €340m

Acquirors

Candover aquired a majority stake with the current management Markus/Dafne and Aida. Candover/Cinven

Candover fought off competition from Warburg Pincus, Apax Partners, JP Morgan Partners and ABN AMRO in an auction arranged by BNP Paribas. NOTE: Bridgepoint is reported to have generated a cash multiple of roughly five times its original investment. Sep-04 Innovia Films Debt financing was provided Speciality Candover It was sold by UCB Group, a by UBS and Royal Bank Pharmaceuticals speciality pharmaceuticals group. of Scotland. (polypropylene (formerly UCB Films) €320m and cellulose films UCB is a quoted Belgian company. & polymer banknotes) NOTE: Unsurprisingly, the polymer banknote business was deemed attractive. Polymer banknotes are difficult to counterfeit and are now used in over 22 countries and Innovia Films produces the high security polymer substrate used in the production of the notes. Jul-04 Vetco International Debt & mezzanine Oil Sector Candover/3i/JPMorgan The company was owned by finance arranged by Upstream Partners/NIB Capital Asea Brown Boveri (ABB) JP Morgan, CSFB combined put in and Bank of Scotland. $420m of equity $925m with a possible deferred consideration of $50m. NOTE: Vetco International Operates through two subsidiaries: Vecto Gray and Veco Aibel. May-03 BertelsmannSpringer Goldman Sachs Media – it is Candover/Cinven owned by Bertelsmann UBS Warburg a specialist in They had previously AG (Germany), which will €1.5bn [£650m] scientific bought Wolters now focus on its TV interests publishing. Kluwer’s academic & Random House publishing publishing arm for in the UK and cut its debt burden some £600m. NOTE: Candover & Cinven hold equal equity stakes. On acquiring the company they announced they would merge it with Kluwer Academic publishers (KAP) to create an STM publisher with combined revenues of some ?800m/year and EBITDA of ?155m. Renamed Springer, the company is the clear No. 2 in the global STM market behind Reed Elsevier. Mar-03 The Gala Group, sold by PPM Close Brothers advised CSFB Retail gaming Candover/Cinven Ventures and CSFB Private Equity Private Equity & Gala group The firms each put in (Before the sale, an IPO had Acquisition finance £274m in equal equity been considered and Close Brothers arranged by CSFB and stakes in the company. had secured some £400m in debt Merrill Lynch. financing had it gone ahead.) €1.9bn NOTE: Gala is the UK’s fastest growing retail gaming company. Enjoying a 40% market share, it is the UK's largest casino owner with 28 sites in the UK, Isle of Man and Gibraltar. Potential deregulation in the UK added to the attraction of this deal in anticipation of an easing of gaming laws Gala signed an memo of understanding with Harrah's Entertainment for the development of large regional casinos in the UK. Candover/Cinven had previously tabled an offer for the group in 2002 as did Permira and BC Partners.

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Company

Sedol

Exchange Country Sub sector

Candover Investments 0171315 London

c-0

c-9

bigger deals, we tend to partner with another buyout firm, galactic in its proportions. “In private equity, the potential and in this instance may allocate 10-12% of our fund as a rewards are in multiples of two or three times for an institutional shareholder, while management could make maximum equity investment,”Gumienny says. Candover currently manages its 2001 Fund, which closed 20 or 30 times”explains Gumienny. Candover is particularly noted for its diverse investment at €2.7bn in June 2002 and is focused on businesses (or more precisely, management teams) across Europe. The spectrum. Offshore upstream oil services, specialist film fund closed higher than its target of €2.5bn, with more than packaging, retail gaming and academic publishing have 110 investor groups taking up investments, including the formed the business backbone of the firm’s principal California Public Employees' Retirement System acquisitions during the last three years (please refer to Table (CalPERS: please refer to FTSE Global Markets, Issue Two, 1: Candover’s principal investments in 2003, 2004 and 2005). July/August 2004, page 24.), The Canada Pension Plan The company has exploited opportunities across Europe via its offices in London, Investment Board, The Paris and Düsseldorf, and Metropolitan Museum of Coming to Prominence – a local advisor in Madrid. Art, HarbourVest Partners Candover Investments vs. 3i Group & FTSE Developed In fact, Candover was LLC, insurance giant Europe Investment Companies All Cap Index among the first of the UK Swiss Re and funds 180 160 buyout houses to open an managed by UBS AG, 140 office in continental Pantheon and Standard 120 Europe (Deutsche Life. UBS Warburg was 100 Candover) back in 1987. A placing agent in Europe, 80 number of deals were the Middle East and the 60 done out of the office, with Asia Pacific regions for the 40 mixed success. By 1995 2001 Fund, while 20 Candover had replaced Benedetto, Gartland & the first office with a joint Company Inc., took on the venture in partnership role in North America. Candover Investments 3i Group with L&G Ventures, which “The 2001 Fund was FTSE Developed Europe Investment Companies All Cap Index ran until 1998 when, due considerably larger than Data as at 31 January 2005. Source: FTSE Group/FactSet to strategic differences, the our previous fund, agreement was called off. reflecting the number and size of investment opportunities we envisaged, both in the By then Candover's 1997 fund had made two German UK and on the continent,”says Gumienny.“Overall, in spite investments: the first backing a pipeline integrity services of the downturn in the buyout sector since 2002, for company, Pipeline Integrity International (PII), to acquire a Candover it was a very productive period for buyout German-based competitor and the second, in PVC investing, with liquidity to hand for good deals, a growing manufacturer, Vestolit. Candover later returned to the European network and a sizeable fund to put to work, we Continent in force, opening offices in Paris in June 2001 were kept busy.”The next round of fund raising will begin and then in 2003, another office in Dusseldorf. Corporate spin-offs and family sales in the all-important in 2005, with the fund closing some time in 2006, expects Gumienny. “On average, we go to the market about once German Mittelstand [loosely translated as middle market] are the main drivers of deal flow in Germany. Dusseldorf, every four years or so,”he explains. Private equity is one of the few businesses “where all the located in Germany's industrial heartland, is an ideal money sits around a table at least once a month and location from which to pursue potential targets. In spite of everyone is pointed in the same direction,”says Gumienny. the firm’s early chequered success in Germany, the opening “It is not like the stock market, where shareholders might of the Dusseldorf office was a logical step. Germany and meet on a half yearly basis.”The philosophy ensures very France are the largest economies in Europe “and presently, few deals go awry. That level of intervention and in our view, are among the countries which offer the most immediacy is also vital to the effective management of a interesting investment opportunities,”says Gumienny. Including the Benelux and Scandinavian countries, over large investment where the risk/reward ratio is potentially

Full Market Member of Capitalisation (GBPm)

Investment Companies 337.2

FTSE UK Mid Cap Index, FTSE Global Small Cap Index Data as at 31/01/2005

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Number of Deals

Value of Deals (€)

FUND PROFILE: CANDOVER

half of Candover’s deal flow now comes from the amortisation (EBITDA) multiples. Sales of mid-sized Continent. This is Candover’s heartland and it is unlikely companies in particular are receiving some of the best the firm will venture out of the region.“At present, the UK prices in years. The market remains strongest for mid-size provides broadly one third of Europe’s buyout volume. If and large buyouts, with a steady performance in terms of you look at the potential size of the market relative to gross number and value.“I think we are in for a major shift in the private equity world,” notes domestic product (GDP), Gumienny. “We are in a then volumes in Europe period where the size of should be four times as large. “Three weeks later, Swissair went bust both deals and funds are It is a huge opportunity,”says as its banks pulled the plug. Again, no rising. There’s a lot of money Gumienny. “The UK, France, swimming about out there.” Germany, Holland and one would have blamed us for walking. The buyout market showed Scandinavia are good But we stayed. We really liked the team, impressive results in an markets for us. Each country we had met them back in July 2001, and otherwise quiet period has its specific issues, but we we wanted to back them. So we gave it during Q3: the value of are not being tempted by our best shot.” buyouts jumped 42% Asia or other continental compared to the same regions. If nothing else, they period last year. The number are too far away!” Candover acknowledges a growing interest in private of buyouts in Q3 reached 113, compared with 99 in Q2 and equity investments among pension funds and mutual was driven by the strong performance of mid-sized and funds. The sector and Candover’s consistent performance in large transactions. Family and private vendors were the most prolific source of buyouts in the quarter, replacing Europe explains why. Private equity in Europe (and the mid-market sector in corporates, while the number of secondary buyouts rose by particular) is witnessing a marked return to confidence 20% from the previous quarter, with the vendors in 30 of after a protracted period in the doldrums between 2001 Q3 buyouts being institutional investors. The mega-deal will become ubiquitous in this latest through 2002 and most of 2003. Exits, in particular, were pretty hard to come by in 2003. The United Kingdom-based cycle, thinks Gumienny.“I certainly think we will see more Centre for Management Buy-out Research (CMBOR) €3bn to €10bn type deals. Undoubtedly, the bigger deals calculated that there was a record £37bn pipeline of private will bring more people to the table,”he maintains.“In club equity-backed buy-outs looking for an exit back in 2003. deals however you need to ensure that everyone has the With trade buyers few and far between and a moribund same philosophy. It is not always easy to secure – and if you initial public offering market, secondary buy-out activity do not, and there are squabbles, you end up with a bloomed. There were only 28 trade sales in the UK in the dysfunctional investment.”Ultimately, in Candover’s world, first half of 2003, according to CMBOR figures, compared it all boils down to the quality of people around the table. with 79 in the whole of 2002 and 95 in 2001. A modest but discernable pick up in merger and acquisitions (M&A) Volume and Value of European Private Equity Backed activity during 2004 and a steady recovery in the debt and Buyouts 120 25000 equity markets have improved exit routes. At €21.7bn, the total value of private equity transactions increased by 43% 115 20000 in the third quarter (Q3) of 2004, compared with Q3 2003, 110 15000 according to the quarterly deal Barometer, published by Initiative Europe, in conjunction with Candover. 105 10000 In the first nine months of 2004, the value of closed 100 5000 buyout deals rose 27% year on year, totalling €60bn. M&A 95 0 deals per se are up across an array of industries, as are Q2 3003 Q3 3003 Q4 3003 Q1 3004 Q2 3004 Q3 3004 earnings before interest, taxes, depreciation and

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CANDOVER FUELS MID-MARKET DEAL FLOW

exploration of new export markets and two acquisitions ANDOVER PRODUCED A string of deals throughout – Italian snow-chain maker Konig SpA and the US 2004 and early 2005 that underscored the firm’s trailer manufacturer C&C Distributors Inc. prestige in the mid-market sector (please refer to Table Thule is now the biggest vendor of car racks and 1: Candover’s principal investments in 2003, 2004 boxes with a 40% world market share, and the and 2005). It began the year as it meant to continue. European leader in bike carriers, trailers and snow In January, working in a private equity syndicate with chains. The firm had sales of Skr2.2bn (around JPMorgan Partners, Candover and 3i, the firm $310m) in 2003 and third quarter earnings in 2004 purchased part of Swiss-Swedish group Asea Brown were reportedly up 34% year on year. Deutsche Bank Boveri’s (ABB's) oil & gas business for $925m, with a advised on the deal, while Royal Bank of Scotland deferred consideration of an additional $50m. The Group plc and UBS Investment Bank provided debt acquisition covered ABB Vetco Gray, including ABB's Oil financing as part of a leveraging strategy to boost the & Gas business in Brazil, and ABB Offshore Systems, firm’s growth rate to an including ABB's annual average of 10%. International Oil & Gas EQT was an ambivalent counterparty and Thule management Modification and Maintenance business. ran a dual-track process: planning either to reportedly took a 20% stake in the deal. Candover, 3i and JPMorgan list half the equity in Thule AB on the The deal came amid a Partners, together with coStockholm bourse or sell it privately, string of buys and exits in investors NIB Capital and whichever option gave it more money. EQT the auto parts industry in Vetco International's senior finally chose the latter, as it made most 2003 and 2004. Recent management, committed a deals include a $1.17bn total of $420m of equity in money via a private sale. sale in September by the deal. Debt and Cooper Tyre & Rubber Co. mezzanine financing of of its auto parts business to Cypress Group and approximately $653m was provided by a syndicate of Goldman Sachs Capital Partners. In Germany, Citicorp banks led by JPMorgan, Bank of Scotland and Credit Venture Capital Ltd. sold German transmission parts Suisse First Boston (CSFB). maker, A. Friedr. Flender AG. Meanwhile Carlyle Group Candover’s previous investments in the oilfield sold engine block maker Honsel International services sector have included Expro International, a Technologies Holdings Sarl and put up ignition provider of oil and gas field services, which Candover specialist Beru AG for auction. backed in 1992 and was floated on the LSE in 1995. Not all of Candover’s deal efforts were successful As stated earlier, the firm had bought PII back in however. The UK Daily Mail & General Trust and 1999, a market leader in oil and gas pipeline Candover submitted indicative takeover bids for Hollinger inspection services. In 2003, Candover had also led International, which owned the Daily Telegraph and the €141m management buy-in of Wellstream, a Sunday Telegraph newspaper titles, to the tune of more manufacturer of flexible pipe for the offshore oil and or less £500m in the early part of the year. In the event, gas sector, from Halliburton Inc. it was bought by the Barclay brothers, owners of The In the ABB deal, as with Swissport, the equity Scotsman, who submitted a separate offer for Hollinger syndicate backed a proven incumbent management Inc, the holding company of Hollinger International. team. That emphasis was also on show in October Candover’s latest deal is the acquisition of 2004 when Candover brought together a high level ALcontrol, a leading European environmental and food board of directors with strong international experience testing company. Headquartered in Holland, ALcontrol for the purchase of Thule AB from Scandinavian uses fully automated testing procedures to conduct buyout group EQT Partners AB for €465m. The deal high quality and rapid sample analysis for customers was won in competition with Investcorp, Montagu who include government bodies, engineering Private Equity Ltd., Nordic Capital and Warburg Pincus companies, environmental and regulatory authorities, LLC. EQT was an ambivalent counterparty and ran a major utilities and food manufacturers. Operating in a dual-track process: planning either to list half the fragmented industry with considerable opportunities for equity in Thule on the Stockholm bourse or sell it consolidation, ALcontrol has a track record of both privately, whichever option gave it more money. EQT organic and acquisitive growth. As regulators impose finally chose the latter, as it made most money via a tighter health standards in both food and private sale. Prior to divesting Thule EQT had pushed environmental areas, the company’s growth prospects the firm into an extensive development program, which make this an interesting investment. entailed the building of three factories in Poland,

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ALTERNATIVES: PRIVATE EQUITY

A NEW LOOK at private equity After a hesitant start, more pension funds are now allocating assets to private equity investments. There are sufficiently strong reasons for growing interest in this sector. Private equity can offer the potential of better returns than some other asset classes and it also provides a degree of diversification from quoted equities. Stephan Breban, a senior investment consultant at global consulting firm Watson Wyatt, explains the principal arguments for and against. VER THE LAST few years, private equity investment has been on the agenda of many fiduciaries. One might expect this to lead to a considerable level of investment in the asset class. In fact, it is not the case. Overall interest in the private equity sector has been surprisingly low. Some caution is understandable. There is no doubt that private equity is among the riskier of asset classes. However, the sector does offer superior returns to investors – potentially of the order of 5% per annum in excess of quoted markets. From that vantage point it is definitely worth a closer look. Private equity should be considered in two separate subsectors, buy outs and venture capital. Each has its own investment characteristics and each offers distinct

risk/returns which should, theoretically, broaden their appeal. Buyout returns, for example, are significantly less volatile than venture returns and can be less volatile than some quoted markets. There are good reasons why this should be the case. Not least is the simple principle that buyout investment tends to have a significant value bias. Market participants generally accept that value style investment is likely to lead to less volatility than index returns. Then again, private equity also involves a higher level of information being put on the table at the point of investment than is the case with quoted investments. Another consideration is shareholder activism, which is inherent in buyouts. If an investor in quoted equity no longer has confidence in a company’s management, they simply sell the stock and walk away. It is a safe option, but it does not, as a strategy, benefit the company. In private equity however, owners consider their options and then involve themselves in helping to sort out problems. Either they add experts to the management team; replace one or more managers; or, in extreme cases, change the whole lot. They do not always get it right, but in most cases some action is going to be better than none at all and in many instances appropriate intervention can reduce downside volatility and enhance performance. What about investments in venture capital? It is accepted that this sector is more volatile than quoted markets.

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Table 1: Private Equity Returns to 31 December 2003 (Returns in US dollar) Asset class

12 months (%)

All private equity (US primary market) Venture capital funds (US primary market) Buyouts (US primary market) Other private equity (US primary market) S&P Composite Overseas equities (FTSE All World (ex UK)) UK equities (FTSE All-Share) UK Fixed interest gilts (FTSE All Stocks Gilts) UK Index linked gilts (FTSE All Stocks ILG)

18.7 7.8 25.2 22.8 28.7 34.3 34.4 13.5 18.5

3 years (% pa)

5 years (% pa)

10 years (% pa)

-5.7 -16.7 -1.3 -0.5 -4.0 -3.3 -1.0 11.3 11.2

7.3 24.4 2.7 3.1 -0.6 0.4 0.4 5.9 6.1

12.8 25.7 8.0 7.8 11.1 5.7 8.2 9.1 8.6

Source: Venture Economics, Russell/Mellon. Past performance is not a guide to future investment returns

However, while this precept is true when the sector is compared to broader markets, venture investing is no more volatile than, say, investing in the NASDAQ. In any case, there are few investors who would place all of their assets into venture capital, or the NASDAQ for that matter. Most invest in both venture and buyouts at the same time. Private equity also offers diversification benefits. We all accept, for example, that small companies add diversification to a portfolio of large companies, reducing total fund risk. On the same basis private equity can reduce total fund risk if added to a quoted equity portfolio and can reduce total fund volatility relative to liabilities.

Return versus workload Invariably quoted equities add risk to a portfolio. They also take time to put in place, administer, and monitor. Even so, pension plans invest in quoted equities to achieve higher returns than they would otherwise achieve in more closely matching assets such as bonds. The equity risk premium varies over time, and is often broadly expected to be within a range of 2% and 4%. Conservative estimates of the additional premium on private equity vary between 2% and 5%. Admittedly we are usually talking of investing a smaller proportion of assets in private equity. Therefore the premium needs to be higher on a smaller proportion of asset in order to justify the expenditure, which tends not to vary with the proportion of assets invested in the asset class. However, other alternatives are included in portfolios when most participants expect them to detract value compared to quoted equities. So if we consider private equity relative to other alternatives we are looking at a premium of 3% to 6%. In addition, allowing for some skill in manager selection, one could assume returns of up to 10% per annum in excess of quoted markets. Even venture capital, which has experienced the worst three years in its history, has outperformed the quoted market over periods longer than five years. Private equity is relatively illiquid. It is difficult and costly to sell early. This could be an issue. There are circumstances when it might become a problem for a pension fund, for example:

FTSE GLOBAL MARKETS • MARCH/APRIL 2005

• The sponsoring company undergoes a corporate action, and some of its liabilities are transferred out, • The plan is wound up and all liabilities are bought out, • A change in the fiduciaries or the governance structure may lead to a different outlook towards the asset class. The severity of these cases varies, but they need not necessarily require an immediate liquidation of the investments. In the first instance difficulties can arise if the plan receiving the liabilities is unwilling to accept private equity as part of the asset transfer in respect of the liabilities. This, like so many other pension fund issues, could be resolved in the original sales and purchase agreement. In the past, the pension fund was the last thing on peoples’ minds when considering corporate actions. These days that is not the case. Hopefully this consideration will be one positive consequence of private equity firm Permira’s failed attempted acquisition of the United Kingdom (UK) high street retailer WH Smith. However, even in the event of the residual plan being left with the entire private equity risk (or exposure) in this kind of situation they can wait for it to run off. A pension fund may have difficulties selling private equity early, but it will automatically disinvest over time anyway. The limited partner structures have circumscribed life and fee incentives, leading the managers to divest in order to receive their profit share. Unless there is an intention to buy out the liabilities then there is no problem. This leads us on to another circumstance. If the plan is buying out liabilities, it will need to sell its private equity investments. While the sale could be costly in terms of the assets held at that point, if it takes place at the end of an extended period of investment, the discount is only applied to a small proportion of assets, and so will not have a major impact on the total return over an extended period. Furthermore, the secondary market is becoming increasingly sophisticated and discounts are reducing. Indeed, in many instances we are actually seeing transactions at a premium. Finally we need to add a little perspective. The only instance where liquidity is an issue is on the complete buyout of the liabilities. Although we have seen many more

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ALTERNATIVES: PRIVATE EQUITY

Stephan Breban, a senior investment consultant at global consulting firm Watson Wyatt

such instances in the UK in recent years, in reality many of these occur in larger plans, typically above £100m. There are few insurance companies in a position to take on such liabilities at an affordable price and so any plan over £100m is unlikely to find itself in this position. Private equity is rarely going to account for more than 5% to 10% of the total assets, and in such circumstances liquidity is unlikely to be a necessity. Illiquidity therefore, is only a problem for those needing to buy out all their liabilities. General partners and fund of funds providers tend to charge fees based on commitments in early years. These are already high, and then they take carried interest on top. Private equity is a relatively labour intensive asset class and fees are high as a result. However, investors often consider performance before the deduction of fees because most performance service providers find it easier and because the fund managers want investors to look at what they have done before the deduction of fees. Importantly, private equity performance should be considered net of fees and that beneficiaries are not paid from gross returns but rather from performance net of fees. In both Table 1 and Table 2, the private equity performance is provided net of all fees, whereas quoted equity performance is provided before the deduction of fees – somewhere between 30 and 80 basis points, depending upon the size of assets and the manager used for active investments.

Governance requirements are higher for private equity than other asset classes. For those who can accommodate the extra time and skill required, we have already shown that it can be a profitable asset class. The issue lies in the management of the level of investment, or the degree of commitment needed to realise a desired level of investment. Although not straightforward, a simple spreadsheet can consider the progression of investments over time. It can also consider how variations will occur, and how different commitment patterns will build up to a certain level of invested capital over time. This needs to be reviewed annually. It is additional work, but can be adequately managed with a small investment in time each quarter, and possibly some advice from a consultant. Clearly the amount of time and effort required depends on the number of managers employed and the degree of complexity of the overall structure. There is mixed evidence in this area and little to support the argument that there is too much correlation. Academic studies suggest correlation levels of about 40% to 60%. Small companies tend to have about 60% correlation with larger companies, so it seems fair to assume that private equity would have a lower correlation (especially on the downside due to both the value bias and shareholder activism). Even accepting that academic studies are based on smoothed valuation data, it seems reasonable to assume a correlation level between 40% and 60%. Around 50% is not unreasonable, and provides suitable diversification from quoted equities, especially given the lower downside correlation. There are many negative perceptions that have held back investment in private equity by institutional investors, but often times these are only perceptions. The Myners Review requires pension fund trustees either to seek education to achieve understanding or to delegate the decision to someone who understands the issues. In light of this trustees should take comfort and not necessarily be deterred by restrictive governance budgets. Private equity offers the potential of better returns than other asset classes and some diversification from quoted equities. It takes more effort, for those willing to allocate the limited additional resources but is well worth the effort. There are sufficiently strong reasons to allocate to this asset class for most trustees to take another, more serious, look at private equity.

Table 2: Returns to 31 December 2003 (Pound Sterling) Asset class

12 months (%)

UK Private equity (BVCA) UK equities (FTSE All-Share) Overseas equities (FTSE All World (ex UK)) UK Fixed interest gilts (FTSE All Stocks Gilts) UK Index linked gilts (FTSE All Stocks ILG)

12.3 20.9 20.8 2.1 6.6

3 years (% pa)

5 years (% pa)

10 years (% pa)

2.6 -6.8 -9.0 4.8 4.7

10.2 -1.1 -1.1 4.4 4.5

14.2 6.1 5.3 7.0 6.5

Source: BVCA, Russell/Mellon – returns are in UK£

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SMALL CAPS

Small caps have performed better than large cap stocks for years. Each year, analysts predict that the cycle will come to an end. But each year, they continue to outperform their larger brethren. Bargains may be harder to find and the general consensus is that small caps will not rise as dramatically as they did last year in the United States, but “significant gains” are set to continue, say commentators.

WHY SMALL CAPS CONTINUE

sweet

T LOOKS LIKE the old chestnut “small is beautiful” still benefiting high growth, high margin sectors. Second, is has some life in it, as smaller capitalisation shares continuing stability in the UK economy, evinced by continue to defy gravity and market expectations and increasing corporate activity, providing support for bring in better returns than larger capitalised company valuations in the small cap sector. Further afield, European shares. The opening years of the new century have certainly small cap equities ended 2004 on a positive note, with the danced to a different tune than the closing decade of the last. FTSE Europe ex-UK index rising by 4.5% in total return. The story is not the same in the United States. In a recent According to data returns from the FTSE 100 delivered online investment chat on returns of 16.5%, compared America Online, US small with 9.8% from the FTSE Battle of the Caps – FTSE 250 Index and FTSE Small cap ‘guru’ H. Giles (Gil) Small Cap Index. Since the Cap Index vs. FTSE 100 Index Knight, portfolio manager start of 2000 however the 170 160 of the Gartmore Small Cap FTSE small-cap index, with 150 Growth Fund, lent a dividends re-invested, has 140 cautionary note to the generated positive returns 130 performance of US small in excess of 6%, while those 120 110 cap stocks in 2005. Despite mid-sized company shares 100 his concerns, Knight said tracked by the FTSE 250, 90 he expected "significant have done even better, 80 70 gains" for small caps this advancing by an annual year, although nothing like average of around 7%. the 18% of 2004. A ‘growth “Small caps have FTSE 100 Index FTSE SmallCap Index FTSE 250 Index momentum’ manager outperformed,” says an Data as at 31 January 2005. Source: FTSE Group/FactSet Knight pointed out that analyst in London, “in the six year up-cycle may particular over the first months of this year. Whether this is sustainable over the peak this year. Early profit taking was taking place he noted, entire year is still open to question, however, it is difficult to but the “economy is in decent shape, consumer spending is call. There will be seasonal effects and small caps tend to good, housing is good, and we do not see a lot of inflation. The system seems to be saying all systems go. We are perform in the first half of the year.” Two main drivers are influencing the small cap sector. looking at a 3.7% GDP growth this year, which for a country The first is the international economic recovery, which is the size of the U.S. is really quite good… overall we have

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SMALL CAPS

tradable stocks are included. quite a positive outlook on FTSE US Small Cap Index vs. FTSE Mid Cap Index and The earnings of cyclical the market as a whole.” FTSE Large Cap Index companies are particularly Even so, he thought that 180 sensitive to the business last year as well. 170 160 cycle. So when “earnings Recent research by 150 surprise on the upside … Standard & Poor’s shows 140 the market is quick to rethat international small cap 130 120 rate the shares. To an stocks fared better than 110 extent this accounts for their large-cap 100 the out-performance of counterparts straight down 90 the cyclicals and hence the the cap-range hierarchy. 80 out-performance of the The exact opposite FTSE 250,” continues occurred in North America FTSE US Small Cap Index FTSE US Large Cap Index FTSE US Mid Cap Index Lenhoff in his paper. That however, where large cap cyclicals continue to do stocks registered the Data as at 31 January 2005. Source: FTSE Group/FactSet well, he suggests, is an stronger returns. According to Nicholas Aninos, an analyst at Standard and encouraging sign, in spite of some signs that “a modest Poor’s in London, much of the decline in small cap slowdown”is underway. That may be true of the United Kingdom, but in Asia, the performance in the US, measured in dollar terms, was however in large part attributable to the dollar’s appreciation story is more positive over the medium term. The key to against other currencies. “The dollar gained against all successful small cap investing in Asia is finding companies developed world currencies to begin the year, with the which few have heard about but have the potential to grow exception of the Korean won.” The trend is both highly and much faster than their counterparts in Europe. As Asia’s fast marginally significant, as small cap stocks (that is, with a growth is expected to continue for the foreseeable future, the market capitalisation of between $100m and $1bn) accounts environment is altogether conducive for smaller businesses for nearly two thirds of investible US stocks. Even so, they to thrive. A note of caution, is however, sounded by Charles Cade, head of research at Close WINS, the investment account for only 8% of the market’s total valuation. If the momentum can be sustained over the next few brokerage and research house, based in London. “Smaller months, then the FTSE 250 mid cap index will be challenging companies can be more volatile as they are generally less its recent peak [please refer to Chart 1: Battle of the Caps].The liquid and less well covered by analysts. Otherwise, the risks performance says Mike Lenhoff, chief strategist at Brewin are similar to other equity based funds,”he says. Although a spate of small cap funds Dolphin Securities in a are available for investors, recent market strategy FTSE Asia Pacific Small Cap Index vs. FTSE Asia Pacific generally the market has paper should not be Mid Cap Index and FTSE Asia Pacific Large Cap Index coalesced around more surprising. “Smaller 200 established large cap companies have had a 180 investment vehicles. There record of outperforming 160 are exceptions. Allianz large companies during the Dresdner Asset Manager, upswing of an economic 140 part of a joint venture cycle… second, in the UK, at 120 with Guotai Jun’an least, the FTSE 250 and the 100 Securities, launched its FTSE Small Cap indices 80 Desheng Enhanced Small have higher weightings in Cap Fund back in 2003 cyclicals than the large cap and reportedly has $1bn FTSE 100 index.”The FTSE FTSE Asia Pacific Large Cap Index FTSE Asia Pacific Mid Cap Index under management. 250 Index is a capitalisationFTSE Asia Pacific Small Cap Index While the only threat on weighted index of midData as at 31 January 2005. Source: FTSE Group/FactSet the immediate horizon in capitalised companies traded on the London Stock Exchange. The index is designed China is that fixed asset investment might slow down, to measure the performance of the mid-cap capital and domestic consumption will invariably trend upwards for industry segments of the UK market not covered by the large some years and therefore the market is considered conducive cap FTSE 100 index. It also represents some 14% of the UK to continued strength in the small cap sector. An additional market capitalisation. The FTSE Global Small Cap Index note of caution must be sounded in that smaller companies, Series provides access to over 4000 small cap stocks in 48 generally, are less well researched in Asia, which can from countries, capturing the bottom 10% of seven regional time to time, create pricing inefficiencies. Grist to the mill markets. Companies are filtered for size, with a $100m then for fund managers willing to invest their time and capitalisation requirement, and liquidity, ensuring only resources to extensive research of the small company sector. Ju n-

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Company Name

Page

3i 77 51Jobs Inc 26 8Telecom International Holdings 26 A Friedr. Flender AG 81 ABB Offshore Systems 78 ABB Vetco Gray 81 Aer Lingus 77 Air China 25 Air Transport Association 45 Airbus 42 Alcontrol 78 American Airlines 76 American Federation of LabourCongress of Industrial Organisation73 AMR Handline Services 76 Apax Partners 77 Apple 24 Arab National Bank 13 Asea Brown Boveri 78 Association of German Mortgage Banks 50 Australian Stock Exchange 14 BAE Systems 44 Baidu 26 Bank of America 70 Bank of Austria Creditanstalt 30 Bank of China 26 Bank of Communications 26 Bank of New York 38 Bank of Scotland 78 Barclay Trading Group 50 Barclays Private Equity 77 Baring Asset Management 36 BayStreetDirect Inc 16 Beijing Media Group 26 Benedetto, Gartland & Co Inc 78 Bermuda Stock Exchange 46 BMP 30 BNP Paribas 14 Boeing 42 BorsodChem 30 BP 26 Brewin Dolphin Securities 86 Bridgepoint Partners 77 Budapest Stock Exchange 30 Caldwell Asset Management Ltd 16 Caldwell Financial Ltd 16 Caldwell Investment Management Ltd 16 Caldwell Securities Ltd 16 California Public Employees' Retirement System 78 Canada Pension Plan Investment Board 78 Candover Investments 76 Candover Partners Limited 77 Cargo Service Center 77 Carlyle Group 77 CDM Pekao 31 Centre For Management Buyout Research 79 Channel Islands Stock Exchange 48 Chicago Board of Trade 57 Chicago Board Options Exchange 58 Chicago Mercantile Exchange 57 China Construction Bank 26 China Life 26 China Nationla Offshore Oil Corporation 26 China Netcom 26 China Securities Regulatory Commission 26 ChinaByte 26 Cinven 77 Citicorp Venture Capital Ltd 77 Citigroup 19 Citigroup Global Markets Polska 30 Clearing Corp. 60 Close WINS 86

Company Name

Page

Columbia Management Group 71 Commerzbank 50 Commodity Futures Trading Commission 61 Compaq 73 Cooper Tyre and Rubber Co 81 COSI China Oil Field Services 26 Council of Institutional Investors 73 Credit Suisse First Boston 81 Credit Suisse First Boston Private Equity 31 CSFB 27 Ctrip 26 Cypress Group 81 Cyprus Airways 77 Daily Mail & General Trust 81 Davis Polk and Wardwell 20 Depository Trust & Clearing Corporation 67 Deutsche Asset Management 73 Deutsche Bank 14 Deutsche Börse 14 Dewey Ballatine Grzesiak 31 DG Hypothekenbank 50 D-Logistics 77 DM Bank Handlowy 31 DPM Europe Ltd 58 Dresdner 50 Dresdner Kleinwort Wasserstein 52 Driehaus Capital 24 EADS 44 Ebay 24 El Al 77 EM Applications 11 Enterprise Investors 30 EQT Partners 81 Ernst & Young Audit 31 EUREKO 30 Eurex 60 Euroclear 19 Euronext 14 Euronext.liffe 60 European Aeronautics Defence & Space Company 43 European Commission 46 European Securitisation Forum 52 European Union 42 Evergreen Investments 23 Expro International 81 Exxon Mobil 27 Federal Reserve Board 67 Financial Research Corp. 71 Fitch Ratings 54 FleetBoston Corp. 70 Folksam 35 FpML 69 FTM Midwest Research 72 FTSE Group 7 FTSEurofirst 21 Fuji 45 Gartmore 85 General Accounting Office 73 German Federal Financial Supervisory Authority 55 Globeground 76 Goldman Sachs 27 Goldman Sachs Capital Partners 81 Governance Metrics 26 Greenwich Associates 8 Grupa Lotus 30 Guotai Jun’an Securities 86 Halliburton Inc 81 Hammonds 42 HarbourVest Partners LLC 78 Harvard 6 HedgeCo. Networks 6 Hellas Jet 77 Henessee Group 6 Hewlett Packard 73

FTSE GLOBAL MARKETS • MARCH/APRIL 2005

Company Name

Page

Hollinger Inc 81 Hollinger International 81 Honsel Internaitonal Technologies Holdings Sarl 81 HSBC 14 HSBC Securities Canada 16 Huadian Power International 26 Huatai Automobile Co Ltd 27 Illinois State Board of Investment 36 Initiative Europe 81 Institutional Shareholder Services 73 International Nickel 17 International Securities Exchange 61 International Swaps and Derivatives Association 67 Internet Security 23 Investcorp 81 Investment Dealers Association 16 Investment Responsibility Research Centre 74 ISLA 19 IVAX 30 JP Morgan 54 JP Morgan Private Equity 77 Kawasaki 45 King Pharmaceuticals 75 KLM 77 Korea Futures Exchange 57 Kreditanstalt fur Wiederaufbau 54 L&G Ventures 78 Lehman Brothers 54 LJH Investments 50 London Stock Exchange 14 Lufthansa 76 Luxembourg Stock Exchange 48 McDonnell Douglas 44 McKinsey & Company Poland 30 Menzies Aviation 77 Mercer Investment Consulting 73 Merrill Lynch 54 Metropolitan Museum of Art 78 Microsoft 24 Millburn Ridgefield Corporation 50 Mitsubishi 45 MOL 30 Mondo Visione 14 Motorola 23 Munchener Hypothekenbank 53 Mylan Laboratories 75 NASA 43 NASDAQ 14 National Association of Securities Dealers 14 National Commercial Bank 14 NationsBank Corp. 71 New York Stock Exchange 17 NGX 17 NIB Capital 81 Nordic Capital 79 Nortel 17 North America Free Trade Association 17 Northern Trust 32 Northern Trust Global Investors 32 Nymex 60 Ogden Aviation Services 77 Opoczno 30 Orsus 26 Pacific Investment Management 54 Pantheon 78 PC Online 26 Penauille Polyservices 76 Pension Fund Partnership 35 Permira 65 Perry Corporation 75 PetroChina 26 PGNiG 30 Philadelphia Board of Trade 61 Philadelphia Stock Exchange 61

Company Name

Page

PingAn Insurance 25 Pipeline Integrity International 78 PKO BP 30 Polish Ministry of Finance 30 Polish Ministry of Treasury 30 Polish Securities and Exchange Commission 29 PZU 29 Qualcom 23 Radianz 41 RadianzNet 41 RMC 15 Royal Bank of Canada 36 Royal Bank of Scotland Group 78 SAMBA 12 Saudi British Bank 14 Schlumberger 36 Schulte, Roth and Zabel 21 SEB Hypothekenbank 52 Second Curve Capital 72 Securities and Exchange Commission 6 Sejm 30 Semiconductor Manufacturing International Corporation 26 Servisair 76 SFS 77 Shanda Interactive 26 Shanghai Automaker Industry Corporation 26 Shawmut National Corp. 72 Sonata Funds 8 Standard & Poor’s 14 Standard Life 78 State Street Bank 38 State Street Corporation 38 Strook & Strook & Lavan 20 Sun 24 Svenska Handelsbanken 35 SwapsWire 69 SWIFT 69 Swiss American Securities 39 Swiss International Airlines 77 Swiss Re 78 Swiss Stock Exchange 46 Swissair 76 Swissport 76 SWX 60 Taiwan Futures Exchange 60 Tencent 26 The Boston Globe 72 The Canada Pension Plan Investment Board 78 The Corporate Library 75 The Metropolitan Museum of Art 78 Thule AB 81 TIAA-CREF 74 Toronto Stock Exchange 16 TSK Markets 16 TSX Group 16 UBS AG 78 UBS Investment Bank 78 UBS Warburg 78 United States Department of Labor 73 Vanderbilt University 51 Vestolit 78 Vinci Group 77 Warsaw Stock Exchange 29 Warsaw University School of Management 29 Webb-site.com 27 Wellstream 81 WH Smith 65 White & Case 29 World Trade Organisation 42 Worldwide Flight Services 76 Yale 6

COMPANIES IN THIS ISSUE

FTSE Global Markets Company Directory

Au st F FT TS rali SE E A a A C Be us lg tria iu FT m/ AC SE Lu x C FT A SE ana C De da A n FT C m SE ar k F A FT inla C n S FT E F d A SE ran C Ge ce FT SE FT rma AC ny Ho SE AC Gr ng Ko eec e ng FT Ch AC SE in Ir a A e C FT land SE AC I ta FT FT ly SE SE A FT Ne Jap C SE th an er Ne la AC nd w Ze s A a FT C l a SE nd A FT No SE rw C P ay FT SE ortu AC g Si ng al A a C FT por e S FT E S AC SE pa F i FT TSE Sw n A e SE Sw de C n Un i ite zerl AC a d Ki nd ng AC d F T om SE A US C A AC

88 FT SE ob

al Al AC l-W or ld In de FT x SE La rg e Ca p FT SE M id C FT ap SE Sm FT al lC SE ap De ve FT lo SE pe Ad d AC v Em er g in FT g SE AC Em er FT gi SE ng Al AC l-E m FT er SE gi n La g AC tin FT Am SE er M ica id dl AC e Ea FT s t SE & No Af FT ric rth SE a As Am ia e ric Pa a cif A ic C ex Ja pa n FT AC SE Ja FT p an SE AC De FT v SE Eu Em ro pe er gi AC ng Eu ro pe AC

FT SE

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MARKET REPORTS BY FTSE RESEARCH

FT SE

MARKET REPORTS

Page 88

FTSE Global Equity Index Series – Global YTD 2004

31st December 2003 - 31st December 2004

FTSE Regional Indices Performance (USD) 150

140

FTSE Global AC

130

FTSE Developed Europe AC

120

FTSE Japan AC

110

FTSE Asia Pacific AC ex Japan

100

FTSE Middle East & Africa AC

FTSE Emerging Europe AC

FTSE Latin America AC

FTSE North America AC

FTSE Regional Indices Capital Returns (USD)

FTSE Developed Country Indices Capital Returns

Dollar Value

Local Currency Value

-10

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

MARCH/APRIL 2005 • FTSE GLOBAL MARKETS

MARKET REPORTS

11/2/05

4:21 pm

Page 89

FTSE All-Emerging Country Indices Capital Returns 140 120 100 80

Dollar Value

60 40

Local Currency Value

20 0

FT SE

Ar ge FT ntin SE a B AC FT raz SE i l A F T Ch C ile S FT FTS E C A hi C SE E na Cz Col A u ec C h mbi Re a A p FT ub C li S FT E E c A SE gy C Hu pt A n F T ga C FT SE ry SE In AC In dia do A n FT e C SE sia AC I FT sr S a FT E K el A SE or C M ea FT alay AC SE si FT M a A C SE ex ico FT Mor A SE oc C Pa co AC ki s FT FT tan SE SE AC Ph Per u ili F T p p i n AC SE es AC Po F FT TS lan SE E R d A So us C sia ut AC FT h A SE fric FT Ta a A S E iw C Th an F T a i l AC SE an Tu d A rk C ey AC

-20

FTSE Global All Cap Sector Indices Capital Returns (USD) 40

Capital 10

Total Return 0

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M O inin il Bu & g ild Ch G in em as St For g M ica ee es at ls El Ae l & try eria ec tro D ros Oth & P ls ni iv pac er ap e c e & rsi e & Me r En Ele fied D tals gi ctr I efe ne ic nd n er al us ce Ho i E t us Au ng qu rial eh to & ipm s ol mo Ma e d n Fo Go bile chin t od od s & er Pe y Pr s rs od & Pa on T rt uc a er B ext s Ph l Ca i s ev le ar re & e s m & Pr rag ac H oc e eu ou es s tic se so al ho s H rs & ld ea Bi Pr lth ot od ec uc hn ts Ge o ne To log b y M r ed Lei al R acc ia su et o & re ai En & ler Su ter Ho s pp tai tel or nm s Te F tS e le oo co d er nt m & v m D Tra ice un ru ns s ica g R po tio et rt n aile Se rs r U t E l vice ilit ec s ie tric s - O ity th In B er ve L In an st ife su ks In m r fo S en As anc rm pe t C su e at cia om ran So ion lity c ftw Te & Re pan e ar ch Ot al ies n e h E & olo er sta Co gy Fin te m H an pu ar c te dw e rS a er re vi ce s

-10

Stock Performance Best Performing FTSE All-World Index Stocks (USD) Aristocrat Leisure 501.9% Orascom Telecom Holdings 217.4% Apple Computer 201.4% Shun Tak Holdings 194.5% LG Corp 189.7%

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

Worst Performing FTSE All-World Index Stocks (USD) Yukos -93.9% LG Card -86.2% Psc Industries -85.6% Quanta Storage -73.8% Converium Holding AG -66.6%

No. of Consts

Value

12 M

Actual Div Yld

7,595 1,082 1,909 4,604 2,991 1,582 176 84 1,542 174 2,701 1,336

305.80 301.39 393.67 359.68 183.08 344.06 470.13 427.00 325.73 422.94 287.25 316.38

12.3% 11.3% 14.0% 15.4% 11.9% 15.0% 21.7% 13.4% 16.0% 27.9% 9.6% 12.6%

11.3% 10.0% 13.6% 13.8% 11.0% 22.3% 41.5% 26.9% 17.1% 35.5% 7.7% 3.4%

14.7% 11.8% 20.9% 22.3% 13.7% 19.3% 40.2% 33.5% 19.1% 43.8% 10.9% 15.8%

1.96% 2.18% 1.72% 1.63% 2.00% 2.79% 3.39% 2.20% 2.67% 2.59% 1.59% 0.97%

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

FTSE GLOBAL MARKETS â&#x20AC;˘ MARCH/APRIL 2005

tio

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FT SE

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MARKET REPORTS

Page 90

FTSE Global Equity Index Series – Developed ex US YTD 2004

31st December 2003 - 31st December 2004

FTSE Developed Regional Indices Performance (USD) 125

FTSE Developed (LC/MC)

120

115

FTSE Developed Europe (LC/MC)

110

FTSE Developed Asia Pacific (LC/MC)

105

FTSE All-Emerging (LC/MC)

100

FTSE Developed ex US (LC/MC)

FTSE US (LC/MC)

FTSE Developed Asia Pacific ex Japan (LC/MC)

FTSE Developed Regional Indices Capital Returns (USD) 30

FTSE Developed ex US Indices Sector Capital Returns (USD)

Capital

Total Return

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

MARCH/APRIL 2005 • FTSE GLOBAL MARKETS

MARKET REPORTS

11/2/05

4:21 pm

Page 91

Stock Performance Best Performing FTSE Developed ex US Index Stocks (USD) Aristocrat Leisure 501.9% Shun Tak Holdings 194.5% Caltex Australia 144.6% Nishi-Nippon City Bank 117.4% Great Eagle Holdings 115.9%

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

Worst Performing FTSE Developed ex US Index Stocks (USD) Converium Holding AG -66.6% Brilliance China Automative (Red Chip) -64.5% Interchina Holdings -57.7% Bombardier (B Line) -53.1% Seat-Pagine Gialle -51.6%

No. of Consts

Value

12 M

Actual Div Yld

1,361 745 2,106 885 513 773 293 3,629 512 1,909 4,604

196.54 495.43 180.18 263.10 197.29 183.38 292.19 328.73 311.80 369.50 394.48

14.9% 8.7% 11.5% 17.7% 15.7% 13.7% 15.7% 15.1% 14.6% 16.1% 16.6%

14.9% 6.4% 10.2% 25.7% 16.7% 9.7% 25.6% 15.0% 14.6% 16.1% 16.1%

17.9% 9.2% 13.1% 24.5% 17.8% 17.6% 24.6% 19.0% 16.4% 24.1% 29.1%

2.35% 1.64% 1.97% 2.61% 2.71% 1.63% 3.18% 2.31% 2.47% 1.72% 1.63%

FTSE Global Equity Index Series – Asia Pacific YTD 2004 31st December 2003 - 31st December 2004

FTSE Asia Pacific Regional Indices Performance (USD) 125

FTSE Global AC

120

FTSE Developed Asia Pacific (LC/MC)

115

FTSE Developed Asia Pacific ex Japan (LC/MC)

110 105

FTSE Asia Pacific (LC/MC)

100 95

FTSE All-Emerging Asia Pacific AC

FTSE Japan (LC/MC)

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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 • MARCH/APRIL 2005

MARKET REPORTS

13/2/05

7:23 am

Page 92

30 25 20 15 10 5

Gl ob al AC FT ia S Pa E D ci e fic ve De (L lop ve C/ e lo M d p ex ed C) Ja A pa sia n P (L ac FT C/ i f i M c SE C) A As llia Em Pa er ci gin fic g FT AC SE As D FT i a ev SE Pa elo Ja ci pe pa fic d n AC In de x FT ( LC SE /M As C) ia Pa ci fic (L C/ FT M SE C) As ia Pa ci fic FT M SE C As ia Pa ci fic FT SC SE As ia Pa ci fic LC As

FT SE

As ia

FT SE

Pa c

ifi c

FTSE Asia Pacific All Cap Sector Indices Capital Returns (USD) 50 40 30 20

Capital

Total Return

O inin il & g ild Ch G in em as St For g M ica ee es at ls El Ae l & try eria ec tro D ros Oth & P ls ni iv pac er ap e c e & rsi e & Me r En Ele fied D tals gi ctr I efe ne ic nd n er al us ce Ho i E t us Au ng qu rial eh to & ipm s ol mo Ma e d n b Fo Go ile chin t od od s & er Pe y Pr s rs od & Pa on T rt uc a er B ext s Ph l Ca s ev ile ar re & e s m & Pr rag ac H oc e eu ou es s tic se so al ho s H rs l & d ea P Bi r l t h ot od ec uc hn ts Ge o ne To log M r b y ed Lei al R acc ia su et o & re ai En & ler Su ter Ho s pp tai tel or nm s Te F tS e le oo co d er nt m & v m D Tra ice un ru ns s ica g R po tio et rt n aile Se rs r U t E l vice ilit ec s ie tric s - O ity th In B er ve L In an st ife su ks In m r fo S en As anc rm pe t C su e at cia om ran So ion lity c ftw Te & Re pan e ar ch Ot al ies e no he Es & lo r ta Co gy Fin te m H an pu ar c te dw e rS a er re vi ce s

-10

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MARKET REPORTS BY FTSE RESEARCH

FTSE Asia Pacific Regional Indices Capital Returns (USD)

Stock Performance Best Performing FTSE Asia Pacific Index Stocks (USD) Aristocrat Leisure 501.9% Shun Tak Holdings 194.5% LG Corp 189.7% Ssangyong Oil Refining 175.4% Caltex Australia 144.6%

Worst Performing FTSE Asia Pacific Index Stocks (USD) LG Card -86.2% Psc Industries -85.6% Quanta Storage -73.8% Brilliance China Automative (Red Chip) -64.5% DBTEL -62.4%

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

No. of Consts

Value

12 M

Actual Div Yld

7595 2918 1345 479 866 1573 293 773 572 480

305.80 327.74 186.42 316.53 357.57 363.79 292.19 183.38 200.21 118.36

12.28% 13.66% 13.82% 13.89% 13.57% 12.02% 15.68% 13.72% 14.22% 12.86%

11.31% 11.05% 11.43% 11.73% 10.21% 7.52% 25.65% 9.74% 18.38% 3.73%

14.69% 17.40% 16.95% 16.57% 18.45% 21.74% 24.61% 17.55% 14.37% 14.57%

1.96% 1.77% 1.78% 1.90% 1.70% 1.78% 3.18% 1.63% 2.38% 0.96%

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

MARCH/APRIL 2005 â&#x20AC;˘ FTSE GLOBAL MARKETS

tru

O inin il & g ild Ch G in em as St For g M ica ee es at ls El Ae l & try eria ec tro D ros Oth & P ls ni iv pac er ap c er e M er & si & e En Ele fied D tals gi ctr I efe ne ic nd n er al us ce Ho i E t us Au ng qu rial eh to & ipm s ol mo Ma e d n b Fo Go ile chin t od od s & er Pe y Pr s rs od & Pa on T rt uc a er B ext s Ph l Ca s ev ile ar re & e s m & Pr rag ac H oc e eu ou es s tic se so al ho s H rs l & d ea Bi Pr lth ot od ec uc hn ts Ge o ne To log M r b y ed Lei al R acc ia su et o & re ai En & ler Su ter Ho s pp tai tel or nm s Te F tS e le oo co d er nt m & v m D Tra ice un ru ns s ica g R po tio et rt n aile Se rs r Ut El vice ilit ec s ie tric s - O ity th In B er ve L In an st ife su ks In m r fo S en As anc rm pe t C su e at cia om ran So ion lity c ftw Te & Re pan e ar ch Ot al ies e no he Es & lo r ta Co gy Fin te m H an pu ar c te dw e rS a er re vi ce s

Eu Al ro l-E pe m er AC gi ng Eu ro pe FT AC SE Eu ro FT zo SE ne De AC ve lo pe d ex Eu FT r SE UK ope Eu AC ro fir st 30 0 FT SE ur of irs t8 FT 0 SE ur of irs t1 00

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FTSE GLOBAL MARKETS • MARCH/APRIL 2005

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MARKET REPORTS

Page 93

FTSE Global Equity Index Series – Europe YTD 2004

31st December 2003 - 31st December 2004

FTSE European Regional Indices Performance (EUR) 115

FTSE Global AC (EUR)

110

FTSE Developed Europe ex UK LC/MC (EUR)

105

FTSEurofirst 300 (EUR)

100

FTSE Developed Europe AC (EUR)

FTSEurofirst 100 (EUR)

FTSE Eurozone LC/MC (EUR)

FTSEurofirst 80 (EUR)

FTSE European Regional Indices Capital Return (EUR)

FTSE Developed Europe Sector Indices Capital Returns (EUR)

Capital

Total Return

-10

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

MARKET REPORTS

11/2/05

4:21 pm

Page 94

MARKET REPORTS BY FTSE RESEARCH

Stock Performance Best Performing FTSE Developed Europe Index Stocks (EUR) Elan Corporation 259.0% Cairn Energy 170.5% OMV 87.7% Almanij 87.2% Almancora 85.3%

Worst Performing FTSE Developed Europe Index Stocks (EUR) Converium Holding AG -69.0% Seat-Pagine Gialle -55.1% Karstadtquelle -52.2% Terra Networks -40.4% Compass Group -35.5%

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

No. of Consts

Value

12 M

Actual Div Yld

7595 1626 210 360 1056 1542 84 751 1041 300 80 100

305.80 276.93 312.10 329.49 337.17 275.95 361.74 287.91 287.88 1041.77 3700.89 3481.41

12.28% 5.98% 5.24% 7.69% 8.96% 6.01% 3.57% 8.62% 7.78% 5.56% 8.18% 4.99%

11.31% 4.93% 4.00% 6.55% 8.06% 4.80% 13.55% 6.63% 6.02% 4.36% 5.34% 3.80%

14.69% 10.66% 7.71% 16.82% 21.46% 10.48% 23.90% 11.02% 11.43% 8.75% 7.58% 5.95%

1.96% 2.66% 2.80% 2.55% 2.40% 2.67% 2.20% 2.63% 2.45% 2.78% 2.80% 2.99%

FTSE UK Index Series – YTD 2004 31st December 2003 - 31st December 2004

FTSE UK Index Series Performance (GBP) 130

FTSE 100

125

FTSE 250

120

FTSE 350

115 110

FTSE SmallCap

105

FTSE All-Share

100 95

FTSE AIM

-0 4

4 -D

FTSE techMARK

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MARCH/APRIL 2005 • FTSE GLOBAL MARKETS

F T S-6% E GLOBAL MARKETS â&#x20AC;˘ MARCH/APRIL 2005

Aerospace & Defence

Diversified Industrials

Electronic & Electrical Equipment

rospace & Defence

versified Industrials

ectronic & Electrical Equipment

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

Food Producers & Processors

Capital

Health

Total Return

Leisure & Hotels

General Retailers

-20

-30

Stock Performance

Worst Performing FTSE All-Share Index Stocks (GBP) Ultraframe -74.4% Tribal Group -56.5% Wolfson Microelectronics -54.8% Eurotunnel/Eurotunnel SA -54.7% THUS Group -52.1%

Overall Index Return 3M 6M 12 M Actual Div Yld Net Cover P/E Ratio

100 250 350 356 706 369 975 100 4814.30 6936.80 2453.95 2758.15 2410.75 3150.17 1005.59 1196.43 5.3% 10.7% 6.1% 7.9% 6.1% 10.6% 9.4% 10.5% 7.8% 10.5% 8.2% 6.8% 8.2% 11.9% 13.2% 2.2% 7.5% 19.6% 9.1% 11.4% 9.2% 20.0% 20.4% 17.9% 3.16% 2.62% 3.08% 2.06% 3.05% 2.45% 0.43% 1.36% 2.15 2.08 2.14 0.35 2.10 -2.07 -0.60 14.69 18.35 15.13 138.64 15.62 -19.76 -384.15 -

Utilities - Other

Total Return

Utilities - Other

-10

Electricity

Capital

Electricity

Telecommunication Services

Food & Drug Retailers

od & Drug Retailers

Transport

FTSE All-Share Sector Indices Capital Returns (GBP)

Transport

Value

Support Services

No. of Consts

Support Services

dia & Entertainment Media & Entertainment

Leisure & Hotels

General Retailers

Tobacco

tio

Pharmaceuticals & Biotechnology

al Care & Household Personal Care & Household Products Products

Health

Food Producers & Processors

Beverages

0% 4%

398.4% 186.3% 171.8% 137.9% 101.7%

Beverages

Jamie Perrett -2% Senior 2% Index Design Executive jamie.perrett@ftse.com -4% +440% 20 7448 1817

Household Goods & Textiles

Gareth Parker 8% Head4%of Index Design gareth.parker@ftse.com 6% 2% +44 20 7448 1805

ousehold Goods & Textiles

Carl Beckley Director, Research & Development carl.beckley@ftse.com 8% +44 20 7448 1820

Automobiles & Parts

FTSE 100 FTSE 250 FTSE 350 FTSE SmallCap FTSE All-Share FTSE Fledgling FTSE AIM FTSE techMARK 100

utomobiles & Parts

Best Performing FTSE All-Share Index Stocks (GBP) Ashtead Group Charter Cairn Energy Topps Tiles Paladin Resources

eering & MachineryEngineering & Machinery

Steel & Other Metals

Forestry & Paper

4:21 pm

teel & Other Metals

Forestry & Paper

struction & Building Construction & Building Materials Materials

Chemicals

-2%

Chemicals

Mining

Oil & Gas

-4%

Oil & Gas

Mining

11/2/05

MARKET REPORTS BY FTSE RESEARCH

M O inin il & g C ild h Ga in em s F g o El St re M ica ec e e s at ls tr on Ae l & try eria ic ro O & ls & sp th Pa p En Ele ace er M er gi ctr & e ne ic D ta er al ef ls Ho in E e us Au g & qui nce pm eh to ol mo Ma en d c Fo Go bile hin t od s e o Pe d s & ry Pr rs & Par od on Te ts uc al er B xt Ph Ca s e v ile ar re & e s m & Pr rag ac H oc e eu ou es s tic se so al ho He r s s l d & Bi Pro alth ot d ec uc hn ts Ge o ne To log M L ral ba y ed ei R cc ia su et o & re ail En & ers Su ter Ho pp tai tel or nm s Te F tS e le oo co d er nt v m & m D Tra ice un ru ns s i c g R po a t e rt io ta n ile S e rs r U t E l vice ili ec s tie tr s icit -O y th e B r In I ve L n ank s i st fe ur s In m A a en ss nc fo Sp rm e t C ur e at cia om an So ion lity p ce ftw Te & Re an ar ch Ot al E ies e no he s & lo r ta Co gy Fin te m H an pu ar ce te dw rS a er re vi ce s

MARKET REPORTS

Page 95

FTSE Research Team contact details

Bin Wu Senior Index Design Executive bin.wu@ftse.com +44 20 7448 8986

Oliver Whittle Index Analyst oliver.whittle@ftse.com +44 20 7448 1887

Andreas Elia Research Analyst andreas.elia@ftse.com +44 20 7448 8013

-6%

MARKET REPORTS

11/2/05

4:21 pm

Page 96

CALENDAR

Index Reviews March-June 2005 Date

Index Series

Review Type

Effective Data Cut-off (Close of business)

Early Mar Early Mar 1-Mar 3-Mar 04-07-Mar 9-Mar 11-Mar 12-Mar 12-Mar 12-Mar 12-Mar 14-Mar 14-Mar 15-Mar 15-Mar 15-Mar 16-Mar 16-Mar 16-Mar 16-Mar 16-Mar 16-Mar Mar/Apr Early Apr April 20-Apr 28-Apr 13-May 17-May May/Jun Early Jun Early Jun Early Jun Early Jun 1-Jun 3-Jun 3-Jun 3-Jun 8-Jun 10-Jun 10-Jun 10-Jun 10-Jun 10-Jun 14-Jun 15-Jun 15-Jun 15-Jun 15-Jun 15-Jun 15-Jun 15-Jun 15-Jun 16-Jun

ATX S&P US Indices SMI Index Family DAX S&P MIB FTSE UK NASDAQ 100 NZSX 10 FTSE All-World FTSEurofirst 300 FTSE/Hang Seng Asiatop FTSE techMARK 100 FTSE eTX S&P MIB Russell US Indices STOXX S&P Europe 350/ S&P Euro S&P 500 S&P/ TSX S&P MidCap 400 DJ Global Titans 50 S&P/ ASX 200 CAC 40 TSEC Taiwan 50 Nikkei 225 FTSE/ ASE 20 OMX H25 Hang Seng MSCI NZSX 10 Russell US Indices ATX KOSPI 200 IBEX 35 KFX OBX DAX OMX S30 FTSE UK FTSE All-World FTSE techMARK 100 FTSEurofirst 300 FTSE eTX NASDAQ 100 S&P MIB S&P/ ASX 200 S&P US Indices S&P Europe 350/ S&P Euro S&P 500 DJ Global Titans 50 S&P Midcap 400 PSI 20 STOXX S&P/TSX

Quarterly review 31-Mar Phase 1 – float adjustment 18-Mar Semi-annual review 31-Mar Quarterly review 18-Mar Semi-annual constiuent review 21-Mar Quarterly review 18-Mar Quarterly share adjustment 18-Mar Quarterly review 31-Mar Annual review Asia Pacific ex Japan 18-Mar Quarterly review 18-Mar Semi-annual review 8-Mar Quarterly review 18-Mar Quarterly review 18-Mar Quarterly review – shares & IWF 21-Mar Quarterly review / Additions Quarterly review 17-Mar Quarterly review 18-Mar Quarterly review 18-Mar Quarterly review 18-Mar Quarterly review 18-Mar Quarterly review 18-Mar Annual /Quarterly review 18-Mar Quarterly review Apr/May Quarterly review 15-Apr Extraordinary review Apr Semi-annual review 31-May Quarterly review 29-Apr Quarterly review 6-Jun Annual review 31-May Quarterly review June Annual review 24-Jun Quarterly review 30-Jun Annual review 9-Jun Semi-annual review 1-Jul Semi-annual review 17-Jun Semi-annual review 17-Jun Quarterly review Semi-annual review 1-Jul Quarterly review 17-Jun Annual review – Emgng Eur, ME, Africa, Lat America 17-Jun Quarterly review 17-Jun Quarterly review 17-Jun Quarterly review 17-Jun Quarterly review / Shares adjustment 17-Jun Quarterly review - shares only 20-Jun Quarterly review 17-Jun Quarterly review 17-Jun Quarterly review 17-Jun Quarterly review 17-Jun Annual review 17-Jun Quarterly review 17-Jun Semi-annual review 1-Jul Quarterly share adjustment 17-Jun Quarterly review 17-Jun

28-Feb 28-Feb 28-Feb 28-Feb 8-Mar

31-Dec 4-Mar 28-Feb 28-Feb 4-Mar

1-Mar

28-Feb 16-Mar 28-Feb 19-Mar 31-Mar 21-Mar 31-Mar 22-Apr 31-Mar

31-May End of May

31-May 30-May 7-Jun 31-Mar 31-May 3-Jun 3-Jun

15-Jun 31-May 1-Jun 31-May

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

MARCH/APRIL 2005 • FTSE GLOBAL MARKETS

UNICEF.QXD

11/2/05

5:10 pm

Page 1

The children of Darfur in Sudan are caught up in a horrific conflict which is having a devastating effect on their lives.

UNICEF/ HQ04-0292/Christine Nesbitt

Over 1 million people have fled their homes and entire villages have been destroyed and hundreds of lives have been lost. Children’s lives are at great risk of disease and malnutrition. Water and shelter are in short supply. Right now, children are depending on UNICEF to stay alive. To find out more about how you and your company can help UNICEF when an emergency occurs, please contact victorial@unicef.org.uk or visit: www.unicef.org.uk/emergencyrelief if you are in the UK or www.supportunicef.org if you´re outside of the UK Thank you for your support

With a presence in over 190 countries, UNICEF (the United Nations Children’s Fund) is uniquely positioned to react quickly to emergency situations such as the one in Sudan. We have been working tirelessly since the emergency began, providing medical supplies and access to safe water and sanitation. To carry out our emergency work, we desperately need the help of individuals and companies. FTSE already support UNICEF (over £900,000 donated through FTSE4Good so far). In doing so, they help us to alleviate the distress and hardship caused to children who find themselves suffering because of emergency situations like the one in Darfur.

MARKET REPORTS

11/2/05

4:22 pm

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