Harvard College Investment Magazine Summer 2008 Issue by Harvard College Investment Magazine

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Magazine Spring 2008

IN THIS ISSUE 9

THE GOLDEN RULE Elements Contributing to the Rising Value of Gold and their Global Effects

13 THE BUSINESS OF BLING

Can Luxury Survive the Masses?

17 ALTERNATIVE ASSET IPOS

PLUS 25 SHOREBANK Interview with Chairman and Co-Founder, Ron Grzywinski, Executive Vice-President, Consumer and Community Banking, Jean Pogge, and Manager of Triple Bottom Line Innovations, Joel Freehling.

luxury Investigating

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The exceptional individuals at QVT come from a wide variety of academic and professional backgrounds not commonly associated with investing, from hard sciences to literature. Every day we confront some of the world’s most complex investment situations, and we find that success comes not from textbook training in finance, but from intelligence, curiosity, and an ability to see things differently from the pack.

QVT is a hedge fund company with over $5 billion under management. We’re going places, and we’re looking for more great people to help us get there.

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The Harvard College Investment Magazine (HCIM) is a semi-annual publication devoted to presenting the significant and current topics of investment and finance. Blending professional articles, interviews, and academic research, the magazine offers a comprehensive array of commentary to the investment field, serving as a platform of intellectual exchange between the professionals and the Harvard academic community.

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Kuanysh Y. Batyrbekov, Lehman Brothers Michael Hauschild, Citadel Investment Group Biran Kozlowski, DC Energy Jennifer Y. Lan, Merrill Lynch Benjamin Yihung Lee, Bain and Co. Anna Haisi Yu, Citadel Investment Group John Y. Campbell Jeremy C. Stein

COPYRIGHT 2008 (ISSN: 1548-0038) HARVARD COLLEGE INVESTMENT MAGAZINE. No material appearing in this publication may be reproduced without written consent of the publisher. The opinions expressed in this magazine are those of the contributors and not necessarily shared by the editors. All editorial rights reserved.

Contents Features The Golden Rule With gold prices recently reaching heights not seen since 1980, many economists speculated about the reason for the surging value of gold. Is the recent uptrend in the price of gold justified by global conditions, or is it more easily explained by speculators and those trying to hedge their financial risks?

THE BUSINESS OF BLING The traditional consumers of luxury are bored. Luxury fashion has seeped into every sphere of our consumer society; it has become the norm to aspire towards owning products from exclusive brands like Louis Vuitton, Gucci and Dior. The sheer proliferation of luxury goods and online shopping has made luxury accessible and affordable to millions. Can luxury survive the masses?

Alternative Asset IPOs

Inside Scope 17

A freeze frame of the film industry in flux.

A rising (or falling?) powerhouse

THE BIG PICTURE

PHARMACEUTICALS

SHOREBANK INTERVIEW

With Chairman and Co-Founder, Ron Grzywinski, Executive Vice-President, Consumer and Community Banking, Jean Pogge, and Manager of Triple Bottom Line Innovations, Joel Freehling.

ShoreBank is not your typical financial institution. As the nationâ&#x20AC;&#x2122;s first and leading community development and environmental bank, ShoreBank pioneered the popular concept of socially responsible investing and environmental lending.

SPRING 2008 | HARVARD COLLEGE INVESTMENT MAGAZINE

Contents Investing Today 29 32

THE GHOST OF CRISIS PRESENT

Structured investment vehicles

REITs

Value investing in Real Estate Investment Trusts During the past few months, fears of the subprime mortgage crisis have

driven down real-estate prices and have lead to speculation of a housing-

The Impending Stock Index Futures in China

lead recession. But taking a closer look at the prime culprits behind this

The Chinese stock market is coming into its position as the weather vane of the national economy.

subprime crisis may present investment opportunities, giving meaning to the old investment adage that “it is darkest before dawn.”

Harvard College Cons ulting Magazine

In this case study, Mega Store, a mediumsized retailer is choosing between expansion to international markets or development of its domestic market, and has sought counsel from a consulting firm. The case study commentary offers general insight into the retail industry as well as recommendations specific to Mega Store’ s circumstances.

HARVARD COLLEGE INVESTMENT MAGAZINE | SPRING 2008

Information technology consulting

Interview with Center of Financial Technologies

Interview with Derek Van Bever

Team Management at Bain & Company:

50 51

Corporate Executive Board:

Interview with Allison Weinberg (College ’96, HBS ’02)

Brave New World of M&A:

Interview with Boston Consulting Group featuring Jeff Gell

MEGASTORE:

A retail case study with guidance from Kurt Kendall of Sears holding Corporation

Dear readers,

Business is about risk, riches and ideas. Business coverage should be too.

In this issue, we show that not all that glitters is gold. We track the high and volatile gold

prices and the increased de-hedging strategies of companies, which have dominated the golden

landscape, to cope with tighter supply conditions. The luxury industry is also going through a period of transition with more players scaling up operations, increasing their global footprint through outsourcing and/or venturing into the most touted growth area. An industry that has touted itself for serving the elite has since been weighed down by the masses.

We also provide readers with a look at the past and the future. Topics on structured

investment vehicles and real estate investment have lost its luster, but have since been re-

invigorated as a result of the sub-prime crisis. Moreover, on the other side of the globe, we investigate the impeding stock index futures in China.

Finally, we reveal the strategies and successes of the most influential consulting firms

of today. The consulting section gets a backstage pass to consulting powerhouses: Bain & Company, Boston Consulting Group, Center of Financial Technologies and the Corporate

Executive Board. In-depth interviews with the most experienced minds in consulting shed light on how to identify and manage competition and leverage a companyâ&#x20AC;&#x2122;s primary assets: its people. These firms have molded the business leaders and technologies that drive the markets and financial sectors.

In brief, we realize that real gold comes from good mining â&#x20AC;&#x201C; we analyze the cultural,

political and economic. Through comparative analysis, we chronicle the activities, strategies, organizational structures and decision-making processes of businesses.

Yours,

Rika Christanto and Alexander Bayers Editors-in-Chief

harvard college investment magazine

LETTER FROM THE EDITORS

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The

Golden Rule By Robert A. Davis

Elements Contributing to the Rising Value of Gold and their Global Effects

ith gold prices recently reaching heights not seen since 1980, many economists have recently questioned what has led to the surging value of gold. A rise in global demand, inflationary fears caused by rising oil prices and the falling value of the dollar, and worries of an economic slowdown in the United States have all contributed to the near-record-high levels for the price of gold. Is the recent uptrend in the price of gold justified by global conditions, or is it more easily explained by speculators and those trying to hedge their financial risks? With the Perfect Storm of elements that can

SPRING 2008 | HARVARD COLLEGE INVESTMENT MAGAZINE

Features contribute to rising gold prices likely to continue, it is probable that gold prices will continue to rise. Many analysts have predicted that gold will reach $1,000 an ounce within the next twelve months. However, others feel that the elements that have contributed to rising gold prices in the past are no longer as viable in the current global economy.

Safety in an Increasingly Volatile Financial Environment

The traditional attractiveness of owning gold has been that there is a much more steady supply of the metal than there is for other units of account, such as the U.S. dollar. The two demands for gold can be categorized as the “use demand” and the “asset demand.” The use demand is for the production of jewelry, medals, coins, electrical components, and other products. The asset demand for gold is used by governments, central banks, fund managers, and individuals as an investment. This asset demand is due to the belief that gold is a hedge against inflation.The reason why gold is thought of as a hedge against inflation is that the supply can only be increased by the continued exploration and mining for gold. Gold that is already in circulation can be reused and refashioned. Thus, it is not like a fossil fuel that is used only once. Still, much of the gold currently in the market is saved by central banks or is owned by individuals in the form of jewelry and will not be reused, even though it can be. As a result, the mining companies control supply. Since the production from gold mines has been falling since it peaked in 2001, it is believed that supply is stagnant as well. Given these factors, particularly the supply stability of gold, the major influence on the pricing of gold should be due to inflation. From 1895 to 1995, this truly did seem to be the case. The 1895 price of gold was $20.70, or $379 in 1995 dollars. During 1995, the average price of gold was $387, meaning that there was approximately no change in the real value of gold during the century. It is clear though that gold is not just a hedge for inflation in the short run, as many factors other than inflation can affect its price. This is why gold peaked at $835 per ounce in November 2007, nearly surpassing the record nominal value of 10

$850 set in January 1980. Thus, gold has more than doubled since 1995 despite the extremely low levels of inflation during that span. This means that other factors besides inflation have a predominant effect on gold prices in the short-run, such as global demand, the state of the global economy, and the strength of the U.S. dollar. Still, gold is perceived by those in financial markets as an inflation hedge, which is why the price has been rising so much as of late.

Behind the Rising Price of Gold

HARVARD COLLEGE INVESTMENT MAGAZINE | SPRING 2008

‘‘

Even though mining companies have extracted less gold in the years since 2001, an equal fall in the demand for gold has not occurred. Instead, the economic expansions in China, India, and the Middle East have allowed for a new middle class to develop. This new middle class is becoming westernized very quickly and, as a result of this, demand for gold jewelry has emerged throughout these regions. Recently, the World Gold Council announced that demand for gold rose 30 percent during the third quarter of 2007 to a record of $20.7 billion. Contributing to

‘‘ ’’ Recently, the World Gold Council announced

that demand for gold rose 30 percent during

the third quarter of 2007 to a record of $20.7 billion. Contributing to this rise was a 5

percent rise in the amount of gold tonnage purchased in India during the quarter, a

25 percent increase in China, a 19 percent

increase in Saudi Arabia, a 15 percent increase in Egypt, a 10 percent increase in the United

Arab Emirates, and a 3 percent increase in the remaining Middle Eastern countries.

this rise was a 5 percent rise in the amount of gold tonnage purchased in India during the quarter, a 25 percent increase in China, a 19 percent increase in Saudi Arabia, a 15 percent increase in Egypt, a 10 percent increase in the United Arab Emirates, and a 3 percent increase in the remaining Middle Eastern countries. Additionally, gold demand set a record in Turkey during the third quarter, while Russian demand increased 23 percent. In contrast, gold jewelry demand in the United States actually fell 13 percent during the quarter. The World Gold Council also wrote in

their report that they expect gold demand to continue to grow, which means that it is likely that the price per ounce will continue to rise from the 2007 low of $600 to a new record above $850. What has also led gold prices to increase is the declining strength of the U.S. economy. The credit and subprime mortgage problems led the Federal Reserve Board to twice lower the Federal Funds rate a total of 75 basis points. Additional future decreases are also expected. By lowering the federal funds rate, the Federal Reserve is effectively increasing the supply

Inside Scope

of dollars in circulation. In turn, this leads to a depreciation of the dollar against other currencies, which has led to alltime highs for the Euro against the dollar. Since the price of gold is denominated in dollars globally, the weakness of the dollar helps to increase the price of gold, as buyers internationally are able to purchase more dollars with a single unit of their currencies. An additional supply of the dollar and a stagnant supply of gold also help to strengthen the price of gold. Inflation is another reason for the rise in the price of gold. With the price of oil flirting with the cost of $100 per barrel, inflationary fears are very relevant. As oil prices rise, corn and soybean prices will rise as well due to the increased demand for ethanol and biodiesel to use in place of oil. The rise in the price of these crops results in higher food prices, creating greater inflation throughout the entire economy. In addition to the risk of inflation in the United States, lower interest rates are likely to occur in the near future in England and the European Union. While these rate changes may help to strengthen the dollar, they will also help to increase the risk of inflation in those areas. At the same time, China, Brazil, Russia, and India continue their rapid economic expansions. Through the third quarter, China’s consumer price index rose 4.1 percent, including a 6.2 percent rise during September 2007. These rising prices were accompanied by an 11.5 percent increase in gross domestic product during the third quarter. Similarly, India has experienced at least 9 percent growth during six of the past seven quarters. These rapid rises in economic activity mean that gold demand will increase in these countries as a hedge against inflation, to be used for jewelry for the growing middle classes, and to be used in construction and other activities.

Effects of Changing Economic Conditions

Even though it seems as though all of the factors for a long-term appreciation in the price of gold are in place, the changing face of the global economy means that these factors may no longer have the same impact as they once did. For one thing, a nominal record for the price of gold is not very significant when inflation is taken

SPRING 2008 | HARVARD COLLEGE INVESTMENT MAGAZINE

Inside Scope into consideration. The price of gold per troy ounce may surpass the $850 record set in January 1980 in the near future but to match the inflation adjusted record price, gold would have to reach $2,250 per ounce. That is unlikely to happen, although many of the economic conditions today are similar to those in 1980. Among these are record-high oil prices, which occurred in April 1980 as a result of the Iranian revolution. However, the rise in inflation due to rising oil prices was much greater in 1980, as inflation in the U.S. reached 15 percent. Currently, U.S. inflation is likely to remain well below 3 percent. The rise in oil prices in 1980 also led to a stagnation in world-wide e c o n o m i c growth that is being mirrored currently as a result of the global banking losses due to losses from CDOs, SIVs, and other struggling f i n a n c i a l instruments. Still though, the current state of the world economy makes it much less likely that a global slowdown would begin, due to slower growth in the U.S. In 1980, the U.S. accounted for a much larger proportion of world GDP than it does today. This is due to the recent growth of Brazil, China, India, Russia, and the Middle East. As a result, a stumble in the U.S. does not necessarily predict a slowdown in the global economy. Others say that current conditions resemble 1980, due to the political tensions that led to increases in gold prices. In 1980, the Soviet Union invaded Afghanistan, leading to safe-haven buying of gold. Currently, political worries exist over the tensions between the U.S. and Iran. However, an escalation of these tensions is far from a certainty and would likely not have as much of an impact on already-elevated

‘‘

gold prices as the Afghani invasion had in 1980.

Should You Start Mining for Gold?

In the near future, it is highly likely that oil prices will remain near $100 per barrel and that the dollar will remain weak against other currencies. These two factors should make investing in gold a safe bet. Another factor that could help gold reach new highs is the consolidation in the mining sector. Already this year, Alcan has merged with Rio Tinto to create one of the world’s biggest mining companies. Further consolidation could occur as BHP Billiton has made a bid for Rio Tinto that is valued at over $130 billion. If this merger were to take place, it would create the world’s largest natural resource company by a large margin. This consolidation could give more pricing power to the remaining companies, which could help to lift the price of gold. The real wild card is whether the US stock market, and the financial sector specifically, can recover from the credit crisis or whether they will continue to deteriorate. Whether or not it deserves to be, gold is still used as a hedge against market risk and volatility. When uncertainty appears in the financial world, investors choose to put their money in gold futures for purposes of safety. Thus, all other issues aside, the fate of the price of gold may actually be dependent upon the stock market, as the two have long been inversely correlated. Since third quarter 2007 earnings fell year-over-year and very small growth is predicted for the upcoming quarters, a recession seems more and more likely. As a result, the best bet may be to buy gold at current levels.

HARVARD COLLEGE INVESTMENT MAGAZINE | SPRING 2008

’’

The

Business of

Bling

Can Luxury Survive the Masses?

By Rika Christanto

he traditional consumers of luxury are bored. Luxury fashion has seeped into every sphere of our consumer society; it has become the norm to aspire towards owning products from exclusive brands like Louis Vuitton, Gucci and Dior. The sheer proliferation of luxury goods and online shopping has made luxury accessible and affordable to millions. The unprecedented rise on global wealth creation, however, has not only commoditized haute couture handbags and custom-made yachts. A new niche investment class has also been fashioned from the fortuitous confluence of sociological, demographic and economic change, which has made luxury brands the domain of the masses. Growing market demand for luxury goods companiesâ&#x20AC;&#x2122; stock has reflected the growing importance of market differentiation, particularly as consumers turn away from generic products. The industry has also learned from past mistakes by relinquishing management to the professionals, limiting licenses, improving services, marketing and logistics. But what accounts for the appeal of these luxury stocks? Why are equity investors becoming more accepting of the luxury goods business model, despite their limited growth potential? After all, not everyone will or can have a Cartier watch or a Tiffany diamond.

SPRING 2008 | HARVARD COLLEGE INVESTMENT MAGAZINE

Features

“Luxury is a Beyond Toilets and Toyotas

It would be wrong to consider luxury is the purview of merely the fashion houses. “Luxury is a necessity that begins where necessity ends’”, quoted from Coco Chanel, has never rang truer than in Japan, which has a closely held monopoly of the world’s market on luxury toilets. An obsession with technology and hygiene has produced the ultimate bathroom accessory replete with a self-cleaning bowl, and devices to check vital signs, finely adjust seat temperature, play tunes and deodorize the air. The US$ 600 million toilet market in Japan is seeing ever growing sales, with the most luxurious of luxury toilets selling at US$ 5,000. The bourgeoning luxury toilet market has been a response to Japan’s ageing demographics; toilet companies have had no choice but to go up-market. While Japan grapples with its graying population, the newly affluent in the developing world has fueled consumer demand expensive handbags, watches, jewelry and other indulgences. The booming Chinese market was one of the catalysts for this vibrant performance. Luxury cars are booming in China, with the world’s top luxury-auto makers viewing the country as an increasingly important market. China imports more than 200,000 cars every year, most of which cost more than half a million,

according to customs figures. While only an estimated 5% of Chinese can currently afford private cars, that still translates into 65 million people. The unprecedented surge in global wealth has driven the buoyant luxury goods market. According to the 2007 World Wealth Report by Merrill Lynch and consultancy Capgemini, there were 9.5 million millionaires worldwide, double the figure from a decade ago. Shares of “luxury” stocks like Christian Dior, Cartier and Chloe have soared past 200% in the past five years. Banks have capitalized on this opportunity by launching global luxury indexes and creating “luxury” stocks as a new investment class. BNP Paribas and the Deutsche Börse launched the world luxury index, a collection of 20 luxury-goods purveyors from Hermès to LVMH, while Merrill Lynch tracks 50 similar stocks on the Merrill Lynch Lifestyle Index. However, there is reason to approach these indexes with caution. Some indexes include non-traditional luxury brand stocks. The Claymore/Robb Report Global Luxury Index, an exchange-traded fund (ETF) launched in July 2007, for example, include investment banks like Goldman Sachs. The Dominion Chic Fund has its largest investments in mass brands like L’Oréal and Nike

HARVARD COLLEGE INVESTMENT MAGAZINE | SPRING 2008

While these indexes have beaten the S&P 500, their longer term performance is up to debate. Nevertheless, the competitive advantage of these luxury lines is unquestionable. How does one rationalize a US$10,000 dress? How do they compete, if not on price?

One Plus One Equals Three

At the top of the luxury pyramid are the traditional European luxury businesses depending on their standards of craftsmanship, design and exclusive distribution lines to justify exorbitant prices. Discounts and mass retail are never considered in their business model; brand reputation is the ultimate priority. Even when brands like Ermenegildo Zegna, diversify from its traditional men’s wear line into cologne and sunglasses, the mystery of the brand that sells US$ 3,000 dollar suits remains intact. Brand management is bolstered by clever packaging. The spirits company, Hennessy, is selling a limited edition of 100 bottles of cognac for $200,000 a bottle. Besides the attraction of the product and the exclusivity the price engenders, the bottle is literally a work of art, created from Venetian pearls and fashioned by artisans who usually make stained glass for cathedrals. The demand for unique items is a

Features

necessity that begins where necessity ends” — Coco Chanel

high growth sector. Luxury is unashamedly elitist in which owning luxury items is not a mere question of affordability but a sign of class and social status. Prices for limited edition items are sometimes no longer disclosed. With luxury brands continuously testing the limits of their brand, even five star hotels are no longer enough; seven is the luxury standard. An illuminating example of the appeal of luxury brands is Japan. Despite its economic problems, Japan remains a healthy market for high-end goods. Hermes, the French accessory retailer of prestige scarves and handbags, reaps 25% of its sales from Japan. For Louis Vuitton, another Parisian luxury retailer, that figure is 50%. Moreover, homegrown brands like Toyota introduced its luxury line, Lexus, into the local market in 2006 with great success. The key to the continued appeal of luxury goods is not merely its stamp of status and taste, but something more basic: service and supply chain management. Buying a car in Japan is a drawn-out ceremonial process. Moreover, Japanese retailers have refined their supply chain operations and developed close marketing ties to their customers. Customer preferences are closely monitored and analyzed in a scientific, methodical manner. Customer genders and age are tracked to build greater customer value. Understanding

the customer allows for better and more customized designs as well as more efficient replenishment of inventories.

The Balancing Act – Catering to the Hoi polloi

The ultimate irony of the luxury industry’s explosion is that in its success are the seeds of its own undoing. As luxury brands promise growth of at least 10 per cent a year and open shops not only in emerging markets, like Russia and China, but also in backwater towns of Western Europe and Australia, they blur the line delineating the exclusive and the mass market. With the chicest of French designers advertising on freeways, have common commuters and truck-drivers become the new target audience? Brand image has become endangered. The traditional high ground of luxury is being eroded by a drive for greater market share Nevertheless, brands like Hermès in the US is unconcerned, having doubled the size of its US business in the past five years as the company branches out into Phoenix, Denver and Seattle. This “mass” strategy has also worked for Louis Vuitton. Industry lore has it that 60 per cent of young Japanese women own one of their trademark printed handbags. The Louis Vuitton flagship store on the Champs-Elysées reports that Chinese consumers are buying at the same

rate as the Japanese. Meanwhile, China has become the brand’s third largest consumer after Japan and the US. Moreover, in 2006, Gucci had 11 stores in China, and make its debut in Ukraine. For others, catering to the masses has not worked as well. Take Burberry as an example. The British company’s trademark plaid has graced not only the traditional trench coats, but under the guidance of CEO Rose-Marie Bravo, also patterns undergarments, baby clothes and a range of other familiar products. While this campaign served to boost the bottom line, it hit a road block when the Burberry plaid was adopted by soccer hooligans and B-list actresses. Even nightclubs in Britain refused entry to people wearing the Burberry signature pattern. A backlash against mass marketing is ensuing. Tom Ford, the former vicechairman of Gucci group has launched a luxury men’s line catering to the ultraexclusive. Brand protection has become a priority. To guard against the cheapening of a brand’s image while broadening sales to the masses, luxury goods companies have introduced greater product differentiation. For example, Gucci has developed its jewelry line, which caters specifically to the ultra-rich. Bags and dresses at Louis Vuitton and Alexander McQueen can be made-to-order to offset more accessible

SPRING 2008 | HARVARD COLLEGE INVESTMENT MAGAZINE

Features designs. The pressure faced by large luxury conglomerates to expand their sales has come from the public listing of these companies, many of which had formerly been private family-owned businesses. With increased demands to please shareholders, the bottom line has become more important than the aura of exclusivity. Luxury is no longer a privilege; it is a classification for a business.

The IPO Bandwagon

The Italian fashion house, Prada, is the most recent luxury business to join the IPO bandwagon, having selected Goldman Sachs, Intesa Sanpaolo and UniCredit to broker their public listing expected in 2008. Although Prada has made efforts to go public five times since 2001, the group’s solid financial performance in 2007 boosts prospects for a successful IPO. The few luxury houses that have held out include Chanel, Armani and Versace. According the Bloomberg, Prada’s IPO will be the largest IPO in the luxury goods industry at 5 billion euros (US$ 7.2 billion). Two kinds of luxury goods houses to go public. The first is the large, diversified conglomerate like LVMH, which owns such design houses as Givenchy and Marc Jacobs, controlled by professional managers. The second is the family-run companies like Hermes, whose voting stock is closely guarded by the Hermes family. Prada is of the latter type. A public offering provides both these types of companies with the financial capital to drive further expansion and diversification. There are alternatives to going public. Other design houses like Valentino and Tommy Hilfiger have opted to use private equity to finance their growth. Nevertheless, the increasing number of fashion houses seeking to go public indicates the rising costs of operating a luxury goods company. Entering new markets to cater to the neuvo riche in China, India and other developing countries is expensive. However, going public exposes the luxury goods sector to the vicissitudes of the market. Of particular concern now to European luxury brands is the weakening dollar relative to the euro. Many companies have artificially suppressed prices to keep American consumers happy. However, 16

greater discounts mean lower margins.

Is the Bling Devaluing?

Even the rich are not immune to the economic downturn. Citing a Chicago Tribune article, the average amount spent by affluent consumers on luxury dropped 21 percent to US$12,142 in the third quarter of 2007 from an average of $15,283 in the second quarter. With luxury items bearing

Given the promising fundamentals of the luxury goods industry, common investors have shattered the highly coveted exclusivity of LVMH, Hermès and Bulgari, once the sole preserve of the aristocracy. the brunt of the decline in spending, the balance may tip towards catering to the masses instead of the exclusive rich. A few years ago, UK head of Cartier Arnaud Bamberger noted: “The purchase of a luxury good is no longer the ordinary privilege of exceptional people, but also the exceptional purchase of ordinary people.” Now, it is rapidly becoming apparent that luxury items are becoming the ordinary purchase of ordinary people as well. The commoditization of luxury has resulted from the fine adjustment of prices, such that items were expensive enough for the middle-class to take pause before purchase,

HARVARD COLLEGE INVESTMENT MAGAZINE | SPRING 2008

but priced low enough to be affordable to more than just a select few. While buying luxury items retains its exclusivity for the majority of people, investing in luxury stock is not a luxury purchase. The appeal of investing in luxury stocks is considerable. The fundamentals appear outstanding as the number of consumers in much of Asia and the emerging markets wanting to buy Western luxury brands is rising every day. The luxury product business generates strong liquidity and most companies have very little indebtedness. The operating margin is often over 15 percent, with the companies able to dictate prices on their goods, depending on their success in brand management and marketing. The significant financial cushion luxury goods firms are reaping from IPOs and private equity funds translate to expansion and growth. Large sums of money are being spent to enter new markets and large luxury companies have the advantage of economies of scale. Several risks remain. Aggressive diversification into developing markets exposes luxury companies to unexpected events such as the outbreaks of bird flu and other crises. This would lead to short-term collapses in sales in the luxury goods industry. Another aforementioned risk is the growing strength of European currencies against the dollar and the Asian currencies. The old-line European luxury goods companies maintain their prestige and tradition through their in-house design and continue to manufacture the majority of their products in Europe. Outsourcing the fine leather stitching of Gucci shoes to China would undermine any brand credibility. Nevertheless, the demand for luxury stocks does not appear to be diminishing in the near future with growing world affluence, despite the recent stock price decline in the latter half of 2007. Luxury goods are still in vogue as the rich get richer. Exchange-rate fluctuations can be compensated for through price adjustments over the long term, however. Given the promising fundamentals of the luxury goods industry, common investors have shattered the highly coveted exclusivity of LVMH, Hermès and Bulgari, once the sole preserve of the aristocracy.

Alternative

Asset

IPOs

The private markets are tapping the public markets By Alex Bayers

Many hedge funds and private equity firms, which are both private unregulated pools of capital, are now tapping the public markets for money. Whether by raising money for investment funds on stock exchanges, or even selling a part of the management company to investors, these private investors are becoming increasingly public. A hedge fund is like a mutual fund, but with many fewer regulations governing its activities. It can invest in anything it wants, including public companies, private companies, bonds, or commodities. The unifying feature of all hedge funds is that they are only open to accredited investors because of SEC regulationsâ&#x20AC;&#x201D;wealthy investors who are presumed to be savvy enough with their money to understand the complicated investments these funds make. Private equity funds, in contrast, typically invest only in private companies, whether start-ups or large, established corporations that

they delist from a stock exchange. Regardless, both investment pools have historically been very secretive, and have had limited access to the public capital markets. However, these firms have now found new ways to raise money from the public. The first of these, and the most common, occurs when a hedge fund or private equity firm raises money for an investment fund through a publicly traded vehicle. In this situation, a hedge fund manager or private equity fund manager creates a company that either invests in one or a combination of its existing hedge funds, or invests the money in a manner identical to the strategy of the fund. Sometimes, funds of hedge funds managers will create companies that invest in a combination of hedge funds run by different managers. While no such funds have gone public in the United States, a number of managers offer these listed hedge funds in Europe, with widely varying

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Features strategies. While one fund, Man Dual Absolute Return Fund, which was to be managed by Tykhe Capital and the Man Group, was to be listed in the U.S. over the summer, its offering was cancelled after Tykhe fared extremely poorly during the U.S. credit crunch. Amongst the European offerings, Dexion Absolute, the largest listed fund of hedge funds, has placed $3 billion with a variety of managers, including activist fund Icahn Partners, while Goldman Sachs Dynamic Opportunities, another hedge fund of funds, has investments in AQR and D.E. Shaw, both quantitativelyfocused investment firms, as well as more conventional hedge funds Eton Park, OchZiff Capital, and Stark. Indeed, to illustrate the risks of hedge fund investing, Goldman Sachs Dynamic Opportunities had even invested in Amaranth Advisors, a large multi-strategy hedge fund that failed after large bets in the natural gas markets. While there are substantially more listed funds of hedge funds than there are listed hedge funds, the ranks of listed hedge funds are growing. Such funds allow managers to access permanent capital— capital which for the most part cannot be withdrawn—and also offer their products to groups of investors which they otherwise might not be able to reach. For investors, such products can offer new investment opportunities, as these investors might not have had enough money to meet a manager’s minimum investment requirements and at the same time might have a balanced portfolio. Because these shares can be traded, they also offer more liquidity than their unlisted equivalents; investors can simply sell their shares to other investors when they want to leave the fund. In contrast, many hedge funds only allow their investors to withdraw money on a monthly or quarterly basis, and the highest-returning funds may force investors to part with their money for a substantial amount of time before their capital can be returned—in some cases up to five years. Examples of listed hedge funds include Brevan Howard Macro, which had a $1 billion

IPO in spring 2007 and invests in fixedincome securities, and MW Tops, a fund that uses a computer system to rank the trading ideas of salespeople and trade off their suggestions. Ironically, activist investment fund Third Point, which buys large stakes in companies and urges them to make changes to their management, has itself listed a public offshore fund. In the other case, a hedge fund or private equity fund manager may take itself public. Hedge fund managers receive substantial fees from their clients, typically

‘‘

Ironically, activist

investment fund Third

Point, which buys large stakes in companies and urges them to make changes to their

management, has itself

’’

listed a public offshore fund.

taking 2% of assets under management (“management fees”) and 20% of profits (“performance fees”). Thus when a hedge fund manager goes public, it sells a claim on these management and performance fees. In recent months a number of funds have done this. The first to do so, Fortress Investment Group, manages multiple listed investment vehicles, hedge funds, and private equity funds, with an aggregate value in excess of $40 billion. The most notable subsequent offering has been that the Blackstone Group, with manages hedge funds, funds of hedge funds, and most notably corporate and real estate private equity

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investments. Other offerings have included multi-strategy hedge funds OchZiff Capital and GLG Partners, while Icahn Partners, an activist investment fund managed by Carl Icahn, sold itself to Icahn Enterprises, a publicly-traded investment fund which Icahn controls. And despite the credit crunch, leveraged buyout fund Kohlberg Kravis Roberts & Co. (KKR) has continued with plans to go public. Such offerings, however, may be viewed with skepticism. Private-equity firms such as the Blackstone Group and KKR have long avoided public view and derided the public markets for inefficiency. Indeed, having long criticized the public markets for their short-term thinking, private equity funds must now respond to such pressures. And given that such savvy investors are now selling, there remains the question of why other investors should buy their stocks. Share performance has largely reflected these concerns, as Blackstone, pummeled by the credit crisis, has traded around $21 per share, down from a high of about $38 per share. The decline amongst its peers has been more muted, with OchZiff, for example, trading at roughly $26 per share, down from a high of almost $33 per share. That said, these firms have tried to mitigate the issues associated with being public. Fortress, for example, requires its five partners to stay at the firm for five years to keep their stake in the firm, while the principals at Och-Ziff have invested their profits in the company’s hedge fund to align their incentives with the investors in the fund. Indeed, there are compelling reasons for a fund to go public, beyond the ability of founders to cash out. Employees can buy stock in the public company, for example, and thereby align their incentives with those of the firm. The firm can also use such stock to induce new employees to join the firm, and thus offer products in new categories. Thus given their depressed prices and the opportunities from these firms being public, for savvy investors now may be a good time to invest.

THE

BIG PICTURE

Freeze Frame of Film Industry in Flux By Dmitri Smirnov

lamorous and prestigious, the movie industry remains a business. Worldwide revenues of the filmed entertainment business reach $65 billion; the industry has been steadily growing at 10% per year, a rate that few other businesses can boast. The $9.2 billion 2006 domestic box office saw an increase of 4.2% compared to the previous year, while the number of movie theater screens has been consistently increasing since 2001. The number

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of pictures released in the U.S. grew by 9.7% compared to the previous year to 606 in 2006. Another factor signifying the current strength and prospective financial gains of the film production business is the records: this year, Spider-Man 3 grossed the highest openingweekend revenue of all time. Naturally, not every film results in such large box office receipts. Even prior to release, films can be distinguished between those that will produce gigantic revenues with little profit margins on huge budgets and those low-budget pictures that may bring good profits on smaller grosses: the former are referred to as “studio” productions, while the latter are called “independent” films. What are the main differences yielding such different financial results? Hollywood studios with deep pockets, such as Warner Brothers, Disney, and Paramount, finance studio productions, while the independents are funded by investors unrelated to studios. Most studios today are subsidiaries of multinational conglomerates, such as NBC Universal, owned by General Motors, or Columbia, owned by Sony. Moreover, most studios have their own independent divisions, like Sony Picture Classics or Warner Independent, leaving “true” independents competing for arthouse audiences.

Studio Productions

The studios do not stop at financing, instead taking a firm grip on the production and distribution processes of the picture. The script is acquired or developed by a studio with studio screenwriters revising it until it is ready to go into production. Once the picture is greenlit, the budget is decided on; the average is about $60 million. The film is then cast, and director, producer, editors, art directors and other production team members are assigned, after which the principal photography begins. In 6 months to a year, the filming and editing stages of production are completed, and the film is ready for distribution. With the average of $40 million marketing and advertising expenditures, the studio promotes the picture with TV, newspaper and other traditional forms of advertising, in addition to reliance on actor and director name recognition. Primetime cast interviews and critical reviews are arranged. Following North American theatrical run, the film is released abroad, with DVD and other home video to complete the 20

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film life cycle. By the time we see a movie on an airplane, the studio is deep into the next production.

Independent Productions

The independents command a much lower budget. From the “micro” $500,000 productions, to low-budget $1 million to rarely $20 million, the independent productions pursue an overall different business model. Attracting investors – frequently friends and family – with a business plan, the production functions outside the Hollywood studio system.The producer responsible for attracting the funds for the picture has the ultimate power over the production of the film; he also has the responsibility to find a distributor willing to cover the marketing costs when the film is complete. As the low budget may not be sufficient to cover the costs, frequently a part of the personnel compensations are agreed to be paid from the revenues of the film. This is also the most frequent form of payment to the producer who attracts the funding, since it signals to the investors the producers’ belief in the project’s success. In addition to less eminent actors, the tighter budgets force independents to use cheaper sets and modest special effects. Although acknowledged actors sometimes appear in lower-end independent films, they do so for artistic reasons rather than monetary gain.

Art Form Implications of Financing

Independent productions are granted more freedom in two ways. On a work-ethic level, production executives and participants have much more artistic liberty in exchange for mild monetary limitations.The director can choose the cast, and the rest of crew, including the editors. Under the Hollywood system, even though the director, if acknowledged, may have the freedom to choose the people he works with, he virtually has no control over how the film is edited and is subject to the studio’s “final cut”. This has compelled even eminent filmmakers like Alfred Hitchcock, who worked under the Hollywood system, to plan the shooting of his films meticulously so as to leave the editor without parts to cut out. An independent film allows the director to create a more personal work, while the rest of the crew benefit from association with a more prestigious project. In addition, independent films allow for a greater degree of experimentation for the

“

Certain trends have evolved over the past twenty years and have an immediate effect on every movie production... For example, only about one-quarter of a film’s total revenues come from the domestic box office.

artists involved. Because the budgets are much lower, the movie has to attract fewer viewers in order to cover the costs, resulting in bold yet inventive creative choices that do not limit the low-cost film’s profit opportunities.Rather,they are signals that target a narrower audience and offer a more engaging experience. As a result, independent films are often more critically acclaimed than typical studio fare, with films such as Pulp Fiction, The Blair Witch Project, and Napoleon Dynamite generating buzz and enviable profits. The stylish nature of independent films trickles down to the roles played by the crews in the process; every member gains more freedom of experimentation, such as the ability to use unconventional lighting. This emancipation circumvents as well as results from the lower budget under command. And although people employed in the independent sector of the industry are often less experienced, some acknowledged filmmakers like Jim Jarmusch choose to remain independent in order to retain their creative autonomy.

Affecting Both?

Certain trends have evolved over the past twenty years and have an immediate effect

on every movie production, independent or studio. For example, only about one-quarter of a film’s total revenues come from the domestic box office. While a record number of films, including Pirates of the Caribbean: At World’s End and Transformers, grossed over $300 million domestically in 2007, the increasing importance of the foreign box office cannot be underestimated as it affords unsuccessful domestic releases with the ability to break even or profit. Moreover, movie theaters take half of a film’s box office off the top. The distribution agreement usually requires that first revenues be sent over to cover the distribution costs. Thus the domestic box office might not cover the costs of theatrical exhibition and advertising. International distribution occurs typically after a film has been released in the U.S. market. The increase in overseas box office receipts can be attributed in part to the growth of foreign countries’ economies, which has resulted in more people willing to pay the price of a movie ticket. Consequently, international revenues have trumped domestic ticket sales by a two-to-one ratio. Even more important, however, are ancillary markets, such as DVD sales, which easily account for over half of total

”

revenue. Apart from major industry transformations and technological developments, most of which are favorable, a recent event undermines the maturity of the industry. As of January 2008, the Writers Guild of America strike, involving 12,000 screenwriters, has yet to be resolved. Both the independents and the studios are affected, although differently. The writers demand increases in minimum pay and residuals for uses of their products online from the Alliance of Motion Picture and Television Producers. This situation reflects the realities of the Digital Age and adversely affects the industry with potential losses estimated at $1 billion in the event that the strike remains protracted and prevents the development of new scripts, especially if the Screen Actors Guild joins the writers when their collective contract expires in June 2008. Still, the recent hedge fund and private equity investment boom in Hollywood signifies the overall strength of the movie industry, especially as investors diversify amidst the subprime mortgage crisis, testifying to both the volatility and vitality of global filmmaking, both studio and independent.

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PHA MA P

harmaceuticals have recently become a high-profile target for retail investors. In fact, 10% of the Dow Jones Industrial Average, measuring the thirty largest and most widely held public companies in the United States, comes from the pharmaceutical industry, namely Johnson & Johnson, Merck, and Pfizer. Two of these three pharmaceutical companies only became part of the DJIA within the past decade, with Johnson & Johnson joining Wal-Mart, replacing Texaco and Westinghouse in 1997, and Pfizer joining in 2004. Merck has had a place in the Index since 1979. Acknowledging that pharmaceutical companies have become a recent powerhouse in the financial world,it is necessary to speculate if they will hold strong like General Electric, which has been part of the DJIA since the late 1800s, or lose momentum as time progresses, like the coal, iron, and steal industries. In order to do this, we must take a look at where the pharmaceutical industry is now and where it is headed, and also consider what entices investors to hold these companies.

Making the Money

Discovering a blockbuster drug often means revenues of over $1 billion a year for its company. In fact, $1 billion is sometimes a gross underestimate; for example, the well known Pfizer drug, Lipitor, generated over 22

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CEUTICALS

Rising (or Falling?) Powerhouse By Yiying Xu

$6.5 billion in sales for fiscal year 2006. With this facet in mind, one drug discovery can allow a pharmaceutical company to operate without financial concern for the next 5 to 10 years, giving the “pharma” time to make its next big discovery. This time span comes from the fact that FDA’s patent with exclusivity only lasts seven years for Orphan Drugs, which treat rare diseases affecting fewer than 200, 000 people; five years for New Chemicals, which are most drugs developed that do not fall into the Orphan Drugs category; and an additional six months if the drug is tested to be safe in children. In other words, generics will be competing in the market when the exclusivity expires. Unfortunately, this means that the pharma companies will be losing most of their income from these new drugs, even with the best marketing schemes, especially since generics often cost 50 percent less than brand name.

The Costs

The pharmaceutical industry is one of the most heavily regulated industries; companies have to spend millions of dollars on training each employee to avoid quid pro quos. Giving and receiving gifts and even the simple act of treating someone to a meal may be subject to a lawsuit. However, the bulk of costs still reside in the process of drug discovery. This entails screening thousands of compounds from a

previously generated private stock of potential money-makers for each company to find one that inhibits or promotes function at a target of interest. Subsequently researchers test and alter the candidate compounds in vitro in cells, in vivo in the animal models, and finally in humans for safety and efficacy. For FDA approval, the pharmaceutical must hire employees, many on the PhD and MD levels, to compile millions of pages of documentation. Further sunk costs arise when employees work on advertising strategies for a candidate drug for a couple of years only to learn later that the FDA has not approved the drug. A few years ago, Bain & Company completed a study which demonstrated that developing and launching a single drug costs about $1.7 billion, taking into account the many failed attempts at discovery.

INVESTING

Many factors come into play when considering whether or not to invest in a pharmaceutical company. Most importantly, investors must search for information on patents’ expiration dates and analyze quarterly and annual reports of these companies. As with other publicly listed companies, investors should look at the pharmaceutical’s profit report charts, especially the detailed listings of how each drug is contributing to overall earnings. It may also be helpful to compile

this data from older reports to produce a trend-line of how their products have been performing. Such research should ideally accompany an analysis of any information on their company restructuring or lawsuits. In addition, monitoring a company’s drug pipeline, or which drugs they have at each stage of nonclinical or clinical trials, provides a reliable indicator of potential FDA approval. To comprehend this information fully, investors must understand that clinical trial phases begin after the drug has been proven effective in vivo in animals as well as in vitro in some human cells, if possible. For clinical trials, Phase I tests for safety in humans and determines a safe dosage; Phase II tests mainly for efficacy; Phase III further tests for efficacy and side effects against existing drugs. If the drug is proven to be unsafe during any stage of the trials, studies will be permanently terminated. Finally, Phase IV involves continual monitoring of a drug after it has been marketed. If a company has several drugs in phase III of clinical trials, this means that these drugs have a high potential of being approved and entering the market within the next year or two, so the company’s stock is likely to rise. Investors must also note which symptoms the drug is targeted to treat. If a symptom is prevalent among the human population and there is limited competition

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Inside Scope

“

The supply of more easily ascertainable drugs is being exhausted, leaving drugs that may take a much longer time to discover and assess.

in existing treatments, then a new drug designed to alleviate this symptom will most likely skyrocket a company’s earnings. An example of limited competition occurs when a newly discovered non-drowsy allergy drug enters an existing market of lethargic ones. Currently, the most money-making drugs are ones that target cholesterol, hypertension, diabetes, depression and anxiety, asthma and allergies, acid reflux, and hypertension. Further investors should remember to analyze the market competition against generic and brand name drugs with similar functions, especially the patent exclusivity expirations for the competing brand-name drugs. Just as in any other industry, recent news and press releases provide vital information for investors. Problems with certain drugs, new discoveries, and structural and management changes are all indicative of stock fluctuations. For example, in 2005 Merck’s Vioxx settlement resulted in the company paying $4.85 billion to the families of heart attack victims. This event illustrates the precarious nature of pharmaceuticals: flawed research on a single drug can cost a year or more of earnings. Furthermore, the massive recent downsizing by leading pharmaceuticals, such as Pfizer, 24

Bayer, Wyeth, Bristol Myers Squibb and AstraZeneca, does not send a good signal to investors. These changes may provide insight to the industry’s future.

THE FUTURE OF PHARMACEUTICALS

It is unfortunate yet true that pharmaceuticals are only profitable when discovering drugs that will treat disease symptoms through continual use rather than cure them. Therefore, the two biggest threats to the industry are an exponential decrease of discovering potential blockbuster drugs and the unlikely but still possible event of academia discovering cures to common diseases. Many are concerned that the supply of more easily ascertainable drugs is being exhausted, leaving drugs that may take a much longer time to discover and assess. And unfortunately, profit-oriented pharmaceutical companies do not have the luxury of time. Leading the way to revamp the methodology behind drug discovery is the Broad Institute of Harvard and MIT, which is integrating knowledge of the human genome and advanced technology into drug discovery to more systematically to synthesize and screen small molecules for potential drugs. If such research institutes

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”

find successful drugs, they might instigate pharmaceutical companies’ demise, whereas their failure might revive the industry. Yet regardless of the outcome, these potential threats are long term by nature. The most immediate concerns arise from the government’s revision of the health care system. For example, if the government finalizes Medicare only paying for one or two drugs for a given disease,many pharmaceuticals may be put out of business immediately, because their blockbusters often overlap in function with those of other companies. This problem also arises with private insurance companies, because they have the power to decide which drugs they will discount to their customers. If pharmaceutical companies do not reach an adequate agreement, such as pricing discounts, with insurance companies, their blockbusters may make very little if any profit due to cheaper alternatives for the consumer. Although many problems seem to hinder pharmaceuticals’ progression into the next decade, the fact that most of the industry’s stocks are still popular investments illustrates that the pharmaceutical industry is alive and well.

ShoreBank Interview with

With Chairman and Co-Founder, Ron Grzywinski, Executive Vice-President, Consumer and Community Banking, Jean Pogge, and Manager of Triple Bottom Line Innovations, Joel Freehling.

By Sarah Wang

ShoreBank is not your typical financial institution. As the nation’s first and leading community development and environmental bank, ShoreBank pioneered the popular concept of socially responsible investing and environmental lending. Founded in 1973 to help combat redlining within Chicago’s South and West Side neighborhoods, ShoreBank pursues a triple bottom line mission. Devoted to revitalizing and building strong, sustainable communities, ShoreBank understands that long-term community prosperity is closely linked to a healthy environment, so environmental impact and profitability are parts of their mission as well. Recently, the Harvard College Investment Magazine had the fortune of conducting an interview with a few ShoreBank executives who have been instrumental in the design and implementation of the company’s innovative financial services and continuous success, including Ron Grzywinski, Chairman and Co-Founder of ShoreBank, Jean Pogge, Executive Vice-President of Consumer and Community Banking, and Joel Freehling, Manager of Triple Bottom Line Innovations. SPRING 2008 | HARVARD COLLEGE INVESTMENT MAGAZINE

Inside Scope HCIM: Ron, you were with ShoreBank from the very beginning as one of the co-founders. What is the story behind ShoreBank’s inception? What makes it different? Ron: At ShoreBank, our guiding mission has always been to use every lever at our disposal to achieve social good. The story behind its inception starts back in the late 1960s, when the four of us—Mary Houghton, Milton Davis, Jim Fletcher and I—were working on Chicago’s South Side to develop the first minority, small business lending program in Illinois. We had the right mix of backgrounds for the job. We all had a history with the Civil Rights Movement, community organizing, and banking. From the very beginning, we envisioned a world in which the power of the marketplace could be harnessed to achieve social good. At the time, this simply wasn’t happening. Banks were siphoning deposits from low-income neighborhoods and investing them elsewhere. We saw the ways the disinvestment accelerated the death spiral of local neighborhoods and how the institutional indifference contributed to an endless cycle of despair and disintegration. We decided to do something about it. We asked ourselves: what would happen if a local bank reversed the flow and targeted its resources on a deteriorating neighborhood? Was it possible to harness the discipline of a profit motive—that is, to be self-sustaining— while still making a positive difference in the community?” In other words, could a bank “do well by also doing right?” We imagined a new kind of institution to support those enterprises, a community development bank—a bank that could be tough-minded about loans, tough-minded about borrowers, satisfy the most demanding federal examiners and yet still make a profit by transforming underserved urban neighborhoods. When the opportunity arose to purchase the South Shore National Bank in 1973, we grabbed the opportunity to put our theories to the test. Needless to say, we had many hurdles to overcome. We had to build a staff, build community trust, and build a deposit base before we could even think about sustainability. Thanks to an abundance of determination, the hard work of our employees,and the trust of our investors, we have been able to translate what 26

started as a good idea into a successful business. [Today, ShoreBank Corporation is America’s first and leading community development and environmental banking company. With banking services and nonprofit affiliates in Chicago, Cleveland, Detroit, and the Pacific Northwest as well as international consulting and business advisory services, ShoreBank is committed to revitalizing and building strong, sustainable communities.] Nothing wrong with this but could be edited out, as has already been mentioned in introduction. In the mid-1990s, we understood that longterm community prosperity is closely linked to leaving a positive environmental foot-print, so we made that a part of our mission as well. After spending most of my life working to harness the power of the marketplace to build low-income communities and alleviate poverty, I believe more than ever that great progress is possible only if we continue to blur the lines between social responsibility and entrepreneurship. It won’t be easy, but few things worth doing ever are. It is possible. And I’m proud that ShoreBank is doing its part.

HCIM: Social responsibility has always been at the core of ShoreBank’s mission. How do you think it will play into other financial institutions and corporations today? Ron: Socially responsible investment and corporate responsibility are rapidly growing developments in America. Consumers are growing more media savvy and sophisticated by the day. They have learned, particularly those at the younger end of the spectrum, to ignore the corporate mouth and to watch the corporate feet. Just proclaiming yourself a responsible corporate citizen doesn’t necessarily make you one. You’ve got to prove it. More and more in these post-Enron days, people are beginning to demand concrete action and measurable results when it comes to social responsibility—a trend that has helped drive more companies to embrace triple bottom line reporting. To my mind, this will be an increasingly important ingredient as we define success in the 21st century. Not that long ago, it was enough to return an appropriate profit or boost our share price to an acceptable level. And that was pretty much where the story ended. Today, of course, the story’s a little more complicated. Increasingly,

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business leaders in the 21st century are being challenged not just to operate a successful business, but also do so in a socially aware and responsible manner.

HCIM: Jean, you have done a lot of work with the financial products that ShoreBank offers to its clients. How do you feel ShoreBank’s mission has manifested itself through its products, and how have they in turn made ShoreBank successful? Jean: Our response to redlining was based on the theory that if the bank had confidence in the future of a neighborhood, that neighborhood would have a future. That belief is manifested today in our aggressive and ambitious efforts to tackle the adjustable rate sub-prime mortgage crisis in Chicago.

During the previous home buying frenzy, thousands of homeowners became susceptible to irresponsible lending practices that put them in mortgages that are now unaffordable, and as a result the foreclosure average in Chicago is twice the national average and the minority communities that ShoreBank serves and has worked to revitalize for the last 30 years have been hit especially hard. In keeping with our mission that the bank is built on, ShoreBank launched a Rescue Loan program designed to provide homeowners with access to the resources and information they need that can help prevent homeowners from foreclosure. Our personal “old-fashioned” character lending practice includes helping borrowers to refinance the sub-prime loans they originally obtained from other banks by offering them a fixed-rate loan from ShoreBank. And of course, our financial

literacy and community outreach programs are designed to teach borrowers how to obtain a responsible mortgage that is best suited to their financial needs and goals. We’ve attacked this foreclosure rate with such a passion because of the negative consequences it has on the neighborhood and members of the community. This is just one example of how our mission can really make a difference. On the flip side, making these loans requires a significant amount of new deposits; we have to raise deposits in order to have money to lend. So this led to the introduction of a new product, a high yield savings account online, www.sbk.com, paying 5% interest. Few banks of our kind offer a competitive rate and a social return for depositors. Depositors know that their money is not only earning them 5% interest on their savings account but

also going towards funding folks at risk for foreclosure or encouraging new green design and energy-efficient developments.

HCIM: You spoke specifically about ShoreBank’s “rescue mortgages.” How has ShoreBank generally fared in the recent homeowner crisis and credit crunch? Jean: Many financial institutions right now are taking losses and cutting back. At ShoreBank, one of our goals is to continue growing our mortgage lending business and double its portfolio to $300 million over the next 12 to 18 months. The difference in our response stems from our experience and history with single family mortgages. While we do make sub-prime loans, charging borrowers with fair credit scores just slightly more than the prime rate, our fixed-rate, escrow-

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Inside Scope included mortgages help our customers ensure sustainable homeownership and that we operate profitably. Our thorough income verification and personal service that includes holding onto the loan and servicing it, once it has closed, has met with astounding success: our portfolio and performance consistently meets or exceeds the performance of other comparable-sized more commercial banks.

HCIM: Joel, I know that you also have a lot to say about social entrepreneurship, especially in relation to green banking, which is something that you deal with through your position at ShoreBank. What exactly does managing triple bottom line innovations entail?

to bring green building practices to smaller projects, such as existing homes and places where the green building sector hasn’t yet made a huge impact. For example, there’s a desperate need for energy efficiency in Chicago, Detroit and Cleveland homes. Our goal is to fulfill this need and in turn help bring more predictable and lower costs of energy to residents of lowto-moderate wealth communities. One program we have to address this is the Homeowners Energy Conservation Loan Program. In this program, we encourage and promote customers to consider energy efficiency when a customer inquires about a rehab loan for their home. We arrange, at no expense to the customer, an energy rater to inspect the home and the rehab plan to

Joel: Most of my job involves creating programs that can help our customers achieve the objectives that we all want for the communities and the people living in them. Our goal is to help customers find ways to invest in the community and promote economic development that enhances environmental sustainability. Essentially, we seek to create a financially competitive product that satisfies the direct need of the customer in a way that is socially responsible as well. By doing this, we create a triple win situation in which we can make money, the neighborhoods become better places to live and work, and the customer saves money on energy costs and has a more economical and safer place to live. This question and answer can be eliminated as long as the last sentence is summarized in the introduction.

The green building industry is an incredibly exciting field. We see how fast it is growing in the number of new institutions that have environmental affairs departments and who are making significant investments, internally and in personnel.

HCIM: On the topic of conservation lending and green banking, what role has ShoreBank taken in this growing industry? Joel: ShoreBank created the nation’s first environmental bank in 1997, nearly a decade before there was a second environmental bank in the US. Now, green banks are proliferating at a rapid pace. We’re tremendously excited for the competition. However despite the buzz surrounding green building in the construction industry, our focus on bringing these ideas and practices to low wealth communities and to projects involving adaptive re-use is what makes us different. We’re committed to finding ways 28

make specific recommendations about ways to reduce energy costs and consumption in the home. In addition, our energy raters also share with the customer the costs and savings that are likely to accrue – in most instances, the upfront costs can be recouped in three to five years. If the customer completes more than $2000 of energy repairs, ShoreBank gives them a free Energy Star refrigerator.

HCIM: Do you have any advice for Harvard students who are interested in getting involved in socially responsible investment or social entrepreneurship?

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Jean: I started off in business. My first career dealt with insurance and management. My second career was in the nonprofit world as the Executive Director of the Woodstock Institute. These two careers really came together when I arrived at ShoreBank. I love business, but I’m a mission-driven person. When I wake up in the morning, how much money I’m going to make is not the first thing I’m concerned with. I want to “do-good and do well,” and ShoreBank’s triple bottom line that values profitability, people, and planet really allows me to do that. That’s why I work here. The combination of business and mission is very exciting. It’s not easy to do both, but there are more and more young and mid-career people who are attracted to this business, and as a result, more and more businesses are becoming triple bottom line businesses. Get involved now. The role of business in the future will be different than in the past. The amount of dollars in socially responsible investments (SRI) continues to mushroom. There is a growing need for concerned business leaders who will create the world that we want to live in. Money is such a powerful force in the world today—when you link that with values, it will change the world in a very positive way. I encourage everyone to think about a career in socially responsible investment. Joel: The green building industry is an incredibly exciting field. We see how fast it is growing in the number of new institutions that have environmental affairs departments and who are making significant investments, internally and in personnel. Another example is simply the attendance at Green Build, the National Expo for the U.S. Green Building Council, which rose from 700 to 22,000 in just a few years. On the other hand, out of the 100 sessions that were presented at this expo, few focused specifically on finance. There is definitely a need for more interaction between the design community and the finance community. We’re just at the very beginning of having these conversations and integrating finance into the design of buildings and enhancements of environmentally sustainable building practices. There’s a need to bridge the chasm between architecture and finance. I truly believe “the world is your oyster” for anyone who wants to get involved in this area today.

The

GHOST of

Crisis Present:

Structured Investment Vehicles

By Maxwell Young

Volatility has become a familiar, albeit unwelcome, face in financial markets recently as consequences from the sub-prime crisis continue to arise. Among these consequences, one stands out as a topic of debate - the state of structured investment vehicles. Structured investment vehicles (SIVs) first gained public attention in the throes of the sub-prime crisis when commercial paper markets became illiquid, but they have existed much longer.

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IVs first appeared about two decades ago – not long after the initial appearance of mortgage-

backed securities, coincidentally – as off-book bank trusts.

By placing SIVs off-book, banks reduce their capital requirement, which allows them to make more loans while still investing billions in the SIV. Although not as preponderant as they are today, SIVs worked in essentially the same manner by issuing short-term debt in the form of commercial paper, then using the proceeds of the sale to buy longterm debt in the form of bonds. The spread in the respective interest rates generated the SIV’s profits, and profit they did. High credit ratings allowed SIVs to leverage themselves several times over, resulting in enhanced returns. As time went on, more banks created these off-book entities, investing in derivatives and debt instruments of all kinds, including student loans, credit card loans, collateralized debt obligations, asset-backed securities, and mortgages. By the time the sub-prime crisis emerged, SIVs were estimated to be worth almost $400 billion. Quietly profiting for year upon year, SIVs were suddenly thrust into the spotlight

“

this past summer. While few investors knew how these entities functioned, those who did perceived the potential for steep losses. The commercial paper market is usually considered mundane and nearly riskless, but when perceived risk does increase, lenders demand higher rates of interest to compensate for the additional uncertainty. The interest rates on commercial paper usually track the LIBOR rate; but when financial and credit market turmoil became focused on short-term money markets, the spread between commercial paper issued by SIVs and the LIBOR rate skyrocketed. By September the spread reached 60 basis points, which paralyzed the commercial paper market. Opaque to investors, SIVs had an unknown amount of exposure to risky sub-prime mortgages. Investors abruptly became unwilling to continue investing their money with SIVs, especially given that the commercial paper they bought paid only a tiny

Unless investors see less-opaque, better-regulated SIVs, it is unlikely their confidence will be restored.

”

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premium over risk-free government bonds. An illiquid commercial paper market left many SIVs in a grim predicament. Without the ability to rollover their debt, these SIVs were forced to sell their assets at low prices as an act of desperation. This is a lose-lose situation for the big banks that sponsor these SIVs. If the SIVs do unload some of their assets at steeply discounted prices, the banks take a sizeable loss on the value of their off-book investment. Alternatively, if the banks move the SIVs’ assets and paper on-book, losses would be incurred by the depressed value of the paper on their balance sheet and, more indirectly, by necessarily setting aside more reserves to cover these assets, thereby reducing loaning potential. Some banks found a third option, which has given rise to both relief and debate. On October 15, Citigroup Inc. (which currently has the largest exposure to SIVs at around $80 billion), Bank of America Corp., and JP Morgan Chase & Co. announced they had put together a plan, with the blessing of the U.S. Treasury Department, to set up a $100

billion fund to aid SIVs. Dubbed the MasterLiquidity Enhancement Conduit (M-LEC), this “Superfund” would borrow money by issuing short- and medium-term debt, using the proceeds to buy good assets from SIVs at a 2% discount to market value, as well as a 4% note. Furthermore, the banks behind M-LEC would repay investors in the event that the debt could not be refinanced. This is where the debate arises: is M-LEC a solution or just another stop-gap measure that further delays addressing the fundamental problem? On the one hand, it is certain M-LEC will allow losses to be spread out over a longer period of time, preventing wild changes in valuation which could further affect credit markets negatively. The realization that in times of scarce liquidity, SIVs possess the potential to substantially destabilize the market indicates that a more critical action may be needed. To be fair to SIVs, they are not liable for the high credit ratings issued for many unsafe mortgage-backed securities, which is a separate issue regarding the ratings agencies and their role in precipitating the recent crises. Furthermore, the primary cause

of the problem was illiquidity, not issues concerning the SIVs themselves; in fact, not one SIV has reported losses due to bad bonds. Downgrading has admittedly taken place: most seriously, the SIV sponsored by German bank IKB saw its commercial paper rating downgraded several notches by S&P as it sold steeply discounted assets to finance its liabilities. Nonetheless, most major money fund companies still view SIVs as having minimal credit risk. Fidelity Investments, for example, recently released a report entitled “A Discussion of the Structured Investment Vehicle Marketplace and Fidelity’s Money Market Funds,” in which they maintain support for SIVs and M-LEC. “We believe our holdings of SIV debt securities…continue to represent minimal credit risk,” the report says. Although Fidelity maintains a lower percentage of assets in SIVs than other companies, this still demonstrates that SIVs occupy, and will likely continue to occupy, an important investment niche. Nonetheless, the effects of the credit crisis have revealed facts about SIVs that investors clearly find unsettling – all the more so,

perhaps, because SIVs had been flying under the radar for so long. At the very least, the lack of both regulation and transparency calls for concern. Investor uncertainty regarding the risks inherent in the assets held by SIVs was the primary force behind the sudden loss of liquidity in the commercial paper market and in the broader market. M-LEC will stretch the timeframe over which bad bonds will be absorbed, and the major banks are doing what they can to protect themselves and the market from additional credit fallout. However, unless current conditions change, the same risks will remain in play, awaiting a new crisis to arrive. Even Treasury Secretary Henry Paulson, who wholeheartedly supports the creation of M-LEC, has said regulatory changes may be needed to prevent future problems. Regulators need to clarify that the ultimate responsibility for SIVs lies with banks. Unless investors see less-opaque, better-regulated SIVs, it is unlikely that investor confidence in SIVs will be restored. The debut of M-LEC should prove a bellwether for investor confidence in SIVs, and will set the tone for how much change the market will demand.

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Value Investing in

Real Estate

Investment Trusts

(REITS)

By Stanley Chiang

uring the past few months, fears of the subprime mortgage crisis have driven down real-estate prices and have lead to speculation of a housinglead recession. But taking a closer look at the prime culprits behind this subprime crisis may present investment opportunities, giving meaning to the old investment adage that “it is darkest before dawn.” Irrational investors have mispriced commercial REITS simply because of their guilt by association with subprime mortgages. Commercial mortgages, however, behave very differently from residential mortgages and have very little subprime exposure.

A Rehash of the Subprime Crisis

The subprime crisis has received enough press to make it a household name and investors wary of touching anything assets that are related to subprime mortgages. But here’s a quick summary of what caused the subprime crisis. Mortgage originators and loan companies, such as New Century 32

Financial and American Home Mortgage, would make subprime loans to borrowers. Instead of holding the loans, these lending companies would sell them to banks and other financial companies for cash, which would be used to ma`e more loans. In turn, the financial companies that bought the loans would securitize them into mortgagebacked securities (MBS), which had cashflows that relied on the principle and interest payments on loans. Furthermore, banks would created structured products, such as collateralized debt obligations (CDO) and structured investment vehicles (SIV), that were designed to protect against risk by creating tranches and by taking advantage of the spread between the mortgage loan rate and the risk-free rate. Through this securitization, originators passed the credit and default risk to banks and third-party investors. This resulted in a vicious cycle where originators would aggressively issuing loans to anyone who would take them— effectively mispricing much of the risk

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that were sold to banks. As housing prices began to drop in 2006 and 2007, refinancing subprime loans became difficult, and foreclosure rates increased. Mortgage-backed assets lost value as foreclosure rates increased and the payment stream became difficult to predict. As mortgage-backed securities lost value, banks and other MBS holders faced financial distress, forcing the sale of MBS at discounted prices.

REITS: Value Investment Opportunity

Although it is possible for the ordinary investor to taking advantage of the subprime crisis by buying mispriced MBS that have driven down by fears of increased defaults on loans, it is difficult to estimate the true value of these MBS without an intimate knowledge of the loan market. So how can the ordinary investor profit from this crisis? One way is to invest in Real Estate Investment Trusts (REITs) that have negatively affected by the subprime debacle. Numerous REITs that have little or no subprime exposure have

lost value because of their association with subprime loans. To find value investing opportunity, we have to understand the different types of REITs there are. There are three general types of REITS: equity, mortgage, and hybrid. An equity REIT generally holds a portfolio of real properties, such as office buildings, residential apartments, and commercial holdings. Conversely, a Mortgage REIT (MREIT) comprises of financial investments, primarily originating and buying loans. These Mortgage REITs can be further separated into those holding Commercial mortgagebacked securities and those holding Residential mortgage-backed securities.These Residential mortgage-backed securities, backed by prime and subprime home loans, are the culprits behind the subprime crisis. Commercial mortgage-backed securities, which are backed by payments on hotels, retail properties, office buildings, have been healthy as the loan defaults have generally been isolated to the residential sector. As

the housing market slumped, homeowners found it difficult to repay the loans on homes that were difficult to sell. The collapse of the infamous Bear Stearns hedge fund and other quant funds have stemmed from their holdings in residential mortgage-backed securities that were based on subprime loans. However, subprime loans are hardly ever issued to commercial entities, and therefore Commercial REITs have lost value simply because of association. Numerous REITs, both equity and mortgage, have no exposure to the residential market, and therefore no subprime exposure. Understanding that the Residential MBS and Commercial MBS markets behave very differently underpins this investment opportunity. I believe that these Commercial equity and mortgage REITs present value investing buy opportunities, as irrational selling has driven their price below their true values. Many investors, however, fear that the loan defaults on the subprime market could spread to prime loans. With an investor-

friendly Fed, I believe that this outcome is unlikely, and furthermore, a protracted housing slump caused by the subprime crisis is improbable as the Fed continues to cut the interest rate. For investors with greater risk tolerances could look into buying opportunities of the financial companies that have suffer write-downs because of the loss in value of MBS. Because of the subprime crisis, it is difficult to estimate the actual value of MBS with subprime exposure, and at times, the impact of the subprime crisis has been overestimated. Many of these financial companies hold healthy operations in other markets besides the loan market, but their involvement in the subprime crisis have caused investors to avert holding equity in these companies. Many REITs with limited subprime exposure have been caught in irrational investment fears. There may likely be a market correction as soon as investors realize that there have been very few commercial loan defaults.

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The Impending Stock Index Futures

The Chinese stock market The successful Split-Share state-owned shares and

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in China

Li Qing

University of International Business and Economics (UIBE), Beijing, P. R. China

is coming into its position as the weather vane of the national economy. Structural Reform of China solved the tough problem of the circulation of the explosive expansion of the Chinese stock market, thus beginning

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Investing Today the pouring of many blue chip firms into the market, such as the Bank Of China, PetroChina, China Shenhua Energy, China Life Insurance, and Daqin Railway, etc. Attracted by the high speed development of the Chinese national economy, international investment capital has swarmed into the Chinese stock market. To hedge against losses in long or short positions in this market, the stock index futures is willing to meet this demand. In brief, the Stock Index Futures is a security that uses composite stock indices to allow investors to speculate on the performance of the entire stock market or to hedge against losses using long or short positions. The settlement of the contracts is typically in cash. According to the analysts’ expectations, the long-anticipated stock index futures in China will launch in the latter part of 2007 or early 2008. Starting back on November 1, 2006, the first stock index futures, CSI 300 Index, stepped into the mock trading stage in which more than 80 futures companies, broker, funds and insurance companies participated. “The country has basically completed systems and technical preparation for the launch of its first stock index futures,” Shang Fulin, Chairman of the China Securities Regulatory Commission (CSRC), said on October 27, 2007. “The commission will continue the final preparation before officially introducing the stock index futures,” Mr. Shang said at the 2007 China Financial Derivatives Conference held in Beijing.

A Feasibility Analysis

China is ready now for the stock index futures partly because of the lessons learned from the failure of 1993 when the Hainan Stock Exchange Quotation Center (disbanded later) issued the primary stock index futures. However, after 14 years of accelerated development of the stock market plus the amount of listed companies and the aggregate market value multiplied, accompanying the modification of regulations & techniques and accumulation of practice and experiences, investors believe the stock market is now ready for the new stock index futures to take off. Just after the State Council pointed out in the Opinions of the State Council on

Promoting the Reform, Opening and Steady Growth of Capital Markets (2004) that “it will be a strategic task to well develop the capital market in China” and “implement the R&D of new financial varieties, as well as financial derivatives, which related to stocks and funds”, the newly revised Securities Law of the People’s Republic of China (Revised in 2005), which was put in practice on Jan 1, 2006. This allowed the development of novel varieties of securities. This law indicates that the stock index future is legal from then on. Since early 2007, quite a number of rules and regulations that benefited the stock index futures have appeared. The long-prepared China Financial Futures Exchange (CFFEX) was founded in Shanghai on September 8, 2006. Soon after the establishment of CFFEX it issued four draft rules for comments as the CSI 300 Index Futures Contract, Detailed Trading Rules, Detailed Clearing Rules, and Risk Management Measures, which paves the way for the financial futures in the near future. The futures market now is facing a golden opportunity for sufficient development which was guaranteed by the new rules and regulations. The newly revised Regulations on the Administration of Futures Trading, adopted at the 168th Meeting of the Standing Committee of the State Council on Feb. 7, 2007, was promulgated and went into effect as of April 15, 2007, while at the same time, the Interim Regulations on Administration of Futures Trading which was promulgated by the State Council on June 2, 1999 was abolished. The new regulation was modified and extended greatly, and also announced that financial futures and options trading is permitted, meanwhile the forbidden clauses were deleted. The implementation of the new regulation is the milestone that will lead the Chinese capital market to a new epoch. The CSRC issued a series of rules & regulations consecutively in 2007, such as Trail Measures for the Administration of Risk Management Indicators of Futures Companies on April 18; Trial Measures for the Financial Futures Clearing Business of Futures Companies on April 19; Trial Measures for the Provision of Intermediary

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Introduction Business to Futures Companies by Securities Companies on April 20. Accordingly, the CFFEX released on its website a series of rules and measures as drafts for comments. On June 27, CFFEX issued the Trading Rules of the China Financial Futures Exchange, approved by CSRC, which consisted of detailed rules & regulations on trading, settlement, risk management, hedging and so on. Other nine matching trading rules of CFFEX promulgated consequently, including Measures on Disposal of Rules Breaking and Contract Breaches, Measures on Hedge Management, Information Management Measures, Membership Management Measures, Risk Management,, Detailed

Clearing Business Rules, Detailed Clearing Rules, Detailed Trading Rules, and CSI 300 Futures Contract. All these regulatory preparations indicated that the basic framework of laws and regulation relevant to the stock index futures has been well established and ready for its launch.

The Elusive Target Index

From the experience of more established foreign indexes, the choice of an appropriate stock index is key in successful trading. As the stock index is the conglomeration of the individual stocksâ&#x20AC;&#x2122; prices, the movement of the stock index shows the increase and decrease of the total capital. An authoritative and representative stock index is the precondition for an

emerging financial futures market which is guaranteed by the high liquidity and extensive participation. Generally speaking, a component stock index is often chosen as the target index, and the market value of all these sample stocks accounts for 60~80% of the aggregate market value, such as S&P500 and HSI. The CSI 300 Index, made up of the top 500 stocks in the Chinese stock market, will be adopted as the target index in the coming stock index futures trading. Serving as the trading target index, CSI 300 Indexâ&#x20AC;&#x2122;s representation, sample scale, liquidity and weight distribution are generally watched by the investors. Compared with other indices, CSI 300 Index is calculated by the negotiable shares with their weights, which

is more dispersed and hard to manipulate. Since its publication on April 8, 2005, CSI 300 Index has shown good performance and rapid growth. The financial statement of the 3rd season of 2007 revealed the outstanding achievements and the profitable ability of the component listed companies. The statistic data shown as follows (current as of November 7, 2007) indicates that the broad coverage and extensive representation of the CSI 300 Index reflects the whole running of the Chinese stock market and major capital trends. On the other hand, the CSI 300 Index is harder to manipulate than the other current indices due to its big amount of component stocks and dispersed weights of them. A glance at the weighted shares

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Investing Today (current as of November 7, 2007), the biggest weighted share is CITIC Securities with a weight of 5.26%. Moreover, the top 20 weighted shares add up to 42.02%, while the average weight of each is less than 3%. Such distribution is close to that of S&P500, CAC40 and DAX30 from the mature capital market, and better than HSI and KOSPI200. Neither the aim of individuals and institutions or conspiracy to manipulate is likely to be successful. In addition, the CSI 300 Indexâ&#x20AC;&#x2122;s wellproportioned coverage of all 13 industries set by the CSRC reflects the outline of China national economy objectively. The top three component listed industries are manufacturing (141 companies), transportation & storage (30 companies), and mining (18 companies), while the manufacturing companies occupy 47%. From another point of view, the top three weighted industries are manufacturing, finance & insurance, and mining, with the weight proportions of 30.64%, 25.47% and 10.25% respectively. Owing to the significant disparity amongst most subindustries of manufacturing, their weights and trends differed greatly. Therefore, the finance & insurance and mining industries laid great influence on the stock index. Since PetroChina was integrated into CSI 300 Index on Nov 19, 2007, the mining

share with the weight ratio of 1.86%.

Building Blocks

China did not launch the stock index futures until the domestic capital market was mature and steady with more and more big blue chips. Otherwise, the immature capital market would have been vulnerable to attack and manipulation. Additionally, the juvenile investment concept, especially the shadow of over-speculation on the previous government bonds, made the administrators much cautious. The foundation of Shanghai Stock Exchange on November 26, 1990 symbolized the birth of the Chinese stock market. Shortly after that, the first stock index futures was born in the form of the Hainan Stock Exchange Quotation Center in March 1993. However, the unsteady and immature futures market faced the crisis of vicious manipulation of stock index by the conspiracy of big clients, and the Hainan Center was forced to close down in September 1993. Nevertheless, as the capital market developed, the market scale was enlarging greatly because more and more big blue chips became involved, and the stock index began to fully represent the whole market trend. Particularly, institutional investors have become the main force of the market, and the basic

Chinese domestic stock market has been re-energized and the basic systems of the securities market were strengthened. On this condition, the desire for the stock index futures came naturally. A keystone in the futures market is the trading of commodities. More than 17 years of smooth performance of the Chinese commodity futures market laid a sound foundation for financial futures. China Zhengzhou Grain Wholesale Market (CZGWM) was the first one to introduce the time bargain mechanism in the marketplace in October 1990. After 17 years of developing, commodity futures market experienced chaos and irregular phases, and now it has achieved the direction to be stable, ordered, and standard. It has also tried out a series of effective managerial measures, for instance, the commodity futures contracts, trading rules, margins and settlement, administration and risk management systems. At the same time, quite a number of experienced specialists and broker companies were cultured. Because of much commonness between commodity futures and financial futures, the precious experiences coming from commodity futures will also apply to the stock index futures. Additionally, the Chinese legal system has been modified constantly over the past 17 years, which will safeguard the coming stock index futures. Moreover, the system infrastructure was reinforced, and the margins supervision center was established. Also, investor security funds will come into existence soon, while the futures company financial safety indicators system is developing now. Therefore, the market supervision measures are much better than ever before. Furthermore, risk management system of Bourses and futures companies has been perfected, which will ensure the financial futures to run steadily.

Therefore, the market supervision measures are much better than ever before. Furthermore, risk management system of Bourses and futures companies has been perfected, which will ensure the financial futures to run steadily.

Behind the Wheel

industry would play an important role in the index from then on. On November 21, 2007, PetroChina became the 7th weighted 38

completion of the reform on non-tradable shares (G-share reforms) by the end of 2006 leads to a full circulation era. The

HARVARD COLLEGE INVESTMENT MAGAZINE | SPRING 2008

The stock index futures is mainly open to institutional investors, which was facilitated by a series of rules and regulations, especially for the full development of the

Investing Today

securities investment fund. According to the financial statement of the 3rd season, 2007, the total amount of securities investment funds reached 343 and the total fund units were 1,903.957 billion, together with the aggregate market value of net assets was 3,074.679 billion CNY. Furthermore, certain kinds of institutional investors are permitted by the CFFEX rules to participate in the stock index futures trading, such as Securities Companies, fund companies, insurance companies, trust companies, social security funds, QFII, financial companies, etc. However, they differ in the participation modes from each other. Multi-tier membership management modes establish safe and sound investor structures. At the present mock trading stage and the future real trading stage, institutional investors will definitely become the main force of the marketplace. Accompanied by the huge influx of capital pouring into the stock market, these institutional investors will optimize the investor structure of the Chinese stock market, and promote it to grow more mature and regular. Chinaâ&#x20AC;&#x2122;s stock market is unsteady, characterized by high fluctuation

and turnover ratio, so that the risk of stock prices is mainly caused by the market system. Institutional investors will suffer big losses if they can not retreat from the market as soon as possible in the case of risk. Consequently, institutional investors and many other individual investors urgently demand effective risk management tools to evade risk and hedge losses. Stock index futures can meet this need thanks to its low trading cost, flexible transactions, and high liquidity. Additionally, it also has the multifunctions of price discovery, speculation and arbitrage, which is suitable for investors to choose as the best hedging tool.

Intended and Unintended Consequences

No doubt that the new immature financial derivative, stock index futures, will exert complex influence on Chinaâ&#x20AC;&#x2122;s stock market, either good or bad, it is a new face to all. In spite of its negative impact, especially the huge financial risk to the whole market, we still need time to let it grow. Along with the globalization of the world economy, the financial markets of

most of the countries tend to connect to each other. Stock index futures have launched in most developed countries and emerging countries at present, which is helpful to form completed security derivatives markets. Any persistence in the single and traditional stock trading mode without financial derivatives is outdated and hard to link to the world capital market. Nowadays there are only main board and growth enterprise markets (GEM) in Chinaâ&#x20AC;&#x2122;s mainland stock market, which lacks the unlisted stock counter trading market, OTC (over-the-counter) market and the third or fourth market especially for the institutional investors. This simple trading mode can not meet the needs of various investors and demanders. The incomplete market system encumbers the capital market and it cannot realize effective financing and collocating functions. It is extremely important to fully develop the multi-level capital market, as well as the financial derivatives market, such as stock index futures, stock option, stock index option, share warrant, convertible bonds, and China depository receipt (CDR), etc. In addition, obviously, somebody else

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Investing Today will take advantage of China’s booming stock market to bring on the Chinese concept of stock index futures in other countries, which in turn exert influence on China’s stock market, either good or bad. For example, the Chicago Board Options Exchange (CBOE) has brought out the China stock index futures (CX. CBOE) in October 2004, which was not the China domestic stock index, but that of 16 China Companies listed in NYSE or NASDAQ. Soon after that, the Singapore Exchange (SGX) also launched a similar stock index futures- SGX FTSE Xinhua China A 50 Index futures - in September 2006. From this point of view, the launch of stock index futures will play a strategic role for China in pricing their own financial derivatives, maintaining monetary sovereignty, and protecting the national economy from passiveness.

Hedging Bets

The main functions of stock index futures are risk evasion, speculation and arbitrage, while the first basic function will protect the investors from financial risk by hedging losses between the spot market and the futures market. China’s stock market is unstable which is characterized by huge systematic risk, whereas that can not be solved by the portfolio management. For example, Chinese securities companies and mutual funds companies were in the red for the whole of 2004 and 2005, mainly because of the lack of hedging tools in China’s stock market, where investors made profits only in the bullish market but nothing could protect them in the bearish market. The impending stock index futures will benefit both China’s domestic and foreign investors. As for the domestic investors, some institutional investors and big clients had to manipulate the stock prices out of their own interests, for there was no ShortMechanism in the stock market, so that big investors could only rely on ramping stock price to make money. These illegal manipulators could be found everywhere in the marketplace before 2002. Since the strict administration for the past two years, the situation was much better but it still could not eradicate it. As for the foreign investors, on November 5, 2002 the CSRC and the People’s Bank of China (PBOC) 40

introduced the QFII (Qualified Foreign Institutional Investors) program as a provision for foreign capital to access China’s financial markets. On December 9, 2007, the State Administration of Foreign Exchange (SAFE) has announced that the limitation of QFII investment capital expanded from 10 billion USD to 30 billion USD. For example, SAFE approved certain limitations to these venture capital investment companies, Citigroup Global Markets 0.55 billion USD, Morgan Stanley 0.4 billion USD, and Merrill Lynch International 0.3 billion USD respectively. Altogether 49 QFIIs hold the A-shares with the market value of more than 200 billion USD, so that the QFIIs have been

All these factors will help the stock market to connect with the real economy more closely, and promote the stock market to act as the weather vane of the country. the considerable component of China stock market. To safeguard all the investors, both QFIIs and domestic investors, stock index futures will play an important role as an effective tool to sell short and go long, and make profits in two directions.

A Volatile Situation

The notable feature of China’s stock market is that it goes up and down dramatically although the macroeconomic environment goes well. Such a situation has nothing to do with the fundamentals, but it is caused by the capital collectively pouring in and pulling out of the market. For example, one factor is the unreasonable soaring stock prices in 2002 and 2006. The bullish market attracted huge capital and

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then the bearish market dispelled them all. The impending stock index futures will stop such irrational situations in the market by diverting various capitals to different directions, so that the market can remain stable and mitigate the fluctuation of stock indices. As the target index, CSI 300 Index has been ever-changing by more and more blue chips, such as PetroChina, China Shenhua Energy, China Mobile, Bank of Communications, etc. returning to the A-share market. These leading companies will attract more capital, while at the same time, the active market also attracts more outstanding companies to participate, so that a virtuous circle will form gradually. Besides, compared with the short-term effect of China’s domestic investors, QFIIs are paying more attention to the long-term profits and growth of the listed companies. What they advocate is value investing, which will penetrate into more investors soon. The concept of value investing will change the speculative quick-in-andquick-out mode and be helpful to keep the market stable.

The Economy’s Weather Marker

It was shown that China’s stock market has not represented the main trends of the national economy from the 17 years of experience. From late 2002 to the end of 2005, the stock market kept falling although the macro-economy went well enough, which was caused by the collective capital movements as aforementioned. The investor will intend to consider more of the true value and the fundamental factors of the listed companies and abide by the market principles. In addition, the stock index futures has such functions such as price discovering that public price competition and automatic matching system will probably reveal the intrinsic value of the stocks. One thing is that many participators will express their stock price expectations as soon as possible; another thing is that investors are more likely to adjust theirs positions in futures market thanks to its low transaction cost, high leverage and flexible trading mode. All these factors will help the stock market to connect with the real economy more closely, and promote the stock market to act as the weather vane of the country.

HCCM

H a rva rd C o l l e g e C o n s u lt i n g M ag a z i n e Information Technology Consulting:

Corporate Executive Board:

Team Management at Bain & Company:

Brave New World of M&A:

Interview with Center of Financial Technologies Interview with Derek Van Bever

Interview with Allison Weinberg

Interview with Boston Consulting Group featuring Jeff Gell

MegaStore:

A retail case study with guidance from Kurt Kendall of Sears Holdings Corporation

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HCCM H a rva rd C o l l e g e C o n s u lt i n g M ag a z i n e

Editor-In-Chief Sergali Adilbekov

Dear Readers, For the second time in HCIM’s history, I am proud to present the Consulting Section. There often comes a point in investment activity that requires hiring additional brains to

Executve Editors Zachary Rosenthal Editors` Lu cas Abegg Polina Dekhtyar

overcome a stage, a problem, or simply become better. This is where consultants come in. Like in any other broad industry, consulting has many different specializations. Dmitri Smirnov explores Information Technology Consulting with the help of an expert. Another key factor of consulting is that consultants are paid to give the right advice to a company in need. Thus, the best consultants are driven by the desire to do “what’s right” rather than what’s more profitable. In an interview with one of the best U.S. consulting companies, Corporate Executive Board, Lucas Abegg, Dilyana Karadzhova and I present a career outlook of Derek van Bever, Chief Research Officer, who, inside the company, is thought of as “keeper of the

Matt Fleck

flame” for his professionalism, values and effort to pass the “right” knowledge to younger

Mika Kasumov

generations of colleagues.

Dilyana Karadzhova Dmitri Smirnov Jack Sun

Polina Dekhtyar and Mika Kasumov, in their turn, discuss a more practical aspect of everyday consultants’ interactions--teamwork--with Allison Weinberg of Bain and Company. Further, Matt Fleck and I discover the largest non-academic study of Mergers and Acquisitions in history--”The Brave New World of M&A”--with its co-author Jeff Gell, a partner in Boston Consulting Group. And finally Jack Sun, with the help of Sears’s Kurt Kendall, develops a narrative case study for a medium-sized retail company that seeks consulting help to understand how it should proceed. I hope that you will enjoy reading HCIM and the Consulting Section! Sincerely, Sergali Adilbekov Editor-in-Chief

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Information

Technology Consulting Interview with Yuri Yushkov of Center of Financial Technologies By Dmitri Smirnov

ehind the shadows of mammoth management consulting organizations like McKinsey and Bain, information technology (IT) consulting firms strive to find a profitable niche of their own. They examine van alternative part of the business: instead of identifying the shortcomings of an organizationâ&#x20AC;&#x2122;s structure, IT consultancies examine the production process of the business implementing an optimized technological solution. It is often hard to differentiate between IT contractor firms that execute a specific project for their client and firms that could fall under IT consultancies: the latter reflect on the business process and offer the solution instead of carrying out a specific task on behalf of the client. SPRING 2008 | HARVARD COLLEGE INVESTMENT MAGAZINE

Center of Financial Technologies, Inc., is a major player in IT consulting and other segments of the IT industry based in Chicago with offices worldwide. The company currently employs over 800 programming professionals globally, and their clients range from health insurance providers to bank chains. Yuri Yushkov, Company Vice President in Custom Software Development, has agreed to share some of the intricate aspects of his business. HCIM: Yuri, could you please describe IT consulting?

YY: Software development can be divided into two broad categories: consumer software sold in stores to the wide public, and more expensive corporate applications. Internet corporations such as Google and Facebook are not really a part of our business: they feed their own army of programmers and do not buy or sell software. Our most frequent clients are primarily non-technologically oriented corporations who merely employ IT to simplify their production process. Those can also be broken up into categories: some seek software applications that will function as a backbone of the organization (such as banking systems that transfer funds between accounts when a credit card is swiped in a terminal), while others require a web application or a database to assist with a specific aspect of their work. Thus, the solutions Center of Financial Technologies and other firms in the industry provide are primarily custom-built. As a software developer, we need to precisely understand our clients’ problem in order to provide a viable solution. This is where consulting comes in. Usually, a client will describe his difficulty, describe what he sees as a possible solution, and expect us to offer a technological solution based on that idea.

HCIM: How competitive is the corporate IT industry and who are the big players?

YY: Thousands of small firms and a few bigger ones operate in the field, with no single firm even close to dominating the market.

In a sense, IT today is close to a perfectly competitive industry: anyone can enter and exit the market, no office space or known credentials required, if you can get the clients, that is. Outsourcing of coding to India has become common practice, which has forcefully pushed down the prices we can charge for our services. From clients’ perspective, little matters besides the quality of the software solution, and thus, clients make their decision solely based on the quality of the work. This opens the doors for foreign firms to enter the U.S. market, currently the largest in custom software development, and with constantly increasing competition.

HCIM: What allows Center of Financial Technologies to compete successfully despite the ever-growing competition?

YY: The international structure of the company is probably our biggest advantage: by dividing the workload among people in our U.S., Russian, and European offices, we are able to cut down our costs, while preserving high quality of service. Offices in [the] U.S. and Europe are responsible for the support, client mining, and the analysis required to identify exactly the client’s problem or objective in undertaking the project. Once we reach an understanding with the client regarding what functions the solution will fulfill, the work is outsourced to our office in ‘silicon taiga’ (Novosibirsk, Russia) where a larger team of programmers will carry out the solution. This enables us to attract some of the most sophisticated professionals on earth at a

lower cost than our U.S. competitors, and offer a lower price to our clients.

HCIM: Could you please describe one of your successful projects?

YY: Recently, a trend to among medical associations has been to develop more sophisticated technological solutions. Medical associations are generally non-profit organizations that seek to educate professionals in the medical sphere about new trends and products. Our client, an intermediary to a large medical association, wanted us to develop a web-based solution that would allow members of the organization to benefit from online materials. The intermediary would then provide the interactive website and the educational materials to the association for a fee. We held a meeting with the client in Chicago and finally decided on the structure of the service: it would feature video streaming, audio streams, pod-casts, video-casts, online exams, and other forms of material. Programmers in our Chicago office outlined the basic structure of the web service [and] identified the different access options and databases suitable for storing such information. Then, the project was entrusted to our Novosibirsk office, where our specialists completed the project in three months. Having created the website, we took on the responsibility of converting the educational materials into formats which allow easy access and use over the internet. Currently we support the solution by publishing additional content, hosting and installing updates.

As cost minimization becomes the main objective in running such a business, the sector will most likely be unable to attract recent Harvard and MIT Computer Science majors as programmers with low wages. Competition from deep-pocket recruiters like Microsoft and Norton, all with extensive training programs, will mostly likely diminish the flow of recent tech graduates to the IT industry, targeted at serving midsize corporate clients. Unlike some other IT startups, or even other business divisions of the interviewed firm, which have an extremely high explosive growth potential, this sector requires gradual building of clientele and operations, as well as innovative costcutting strategies, to continue operating. One such strategy that the interviewed firm has undertaken is outsourcing, thereby cutting its programming costs while preserving the quality of its solutions.

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Interview with

Derek van Bever Chief Research Officer of

CORPORATE EXECUTIVE B O A R D By Sergali Adilbekov, Lucas Abegg, and Dilyana Karadzhova

erek C.M. van Bever is the former Chief Research Officer of the Corporate Executive Board (NASDAQ: EXBD), based in Washington, D.C. The Corporate Executive Board maintains over 45 standing membership programs that conduct best practices research and build decision and implementation support tools that improve the performance of over 4,000 major corporations on a global basis, including 80 percent of the Fortune 500 and 70 percent of the FTSE 100 companies. The Corporate Executive Board has been named repeatedly to Forbes’ list of Best Small Companies and to Business Week’s list of Hot Growth Companies. Prior to assuming the role of Chief Research Officer, Mr. van Bever served as Publisher of the Advisory Board Company, the Corporate Executive Board’s former parent. Before becoming the Publisher, he served in a variety of research and management positions within the Advisory Board Company, including executive director of the financial services practice. Mr. van Bever’s own research interests center on the barriers to growth in large companies as well as on the economics of customer loyalty in service businesses. He has been invited to lecture on these and other topics at the Harvard Business School and the McDonough School of Business at Georgetown University, and he advances the presentation and teaching crafts at the Corporate Executive Board through his leadership of the firm’s research and executive education communities. Mr. van Bever holds an undergraduate and master’s degree from the University of Delaware and received his MBA from Harvard University. He and his wife, Ellen, have three children. In addition, Mr. van Bever serves as a director on the boards of the National Society of Collegiate Scholars, an undergraduate honors society and service organization, and the Firefly Children’s Network, a nonprofit organization dedicated to assisting at-risk orphans in Russia through advancement of a global standard of medical care for these children, as well as support for their deinstitutionalization. Mr. van Bever has kindly agreed to share some insights about his business and career path with HCIM.

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HCIM: You have been a part of the Corporate Executive Board for many years. What attracted and kept you in the company? And what do you like most about working at CEB? DVB: Well, actually I have been part of the Corporate Executive Board and its former parent(s) for more like 26 years! (I started with the Research Counsel of Washington, predecessor to the Advisory Board Company, in 1981). What attracted me here, enticed me back after business school (1986-88), and has kept me engaged ever since is the distinctive mission and value set of this company. We really have a sense here that we are on an audacious mission—to revolutionize the way that executives improve their performance—and that our values differentiate us in the world and support us in that mission. We would count ourselves among a handful of companies in the world that are really distinguished by their commitment to mission and values. As [for] what I like most about working at CEB, I’ll tell you the same thing that I bet any one of my colleagues would say: “the people.” Because we hire for values, rather than experience or connections, our workforce is pretty consistently populated with bright, engaged, service-oriented individuals.

HCIM: How would you describe the day-to-day expectations and responsibilities of your job? And what are the main challenges you have to deal with? DVB: While I grew up in the firm “doing” (research, presentations, team management), most of my time now is spent “teaching”—that’s where the leverage is for me in a fast-growing firm of 2,500 people. A typical week will find me teaching an orientation class on our mission and values to a group of new recruits, working with a research team to refine their thinking on a large-scale business challenge, and attending a member meeting to help make sure that we’re performing to standard. The main challenge that I have to deal with is making sure I wall off time in my own schedule to think and plan and write. We are publishing a book called Stall Points through Yale University Press in the spring (look for an article from us in the March Harvard Business Review); carving out the time to help with the writing of that book and article was really hard, but also really rewarding.

HCIM: How has your experience as Publisher of the Advisory Board facilitated your career as Chief Research Officer? DVB: My time as Publisher at ABC was important to my development because it was at a stage in our company’s development when we were documenting the core processes that we use to produce our research, to structure presentations, and to teach insights to our members. I was able to use pretty much all of what I learned at the Advisory Board to help the Corporate Executive Board get out of the gates fast as a public company when we spun out in 1999.

HCIM: CEB has been repeatedly listed among America’s best small companies, and according to the last data, the number of clients increased from 2,368 to 2,831 last year alone. What do you think are CEB’s greatest strengths, and how is it able to withstand competition from larger consulting companies? DVB: The Corporate Executive Board’s greatest competitive strengths are our close working relationships with over 15,000 member executives around the world and the intellectual property that we have built up across 25 years of business. Not to be immodest (and don’t get me wrong—we are very watchful on the competitive front), but these two assets are extremely formidable barriers to competitive entry. It works like this: The scarcest asset an executive has is his or her time, so if they intend to join a network such as ours they are naturally going to select the one that is the most well-developed and capable. Given our size, and the fact that executives from over 80 percent of Fortune 500 companies already participate in one or more of our membership programs, the choice for that executive is pretty easy.

HCIM: One of your research interests is barriers to growth in large companies. What are the most typical problems inhibiting growth of your large clients, and how do you deal with them? DVB: Have I got a book for you! [See Stall Points reference above.] There are a lot of reasons that large companies stop growing (we mapped and describe 42 in the book!), but the “Big Four” account for over half of all growth stalls. In order, (1) successful companies become

“Because we hire for values, rather than pretty consistently populated with brigh 46

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complacent and allow a new entrant to come up underneath them, (2) some weakness in the process by which they manage innovation leads to a breakdown in their new product pipeline, (3) they abandon their core business prematurely in search of (supposedly) greener pastures, or (4) they face some debilitating talent shortage, usually because they have not been open enough to the external talent market. I’d be pleased to come and give a presentation on this work. It’s fascinating, and the book is a great history-between-two-covers of the past 50 years of growth challenges in the large corporate sector.

HCIM: Besides the United States headquarters, CEB has offices in England and India. Does CEB consider future opportunities of expanding its business to other countries in Europe and Asia? DVB: Yes. We just announced the opening of our Sydney office this coming year, and you can expect additional activity in both regions. (By the way, we also have sizable offices in Chicago and San Francisco, in addition to our D.C. headquarters.)

HCIM: You are also actively involved in non-profit organizations such as the Firefly Children’s Network. What is your motivation? DVB: Compassion for kids who need to know that someone cares. I could go on about Firefly for a long time, but in a nutshell: One of my colleagues, Jonathan Baker, started this organization after he and his wife went to a Russian orphanage to bring the daughter they were adopting back home to the States. They peeked into a room they were not supposed to look into, a “lying-down room,” where kids who suffered from a range of treatable conditions (treatable here in the States, anyway) were just sort of warehoused. Awful, awful. Unimaginable. Jonathan came back to the States resolved to help these children, and with the support of some terrific doctors from University of New Mexico and University of Minnesota they have been teaching world standards of care to caregivers there and providing prosthetics and operations to individual kids. As the father of three ridiculously blessed kids, it is my pleasure to serve on the Firefly board, and I would love to introduce the organization to any of your readers who are interested in getting involved.

HCIM: How has your academic experience at Harvard contributed to your professional success? DVB: I think the MBA program was quite helpful to me (challenging too!). As a liberal-arts major in my prior undergraduate and graduate career, I had a lot of gaps in my education in areas such as finance, accounting and statistics—the more technical aspects of the curriculum. I also made connections with faculty members that I have valued across my career; I was just up at the school attending a conference on organizational transformation that Clay Christensen invited me to, and it was great to spend two days reconnecting and remembering what a special place it is.

HCIM: CEB runs a firm-wide internship program for rising undergraduate seniors. Besides this opportunity, do you offer any programs for interested students after the completion of their second year of college? Would you be willing to provide such students with an opportunity to design their own internship program? DVB: We offer no formal program for rising juniors. We are always interested in talking with anyone who is interested in our firm, at any point in their college careers, and [entertaining] ideas about how we might expand our existing programs.

HCIM: What is your advice to current Harvard students who are considering a career in consulting? DVB: Try to rise above peer pressure in making your decision about where to go. After you leave school and settle into the job, you find that there are a few factors that really matter to your enjoyment and learning: Who is my direct manager? Is this person really committed to my development? Is the firm really invested in my development? Do I enjoy what I am doing day-to-day? If you choose a firm where you are merely “variable labor”—on a plane on Monday morning and back home Thursday night—you will find that that gets old real fast. Go where you are going to learn the most, and where you are more than just a cog in the machine.

n experience or connections, our workforce is ht, engaged, service-oriented individuals.” SPRING 2008 | HARVARD COLLEGE INVESTMENT MAGAZINE

Team Management at

Bain & Company By Polina Dekhtyar and Mika Kasumov

As anyone who is considering a career in consulting likely knows, teamwork is one of the basic components of a consulting job. No matter the type of consulting a firm specializes in, no matter the specific nature of the case—consultants typically work in groups to address their clients’ needs, with each team member bringing his or her unique interests, skills, and experiences to the mix. But how does group work in a consulting firm actually work? How are teams put together? Once selected, how do they function and allocate responsibilities? How do people with a variety of interests, skills, work habits, and—perhaps most fundamentally—personalities successfully collaborate for months on a single case? And do all those college extracurriculars really prepare students for professional teamwork? HCIM decided to ask Harvard alumna Allison Weinberg (Harvard College ’96, Harvard Business School ’02), now team manager at Bain & Company. Weinberg joined Bain’s Boston office in 2002, after working as a Summer Associate the previous year. She has since worked in the tech and telecom, consumer products, and industrial products practices.

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HCIM: Could you tell us about the team structure and allocation of responsibilities?

AW: A typical case team includes two to three Partners, one Manager, two post-MBA Consultants, and two postundergraduate Associate Consultants. The teams are determined by staffing officers, in conjunction with the Manager and Partners on each team. There are three separate individuals whose primary responsibility is to make sure that each team is appropriately staffed with the right mix of Consultants and Associate Consultants based on their respective interests, skill sets, and developmental goals. The Manager works closely with each of the staffing officers to make sure that the right mix of individuals is staffed on each assignment based on tenure and level.

HCIM: How are tasks and responsibilities allocated within each group?

AW: The Manager works with the Partners and the rest of the team to allocate the work, taking into account each team member’s unique skills, interests, and preferences. As part of this process, the Manager solicits input from each team member about his or her unique goals for the case as well as the specific role(s) on the case that he or she prefers. Managers take this input very seriously when allocating work across the case team. Ultimately, each consultant at Bain has the opportunity to work across a number of different industries on a broad range of business issues to develop a solid foundation in general management.

HCIM: Can you give an example of a challenge with teamwork that you have encountered in the past? one

AW: When I first became a Manager, of my biggest challenges was

understanding that each team member had different working styles and goals, and that accommodating each person’s unique style was critical. For example, some team members prefer to get to work early and leave early, others have exactly the opposite preference and prefer to come in much later. Without explicitly understanding each team member’s preferences and expectations, team management was more challenging. I learned early on that sitting down with each team member at the very beginning of the case in an informal setting—over lunch, for example—is a great way to get to know each person better and also understand their respective preferences. In this way, I can do my best to cater to each person’s preferences to the greatest extent possible.

HCIM: Does Bain, as a whole, have a corporate culture to make sure that teamwork is as smooth as possible?

AW: Yes, Bain has two specific tools for this purpose. The first is called “case team norms” and the second is the “case team status update.” The overall goal of these two strategies is to ensure that everyone has the best case experience possible. In terms of case team norms, at the beginning of each case, the team as a whole works together to set cultural norms for the case. Most of these norms are standard across the office, but each team can and does set unique norms. Norms cover topics related to working hours, vacation, communication modes (email versus voicemail), [and so on]. For example, on my last case, we set a norm that no meeting should be scheduled before 9:30 a.m. or after 5 p.m. unless absolutely necessary. Case team status update, inside Bain, is more informally referred to as “case team scores.” Every month, every member of each case team in the entire office fills out a brief survey to assess different aspects of

the case experience. The individual results are aggregated to the team level and shared across the entire office. In this way, the team management from each team understands how the team is feeling about the case and can make real-time changes to the case team process, if necessary. By creating a competitive spirit across the teams, case team scores help spur on the case teams and management to optimize the experience within each team.

HCIM: What personal qualities do you think a consultant should have to be a successful team player?

AW: We are looking for bright, passionate, committed individuals who want to make a difference. Candidates must have strong analytical skills, as that is the crux of our work; in addition, the ability to think and act like an owner is critical. Our consultants work with our clients to help drive change, and leadership is a critical factor for team success. Also, it is important for Bainees to be confident and articulate. This builds confidence among clients and facilitates communication across the team. Above all, consultants should be passionate, motivated, and rewarded by what Bain does.

HCIM: Have your college activities helped you become a better team player?

AW: Almost all extracurricular activities at Harvard and other schools help students develop and demonstrate a number of skills that are critical for success at Bain, including analytical, communication, and team skills. In almost all extracurricular activities, students work closely with a team to accomplish a common goal. Above all, the leadership experience and skills that one develops through extracurriculars are solid preparation for successful team work at Bain.

SPRING 2008 | HARVARD COLLEGE INVESTMENT MAGAZINE

Brave New World of M&A An Interview with Boston Consulting Group featuring Jeff Gell

By Sergali Adilbekov and Matt Fleck

eff Gell is the North American Mergers and Acquisitions topic leader at the Boston Consulting Group and a coauthor of one of the most extensive nonacademic studies of mergers and acquisitions in history, “Brave New World of M&A.” Mr. Gell is a partner in BCG’s Chicago office and a member of the Corporate Development and Consumer practices. He has worked primarily in the consumer products and industrial goods sectors on a range of client issues including strategic due diligence, postmerger integration, and new market strategy. Mr. Gell has an A.B. in economics summa cum laude from Harvard College and an M.A., first-class honors, in philosophy, politics, and economics from Oxford University, where he was a British Marshall scholar. Mr. Gell has kindly agreed to answer HCIM’s questions on the “Brave New World of M&A.”

HCIM: “Brave New World of M&A” is one of the largest nonacademic studies ever written on the subject. What prompted you to write such a comprehensive piece?

waves, with distinct periods of growth and decline. The latest growth era ended in July or August. There are two key themes in this era. The first is the rise of private equity, and the second is the increasing trend of companies within many industries to consolidate. Private equity has been around for many years, but only recently had they been able to do so many large deals in such a short amount of time.

HCIM: What role does cash play in the execution of M&A deals?

JG: There are two main ways to pay for an acquisition: with existing cash or with shares of a company’s stock When you choose to use cash in a deal, you generally get higher returns. That’s because when using cash, you get all of the upside along with all of the downside. You are signaling to investors that you have high confidence that the deal will be a success since you’re exposing yourself to all of the downside risk. When paying for an M&A deal with shares, you give up some of the upside for less risk in the downside. Investors, in this case, are less sure if it’s a good deal or not.

JG: BCG is in a client service business. M&A is a key piece of many of our clients’ strategies. Many of our clients believe that most M&A deals destroy value. We did this study to help our clients understand that this is not necessarily the case and that they can create value through M&A.

HCIM: What about the trend of increasing acquisition premiums?

HCIM: What is the “6th wave of M&A”?

HCIM: LBOs activity has decreased sharply recently. Why has the market for LBOs dried

JG: The M&A market tends to go in

JG: Premiums are cyclical.True, multiples have gone up over time, but premiums themselves have not gone up over time. We can expect them to behave as they have for as long as they have.

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up? What do you think will happen to them in the future?

JG: As far as LBOs are concerned, banks have not been as willing to lend to companies to get deals done. Instead, banks don’t want to take risks—they don’t want to get burned again since they just got burned recently. Unfortunately, the attitude of many banks today is that if they don’t lend money out, they won’t lose money. But this is cyclical and by no means a permanent downturn in the market.

HCIM: What role do consultants play in M&As?

JG: We think of consultants as playing a key role across the end-to-end M&A process. In the beginning of the process, we help companies determine their strategy: where the company will compete within the market, as well as how they will compete to win. We have early thoughts around whether companies need to buy other companies to execute their strategy and early thoughts on how much they might need to pay. When companies are involved in a specific deal, we work along side investment banks to help our clients make sure they have a sound business plan for the deal that justifies the price they are about to pay. We also play a very important role after the deal is made—making sure that our clients realize the value they identify from the deals. There is a lot of change that happens after an acquisition, and if our clients do not manage this change well, they risk seeing major disruptions in their business. We make sure these disruptions don’t happen.

MEGA STORE A Retail Case Study:

MEGA STORE By Jack Sun

with Guidance from Kurt Kendall of Sears Holdings Corporation

n HCIM’s Consulting Section, we strive to help our readers understand what consulting is, what professionals in the field can expect on a typical day, what kind of work they will be doing, and how this exciting field fits in to their future careers and interests. In line with this goal, we would like to present a narrative case study. Consultants are problem-solvers, yet readers understand little of what this means from just those words; a case study, however, helps readers comprehend what consultants do on a daily basis – that is, helping offer complex solutions to business dilemmas from an analysis of company data and strategy, industry trends, and countless other factors. Finding the right balance between length and depth is always a challenge for case study authors; a typical Harvard Business School Case

Study easily surpasses forty pages in length, while a mock case study on consulting firm websites barely contain a page of information. Making the study too technical may not appeal to the newly initiated, while making it too general would turn off those that already have a footing in the industry. As such, we looked to a compromise. In the following case study, a medium-sized retailer is deciding its next course of action and has given the job to a consulting firm to help them decide their next move. The commentary features insights on the retail industry as a whole, and then offers suggestions particular to Mega Store’s situation. We hope that you find this case study interesting and enjoyable to read. In future case studies, we hope to offer increasingly complex problems and situations in a wide array of industries.

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W holesale. ld This u o h S : e r o Mega St r t Outlook ed Retaile The Curren sively Medium-Siz l a n o i t a n looking to aggres r Inte The company is ional at Expand To rn te d in th its domestic an bo nd pa g ex open in to Markets? om s it plan an up-and-c ns. In America, io at er Mega Store, pany op ss m ro co ac e er, th erates 600 stores w stores; howev ne y in an m ng ed pi st retailer chain, op re op sh inte ar y to the sterile me increasingly co be n, s pa ha at Ja e, America. Contr ce fa op rs to Eur at many shoppe n from America io ns s pa en ex is op t at environments th ar th e Wal-M the halfway hous ibly China. As ss po r d be e an em th Wal-Mart and ov g N in br on th international store oreâ&#x20AC;&#x2122;s goal is to 00 el 30 fe s its e ue or Target, Mega St iq St ut a bo ecutives at Meg ng at fashionable e sing 14th, 2007, ex essence of shoppi cu fo by out on the wav er om cust ey are missing th e gh t lik hi en to the average in nm ro ly vi cial e shopping en t grabbing, espe ke ar m e of th on making th In . al . tive, and person veloping markets distinctive, attrac Mega potential de n, also see the io m at iz fir al e on th rs g pe xecutives in E as its age of increasin om fr United States distance itself market in the il ch ta e su re ic rs rv Store seeks to ile se ta ss many large re oviding first-cla use saturated with competition by pr and Target; beca s. tco, Wal-Mart, os C rge a la as e eg to all its customer es M th n one of nce betwee stomers shop at cu t os um A main differe m al -s ro iti in ze e a th ket is mpetitors is in , the retail mar ns ai ers ch ch om st hi Store and its co w cu , es to gain each of its stor the only way e: m us, t ga Th ar s. investment on -M or al tit om compe as that of W fr gh em hi th as e ke ic ta tw level ill is to may be to compete on Mega Store st le , er ab ev un ow el H fe . ey et or Targ cutting as th titive advantages titive prices by with the compe nd ou gr ns gi maintains compe ar m t ed retailers such ady slight profi ady well-establish re al feel d of an back on its alre re tu uc Store executives amlined infrastr al-Mart, Mega W the g l as ve on and through stre le am ay ly m rite not on expansion l vo fa na a io at it g rn te in in ak scale, m e idea of that step toward that who scoff at th field. Taking a g in ay t pl d the bu , trendy teenagers et rg ega Store acquire al-Mart or Ta M W ar at ye s is he th ot cl , by goal France, buying ious customers r-mart chain in on pe im hy rs t pa es rg g la on also am in the third titive prices with Cauliflower. a Store providing compe e. -sized firm, Meg er m iu ph ed os m m a at s g A rin l that pampe amount of capita e th ve ha t no it must tirely does petitors enjoy, so rrently almost en m cu co is ic e or ith ol St a on eg m M ational wever, its vesting in intern ted States; ho In ni s. U ie rit e io th pr in its for set ts, but based mous investmen s been yearning or ha en it il ta s ar en ye ts ke nt and a ns of mar in rece enormous profits through acquisitio e g m in co ot ay fo l m na it io at nd- with petitors. intern Strumpets, a seco tables on its com e of th l ar rn E tu . rs to ile ce ta an and ch ld allow local re ain and grocer y, estic markets wou ch m il do ta in re g h in lis st ng ve tier E tailer In pace with pand at a quick -sized, trendy re m ex iu to ed e m or a St , a ne eg ce of it Bakarecent M k, but the chan ere acquired in ris w tle n, lit pa y Ja el o, tiv ky la in To ent store ational re remost departm capturing intern fo of e al th go g e in th m r co fo ion, be years ure with â&#x20AC;&#x2122;s major competit e industry is mat ny th pa as m co w, e lo Th ry . ts ve marke merican is from largely A ished champions. however, is still Costco well-establ d an , et rg Ta t, ar -M firms such as Wal or develop ion ational markets rn te in The Quest to nd ore expa Should Mega St

HARVARD COLLEGE INVESTMENT MAGAZINE | SPRING 2008

arket?

its domestic m

Commen tary An

retail face s such ch allenges to is that re In an age tailers co ex n w duct busi pansion on largely on hen deve have start ly mana lo n e p o ss in n ly two fa g ed to op ged to ctors: atm based mark en up an markets and price. R themselve capture et. By 200 e o d ta sphere s into 2% of th ilers serve integrate betw 6 it the wo h a companie e e s a e d sold its M th n manufa e direct li etro AG rld, ma s have re 85 stores c n a tu k n re d so ny rs e alized en x in to it by leapin a e n d e lo d very the ss o co ormous g g headlo ains the atmo new market they nsumers, on f $1 billion. This lo market with a ng into environm ly ss was cau sphere th m b u y these ne st ents. Volk W find al-Martâ&#x20AC;&#x2122;s at would sed not w to the new swagen a Fried Ch ignorance norms in b e a c nd Kentu c c o e icken are p n ta su o G f b m le c e ultural rm e rs c b ky e an ard . As this any, but two leapt into entrenche uous task also beca comes to d the Chin companies that pow , p o u , w se of even erful loca inception erf ese mark knowledg l retailers et at its obta ul local partners m retailers with and hav e o f w W h al-M ose e an profits f in the pro competiti rom doin reaped enormo mised be y times do not ve advan artâ&#x20AC;&#x2122;s home-countr us market; in g so. H n ta y discovery e fi g a ts e c ti a of the ne ste owever, of El Dora w m vely limit that adv llowed them to the and resist ad, they are met do in the exception a a n with loss rket. Ente anc tage in th new era is , not a rule es e new an example o e to their model. .E of retaile Wal-Mart ring the Germa A specifi f internati rs, compa specially in the ca n in m c st o arke a it n w se u n a ry ted Ame le ies should internatio such as g rican serv t, nal expan undertake wh that should be note xpansion gone ro c e r y ices b sio ether Me agging an d when d planning, customers ga Store eciding d smiling deliberati n only after muc th a t in se h o sh te at em quite n, and an rnational alternativ o alone cou inquiry in harmless, e opport markets is uld expand to rteous, to to into Germ le W t a th le M In genera unities for growth A S artâ&#x20AC;&#x2122;s mov any. merican sh hoppers l, retail ha . e in Germ opper. prone to S in s n c e o a t been starting o n not appre ex perations ciate such y, however, did market.O pansion to the in a sector in 1998, by in Germa se 2 a ternation ne reason rvices; Ge re 0 0 5 quite spari ny Wal-Mart al h a d why rmans ng

Overview

of Retail

SPRING 2008 | HARVARD COLLEGE INVESTMENT MAGAZINE

eloped are dev ering s t e k r ent n ma uropea ch a new firm state of E . w o for n to a n whi point i ill be put in cal retailers urrent e c h t s t o i t. t market w nt lo imes age, four t turation poin cumbe ntry advant s e n r h i t o e e h thre by t rmou he sa e-cou tailers cale to l it reaches t e largest re 488 siege ve the hom markets eno ty in s i a y t n th over 1 vel un d onl who h developing m uncertai nas. ne of o les an tween le en Target, o tates with mestically n re r i i f m e c l s i i d S e lve v ir o wh om a s on b e o d n E d v h o e y t n t c l i i e e n r m in e U rs enti focu s are l and ge th nsume in the of 2006, is l risk the politica do better to rations, u f s exchan and co s t s e a a c h both tore would e suc ic ope stores . s, ct t omest ins and an nies ar the most S f riend d a d e fa g their a e p s t t h g i t a m e r f o e o op d lin marg so sful c ered re M challenges dislike were hand -Mart’s profit in its stores Succes they pione cause they a r e e h t l w s a o r e l e e n e b strang . Even W ne-stopely its atmosphere g experienc becaus roducts,but sources give m a t n o n n s o i g ie opp chin ause and p eir re grocer model as a umers in arkets t exploit th tances. Bec ns over-ar boutique sh agmented. ons, m s s n s o s e s r c fr e e ti u busin lapsed, as to go le to b cular circum in large ret lly that th become too ional acquisi to e b t a a t i l s o i e a t is a t t shop c did not h her to find ir par e can still g al domestic e does no r its interna ega Store rd e h t y t r o it th an As fo tegy for M may be ha ga Sto ing its cap should be Germ shop to an rman leader e M t t stra e tores ore’s ke es ne is , e best ernational s to Mega St sh e mar m inv al risk, th h f rom o t price. The G sand stores o t m r o f h es f ou inim s its ts int sp on Engli y add the low th four th d in the art o with m ice: it know it has a gra can sell. I age and ma mple, its ts i t e w it an with i exa e, rcu cho enc s m i e , d r a t s d r n t o s e b o t n a e e p Aldi, u F p b r x , f e s r Scrum to be e uently layer o enges. antage onsum ing furthe proved ng and f req t, provid a and c petitive adv ges to gain e, in chall ny Earl of may add a has to or ta m ian pa it d nti nt, discou merican g ubiquity an st its co these advan et. Furtherm filling com y compone erations as dition, r p p d o k e l A ts develo in the mar a Store is level groc xity to its o ealers. In a esting the with i . Wal-Mart e c e n g d l v e e e i e leverag market, M both high here comp f rom local isposed to in and as conven with its pric d w p n tmos e US viding o ne source eet is not pre g industries, uld bargai l f ronts. er int risks. th oid by pro shopping a unt mass t tr in wo n l e a n Wall S e, slow grow operations mic co s nice a v i out o ailers who face great d a e c – i d r s r o n p u o it a er Ret in mat estment for urrent econ ore nd int ervice erage shopp t entirely on arkets a s p m s x i l e a do and ch m . C e av there h inv mos ation intern hen retailers usually exp ns to th nts focus al here, and stores, suc ard to find ke debt mu gained a p a o l h s i h y w Even arkets, they ugh acquisit ea, merc ot on atmo ntil specialt tailers, be itions also m d-up capita lp fund e u r e e o d n m a r r r n h n f e h o y d d t e e l c e n n h n e w y such ive. Th ould not o ansion, but ly onl tailers in t arkets a thing in bet , and high-e nd not on l s u n f e s p s e x e m re no succ ilers ere a on c exp sales w largest in foreign ger gain ox reta n atmosph m the y’s domesti pany focus e b o h r t g f i b f n o s o s lle or e com Mega ompan w cha in a h focu mpetit about t it the c also help th as co ot let the ne y would ga he whic y for a s t n . can he ving te tha m would usiness. a a r n c u would scale that t dvantage in art price fact, one t r b ro fo Until s a In it is e returns f tic its core a Store’ premature. its t a such a ive pricing with Wal-M he h t Meg f rom omes kets is id equat ft tit e is al mar piece of gold should compe as K-Mart d cquisitions o ive Stor till gain ad sing on its d always n o i t a s A t, ns focu uld intern ken the last Store marke nited States. remely expe d- can a g and al-Mart co ng in the Mega ital, as it is h n , i s s d s n n t a n o o x U i a h c e t exp If W ut se in the etailer are nvesti ly it estic opera with its cap r which r sible, b ot suffice, operations. urns f rom i d indefinite fo s t om sks o s e p g r e la ul ret rn d take such ri ng company the face dn o l u ot b e t w u a g n e o r r t a i y h l w t a h i , t i n and m tier retailers end up w ons gain ican market low-risk, hig chose no idly expand , especially i . Mega y s p r s i y l t t a a d e a b r r a n i a e g c m m u a r h b o t m a o A rl m in ives for su ny rc to uld it o e a a r t o l o p l e p fi p w s o e o t m t u r d r b n i o a i a p c c ct h s ld do so; nt. Wal-M ets be when eac eady lower tify its obje more as the dge of store se that wou k r a e m s r n a po investm t in foreign int nearing, g in of al eeds to ide new market e in arket b hodge m l l n a s n o i ev e e sm to inv saturation p lar of invest d by Store ing into th ying to achi not with a to develop. l e tr o s an nd lt saw it rn on the d is outweigh eign expa : what is it ket that it c ga difficu n r e d r o y t a u e o l t t e f r i M e m k a r n ? r s Solutiores in the U e a the omestic ma vesting in a estment cle international estic market efore ’ re o t c d Mega S ith only 600 st executives fa tives the benefits of international inv ent and the ieve in its domng way to go b es a u e c e W r ach e h stm x se in s a lo ecom t to Becau assive inve ers in their ega S tion than e l-Mart, still ha expansion b . t e e r M k o r , t s a S m a m State erent situ oy il play onal s Wa such nt reta usually empl uch a hile these ternati rategy. iff uires a s n d q n i i e s r y r r m e e l y o l v d ai es ic st the on epot. W er ret overs, only ountri realist at larg d Home D problem of uld risk ctive home c y are usually an he wo respe tegy, as the GAP, tailers face t xtra store to a g e e stra rd it. o need M re larger n where an earby store, size this that can affo re, there is n markets n io to w ts es saturat ize sales at a y increase i per on For Mega S nto these ne i l l e r a b e u b a t i reven cann mfort r to en can co nd increase its current so eage e e r b o t S a In space. tically ase its domes oot of floor mably incre f su square , it can pre | on 54 HARVARD COLLEGE INVESTMENT situati MAGAZINE SPRING 2008

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