Harvard College Investment Magazine Winter 2006 by Harvard College Investment Magazine

Investment Harvard College

Magazine WINTER 2006

IN THIS ISSUE 14 Browser Wars 16 Ring the Alarm 23 Building the Vision Joseph M. Gregory, COO of Lehman Brothers

28 Investing in Israel 35 Force of ideas, Spirit of Generosity Thomas L. Monahan III, CEO of The Corporate Executive Board

49 The Private Equity Explosion

PLUS 9 Driving up the Gas Tax 31 Confucian Capitalism

ahead Staying

of the game

Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

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,EESBURG 0IKE &IFTH &LOOR s 6IENNA 6! s WWW DC-ENERGY COM

BREAK AWAY. Geographically, we’re in the center of the financial world. Philosophically, we couldn’t be further away.

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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HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

Kuanysh Y. Batyrbekov Jennifer Y. Lan Alex Bayers Roxanne E. Bras Rika Christanto

Stanley S. Chiang Robert A. Davis Henry J. Foo

Vivek Kuncham Mike T. Lapsa

Sergali Adilbekov Jeffrey S. Bramson Polina Dekhtyar Samantha T. Fang Matt Fleck Jonathan S. Greenstein Donna Ivry Alexis M. Pacheco Mate Pencz

Zachary P. Rosenthal Dmitri Smirnov Hagop Taminian Michael J. Weglarz Mimi Yu Betty Y. Zhang Chelsea Zhang Anna Y. Zhang Jan Zilinsky

Y. Joy Ding F. Jovan Jester Grzegorz Babiarz Joy Z. Chen A. Sophie Hilgard

Claire Saffitz Yiying Xu

J. Francisco Martinez Pavlo Kononenko Helen Poldsam Kristi Poldsam Andrew J. Flynn Michael G. Jordan Nate D. Kiechel John M. Mistovich Alexis M. Pacheco

Kareemah L. Sabur Yichen Shen Dmitri Smirnov Burak Tekin Sarah Wang

Tian Huang (Northwestern University) Bryan P. Farney (Texas A&M University) Kristen Lovin Anna Haisi Yu (Citadel Investment Group) Michael Hauschild (Citadel Investment Group) Brian Kozlowski (DC Energy) Benjamin Yihung Lee (Bain and Co.), John Y. Campbell Jeremy C. Stein

COPYRIGHT 2007 (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 Winter 2006

Features

Browser Wars The Saga Continues

by Samantha Fang

Ring the Alarm The Inevitable Evolution of the Music Industry by Tian Huang

Building the Vision An Interview with the President of Lehman Brothers, Joseph M. Gregory

by Kunai Batyrbekov

Investing in Israel An Interview with Yair Shiran, Israel’s Economic Minister to North America

by Jonathan Greenstein

Force of Ideas, Spirit of Generosity An Interview with Tom Monahan, Chief Executive Officer of The Corporate Executive Board Company

by Jennifer Ying Lan and Bryan P. Farney

The Private Equity Explosion and The Future of European Private Equity by Drew Davis, Alex Bayers, and Mate Pencz

Inside Scope

Driving Up the Gas Tax The Need for Diversification by Chelsea Zhang

A New Virtual Reality Google’s Purchase of YouTube Signals Future Expansion by Zachary Rosenthal

Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

Inside the Profession

College-Age Investment Must Knows 18 An Interview with President and CEO of Harvard University Employees Credit Union, Eugene Foley

by Mimi Yu

Global Outlook

Grameen Bank

Social Entrepreneurship as Investment by Mike Weglarz

Confucian Capitalism

Ancient Practices in Modern China by Rika Christanto

Investing Today

Mortgages

The Real Estate Market’s Delinquent Sibling by Henry Foo

Real Opportunities in Real Estate

Why Developing and Renting in Central Europe Will Bring You Money

by Jan Zilinksi

Harvard College Consulting Magazine

The First Edition of HCCM

Harvard’s Insider to the World of Consulting

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

Dear Readers, Welcome to another issue of The Harvard College Investment Magazine! As always, our entire team is really excited and proud to be able to present to you yet another issue of Harvard’s largest and completely student-run financial publication.

With the high rollers in the world of investment never taking the time for a single pit stop, the accelerating investments of this past year of 2006 have been no exception. From the groundbreaking largest private equity deal in history with Blackrock paying US $36 billion for Equity Office Properties to the acquisition of online video phenomenon YouTube by internet search giant Google for US $1.65 billion, the markets have experienced one continuous surge after another. In this issue, our editors examine such pertinent matters as online revenue intake and expansion, real estate booms and busts, and private equity practices and trends. Our everpopular Global Outlook section features an interview with Yair Shiran, Israel’s Economic Minister to North America, discussing the development of the Israeli economy despite the recent conflict with Lebanon; an excellent spotlight feature on Grameen Bank, one of the world’s most successful social entrepreneurship and financial institutions; and an analysis on how to conduct business with a Confucian flair in the booming Chinese economy. As proud as always of our growing collection of exclusive interviews with the hottest CEO’s and Presidents in the business world, we are proud to welcome Thomas L. Monahan III, Chief Executive Officer of The Corporate Executive Board; Joseph M. Gregory, President and Chief Operating Office of Lehman Brothers; and Eugene Foley, President and Chief Executive Officer of the Harvard University Employees Credit Union to our fold. Without the hard work of our dedicated staff, this endeavor would not have been possible. Also, a big Thank You to HCIM alumni at various firms like Bain & Co., Citadel, Lehman Brothers, and Goldman Sachs for their continued support and advice. We at HCIM look forward to an amazing 2007! Sincerely,

Jennifer Ying Lan Editor in Chief

Kuanysh Y. Batyrbekov Co-Editor in Chief

harvard college investment magazine

LETTER FROM THE EDITORS

Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

he prospect of global warming has chilled economic forecasts for the 21st century. An increase in average temperature and a change in precipitation patterns mean that “economic damages are inevitable,” predicts the Pew Center on Global Climate Change, a global think-tank composed of business leaders, policy makers, and scientists. Sir Nicholas Stern, head of the British Government Economics Service, recently stated that if greenhouse gas emissions continue to increase at their current rate, global markets stand to lose five to twenty percent in economic output over the next two centuries. Thus, the question is not whether global warming has economic consequences, but rather what solutions to climate change would effectively stem global warming and simultaneously make economic sense. Some economists and policy makers believe the most credible solution is to raise taxes on gasoline. The tax hike, they argue, would cut gas consumption and curb the pollution that leads to global warming. In support, Gregory Mankiw, Professor of Economics at Harvard

University, states that higher gas taxes “would be the most direct and least invasive policy to address environmental concerns.” While economists like Mankiw point out that the tax hike has spillover benefits, opponents point to its potentially damaging effect on investment. Navigating the strengths and weaknesses of these arguments makes for a winding and sometimes surprising journey.

Prices, Prices

The gas tax was not always meant to discourage consumption. In fact, the U.S. first implemented the gas tax with the purpose of earning revenue to balance the federal budget. The initial one-cent-per-gallon tax in 1933 raised over $125 million. Since then, a series of tax hikes have brought the federal gas tax to 18.4 cents per gallon, where it has stayed since 1993. Other countries, taking stricter stances on emissions, have pumped up their gas taxes. According to recent data from the International Energy Agency, total gas taxes in August 2006 averaged $4.24 per gallon in Great Britain, $3.99 in Germany, but a mere

DRIVING

UP THE

GAS TAX By Chelsea Zhang

Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

Inside Scope $.40 in America. In explanation, the U.S.’s lower gas taxes correlate with the higher consumption of gas in the U.S. as compared to other developed countries. In 2005, economists Ian Parry and Kenneth Small estimated that the optimal gas tax in the U.S. was $1.01 per gallon—two and a half times the current level. The data squares nicely with the views of Arthur Pigou, the famous British economist who supported correcting externalities with taxes.

No New Taxes

However, it should come as no surprise that the public would recoil at the idea of more expensive gas. The proposed tax increase to stem pollution faces political hurdles as high as the skyrocketing gas prices of the summer of 2006, when trips to the pump dug deeply into the pockets of frustrated consumers. Average gas prices rose above $3 per gallon then, eventually falling to $2.20 by late 2006. Alongside the political opposition are also detractors with economic arguments. Many believe that tighter emissions standards, tradable pollution rights, or increased taxes on oil companies would also decrease oil supply, thus making gas more expensive and reducing consumption. These critics argue that their proposed methods would not draw as much public hostility as the proposed tax hikes. In fact, Corporate Automobile Fuel Economy (CAFE) standards targeting emissions are already in place. However, Christopher Farrell of BusinessWeek argues that the government should step back let the market discourage gasoline consumption instead of imposing regulations.“A high gasoline tax is a far superior tool for encouraging consumers to choose fuel efficiency,” he wrote. Corroborating his view is a recent study by the Congressional Budget Office which considered two options for achieving a 10 percent decrease in gas consumption: making CAFE standards more stringent or increasing the gas tax by 46 cents per gallon. The study found that with the higher gas tax, total social welfare would decrease by $2.9 billion. However, by not letting the market dictate consumption and by raising CAFE standards, the cost to welfare would increase to $3.6 billion. Some criticize the gas tax increase because it would disproportionately affect 10

the poor. Surveys have shown that poor households spend a greater share of their income on gasoline than middle and highclass households do. Still, James Poterba, Professor of Economics at M.I.T., disputes this statistic by restructuring the way at which gas consumption by poor households is looked at. He believes that by analyzing a household’s annual expenditure rather than its annual income, the gas tax appears less regressive than previously thought. Another argument against a higher gas tax is that it will damage the economy. The fall in oil consumption would shrink investment

“

By decreasing America’s heavy dependence on oil, the effect of such an attack on our national economy would also be lessened.

”

in the oil industry and in technologies for expanding oil production. However, this decreased oil consumption would, in turn, provide an incentive for oil companies to invest in alternative fuels and for the auto industry to invest in more fuel-efficient cars. The jobs created by the push for better technologies may very well compensate for the jobs lost to reduced investment in the oil industry.

Optimism

Weighing in against the counterarguments, Professor Mankiw believes that several benefits of a gas tax hike reside beyond reducing emissions. For one, because people would choose to drive less, the tax increase would relieve street congestion. In addition, the government could direct the

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

additional tax revenue toward reducing the federal deficit, which measured $247.7 billion in 2006. Mankiw believes that a “$1 per gallon hike in gas tax would bring in an extra $100 billion a year in government revenue and make a dent in the looming fiscal gap.” Former Federal Reserve chairman Alan Greenspan paraphrased another benefit of increasing the gas tax when he said, “That’s the way to get consumption down. But it’s also a national security issue.” Decreasing gas consumption would help the U.S. become less dependent on the Middle East for oil—a particularly weighty issue in light of the attacks from September 11th. In a recent policy paper entitled “Oil and Security,” former presidential advisor George Shultz and former CIA director R. James Woolsey stated that “a single well-designed attack could send oil to well over $100 per barrel and devastate the economy.” By decreasing America’s heavy dependence on oil, the effect of such an attack on our national economy would also be lessened. To policymakers, the advantages of raising the gas tax are much more than just economic.

Political Promise?

Still, a gas tax hike must overcome political roadblocks, including lawmakers who are reluctant to levy it on their constituents. “The main critiques of it are political rather than economic,” said Mankiw. “If you put the political arguments aside, it’s hard to argue with the economics.” The American public has mixed opinions on the matter. According to a New York Times/CBS News poll from 2006, 85 percent of Americans said they opposed an increase in the federal gas tax. On the condition that the tax revenues would help make the U.S. less dependent on foreign oil, though, only 37 percent opposed the tax hike, while 55 percent approved of it. When told that the tax hike would reduce energy consumption and mitigate global warming, 34 percent opposed it, while 59 percent favored it. Only time will tell whether a gas tax hike will pass the political gauntlet. Nonetheless, the longer Americans go without an incentive to drive less, the more their emissions will drive up the dangerous effects of global warming and national dependence on foreign sources of oil.

a new

virtual reality “O

n the web…Google calls the shots. For video, it’s going to be YouTube.” Thus, declared Wharton School of Business marketing professor Peter Fader exactly one month before the merger heard around the web finally materialized. In November 2006, after months of anticipation, online search engine Google Inc. closed a deal to purchase YouTube, the universally popular website that showcases free video clips, for $1.65 billion in stock. Although the purchase will result in various benefits for both companies, Google will have to contend with the ramifications of YouTube’s illegally uploaded content while attempting to parlay its massive expenditure on the company into a future stream of profits. Thus, it is important to analyze the

Google’s Purchase of YouTube Signals Future Expansion By Zachary Rosenthal

expectations of both Google and YouTube as they begin a new partnership before forecasting Google’s future acquisitions and growth patterns.

Reasons for the Acquisition

A study of the sources of Google’s previous growth and profitability reveals that the company’s main reason for purchasing YouTube was to maintain high revenue from the sale of advertisements. According to The Wall Street Journal, online advertising helped push the revenues of both Google and Yahoo! Inc. over $1.2 billion in 2004, Google’s first year as a publicly traded company. In fact, since Google does not charge user fees unlike other online companies, advertising

is the company’s main source of revenue. Statistics from Wharton show that over six million spectators use YouTube everyday, meaning that its market share for online viewers is greater than those of Google and Yahoo combined. As a result, acquiring YouTube provides Google with a far greater audience, thereby increasing Google’s appeal to companies which place advertisements online. Google’s previous acquisitions in the months leading up to the YouTube purchase elucidate its stated desire to expand into print, radio, and television. In January, Google acquired dMarc Broadcasting Services for $102 million, a company which allows users to identify songs and artists playing on the radio and gains it profits from radio ads. Then

Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

Inside Scope in August, Google started providing ads for eBay, a site whose frequent customers make it another worthwhile enterprise for advertising companies. Google’s quarterly report issued in September 2006 further emphasized its partnerships with eBay, Fox Interactive Media, and Intuit,a developer of business management software. Finally, JotSpot cofounder Joe Kraus confirmed in late 2006, that his company, which creates wikis, which are convenient organizers of information, became a member of the Google family in part because “Google shared [his] vision for how groups of people can create, manage, and share information online.” YouTube was also a wise purchase for Google because it is a small company with a staff of only 67 employees and a truly nascent business that exploits a specific medium of communication. In addition, YouTube was taking steps to insure the legality of its content. By the time negotiations with Google had surfaced in November, YouTube had already publicized its deal with Warner Music Group to circulate their music videos and pay artists for the use of their copyrighted material. Furthermore, YouTube and the other acquisitions will benefit greatly from the legal protection a huge corporation like Google can afford. In the future, Google will be completely responsible for the costs of settling suits against YouTube for streaming copyrighted television extracts uploaded by users. Simultaneously, because Google profits from ad sales contingent on heavy site traffic rather than subscription fees, companies like JotSpot will no longer have to bill its users. Thus, the purchased companies stand to expand their user bases because in addition to being free, Google is also familiar, popular, and easy to use.

Flagging network television ratings suggest a gradual shift toward watching programs via the Internet, a movement that would greatly entice advertisers to Google if YouTube could operate as the primary provider of such content. In the United Kingdom, the policy of contracts rights renewal in the network television arena allows advertisers to lower the number of ads they annually place on a series of British channels. Thus, with more options for advertising, they can now leave their

“

Given that all of Google’s previous purchases are platforms for virtual entertainment and communication, a future acquisition of either Facebook or MySpace (with which Google already has an advertising deal in place) is not out of the picture.

Implications for Google in the Market for TV Entertainment In addition to the legal battles regarding copyright, Google must contend with the declining popularity of other types of media. Its desire to expand into television, print, and radio reflects the increasing proliferation of all three forms of media via the Internet. 12

A Competitive Marketplace: Forecasting the Future Given that all of Google’s previous purchases are platforms for virtual entertainment and communication, a future acquisition of either Facebook or MySpace (with which Google already has an advertising deal in place) is not out of the picture. However, it is unlikely that Google will shelve out as much as $1 billion for another social-networking site so soon after its costly YouTube purchase. These websites unite many teenagers and young adults—the key demographic of most advertisers—but repel a growing number who are concerned about their privacy or otherwise see little entertainment value in their use. It is more commonly rumored that Google preemptively acquired YouTube in case Yahoo chooses to reach a similar agreement with Facebook. Google’s stock price surged past $500 per share for the first time after the YouTube purchase, reflecting investor confidence towards Google’s strong leadership and capacity for sustained growth. The Google-YouTube union can be likened to the AOL-Time Warner merger in that two high-profile companies took advantage of the Internet’s massive popularity. Yet, by focusing on the importance of advertising revenues by increasingly boosting its appeal to users, Google can hopefully avoid the setbacks which have plagued the online mergers which came before it.

”

budget open for advertising with Google. If a similar policy is adopted in the United States and the networks fail to create more programs that sufficiently entertain audiences, they might lose the support of viewers and thus financial backing from advertisers. It comes as no surprise that Google, now armed with a ready supply of entertaining and popular videos on YouTube, will be waiting. Nonetheless, Google is also heavily focusing on attaining the rights for uploading network programs onto YouTube, so it is

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

clearly unwilling to bank on the possibility that online users will be satisfied with only amateur videos and fictional programs created by YouTube users. Moreover, Google most likely wants to avoid incurring the costs of hiring Hollywood scriptwriters and actors to produce mini-series of its own which would be equally precarious in appeal as those currently airing on television. Google instead trusts that there will always be an audience for network TV, since it stated that it wants to increase revenue from companies that advertise on these typical forms of media. A deal with Showtime Networks to upload news and sports videos from its parent organization, CBS, reinforces Google’s reliance on pre-existing programming.

As the Internet enters a new phase of development, browser developers are scrambling to capitalize on the personalization of the Web. Having won the first generation of Browser Wars against Netscape, Microsoft is lining up for yet another battleâ&#x20AC;&#x201D;this time, with Mozilla. At the same time, young techies and entrepreneurs see possibility in an expanding market with low-entry costs and high stakes. By Samantha Fang

Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

Inside Scope

m Malik of Business 2.0 Magazine knew what he was talking about when he made a bold assertion: “The browser is the new operating system.”Though considered highly optimistic and slightly premature by critics who discount his statement, his words give proper significance to the importance of Web browsers as the next frontier of competition. Largely unnoticed by most, the browser, a user’s portal to the Internet, is instrumental in understanding the high-paced, progressive development of the Web and looks to shape the future of the Web experience. Om Malik of Business 2.0 Magazine these potential profits. knew what he was talking about when he We are now at the verge of a new made a bold assertion: “The browser is the Web revolution, one that has opened up new operating system.” Though considered the possibilities of the browser market. highly optimistic and slightly premature With the expansion and increasing by critics who discount his statement, universality of the Internet, users are his words give proper significance to the increasingly dissatisfied with only importance of Web browsers as the next passively “surfing the Web” and seek frontier of competition. Largely unnoticed more active participation in the growing by most, the browser, a user’s portal to the online community. Already, the big names Internet, is instrumental in understanding in the browser business—Microsoft, the high-paced, Mozilla, and a newlyprogressive development revamped Netscape— of the Web and looks to have recognized the shape the future of the new potential of the the purported amount Web experience. browser and have begun that Firefox generated for In the early 1990’s, innovation, redesigning Web browsers simplified and recoding their Mozilla in 2005 access to the online browsers to increase world, transforming the user interaction. Smaller Internet from an obtuse companies and startcommunication system ups, such as the popular the amount per year that used solely by academics European Opera, Apple’s it takes to maintain the into a mass consumer Safari, and Mozilla-based Firefox browser phenomenon—in fact, Flock, are also seeking it was the dissemination to enter the market of browsers which made way for the and get their slice of the browser pie. As popularity of the Internet. As a gateway these firms compete for the Internet user’s to the Web experience, browsers therefore attention, millions of dollars in revenue are have the ability to influence the activities up for grabs. Let the new revolution of the of users on the Web, making browsers “Browser Wars” begin. a profitable market. A lot is at stake: popular browsers could generate millions A Whole New World of Interaction in revenue by running advertisements, When considering how the world uses making deals with search engines such as the Internet today, it is clear that we have Google and Yahoo!, and collecting affiliate entered a new generation of the Internet fees for referring users to commercial sites. experience. The realm of cyberspace has “Browser Wars”—aptly named after the become that much more fruitful. Being on Star Wars saga—are fought in the attempt the Internet is no longer about passively to gain market share, capture the attention reading, watching, or surfing. Today’s users of Web users, and most importantly, grab want greater control of their experience.

BROWSERS

IN BRIEF

72 million 10 million

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

Across the globe, the Web is about sharing, collaborating, networking, discussing, and—most of all—creating. Each day, thousands of individuals create their blogs and podcasts, flood the Internet with personally directed films through sites like YouTube, and share games and photos through sites like Yahoo’s Flickr. Media aficionados share photos and music clips on the Internet—often to the dismay of copyright authorities—and create virtual communities based on music and artistic preferences. Tech and ‘selfhelp’ groups are rampant. The new Internet has also shaped the world of politics as campaigns are increasingly targeting the mass audience on the Web. “Discussion boards” allow constituents to interact with their representatives and each other, making the political process more personal and unique. It is unbelievable how much political discourse occurs via the Internet as political junkies exchange opinions

MOZILLA

FIREFOX

INTERNET EXPLORER

NETSCAPE

BROWSER

CURRENT VERSION: 2.0 (Oct. 24, 2006)

CURRENT VERSION: 7.0.5730.11 (Oct. 18, 2006)

CURRENT VERSION: 8.1.2 ( Sept. 27, 2006)

BRIEF HISTORY: An open source, cross-platform browser, Firefox was first developed by Mozilla Corporation and has been improved by techsavvy users. Since its release in November 2004, Firefox has become one of the most downloaded applications on the Web and has garnered over 10% of the browser market share.

BRIEF HISTORY: Internet Explorer was Microsoft’s response to Netscape’s dominance of the browser market in the early 1990s. Packaged with every copy of the Windows operating system, IE dominated the browser market. It is still the most widely used browser, with more than 85% of the market. However, recent pressure—especially by Mozilla Firefox has compelled innovation in IE.

BRIEF HISTORY: Netscape Browser is the revamped version of the now defunct Netscape Navigator, which was originally developed by Netscape Communications Corporation. The browser is now developed by AOL, which is responsible for its recent advertising campaign. Netscape Browser now has less than 1% of the market share, and the number is falling.

PRAISE: As the leading browser in the market, IE can view the broadest range of pages on the Web. Recent versions imitate Firefox, featuring tabbed browsing and pop-up blocking, as well as some downloadable extensions. The new Download Monitoring and Install Monitoring helps users prevent the installation of malware.

PRAISE: Netscape Browser uses two different layout engines—IE’s Trident and Firefox’s Gecko—that allows customized security settings for different sites. Features include enhanced tabbed browsing, pop-up blockers, “widgets,” an email link, and integrated ID Theft Protection and Spyware Protection.

CRITICISMS: Internet Explorer is highly criticized for its lack of security. Spyware, adware, and computer viruses exploit the flaws in the architecture of IE and infect user computers. Though other browsers face similar viruses, the amount of malware for IE is much larger. As a result, the majority of bugs and flaws in IE remain unpatched. In May 2006, PC World rated Internet Explorer 6.0 the eighth worst tech product of all time.

CRITICISMS: Critics claim that the use of both Trident and Gecko rendering engines gives Netscape Browser the inherent vulnerabilities of both, making the browser less secure on the whole than either Internet Explorer or Firefox. Furthermore, Netscape Browser collects personal information by default, which raises concerns from users about safety and information protection.

PRAISE: The sleek and simple design of Mozilla Firefox has captured the attention of Internet users. Main features include tabbed browsing, live bookmarking, and a built-in search toolbar. Firefox has already acknowledged the new Web revolution, and users can customize Firefox with different skins, themes, and downloadable extensions, all of which are available on the Mozilla website. The main draw of Firefox, however, is that it has fewer unpatched security vulnerabilities than Internet Explorer. CRITICISMS: According to Internet Week, Mozilla Firefox requires more memory usage and experiences misbehaving extensions and plug-ins, although tests by PC World and Zimbra show that the new version of Firefox uses less memory than Internet Explorer 7.0. Firefox takes more time to launch on Microsoft Windows than other browsers.

and election predictions through personal blogs. For example, a Google search for “’2006 Election Results’ blogs” came up with 5,650,000 hits. Furthermore, Howard Dean was able to raise $7.4 million in online donations in three months during his bid in the 2004 presidential campaign – a true testament to the power of the Internet. The Web bustles with economic activity as well, with millions of individuals buying products online, contributing feedback on services, and bidding on and selling personal belongings. In the sphere of social networking, sites such as MySpace, LiveJournal, and Facebook have generated millions of visits by users and have begun raking in the money through advertisements. MySpace has become the most visited Website on the Internet with over 21 million visitors logging in monthly. Facebook, a site with a targeted demographic of college and high school students, boasts a staggering 3.85 million

members, a number that continues to increase. The popularity of such sites shows the trend towards the personalization of the Web: this time, the revolution is about your Web, an Internet experience built and shaped by the user. In a blog post, Ross Mayfield, CEO of the Palo Alto-based startup Socialtext, Inc., aptly captured this spirit: “Users are ‘googling,’ ‘blogging,’ contributing to Wikipedia, Socialtext, Meetup, posting, subscribing, feeding, and above all sharing. In other words, the Web is increasingly less about places and nouns, but verbs.” This independent, do-ityourself attitude is revolutionizing the way businesses advertise and sell on the Web.

Enter the Browser

The first “Browser Wars” of the 1990s pitted Microsoft’s Internet Explorer (IE) against Netscape’s Navigator. As the frontrunner in the browser market, it

seemed that Navigator would continue its dominance. However, it was Microsoft which eventually prevailed in the ensuing struggle. Microsoft’s advantage was its monopoly on the operating systems market – IE was bundled with every copy of Windows. Therefore, though IE was technologically inferior, its free cost and availability enticed users—for the time being. At the same time, Microsoft spent enormous amounts of capital on research and development to enhance IE until it was almost identical to Navigator, making Navigator unnecessary. To capture the market, Microsoft also made strategic alliances with the then-popular AOL and the Web-authoring tool FrontPage. The problem with this first war was the lack of browser quality. In the race to build a solid base, both firms designed browsers that had appealing features, yet were characterized by unfixed bugs, poor quality control, and shabby maintenance of standards.

Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

Inside Scope Some critics have called Microsoft’s vested interested in the browser market particularly insidious, as Microsoft had no interest in making revenue off of Internet Explorer. Microsoft had more pressing concerns: middleware. A decade before Malik’s assertion, Microsoft realized the potential of browsers to serve as interfaces for cross-platform applications—in other words, for browsers to eradicate dependence on the operating system. We have already seen the beginnings of the “browser as OS,” as Web-based programs such as Gmail and Yahoo! Mail can be accessed from different computers with any operating system. For Microsoft, control of the browser market amounted to slowing down the progress of “middleware” and solidifying the future monopoly of its applications and operating systems. Until now, Microsoft’s domination of the browser market has stifled progress and discouraged competitors. Design innovation following the first “Browser Wars” had been stagnant: Web browsers maintained the same basic features that they had more than a decade ago, suitable for the oldfashioned Internet experience of surfing and reading. However, the recent Web revolution has offered new opportunities and reduced previous barriers of entry. Firms have been quick to pick up on the new trend of Internet usage, resulting in an unprecedented flowering of browser innovation and challenging Microsoft’s monopoly on the browser market. Unlike Microsoft, these firms expect considerable revenue from their browser creations. Let us consider a young upstart that expects to make it big with its ideas. Flock, a Palo Alto-based startup, has already capitalized on the new wave of personalization, creating what it calls a “social Web browser.” With an innovative interface, Flock is the launching pad for group Internet activities. Its home page advertises, “Flock is an amazing new Web browser that makes it easier to share media and connect to other people online. Share photos, automatically stay up-to-date with new content from your favorite sites, and search the Web with the most advanced Search Toolbar available today.” For the new generation of Internet users, Flock

offers endless possibilities, allowing users to seamlessly drag and drop photos into sites like MySpace, LiveJournal, and eBay and post blogs with ease. Updates notify users when their Flickr and Photobucket friends upload new photos. Like many other competing browsers cropping up, Flock incorporates RSS (Really Simple Syndication) News Feeds. With the personalized catch phrase “Become your own media mogul,” RSS allows people to subscribe to blogs and news sites, allowing

“

Each day, thousands of individuals create their blogs and podcasts, flood the Internet with personally directed films through sites like YouTube, and share games and photos through sites like Yahoo’s Flickr.

Microsoft in Trouble? The Future of Web Browsers These new browser companies have made their goals clear: to take the market away from Microsoft and to capitalize on the new consumer preference. They bank on their innovation and vision, believing that the giant Microsoft lacks the agility to maintain its grasp on the market. In the words of David Cowan, Flock’s lead investor, “The incumbents are vulnerable. Today, they are the juiciest targets.” Browsers such as Mozilla Firefox and Opera often refer back to the first “Browser Wars,” hoping that the underdog will succeed yet again. Nonetheless, it does not look as if Internet Explorer is going anywhere soon. Microsoft still has 86 percent of the browser market with an often entrenched consumer who has no interest whatsoever in switching to another browser. The problem for these new browser firms—and the reason why they so desperately want to enter the market—is a browser’s “stickiness.” In this particular market, it is easy to consolidate loyalty and to build a dedicated group of users. Therefore, once in the market, a browser stands a good chance of sticking around for a long time. Furthermore, Microsoft is proving to be a staunch competitor, pouring its vast resources into improving security and incorporating novel features in its new versions of IE.

”

them to create a customized bundle of information related to their particular interests. Bart Decrem, the co-founder and Chief Executive of Flock, has set his goals to take the browser market en force. He hopes to have over 100 million users within the next five years. Furthermore, Decrem expects big money. The business plan for Flock calls for raising revenue through ventures like Google advertisements, affiliate fees from commercial referrals, and cooperation benefits with other Web services. Click on a link to Amazon.com? Use the Google toolbar to search? Drag a photo onto Flickr? Flock will get a share of that. With a sufficient user base, these dollars and cents can add up to millions in revenue. Flock is only the newest example

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

of the various browsers lining up for the second “Browser Wars.” With more presence in the market, browsers such as Apple’s Safari, the European-based Opera, Mozilla’s SeaMonkey, and a new version of Mozilla’s Firefox look to be key contenders in this renaissance of browser innovation. Already, Mozilla Firefox has made steady gains on the browser market, taking nearly 10 percent of the market from former monopolist Microsoft. With a small but significant hold on the market and a deal with Google, Firefox generated a purported $72 million for Mozilla last year—not bad for a browser that takes less than $10 million a year to maintain. The competition against Microsoft is only getting tougher, and the amount spent—and gained—on browsers looks to increase.

Ring the

ALARM

The Inevitable Evolution of the Music Industry By Tian Huang

ith the advent of Napster seven years ago, point-and-click could have meant saving 15 dollars on the first Britney CD or listening to the Metallica demo

before it was released. After free music downloading services were shut down due to copyright infringement laws, however, fee-based services have been a new hot source for music. Now, point-and-click can mean paying 99 cents for a song on iTunes or enrolling in a subscription service like Rhapsody. But for the music industry, selling music online still causes concerns about how the digital technology has and will affect their sales.

Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

Inside Scope The Outside Attack

In 1999, EMI Music, a top international recorded music company, presented David Bowie’s “Hours” as the first album available for digital download in the world. Since that year, which also saw the launch of Napster, physical music product sales have been steadily declining. In fact, Best Buy, the electronics, software and appliances specialty retailer, has seen a ten percent decrease in music CD sales, which contribute to approximately five percent of the retailer’s total revenue. Warner Music, one of the largest music companies, became the only one to increase its market share in the first half of 2006, rising from 16.7% in 2005 to 19.3%, according to Nielsen SoundScan. While some analysts downplay the negative effects of digital music, as approximately 90 percent of the music purchased is still sold on compact disc, other analysts believe that CD sales are destined to be dominated by online music

“

downloads. Analysts expect six percent of all music sales to be from downloads in 2006, a steady rise from the two percent of sales made in 2005. Though download sales aren’t predicted to equal store sales for another ten years, it is in hyper-growth mode. According to the International Federation of the Phonographic Industry (IFPI) World Sales 2005 report, the music industry saw international digital music sales nearly triple. Revenue for Digital Music Group, which buys digital music rights and then distributes them to online music stores, for the second quarter in 2006 was almost seven times larger than last year’s second quarter revenue and also increased seven percent from the first quarter of 2006. Because of this, music publishers have economic incentives to issue licenses to legitimate online music services so that both music publishers and songwriters will be compensated. For this reason, the music industry has begun to work with digital

As technology accelerates at a hyper speed velocity, what you now use to keep in touch is already

”

becoming what you use to

listen to music.

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

companies to gain more public access to their music catalogs. Nonetheless, most of the new online music companies have put an enormous strain on the music industry, demanding that a million or more tracks be immediately offered to their users. These new business partners, the music industry has found, are unlike the traditional music retailers who had the same goal as the music industry in wanting to maximize the value of music. Indeed, these new partners have other priorities, such as selling digital music players. Instead of selling music, they are merely using music as a tool to maximize their brand values.

Fighting Back

Determined not to go down without a fight, the music industry has learned to evolve. SpiralFrog, an online service that will offer free music downloads before the end of 2006, has already announced that two major record labels, Universal Music Group and EMI Music Publishing, have agreed to offer free, copy-protected downloads on their site in exchange for advertising participation. The iTunes model, which most major music companies have a stake in, has been widely applauded by record labels for Apple’s dispersal of 70 cents for every 99-cent song sold. EMI Music, meanwhile, has been transforming itself from into to a software company. The company, which employs approximately 6,000 people globally and represents more than 1,000 international recording artists, has seen its number of key digital partners, telephone, cell phone and digital distribution companies and online stores, increase during the past few years. The EMI’s digital formats’ popularity also varies globally. For example, in Asia, digital downloads on cell phones have been a huge market, reporting a 724 percent increase in revenue in 2005. North America, on the other hand, has been slower to take up the new technology, but also experienced an impressive 165 percent increase in revenue in 2005, according to EMI Music. Certainly, the digital revolution is demanding the music industry to venture into the IT and business processes, but

With all of the upcoming possibilities, the big record labels can no longer rely solely on the sales of CDs.

again, it is still growing. EMI Music’s revenue from digital products currently represents only 5 percent, or $67.6 million, of its total revenue. Nevertheless, by 2010, the company predicts that that number will jump to 25 percent. One thing most analysts agree on is that digital technology has permanently changed how the music industry operates and will only continue to do so. The Inner Struggle Everyone wants a bite out of the online music apple. Microsoft declared in July 2006 that it was tossing Zune into the ring of digital music players while MySpace.com, the popular social networking website, announced it would start selling songs from its music pages. MySpace, however, sells unprotected MP3 files. Because of this, major record labels have yet to agree to participate in MySpace’s music venture

that will provide unlimited on-demand streams and downloads of both audio tracks and music videos. Unlike other feebased download services, AOL Music Now lets its users play as many songs and music videos as they want, in their entirety and on-demand. Electronics retailer Best Buy is even joining in the online music market with its new Digital Music Store, which, like most of its new counterparts, also offers songs singularly or a subscription service. However, analysts have noted that all of these new ventures might not be very profitable if no major deviations are made from Apple’s iTunes online music store, which is currently dominating the online music market with sales of 70 percent of online music in the United States.

The Future Battle

What you now use to keep in touch

cell phones. Sprint Music became first U.S. cellular carrier to allow full-length songs to be downloaded through the Sprint Music Store. The store also became the first mobile music service to have one million song downloads in February 2005 and now can boast more than three million downloads. In August, Nokia purchased Loudeye, a digital music content owner, for $60 million to jumpstart a music service into its phones. Nokia also has introduced music editions of Nokia Nseries multimedia phones. Samsung also has set its sights on entering the cell phone music arena. The electronics giant has already announced plans to open its own music store to sync with the company’s music players and phones. Apple won’t be sitting back and watching the competition, however; a new phone from the company could be introduced as early as next year. While usage of OTA is currently low,

Along with its new digital music player, Microsoft teamed up with MTV Networks on URGE, a new digital music service that is integrated with the new Microsoft Windows Media Player 11 and currently demand that all distributors limit the copying. Along with its upcoming digital music player, Microsoft teamed up with MTV Networks on URGE, a new digital music service that is integrated with the new Microsoft Windows Media Player 11. URGE offers its users both single song purchases as well as an unlimited subscription service. AOL also launched AOL Music Now, the first digital music subscription service

may soon become what you use to listen to music. Analysts believe that cell phones will soon become the music player of choice since the parts of a MP3 player are similar to the parts in a MP3-playing cell phone. Furthermore, there is a reasonable market for cell phones with the capacity to play music. Phone companies have already begun to take notice of wireless over-the-air (OTA) music services, which sell music on

analysts forecast that U.S. wireless music services will have over 50 million users and generate more than a billion dollars in revenue by 2010. The number of OTA customers in America will be approximately half the number of online music service users by the end of 2006. By 2010, close to 60 percent of all cell phones in the U.S. are expected to have music playing capabilities. With all of these upcoming possibilities, the music industry has several obstacles to overcome but an almost limitless potential if it succeeds.

Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

College-age inv Must K As a non-profit cooperative overseeing $200 million, the Harvard University Employees Credit Union (HUECU) ranks within the top five percent of all credit unions in America. Recently, the Harvard College Investment Magazine had the chance to conduct an interview with the President and CEO of HUECU, Mr. Eugene Foley, about the growth of HUECU and his advice to Harvard students.

Can you discuss your background and how you became president of HUECU? After graduating from Boston University on a full-ride academic scholarship, I started as a credit analyst on commercial lending and collection, thinking I would later attend law or journalism school. However, after joining HUECU, I started down the path which has led me to where I am right now. I have spent twenty-five years at HUECU, seeing this financial institution transform from a credit union with $20 million to where we stand now, an institution worth over $200 million. Instead of law school, I decided to get an MBA. After the last CEO retired from HUECU, I was made CEO in 1994. Can you describe the changes that have taken place at HUECU? Let me first preface by introducing what a credit union is. A credit union is a non-profit financial cooperative with the ability to offer consumer finance products to a defined membership. In this case, it is the faculty, staff, alumni, and students of Harvard University, and many affiliates of the University. We also have non-profit status. One of the challenges that I had when I first assumed the CEO position was the cultural change. 20

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

Inside the Profession

estment Nows

An interview with Eugene Foley, President and CEO of Harvard University Employees Credit Union

There was the mentality that HUECU was another Harvard department funded through the endowment. I tried to make it clear that even though HUECU was a non-profit, it was still a business. I have to confess that this was a difficult thing to do. HUECU underwent many infrastructural and organizational changes to better serve our clients. Once deregulation hit the U.S. banking industry, new competitors entered all areas of retail banking. Deregulation has been an opportunity and a threat to the credit union. Deregulation allows us to offer a full range of retail consumer products that we were not able to offer prior to deregulation. Yet, deregulation also posed threats. Prior to deregulation, the government had a major role in how the industry grew. The

There is a niche that credit unions have filled. Because credit unions are nonprofit cooperatives, we have a lot more flexibility and social responsibility than other banks. We use the nonprofit structure to keep our prices and rates low and try to do as much financial literacy training as we possibly can to reach out to our customers.

government wanted to maintain risk, and it is easy to do so if each town had its own community bank. What we have seen since deregulation is that banking comes down to economies of scale. Because technology and compliance are so expensive, there is consolidation in the U.S. banking industry. The big ten banks dominate the industry, and local community banks and credit unions are now at a competitive disadvantage. We simply do not have the economies of scale nor the resources for R&D. This was a threat to the credit union industry. But, HUECU takes it as a challenge and an opportunity. Because we are familiar faces for our customers, there is the automatic trust that people enjoy having with their finances. We thus strive to provide the best service possible in the midst of consolidation.

financial life with a solid understanding. We started doing financial literacy classes for Harvard students, and they were very well attended. It has been a great experience to have students in the membership, and we strive to offer them a unique service that no other provider can match.

What are the history and goals of HUECU? HUECU was founded by twelve Harvard employees in 1939 and was open only to employees. We extended membership to students and alumni groups in 2003 after acquiring the ability to deliver a full range of products, including electronic delivery, debit cards, etc. We aim to help students start out their

enough financial education. A big part of financial literacy with students is giving them some very basic information to use as benchmarks in managing their financial life. We aim to educate students on how to figure out what your maximum debt level should be, whether or not you should take that credit card offer, how you can get a high credit score, how much of your salary you can dedicate to funding an apartment, how much you should pay for rent and debt servicing, and so forth. Identity theft also concerns students. The internet accounts for about 2% of identity thefts. We have no control over many identity thefts. There are two basic things I would suggest: first, try to shred all your credit card statements and be careful with any personal information; second, I suggest

One major consideration, especially for undergrads, is that it is difficult to understand oneâ&#x20AC;&#x2122;s debt burden after graduation when still in school...

What financial advice do you have for students? The world has changed. It used to be that no one would lend to students. However, because of deregulation, lenders will offer students anything. One major consideration, especially for undergrads, is that it is difficult to understand oneâ&#x20AC;&#x2122;s debt burden after graduation when still in school. It is very easy for students to get into trouble after graduation because of their student loans and credit card debts. A lot of this has to do with the fact that people do not have

students check their bank accounts online once every week. What do you think of students opening up investment accounts? Many college students are smart about day trading. However, unless you have over $300,000 to invest, I do not see the advantages in buying any particular stock. Mutual funds have a place for students if they have money they will not need for a while. I advocate that college students and graduates maximize tax deferral plans. Through compound interest, the money you put away is going to accumulate significantly. You need to remember that when you are investing, you have to give back roughly a third of whatever you earn back to the government as taxes. Then, I would suggest that college students first pay all their debts. Second, look at maximizing tax-deferred investments. Then, one can go

Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

Inside the Profession to mutual funds. Later, if resources permit, you can look into stocks. On the mutual fund side, be certain that one can afford to lose the money in the fund or that they can afford not touching it for a while. If not, students are better off getting fully insured bank products at a guaranteed return. What should a student do if they do not want to invest in mutual funds? If the initial amount of investment money is not large enough, after the service fee and volatility, the investment in the funds will not be worth it! I do not think there is anything wrong with using that money and putting up a laddered CD portfolio. So a student should buy some CDs that will mature in six months, some in a year, some in two years, some in three years. By doing a laddered CD approach, one gets the yield curve to work in oneâ&#x20AC;&#x2122;s favor as interest rates go up or down. We are in a very unusual economic time right now since the yield curve is inverted. That means that money invested for a shorter period of time actually yields a higher return. But, this is highly unusual. In terms of my one-on-one

counseling with students, for the amounts of money students have talked about investing, I would say open up a trading account if they want to gamble. If they are looking for strategic savings for the future, then an insured, laddered out CD portfolio would be the best option. What mistakes do students often make? Some students are so busy with their lives that they do not have time to think about money and are not able to figure out what they cannot afford. Students have to be especially careful with credit cards with high limits on them. They have to take into account that they will eventually have to pay that money back. On a credit card, if one pays the minimum payment each month, it will take about twelve years to pay off the debt. Since there are so many credit cards out there, how can students choose the right option? There are a number of triggering terms that students really do not want to see in their credit card statements: most alarmingly: universal default. With a universal default

clause, if one is late paying any lenders, the credit card company can raise the interest rates to wherever they want. Therefore, students need to be careful and cannot just look at what the offered interest rate is because there are different clauses that can be written down to alter the interest rates. Credit card companies hire marketers to write these advertisements in a way that cannot be easily understood. So my advice is, if you are a Harvard student, open up your credit card with HUECU. We are here to help you. How many credit cards should a student have? One or two credit cards, as long as the combined balances are not more than $2000 dollars. My real advice is this: unless you know you have some sort of revenue to pay those balances off, put the card away if you have a balance. Debt has a huge implication for young people who are just starting out their careers. It can even determine what job you take if you put yourself in the tough position of needing money immediately in order to pay off debts. In short, life is coming, start smart!

Donâ&#x20AC;&#x2122;t fall victim to the fine print. As a college student, you are bombarded with credit card offers everywhere you go. Though many may sound like great deals, beware the fine print. Major credit card companies collected billions of dollars in penalty fees last year. With such a large portion of their profits coming from fees, itâ&#x20AC;&#x2122;s no wonder they try to confuse and deceive consumers into making mistakes. Fortunately, you have an alternative. The Harvard University Credit Union is the only financial institution exclusively serving the students, alumni, and employees of Harvard. As a not-for-profit cooperative we offer a lowfee, low-interest, no gimmicks credit card to all Harvard students. If you are interested in getting a card, or if you just need some sincere advice, come see us anytime. Life is Coming. Start Smart.

Harvard Credit Union Main Office 16 Dunster Street, Cambridge, MA HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006 617.495.4460 huecu.org

L E H

MBUILDINGP AKYUETHEXRMJI DZKNWQVISIONRALCFH

An Interview with the President of Lehman Brothers, Joseph M. Gregory by Kuanysh Batyrbekov Mr. Gregory, you are the highest-ranking banking executive that has visited Harvard in the last four years. What is the purpose of your visit? I’m surprised to hear that, actually. The reason is simple and clear: we are in a never-ending quest for the best possible talent that we can attract to Lehman Brothers. Our business is about people more than anything. It is not a manufacturing concern—we don’t make cars, we don’t make computers, we don’t sell technology. We are about solving clients’ problems. To solve the increasing complexity of our clients’ problems, we need to have the best minds attacking them, and some of the best

minds in the world are associated with this particular educational institution and some of the other institutions that compete with it. We want to spend a lot of time trying to attract students to what we see as the mission of Lehman Brothers. You went to Hofstra as an undergrad, but never got an MBA. Could you please talk about its increasing importance for advancement in banking? It’s a great question. I certainly grew up in a different climate in the business. I will be 55 in February, and although it was not uncommon to have a Master’s degree in business in those days, it was not, by all

means, a requirement. The job experience that I was getting at Lehman Brothers was viewed simply by me, and the people who advised and mentored me, as infinitely more valuable in real-time than perhaps the extension of my education. I think they were right. I think there were certain things that I missed by not having an advanced degree. I missed a campus environment because when I went to Hofstra I was a commuter student with a full-time job, so I never had that experience and I am jealous of my children, as they have it. But for me it was fairly simple: I was on a good career path, I was advised by people who I trusted tremendously and who I thought had my

| Winter Winter 2006 2006 | HARVARD HARVARD COLLEGE COLLEGE INVESTMENT INVESTMENT MAGAZINE MAGAZINE 23 23

Inside the Profession

So, instead of asking “who is hot and who is not?,” try to determine how you line up with the culture, the operating style, the experience of the company, and find the one that matches you the most. best interests in mind, and it worked out fine for me. I think it is actually now a question again: the advanced degree. For years and years—I’d say the most recent ten years— it’s beyond a shadow of a doubt and viewed as the right approach. I think for many people, it is a right approach, and I’d say especially for investment-banking career path, it’s a requirement. I think in Capital Markets jobs there is a growing debate about whether or not the experience that one gets in the workforce (just the way that I did, frankly) is of greater value than an immediate or near-immediate return to an educational environment. So, I think that strong cases can be made for both career paths; I think the good news is that increasingly there is a choice, and I think it’s always great in the world when there is choice. What advice would you give to undergraduates looking to go into the financial services sector upon graduation? What market trends should they be on the lookout for? So the advice is macro, and then we’ll turn it into micro in terms of market trends. The macro advice is to trust your intuition and judgment. At their young ages, people in the undergraduate program have a tendency of underestimating their life experiences, and I don’t think they should be underestimated. I think experiential learning is the best learning, and I think you’ve all already got lots of it. You have tons of advisors: “Oh, you shouldn’t go to this firm for this reason; no, you shouldn’t go to that firm for that reason” – you’ve got those advisors all over the place, and everybody’s got the right answer for you. I think what it comes down to is to sort through all of that - it’s very hard, and they’re all people with good intentions. Mostly it’s people 24

with good intentions about you, because they obviously care about you – why else would they be advising you? So I think in the end you’re left with the white noise, and the white noise tends to be about too many advisors. So the only way to deal with too many advisors is to come back to the very reasons you made the decision to come to this school. Lots of people may have endorsed you, lots of people may have leaned on you, but I would suggest that for the people that have a useful four years, it is not about “mommy and daddy say I had to go here,” right? Because you don’t survive on that you hate mommy and daddy and you leave after a semester. So the people that are here for the long haul have their own ambition and their own energy about why this is the right school for them. That means you need to find that right energy about what is the right place to work for you, and it is to be found within yourself. I think trusting your intuition, trusting your judgment is always the best advice I can give to people who are afraid of making those decisions. In the micro perspective, our business is incredibly cyclical. I don’t think that the first job you have after your undergraduate experience, as an Analyst, or beyond that if you continue on, or after your Master’s program, as an Associate, is the most critical thing. I think what the most critical thing is that you do a good job at it. You extract what it is that you care about, how you think you can add value to the institution, how you want to be reckoned with, and what “extra” of you that you can give. I think the people who find a way to give “extra” of themselves, more of themselves, are the people who are most often recognized. Sometimes they are not recognized at the moment: “Oh, you wanted that department? Well, we can’t give you that department yet because of this department.”—“Ok, I’m not recognized, I

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

can’t stay here.” You know—bad answer. I think that the right thing to do is to simply try to get lined up with your own sense of what the hot business is. I don’t have a sense of what the hot business is, because they’re all hot! There is no part of Lehman Brothers where at the end of the day we can settle for mediocrity or subpar performance in any of the things we do. Everything is incredibly important. People decide what the important areas are—you know, “Private equity! I’m really in love with private equity this week.” Next week, it’ll be equity derivatives, and the week after that it will be credit derivatives, and the week after that it will be something else. The bottom line is that there are tremendous opportunities to show what you are made of, to show how you can perform, how you can lend your energy, your effort, your passion, your desire, your optimism to the franchise, and I think doing it at your highest level is the most important thing, no matter what your first job is. HCIM: You mentioned how important the economic cycles are for business. How can you explain Lehman’s success regardless of the cycle? I think there are two things that explain Lehman Brothers’ success. Success is also measured from where you are. In the Shearson era (this is ancient history already), we had this period of time that I have often described as a ten-year prison sentence. During that period, Lehman Brothers as an enterprise was misunderstood within the house of Shearson and American Express. Our ability to invest in our businesses was dramatically damped down. During the time we got out from under Shearson and American Express, we were behind some of our major competitors in terms of the investment. However, we caught up, and we caught up in a market environment

Inside the Profession and with skills that enabled us to not just spend ourselves into a problem, but spend ourselves into investments that were appropriate for the point that we occupied in the lifecycle of our company. The growth that we had, which has been tremendous, has been from starting from a base where we hadn’t grown as quickly as some of our competitors. I think that these franchises are tremendous. If you look at the top ten global institutional investment banks in the world, they are substantially great businesses. They are businesses that are remarkably hard to kill, they are resilient, and they survive crises. You know, it wasn’t a year ago that we were all reading in the media about “beleaguered” Morgan Stanley, how they “lost their way”, “the end of the world” wasn’t far, and all that. It is ridiculous, right? What do we have now? Do I believe that John Mack is the individual savior of the company? No. I think that that each company has its “down” cycle. I think companies have tremendous growth cycles, they have their “down” cycles, and occasionally they even go way off the rails. I think that there are firms that have had a traditional lack of success, and their cultural approach is certainly different than ours, those aren’t the companies I would want to work for. Obviously—I stayed with the same company for all these years. Instead of asking “who’s hot and who is not?” try to determine how you line up with the culture, the operating style, the experience of the company, and find the one that matches you the most.

Joseph M. Gregory, 54, has been President and Chief Operating Officer of Lehman Brothers Holdings Inc. since May 2004 and is a member of Lehman Brothers’ Executive Committee. From May 2002 to May 2004, Mr. Gregory was the Firm’s Co-Chief Operating Officer. Before that, from April 2000 until May 2002, he was the Firm’s Chief Administrative Officer, and from 1996 to April 2000, he was Head of the Firm’s Global Equities Division, in charge of the equities business. From 1991 to 1996, Mr. Gregory was Co-Head of the Firm’s Fixed Income Division. From 1980 to 1991, he held various management positions in the Fixed Income Division, including Head of the Firm’s Mortgage Business. He joined Lehman Brothers in 1974. Mr. Gregory is Chairman of The Lehman Brothers Foundation and oversees the Firm’s Diversity and Inclusion initiatives, as well as its Leadership programs. He is a member of The National Advisory Board of The Posse Foundation, Inc. and The Board of Trustees of Harlem Children’s Zone. He is a Trustee of Hofstra University, where he serves on the Finance, Endowment and Investment Committees of the University. Mr. Gregory received his B.A. from Hofstra University. Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

Grameen Bank

Battling poverty through social entrepreneurship

he Grameen Bank in Bangladesh is not your average financial institution. Founded by Dr. Muhammad Yunus in 1976 and dubbed the “Bank of the Villages,” Grameen Bank is responsible for providing small loans to the poor citizens of Bangladesh. A business built upon the concept of microfinance, it usually makes loans worth from US$50 to US$100 of “micro credit” without requiring its borrowers to present collateral. As a result, sources at Grameen Bank

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

Global Outlook champion that Dr. Yunus’ brainchild has become a “cost effective weapon to fight poverty, serving as a catalyst in the overall development of socio-economic conditions of the poor.” By providing microcredit to those too poor to obtain capital via traditional banking methods, Grameen Bank has successfully battled poverty and inequality in Bangladesh. The bank has already lent nearly US$5.3 billion to more than 6.7 million impoverished entrepreneurs, about 97 percent of whom are women. A senior authority on microfinance at the Consultative Group to Assist the Poor, Syed Hashemi finds that the bank’s practice of microfinance has allowed women to “become visible, productive, assertive members of Bengali society.” Additionally, Grameen Bank has contributed an estimated 1.8 percent to the annual GDP of Bangladesh in recent years, proving that even the small scale of microcredit can produce significant results. Perhaps just as impressive as Grameen Bank’s social responsibility is the accountability of its borrowers—98 percent of all loans are repaid in full. Such a high repayment rate can be attributed to the bank’s unique process of loan recovery. Individuals applying for loans must do so in groups of five, with all members bearing responsibility for one another. If one member defaults on the loan, the entire group is denied financing in the future. Borrowers are thereby highly motivated to remain in good standing with their microcredit group and with Grameen Bank—usually their only available source of credit—by repaying their loans promptly and in full. Furthermore, by loaning to groups of five, Grameen engenders a process which encourages cooperation among entrepreneurial ventures. On October 13, 2006, Dr. Yunus and Grameen Bank were jointly awarded the 2006 Nobel Peace Prize “for their efforts to create economic and social development from below.” Dr. Yunus was recognized as one of the world’s foremost social entrepreneurs—a man who utilized his entrepreneurial skills to plan, establish, and manage an endeavor to generate social change. As of late, social entrepreneurship has become one of the most popular up-and-coming business models taught among the most prominent business schools.

Origins of Social Entrepreneurship

Traditionally, non-profit organizations and various governments have been responsible for rectifying societal shortcomings. The environment, in which these non-profit groups operate, however, has changed drastically in recent times. As needs have expanded and diversified around the world, non-profits have found their resources spread too thinly. In addition, more and more non-profits have begun to compete for a limited amount of government and philanthropic funding. As a result, the primary conventional sources of funding for non-profits have declined and become

7 2 $ U IO During the Bangladesh famine of 1974, Dr. Muhammad Yunus made a loan of US$27 to a collection of 42 needy families.

inconsistent. In response to this new competitive environment, many non-profit organizations have adopted various business model approaches, resulting in the birth of social entrepreneurship. Unlike traditional business entrepreneurs, social entrepreneurs do not measure success only in terms of profit. Social entrepreneurship is instead based upon a “double bottom line” business model, one in which success is defined by both financial and social returns. According to Dr. J. Gregory Dees, Professor at the Fuqua School of Business at Duke University, social entrepreneurs combine “the passion of a social mission with an image of business-like

discipline, innovation, and determination.” As a result, profits are a means, not an end, as they are reinvested into the surrounding community to complete an overall social mission. While the future of non-profit organizations may be in jeopardy, social entrepreneurship initiatives may create a more sustainable and self-sufficient method of serving similar community objectives.

Social Entrepreneurship as a Profitable Investment As Grameen Bank strives to eliminate poverty within Bangladesh by way of microfinance, the bank is consistently able to turn a surprising and consistent profit. The high repayment rate has led to net gains in 27 of the bank’s 30 years of existence. In 2005 alone, the bank reported a US$15 million profit. Earnings are expected to expand at an increasing rate as Dr. Yunus claims that “if [banks] enter with a social mandate to help the poor get out of poverty, they can certainly make more money, once more and more people get out of poverty.” Due to its diligent business practices, Grameen Bank has now grown to encompass over 2,200 branches, providing services to 86 percent of Bangladesh’s 84,000 villages. The bank’s services have broadened as well, currently including education and housing loans, pension funds, and savings accounts.

Small Beginnings, Big Results

During the Bangladesh famine of 1974, Dr. Muhammad Yunus made a loan of US$27 to a collection of 42 needy families. Now, 23 years later, Dr. Yunus and Grameen Bank lend billions of dollars to millions of underprivileged Bangladeshis. In addition, the framework of the microcredit system that Dr. Yunus has established is currently employed in over 40 countries. Grameen Bank, however, has not remained Dr. Yunus’ only innovation: the Grameen Family of Enterprises now consists of more than two dozen social venture businesses, each offering a creative solution to the challenge of poverty. If Dr. Yunus and his Grameen Family have demonstrated one principle to this generation’s entrepreneurs, it is that business and altruism need not be separate pursuits. Social entrepreneurship is here to stay.

Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

Investing in

Israel

An Interview with Yair Shiran, Israel’s Economic Minister to North America By Jonathon Greenstein Following his purchase of Iscar, Ltd., a Galilee based tool making company, Warren Buffet asserted that “Israel is a remarkable place, particularly the talent” and that “everyone might do very well over here.” With that ringing endorsement from America’s investment hero, HCIM met with Yair Shiran, Israel’s Economic Minister to North America and former Wexner fellow at the Kennedy School of Government, to learn more about Israel’s resilient economy in the face of turmoil. In spite of war in Lebanon, persistent terrorism, and the looming threat of nuclear war with Iran, the Israeli economy has thrived, now experiencing its third consecutive year of growth. Minister Shiran explains that despite past and present conflict, now could not be a better time to invest in Israel and that economic opportunities are only improving.

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

In 2003, Israel was facing the worst recession in its history, the government was almost bankrupt, over 70,000 small businesses had folded over a three year span, and Israel had difficulty borrowing in the foreign markets on favorable terms. How has the Israeli economy come back from the abyss? Faced with a potential economic collapse, the government chose to embark on a clear and consistent path of reform focusing on four key objectives: instituting greater budgetary discipline, reducing taxes, curtailing welfare by providing and encouraging work, and creating a strong market economy by eliminating government monopolies through privatization. While fiscal responsibility and economic reforms have been attempted to one degree or another in the past, we have demonstrated that we can adhere to these policies even while engaged in battle. We believe that it is imperative to demonstrate to investors, Israel’s commitment to maintaining a strong and opportunistic environment. Under its plan for fiscal responsibility, Israel’s stated budget deficit goal as a percentage of GDP is the 3% that the EU requires of its members. In 2005, Israel’s budget deficit was 1.9%, down from the 5.4% in 2003. Israel has also significantly reduced its general government expenditure from a global high for comparable industrialized nations of 55% in 2003 to a forecasted 47.4% for 2006. In step with minimizing the public sector, the government has also energized the private one. The strategy behind Israel’s program of alleviating the tax burden is to incentivize companies and the workforce. The reduction in corporate taxes from a 36% tax rate in 2003 to the current rate of 31%, and a forecasted 25% in 2010 is reflective of Israel’s strong commitment to having foreign investment come to Israel rather than go elsewhere. Equally impressive, Israel has had success in addressing its unemployment problem by decreasing taxes on personal income from an average tax rate of nearly 50% in 2002 to just above 40 percent in 2005. As recently as a couple of years ago,

Yair Shiran is Israel’s economic minister to North America. Israel was facing one of the highest relative ratios of foreign to domestic workers in the world. The government has taken multiple steps to balance the workforce, including reducing welfare fees and increasing minimum salary. In fact since 2002, Israel’s workforce participation rate has risen from 54.1% to 56%, transfer payments as a percentage of GDP have decreased from

6.5 to 5.5 percent, and unemployment has also decreased significantly. The fact that Israel has seen more people working, as evidenced by the increased participation rate, while also being able to provide jobs for them, as evidenced in the decreased unemployment is a tremendous indicator of the economy’s strength and of the potential for even greater improvement.

Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

Global Outlook Most of Israel’s difficulties lied with its monopolistic banking, which had come to control more than 80% of all Israeli savings. Through privatization and reforms, Israel has taken serious steps towards a competitive market economy. Within the past few years alone El Al, Bank Leumi, Israel Discount Bank, Bezeq and Zim have been privatized, while reforms on sea ports, taxation, pension funds, and primary dealers have been initiated. Additionally, reforms in capital markets have increased competition by facilitating entry for smaller companies. Specifically, an investment encouragement act that streamlines the process by which companies apply for tax holidays and government grants has led to a repopulation of the small business community. Additionally, other substantial tax incentives are provided by the Israeli government, including a 10% tax on investments in designated areas, primarily in the northern part of the country (to expedite the rebuilding process), a 0% tax on capital gains for investments by foreign investors until the end of 2008, and 0% tax on mega investments in designated areas aiming towards attracting the major multi-national companies to Israel. All these initiatives

“

Israel ranks the highest in the world in number of engineers and technicians per capita as well as investment in R&D, while patents per capita ranks third highest, globally.

Foreign Investment in Israel

(US$ in billions)

OTHER

Foreign DIrect investment 20

9.4

5.1 1.8

7.2

2000

3.9

3.6

1.8

0.5

1.4

2001

2002

2003

6.3

2004

5.6

7.2 6.0

2005

Jan-Sept 2006

have achieved remarkable results.

$4.5 billion.

Let’s start by putting the economic cost of the war in perspective. The war mainly affects tourism, however, tourism from abroad accounts for less than 2% of overall GDP. The direct costs of the war include approximately $500 million in lost tax revenues in 2006 and 2007, $2 billion in defense costs through 2008,and an estimated $750 million in civilian compensation. It is also important to recognize that the damage from an economic view is mainly limited to the northern part of the country, and for the majority of the population the war is over and the economy has already recovered. Notably, the war did not affect investor confidence as we have witnessed the Tel Aviv Stock Exchange exceeding its pre-conflict level and the growing strength of the Israeli shekel which reflects the flow of foreign currency into Israel. Moreover, even during the war, companies continued to invest in Israel. For example, HP bought the Israeli company Mercury Interactive Corp., a leading IT management software and services company for approximately

entrepreneurial spirit and world class institutes have attracted investors to Israel over the past six decades. Israel ranks the highest in the world in number of engineers and technicians per capita as well as investment in R&D, while patents per capita ranks third highest, globally. These factors enable a small country like Israel to be a globally recognized center of telecom, IT, medical devices and life sciences. Major players such as Intel, IBM, Microsoft, Motorola and Cisco have opened shop in Israel to exploit its talent. I would like to leave you with the following thoughts about Israel’s economic performance. Israel has achieved record high foreign investment and equity market levels, and reduced government debt, interest rates and inflation. The confluence of these events is incredible considering that in the past six years we have faced the second Intifada and the conflict in Lebanon. That is why I am bullish about the future of the Israeli economy and the opportunities it affords to foreign investors.

So as Economic Minister how do you There is no doubt that the engine attract foreign investment during these of the Israeli economy is its high-tech politically uncertain times? sector. Its brain power, coupled with its

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

Confucian capitalism in

Modern China By Rika Christanto

hina is on track to become the world’s most powerful economy, impressing everyone with its supersized hypermarkets. On a global stage, China commands visible and immediate influence in the international market. Its accumulation of U.S. treasury bonds has influenced American interest rates and consumer spending; its insatiable thirst for energy has propelled oil prices; and its contribution to global economic growth has already surpassed that of America’s. We are witnessing the economic ascent of a future world power, more similar to the rise of the United States one hundred years ago than the emergence of Japan and the other Asian economic powerhouses. However, appearances can be deceiving. Underlying the dazzling efforts to modernize, the Chinese hold fast to ancient ways. Confucian traditions still dictate proper social norms; thousand year old manuscripts are preserved and studied by present-day scholars; the early art forms of calligraphy and paper-cutting are practiced exactly as they were; and the rulers of the day still sanctify a united Chinese empire. The reality of doing business in the

world’s most populous country requires a distinct understanding of the themes of Chinese culture, which has been inherited for millennia and pervades the business sphere. While Chinese culture appears to be an amalgam of influential doctrines,

“

The concept of li is significant in explaining the Confucian hierarchical model of society.

”

inherited from millennia past, the dominant ideologies of Confucianism and Daoism have prevailed. The influence of Chinese

philosophy also extends beyond China’s borders to the East Asian “Confucian” societies of Hong Kong, Singapore, and Taiwan. Whether or not these ancient traditions hinder or enhance Chinese economic performance is still subject to debate. Thus, to understand how to do business in China with a broader applicability throughout Asia, it is essential to understand how Chinese behavior has evolved in conjunction with Confucian ideology. Moreover, with China’s embrace of capitalism since the 1980’s, it is even more intriguing to examine how a controlled capitalist economy, coupled with Confucian and Daoist principles, will emerge as an economic juggernaut in the global economy.

The Confucian Way

Taking a reductionist approach to the nuanced and complex Confucian ideology, there are two words pertinent to doing business consistent with the beliefs of Confucius: li and guanxi. Li is difficult to translate; “propriety” and “virtue” are reasonable English equivalents. To the Chinese, the term

Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

Global Outlook conveys a sense of an individual’s proper behavior and obligations in society. The concept of li is significant in explaining the Confucian hierarchical model of society. Family relationships are explicitly defined in a non-egalitarian manner: parents outrank children and older siblings outrank younger ones. The same goes for social groupings and occupational categories: scholars outrank merchants who outrank farmers. The stress on deferring to superiors, often defined by chronological order, largely accounts for the instinctive unwillingness of Chinese to confront authority and hierarchal organization. The effect of li in the business world is profound. Protocol, for example, is imperative when dealing with public officials. Every businessman has a perceived rank when dealing with the government, equivalent to the level of the official he is negotiating with. This echoes the Confucian view that each individual has his or her proper place in society. The hierarchical system supported by Confucius inculcates a more conformist attitude among individual workers to the goals and behavior of their leaders than their Western counterparts. The formality of social relations through conservatism in dress, speaking softly, and general deferment to elders might appear submissive by Western standards. However, this is not an issue concerning strength of character; rather, it is solely based on Confucian tradition. When businessmen do not act in such a way, it is actually considered an affront to manners. The second Confucian concept, guanxi, translates into an informal understanding between individuals that provides for an exchange of special privileges or services when the need arises. Guanxi takes a variety of forms of social capital, currying favors over time and waiting for the opportune moment to exercise the accumulated goodwill. Higher-ranking officials usually demand more long-term benefits such as joint venture projects and education or job advancement opportunities for their children as compared with lower-ranking officials, who are mainly preoccupied with cash. Some firms try to overcome these types of donations by banning all such contacts because doing personal favors for officials is often a slippery slope. However, gifts and donations are being replaced by less direct 32

methods of just being a good corporate citizen to gain favor with officials. Contributing to an educational foundation or flood relief wins bonus points. Most ministries have research centers run for profit, and by hiring their researchers can make it easier to get a meeting with officials. In commerce, this practice implies that it is more important to know “who” than to know “what.” This creates a definition of corruption that is culturally dependent and inherently inimical to the Western idea of corruption. While in-kind donations and monetary rewards may be a means of developing relationships in China, such

The Culture of Corruption

More controversially, nepotism and corruption is not inconsistent with Confucian teachings. Bath University Professor of Sociology, Leslie Palmier, has famously said “In India, corruption is under the table. In China, it is over the table, while in Indonesia corruption includes the table.” However, the Confucian principles of a stratified society, in which individuals blindly defer to their elders, provide insight into the culture of corruption. The Daoist framework of self-maximization and traditional disdain for externally imposed rules also has much to do with corruption in China. Daoism recognizes that individuals have the need and right to act in their own self-interest. Thus, the behavior of government officials who accept gifts and whose salaries are far below the minimum required to raise a family is accepted. This is why corruption is

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

quite open and direct; you can almost predict what any particular activity will cost. The practice of nepotism, by favoring one’s own family over others, is propagated by Confucian ethics, which stresses the importance of one’s family over others. Thus, in Chinese society, nepotism does not carry the strong negative connotation which it does in the U.S. In fact, in the Chinese culture, for someone to pick a stranger over a qualified family member would be considered wrong. Due to the continuity of Confucian and Daoist traditions beyond the border of mainland China, an understanding of the role of Chinese philosophy on corruption is even more pertinent. The impact of Chinese culture on business, however, poses a unique intrigue due to its inherent tendencies towards practices which are viewed as corruption in the West.

One China

The ambiguous legacies of Chinese culture could potentially have a deleterious consequence on China’s global standing if corruption and quality concerns are not reigned in. But even among Chinese societies, business culture is not homogeneous. The strength of belief in the Confucian and Daoist tradition varies between the Chinese societies: China, Taiwan, Hong Kong, and to a lesser extent, Singapore. The distinctive nature of Chinese societies has significant differentiating influences on their economies. Nevertheless, whether in mainland China or Greater China, the common values embodied in Confucianism provide a structure for China’s turbocharged economy. Even in Hong Kong, the most westernized among the “Chinese” economies, onethird of all agreements are still made orally, harking back to Chinese tradition. The clearly defined family and social order wins over Western formulations of legal codes. Although this set of procedures has never been formally adopted into the law, the teachings of the ancient Chinese scholars transcend and permeate every aspect of Chinese life. As certain features of the traditional Chinese philosophies may obstruct China’s development toward Western capitalism, the challenge lies in reconciling these differences towards the creation of a successful economy.

on CM cti HC Se of al on eci iti Sp st Ed Fir

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Winter 2006

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

An Interview with Tom Monahan, CEO of The Corporate Executive Board 33 An Introduction to Consulting

Consulting vs. I-Banking Firm Profiles: New Sector Alliance & SCORE

38 39 Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

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

Editors-In-Chief Sergali Adilbekov Kuanysh Batyrbekov Jennifer Ying Lan Executve Editors Rika Christanto Pavlo Kononenko Head Designers Y. Joy Ding F. Jovan Jester Illustrator Grzegorz Babiarz Editors Lucas Abegg Polina Dekhtyar Bryan P. Farney Matt Fleck Omar Halabi Mate Pencz Dmitri Smirnov

Dear Readers, Welcome to the inaugural issue of the Harvard College Consulting Magazine! In the past couple of years, the consulting industry has become increasingly attractive to college students as more and more consulting firms have begun to recruit on campus. However, due to the lack of publications about this industry, â&#x20AC;&#x153;consultingâ&#x20AC;? still remains a mysterious term for many students, who, if properly informed, would consider it as an opportunity for a future career. Therefore, the goal of our student-run magazine is to educate those who desire to better understand their options before they start to build a career. The theme of this first issue published in cooperation with the Harvard College Investment Magazine is An Introduction to Consulting. We provide the insight into what types of consulting are out there and how consulting differs as opposed to investment banking. In addition, we offer highlights of a couple prominent non-profit consulting firms, New Sector Alliance and SCORE. These articles will familiarize you with the way the world of consulting functions and hopefully give readers a general impression of what consultants actually do on a daily basis. Our main feature is an exclusive interview with Tom Monahan, the Chief Executive Officer of The Corporate Executive Board Company (CEB), a best-practices research firm based out of Washington D.C. CEB has been growing at 25% or better every year since the company went public in 1999. With access to an amazing network of the senior executives in every industry and the ability to call over 80% of the Fortune 500 as clients, CEB is a consulting firm which is growing at an astronomical pace. Our interview with CEO Monahan brings insight into just how this company is growing at such a dynamic pace and why CEB is such an amazing place to work! Our second issue will be published in Spring 2007, and we hope to expand the contents of the magazine both quantitatively and qualitatively. Each issue will have a definite topic related to consulting, and you may join us in choosing it. We will also be expanding our editorial collective, and anyone interested in writing in our magazine is welcome to try. Apply for a spot in HCCM by sending your resume and cover letter to hccm@harvardinvestmentmagazine.org. We look forward to seeing your applications! Thank you to The Harvard College Investment Magazine for providing us the platform to launch our publication. As always, the success of our magazine would never have been possible without the amazing dedication and hard work of our incredibly talented staff! Sincerely, Sergali Adilbekov Kuanysh Batyrbekov Jennifer Ying Lan

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

Force of Ideas, Spirit of Generosity By Bryan P. Farney & Jennifer Ying Lan

ased in Washington D.C., The Corporate Executive Board Company (CEB) is a best-practices research firm which provides decision support tools and executive education to leaders of the worldâ&#x20AC;&#x2122;s biggest corporations and non-profit institutions. With 700 employees only three years ago, CEB has now expanded its staff to over 2,500. With plans to hit 5,000 in the next few years, the talent search which CEB is currently undergoing makes the firm a strong candidate for top students at Americaâ&#x20AC;&#x2122;s major universities. Growing at an average rate of 25% per year since 1999, CEB focuses on research for corporate strategy, operations, and general management. Continuing to dominate the best-practices research sphere with over 20 years of experience, CEB has over 2,400 corporate members around the world. Recently, Tom Monahan, the CEO of The Corporate Executive Board, sat down with The Harvard College Investment Magazine for a discussion regarding the past and present of CEB. Mr. Monahan, how was the CEB research model conceived? In 1983, we spun off from The Advisory Board, a health-care consulting firm. CEB started by doing industry-based research for the financial services sector. In 1993, we launched our first cross-industry research program tailored for the heads of Human Resources at various companies. Our model identifies management initiatives, processes, and frameworks which allow our members to avoid reinventing the wheel by addressing problems they share with their peers. CEB is the central research engine that reveals the best solutions by highlighting the

Tom Monahan, CEO of The Corporate Executive Board

Winter 35 Winter 2006 2006 || HARVARD HARVARD COLLEGE COLLEGE INVESTMENT CONSULTING MAGAZINE MAGAZINE 35

CEB looks for students who are really intelligent, compassionate, and show energy for solving the most difficult problems facing the top executives in the business world today. issues that keep executives up at night. We offer this service to people at the same jobs at different companies who often have challenges in common. They can benefit much more by having a research team in the center which acts as the conduit for sharing ideas and best practices data. One reason why CEB has grown so quickly is that no single industry can ever get you the number of scale points than that of a cross-industry program. We solve the problems facing the CEO’s of every industry rather than a single industry. Proving that the concept works for heads of HR, our services were extended to 40 different constituencies, such as the IT and the Legal Counsel Roundtables, etc. Putting your spectacular growth (27%) in perspective, how does CEB continue to grow? We have three main strategies for growth. The largest factor is that more than half of growth comes from cross-selling. We sell additional programs to companies which already have one; for example, selling the CFO program to someone who already has the IT program. This is a significant source of growth. The second factor is the number of new programs we have in the works. As we come up with ideas on how better to serve our members, we will offer more programs which cater to their needs. The third major factor is extending the membership to new companies. We tend to see that companies buy one program over the first year, but over time as their tenure increases, our ability to enfranchise and to cross-sell grows. When they are with us for more than three years, we average six programs per member. This is a testimony to how satisfied our members are with our quality of research and customer service. CEB has an amazing network which is a major barrier to entry for competitors, but what about others entering your field? Our posture towards competition might

be termed as paranoia, haha. Since we went public in 1999, our business model has been out there for people to see. With that said, our comprehensive network and archives of ground-breaking research are hard to beat. If someone joins the membership today, they can get an answer on their desk by this afternoon. A small facet of competition comes from firms which deal with specific things like IT. These firms might compete with our IT roundtable, but it is very hard for someone to beat the best-practices network we have established. How do you view the potential saturation of CEB’s market? Is CEB looking at expansion into the middle market, implementation of traditional consulting strategies, etc? Right now, 80% of the Fortune 500 subscribes to at least one product. With our average cross-sell rate at 2.82, we still see U.S. $1.4 billion worth of cross-sell potential sitting on the table. We have a lot of organic growth opportunity. We see another five billion dollars coming in our launching of at least 20 new products in addition to the 40 we have. Furthermore, we have a list of 90 product ideas in the works. Diversifying from the Fortune 500, we just launched our first program into the middle market, but we will definitely continue to concentrate on our core market. I am not saying it will be easy; but if we maintain the integrity of our research and membership programs and keep our heads down and execute, we will continue to grow. As for implementation, this is a very small part of CEB. The overwhelming majority of what we do is to function as a research locus for our members. However, there are times when we will tailor our research for a member’s interests. For example, members sometimes ask if we can do a custom version of a survey that we have done across the board. Rather than say no, we have created a very limited capability, so when that happens we can accommodate the request.

36 HARVARD HARVARDCOLLEGE COLLEGECONSULTING INVESTMENTMAGAZINE MAGAZINE || Winter 36 Winter2006 2006

Can you talk about your personal career? I graduated from Harvard in 1988 as an English concentrator from Eliot House. I went to work for Arthur Anderson’s consulting division. I left business and worked in the policy world, The Committee for Economic Development, a business-sponsored economic research organization. I then went back to consulting at Deloitte for a few years. When I first started at CEB, I served in a variety of research positions. Prior to my current position, I served as the General Manager of the Finance, the Legal & Governance, the Strategy & Innovation, the Information Technology and the Operations Divisions. What gets me out of bed everyday is that I love the platform we have. We work with interesting teams of people who cooperate to solve difficult problems. Many people prioritize different things when considering a career, but what really matters is the day to day, do what you like to do. How does CEB convince executives to share their best-practices information, especially to their competitors? That was the very first question I asked when I joined CEB over 10 years ago. There is no easy answer. There are a couple observations I can make. We’re not asking people to share their secrets. We’re not asking for the secret recipe to Coca-cola. There are certain questions to ask. If the CFO of a Fortune 500 firm has 10 items which need to be done that year, five of them are unique to that company, but five of them are in common with other CFO’s. That’s where CEB comes in. Members trust us, we have developed this trust and skill over time and we treat our members with great care. We employ a lot of give-get. By sharing something with us, you’re getting a lot of value in return. Whatever you share with CEB, it is literally being reviewed by hundreds of your peers. For example, your peers from all over the world are going to review your supply chain and offer commentary which we then get back to that member.

We carefully audit to make sure the giveget is high. Companies do not have to share so we created a value proposition in order to encourage the sharing of best-practices information. When you ask what our researchers are great at, this is it. What is CEB’s delivery format? First, we produce major research reports on problems shared by executives. Second, we provide call-in support to our members which compliments our research. For example, a member needed to know a good IP-law firm in Estonia. We’re not going to start a sixmonth project on IP law firms, but from our from General Counsel round table, we were able to ask who’s good, who’s bad, and got the answer for our member immediately. Third, we have member meetings (executive retreats) where we present our data, share ideas on how to solve problems, and analyze what our members want us to focus on. Fourth, the Web is our dominant delivery channel. Say it is an audit related to Sarbanes-Oxley, we have online tools which will take you through this according to best-practices research. This integrates our research into people’s workflows, it becomes a part of their workday on a day to day basis.

This is something that is really remarkable because rankings are based on total hours volunteered. So, our little 2,000 employee firm is ranked with those giant companies because of how active our staff is in the community. I think our staff would agree, our support of community service is almost an employee benefit. What distinguishes CEB from big consulting firms like Bain & Co. and BCG? My wife is a partner at BCG, so I have great respect for big consulting firms. There are three main things which distinguish CEB from these consulting firms. At CEB, our researchers have ownership of their product and of their own intellectual capital. We put our people in situations from very early on where they interact with senior executives. The level of exposure is very impressive. If you do a great piece of research, the number of organizations which will touch it will be

literally hundreds. In other consulting firms, you might have the ability to have an impact on one client, but with CEB, your research will go across to the table to hundreds of firms. What was the biggest lesson you learned during college? My biggest lesson from Harvard was that I gained a huge appreciation for how many talented people there are. There is a multiplier effect when one is able to work in a team. I thought I was good at some things, but then you meet other people who are tremendous at things which I wasn’t great at. By learning how to operate within a team dynamic, you can leverage other people’s strengths and create an amazing product. We need to learn how to be responsive to constructive criticism. CEB looks for students who posses the intelligence, compassion, and energy for solving the most difficult problems facing the top executives in the business world today.

CEB is known for being very dedicated to community service, is this an integral part of the CEB culture? We have two core focuses: force of ideas and spirit of generosity. We truly believe that a big idea in the right hands can really help someone be successful. We like people who are wired to serve, and we have noticed that people who are wired to serve in the boardroom are ready to serve in a broader societal format. ServiceCorps is a program for someone who is interested in volunteering. For example, Tuesday nights, your team goes to a soup kitchen and helps serve dinner. These are great team-building events and there is a lot of bonding which happens. We were named as one of D.C.’s 10 biggest philanthropists in terms of volunteer hours.

A CEB consultant at work Winter 2006 2006 || HARVARD HARVARD COLLEGE COLLEGE CONSULTING INVESTMENT MAGAZINE 37 Winter MAGAZINE 37

An Introduction to

The Business of Ideas

Consulting

by Matt Fleck and Mate Pencz

he role of a consultant is seemingly a paradox. Often, organizations which hire consultants are already fully staffed with specialists of superior experience, ones who possess a more nuanced understanding of the problem. But as businesses, governments, and society become more encumbered with a surfeit of information, consultants provide the resources to define and simplify problems into more manageable digests. As business and industry become increasingly intertwined with government and society, and as technology advances to connect us in an increasingly interdependent world, consultants provide the key evaluative questions to be answered. As such, consultants are continually handed cases that border on the unusual and unfamiliar, sensitive cases that cannot be resolved internally, and particularly, cases in which an outsider would have a comparative advantage. When the natural function of a consultant is to intervene between the most complex problems and novel solutions, the dramatic rise in the demand for consulting careers is of little surprise. The application of a consultant’s services has evolved with the changing global landscape, often shaped by macroeconomic and social trends. Consultants have integrated themselves and found niches in each part of an organization’s strategy; they are in the business of anticipating future business and technological movements, understanding how sub-trends interact with each other and impact various industries, and assisting global organizations to take advantage of these new developments and markets. Moreover, consultants provide a framework to evaluate the events happening around us and in the world. While consulting most frequently denotes advisory services to a profit-driven corporation, maximizing shareholder value is no longer sufficient. Consulting has extended into a diversity of fields, including the public sector, human resources, and information technology. It also specializes on specific industries such as pharmaceuticals, consumer packaged goods and energy. This has been a result of the compounding issues of globalization, environmental regulations and a rapidly advancing technological frontier, just to name a few. In consulting in general, hiring is

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

surging, but firms are now increasingly on the lookout for experienced recruits. As the McKinsey & Company Quarterly reports, “With more sophisticated clients demanding specific capabilities to solve complex problems, recruitment and retention of specialized talent has become crucial, while demand for generalist consultants has waned.” Those with deep financial knowledge, especially in mergers and acquisitions, operational risk, and regulatory compliance, are prime candidates for recruiters. Also in demand are consultants with government backgrounds for firms bringing in a growing number of public sector consulting contracts. Candidates seem to have gained the upper hand since specialized talent is in short supply, and top students can afford to be choosier about which firm is the best “fit” for their goals. For those whose interest has been piqued by the consulting profession, the variety of consulting firms provides many different areas and divisions to work in. They are very diverse in the kind of cases they treat and therefore appeal to recent graduates from all different backgrounds. Generally, there are six major areas within consulting that are the most established and important fields:

Management Consulting Students at leading universities who face recruiting during their junior and senior years will encounter mainly management consulting. Management consulting firms advise their clients on how to structure its human capital. A company, for instance, might have a traditional hierarchical management structure, which may inhibit the productivity of the employees and hence, the profitability of the firm. A management consultant would first define the source of this problem and then, advise a rearrangement of the management structure for greater efficiency. Ford, for instance, recently outsourced its jobs from Detroit to China based upon advice from externally hired consultants.

Operations and Implementation Consulting Operations refer to the critical step between strategy—making a plan—and putting that plan into action. Operations consultants look at a client’s internal workings, such as the production

processes, distribution, order completion, and customer service. While strategy involves setting a client’s goals, operations ensures that clients reach these goals. Operations consultants may investigate customer service response times, cut operating costs, assist with outsourcing, or look into the allocation of client resources. Typical engagements may include streamlining the equipment purchasing processes of a major manufacturer, outsourcing customer call centers to India, or working with a newly-merged commercial bank to increase customer response.

Human Resources (HR) Consulting The best business strategies and finest operational processes mean nothing without the people to put them in place. HR consulting addresses the issue of maximizing the value of employees and placing the right people in the right roles. HR consulting firms are also hired for organizational restructuring, systems implementation, and ongoing studies and initiatives. In 2005, HR consulting services grew over 10 percent. And in the U.S. alone, spending on HR consulting expanded 12.5 percent in 2005, according to the International Data Corporation. With a low unemployment rate and an improved economy, HR consulting is steadily on the rise. An important corollary to HR consulting is HR outsourcing. Increasingly, clients are turning to HR consulting firms to manage their internal HR systems. Examples of typical human resources consulting engagements include creating or updating a client’s compensation structure, counseling and processing laid-off, downsized, or “right-sized” employees and assisting them with outplacement, as well as helping to blend the cultures and processes of merged companies

Financial Consulting In 2005, global spending on financial consulting services rose 15 percent to US$63 billion. Growth in this sector is predicted to

As businesses, governments, and society become more encumbered with a surfeit of information, consultants provide the resources to define and simplify problems into more manageable digests. remain steady at 12 percent per year over the next few years. As the market regains energy, consultants are required to help companies deal with shareholder lawsuit and regulatory compliance issues and business disputes. Other financial service areas driving the expansion are mergers and acwquisitions and corporate planning and strategy. Financial consulting firms tend to be run one of two ways; either they work with financial services firms to enhance their strategies and performance, or they have a specific financial model they use with clients to improve their performance. In either case, the focus is typically on enhancing shareholder value. Examples of financial consulting engagements include presenting market position analysis to a company’s senior management or refining online strategies for a commercial bank

Economic Consulting As the global economy becomes increasingly interconnected and complex, clients often turn to think tank-like economic consulting firms for guidance. These firms are typically staffed with economics PhDs and MBAs, as well as industry experts. They investigate economic factors to give clients the ability to resolve problems resulting from greater competition, antitrust issues, public policy, and regulations. These consultancies are prized for their independence and ability to give counsel to clients buffeted by the vagaries of the economy. Examples of typical economic consulting engagements include assessing the impact of deregulation of the utilities industry, helping to create rules for more efficient government auctions, or creating a sophisticated economic model to improve upon the bundling of services

Non-profit and Health Care Consulting The two fastest growing areas of consulting are non-profit consulting and health care consulting. Non-profit consultants oversee the operations of non-profit organizations, advising for projects extending over a broad array of fields. Education and healthcare are two of the areas covered by non-profit consultants, but as many of the considerations of for-profit corporations are also relevant to non-profit organizations, a more general mode of management and operations consulting is widely applied in the non-profit sector as well.

Health care and pharmaceuticals consulting is also one of the growth areas in consulting. As the proportion of the elderly population in the United States and other industrialized countries rises, and as scientists steadily unlock the mysteries of genetic engineering, the health care industry continues to thrive at a time when many other sectors of the economy are faltering. Total U.S. health care expenditures are projected to increase annually, at an average rate of seven percent per year, from US$1.8 trillion in 2004 to US$3.4 trillion in 2013. Furthermore, as reported by the Kennedy Information Institute, health spending in the U.S., at 16 percent of GDP, accounts for a larger share of GDP than in any other major industrialized country. Nonetheless, just because the market is large does not mean it is easy to profit from it. Health care consulting firms assist clients like hospitals, drug companies, and medical supply distributors who cope with an increasingly complicated maze of legislation, competition from other health care providers, cutting costs on vendors and equipment, and managing new technology. Examples of typical health care or pharmaceutical engagements include creating a strategy to help a hospital become competitive in new market, helping drug companies speed up the R&D and marketing process for products, and promoting usage of a fertility center.

Future Opportunities Engagements in all of the mentioned areas of consulting are increasing, which is why consulting firms are back on campuses trying hard to attract talented students. In 2005, firms increased consulting staff by 27 percent and recruitment hit a four-year high mark, according to Consultants News. This hiring frenzy is expected to keep pace for at least the next three years. “After recruitment had ebbed following the market bust, the peak is a positive indicator of firms’ renewed confidence that work will continue to flow in,” says The McKinsey Quarterly. Now, more than ever, candidates have a wider breadth of options available to them. Aside from the giant consulting firms to choose from, these days, candidates also have dozens of specialist firms to consider. Never before have the opportunities been so diverse for both students looking into summer internship and full time possibilities in the world of consulting.

Winter2006 2006 || HARVARD HARVARDCOLLEGE COLLEGECONSULTING INVESTMENT MAGAZINE MAGAZINE 39 39 Winter

Consulting

VERSUS Investment Banking

nvestment banking is a prestigious career which attracts college graduates every year. However in the recent years, its recruiting rival—consulting—is growing stronger. As more people enter the job market, many face a serious decision between consulting and investment banking. One of the major differences between consulting and investment banking is that while banking requires a focus on time-sensitive market situations, consulting demands a broader analytical perspective on business in a larger time span. Bankers often care more about the impact of short-term action, whereas consultants usually look into the future to determine how their client can ultimately benefit from a new managerial perspective. Consulting mostly deals with optimizing the structure of a company in order to maximize its profits in the long run. Therefore, this distinguishing feature of consulting, the general knowledge of the industry and the economic mechanisms governing it, allows the employees to have more exit opportunities. Banking rarely leaves analysts or traders, even those with many years of experience, with a variety of exit options. A former consultant is welcome in a range of enterprises, from an investment bank to a nonprofit organization, because they have developed a general view of the market. In addition to developing a broader knowledge base, many other factors play a role in driving students to consider a career in consulting. The first significant factor is the number of work hours per week. Whereas consultants are generally able to break their job into regular intervals, bankers often have to account for various unexpected nuances. These unpredictable events (e.g. a company suddenly deciding to acquire another one or a downturn in the energy sector) require immediate reaction, which traps a banker in the office for much longer hours than a usual 40-hour workweek. A general trend is that consulting hours are fewer by 5-10 percent in the top consulting companies, while this margin increases to 30

percent in small companies. Earnings also play an important role in this comparison. Due to working fewer hours, consultants are technically paid more than investment bankers on a per-hourly basis. However, bankers’ total salaries, once you add in year-end bonuses, will eclipse the consultant’s overall compensation. Earnings differentials between the two careers is due in part to a lower variability of extreme occurrences which could happen in a consulting project. When a banker makes a lucky transaction that brings in a lot of money due to a quick spike in the

relatively little direct attachment to processes that require immediate reaction (stock market fluctuations, hostile takeover proposals, political events, etc.) Thus, a consultant may be in a much better shape on average than a banker is: less stress, fewer hours, and more opportunity to exit into a variety of jobs. Anotherpossiblyadvantageouscomponent of the consultant’s job is the opportunity to travel. Consultants get to travel more than investment bankers, because consultants travel to the clients’ locations to do ‘onsite’ research, while the clients of a bank travel to New York

General comparision factors

management consulting

Lower risk

X X X X

Better exit opportunities Fewer hours Higher pay per hour

Higher salary with bonus Schedule flexibility Work from home More travel opportunities

X X X

More dynamic prices of stocks which he foresaw correctly, the bonus (usually measured as a percentage of the profits made by a person annually) reaches astronomical value. Such quick guessing does not occur frequently in the consulting industry, because the field deals more with conceptual solutions than with rapid transactions. On the other hand, consulting is a less tiring career than investment banking. This may not only explain the lower earnings, but also support the hypothesis that in the long run consultants benefit even more. Even while in the office, consultants still have a pretty flexible schedule, because, unlike in banking, there is

40 HARVARD HARVARDCOLLEGE COLLEGECONSULTING INVESTMENTMAGAZINE MAGAZINE || Winter 40 Winter2006 2006

investment banking

X to do business. Therefore, one who decides to work in consulting should be ready for excessive traveling, which they hopefully will enjoy. Thus, consulting increasingly takes on investment banking in the bid to take over the market for top students. Although the compensation may be lower, the job of a consultant appears to have more highlights than the job of an investment banker. Just as intellectually challenging as banking, consulting also offers fewer hours and more exit strategies. When deciding upon a career, students should stop to think about the pros and cons of both before making a decision.

s students explore their options for growth and scaling, performance management, jobs upon graduation, -who feel uneasy marketing, and strategy and operations. about profit-driven business, the ones Nonprofit consulting is still a small, albeit who are concerned about “selling expanding, field. Naturally, it comes equipped their soul” as some have branded it. However, with its own set of goals, approaches, and as newer forms of consulting emerge, especially concerns, often quite distinct from those of more the ones more palatable for those who want to mainstream business consulting. Komendant, “save the world,” more and more students find who coordinates the Academic Year Program, themselves drawn towards the business world. cited the complexity of the structure of interested Interested in consulting but unwilling to give up parties in the nonprofit sector as a major the nonprofit world entirely, Kristi Komendant, a distinguishing characteristic. There are many recent UPenn graduate, was delighted to discover different stakeholders in a nonprofit organization: New Sector, a small firm founded in 2000 by staff, board members, donors, foundations, a Harvard Business School graduate. NSA constituents of the organization, the community provides nonprofit strategy consulting through at large. Learning how to understand and mediate partnerships with students and professional those diverse interests is extremely challenging, consultants from the mainstream firms such as and unique to the nonprofit sector, but it equips McKinsey, Bain, and Boston Consulting Group. one to handle those kinds of challenges in any With a permanent staff of just five people, New sector. Sector still manages to coordinate a growing “When you have business consulting, number of projects and works with nonprofit it’s very clear what the bottom line is; it’s clear organizations in Massachusetts, New York, who your shareholders are,” states Komendant. Washington, and England. “In nonprofits, it’s not that clear-cut. There are While New Sector multiple bottom lines because “When you have business is certainly not the only they need to be aware of their consulting, it’s very clear nonprofit consulting firm social impact.” Komendant in existence, it may be of what the bottom line is; it’s also commented on the relative particularinteresttostudents. difficulty of measuring success clear who your shareholders in a nonprofit context. “In The firm has taken a unique are. In nonprofits, it’s not approach which incorporates businesses, you can look at your small teams of students growth, you can look at how that clear-cut” under the mentorship of your revenues are increasing; Kristi Komendant professionals from large one of the huge challenges consulting firms and thus exposes students to a nonprofits face is measuring their impact. The hands-on alternative consulting experience. Its goals are so long-term that it’s not something that ‘Academic Year Program’ was originally created you can necessarily funnel down into one specific exclusively for MBA candidates, but has since metric.” been tweaked to include undergraduates as well. But despite the occasional ambiguity or lack Students work with professional mentors on a of established procedures, nonprofit consulting is semester-long consulting project. This is no case a growing phenomenon which should, if current study or simulation—the projects are real and trends continue, expand significantly in coming the students’ work is used by the firm’s nonprofit years. New Sector itself has been expanding its clients. A smaller summer program provides a student programs, hosting its largest Summer similar, though shorter, experience. Students work Program to date this past summer. An expanding in teams of about five people, with professional clientele, paired with a 50 percent return rate consultants from elite firms such as McKinsey, for clients, gives the firm the opportunity to Bain, and Mercer Management Consulting acting increase the number of projects. Additionally, as mentors and overseers. the real-world experience appears to impact So what exactly does a nonprofit consulting participating students in the long run. Whether firm do? NSA’s projects span a wide range of interested in consulting or nonprofit work after fields, catering to the missions of a variety of being introduced to the fields by a New Sector nonprofit organizations. Youth and education, program, many former participants have gone economic development, health, and leadership on to work for nonprofit organizations, found development are some of the more popular their own nonprofits, or find positions in large projects undertaken by NSA staff and interns. consulting firms. Projects usually fall into one of four categories: For more information, please visit http://www.newsector.org/

NEW FIRM PROFILE:

sector ALLIANCE

Piecing together nonprofit and consulting. By Polina Dekhtyar

Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

SCORE FIRM PROFILE:

is the largest provider of not-for-profit (NFP) consulting services in the United States, specifically targeted at small businesses and startups. It was established with a government subsidy in 1964 following President Eisenhower’s Small Business Act of 1953, which stated that the government “should aid, counsel, assist, and protect the interests of small business.” A key difference between SCORE and their larger rivals who make handsome yields lies in fundamentally different approaches to business. Whereas prominent consulting firms take a timely and expensive dive into research for their client, SCORE skips this time consuming step initially. Instead, their consultant working with a client relies upon the facts that are presented within an hour’s time on their first visit, drawing general conclusions and presenting his or her own ideas to the client on how the business should be run. Many times it is just a small problem that requires a fresh look upon and common sense to figure out the solution. Even though the service is completely free to the client, the agency only depends on the government to provide office space for its counselors; otherwise it is a completely separate entity which functions on its own profits and losses. SCORE accomplishes its goals efficiently by relying on over ten thousand volunteers, all of whom possess extensive experience in the sphere of business. Consultants admitted into SCORE come from diverse backgrounds with unique experiences. Jack Calkins is the current Chair of the Boston Chapter. When he retired after a fulfilling career in business, he realized that he did not want to leave his profession completely, which was his reason for joining SCORE. He feels a sense of fulfillment, he says, of helping others ascend the pathway to success. Another member of the organization is Jack Calechman, the former Chairman, who joined SCORE after he retired from a long career in law. He now finds himself busier than ever, arduously helping others succeed. SCORE provided him the chance to pass on his legal knowledge and organizational skills. He, like everyone else in the firm, genuinely enjoys lending a hand to others, and he says that “the most frustrating thing for us is when someone doesn’t show up for an appointment.” John Fanton, a Business Counselor and IT manager at SCORE, worked in the technology business for Hewlett-Packard and Phillips before coming

From 2004-2005 SCORE Foundation Annual Report: Some of the ways The SCORE Foundation and SCORE Association were able to put your philanthropic support to work in fiscal year 2005-2006:

42 HARVARD HARVARDCOLLEGE COLLEGECONSULTING INVESTMENT MAGAZINE MAGAZINE | | Winter 42 Winter2006 2006

Sponsorship for the production of the nearly 100,000 copies of two educational workbooks How to Really Start Your Own Business and How to Really Structure Your Own Business. Sponsorships for the Chair and District Director Conferences - both which help enhance the leadership abilities and functions of SCORE’s all-volunteer network. The development of a new SCORE resource tool and workshop model for non-profits that is now available to all 389 chapters thanks to the W. K. Kellogg Foundation. An opportunity for up to 3,000 copies of new small business accounting software offering for SCORE volunteers More than $160,000 of Microsoft software for all attendees of the SCORE Chair conference. Surpassing the $600,000 mark in total expectancies which will help build the future endowment of SCORE. 11 new individuals, named SCORE in their wills or life insurance in 2004-2005. The total number of Titley Society members at the end of 2004-2005 was 33. More than $10,000 raised in disaster relief funds for SCORE significantly impacted by hurricanes and disasters More than $5,000 in funds through the new Mini-grant program to implement innovative volunteer recruitment programs

to SCORE. He was able to bring a fresh outlook on ventures involving technology and maintains the Boston Chapter’s website (scoreboston.org) which helps attract additional clients.

Operations When a client calls in, he is assigned a consultant whom SCORE deems competent for this particular client’s problem. The counselors submit their availability on a monthly basis, and the SCORE counselor handling the phones can consult them to see what the best match for the

EXPENSES:

34% Management/ operational expenses

64% Program grants/ services

3% Fundraising

INCOME:

94% Unrestricted

2% permanently restricted

4% temporarily restricted

potential client is. While SCORE maintains the focus on being consultants for only small business, there are no specific qualifications which a client needs to meet in order to receive counseling: all small businesses are welcome.

Human resources A few years ago, SCORE changed its motto from “Service Corps of Retired Executives” to “Counselors to America’s Small Business.” However, the youngest counselor at Boston Chapter is still 60 years old, so the demographics of the consulting have staid pretty consistent over time and across chapters. Most SCORE consultants are retired or soon-to-be retired males and females who have spent their careers in the fields of business or law. The recruiting of consultants is done by word-of-mouth and new recruits go through a three month training process. Following the training process, the consultants spend considerable time co-counseling prior to full acceptance into the Chapter.

Organization

Marketing, Fundraising and Partnerships The budget of each Chapter is negligibly small. The expenses are next to nothing, since the office space is provided, 100% of labor force is free, and computers and other office equipment are provided by the local Small Businesses Administration (SBA) offices. However, the Chapters still have to account for cost like phone bills and web hosting. The fundraising for the chapter as well marketing is done through the monthly workshops. The cost of attendance is normally $35-45 and it covers the expenses of the workshop itself. The surplus left covers general office expenses above. Another source of funds involves grants and gifts. However, at the end of the fiscal year the expenses almost always tend to exceed the revenues, so the counselors tend to altruistically invest their own money as well. Marketing is done by means of advertising in local news media and public transportation. The advertising for SCORE is often free of charge to SCORE itself because it is sponsored by local banks or other benefactors. Jack Calechman, former chair, is currently involved in a project which will partner local law firms with SCORE’s clients. Law firms which do pro-bono work can actively help small businesses deal with legal issues.

SCORE accomplishes its goals efficiently by relying on over ten thousand volunteers, all of whom possess extensive experience in the sphere of business.

In order to perform efficiently, SCORE has implemented a vertical structure. On the regional level there are Chapters, such as the“Boston Chapter.” Since Boston is a highly urbanized area, the local Chapter has branches at The Chamber of Commerce offices in seven local areas like Newton and Watertown. Local chapters receive limited funding and support from SCORE National – the headquarters of the organization. While the local chapters have only volunteers and no real operational budget, SCORE National has paid staff who efficiently perform fundraising, deal with partnerships, perform coordination tasks, and aid 400 federal chapters. Within each chapter, one will find a chairman, who is the leader of the local team of counselors, elected for this position for two years. The rest of the team is split into the executive committee, the marketing committee, the workshops committee, and the employee recruiting and training team. The chairman is in charge not only of managing and strategic work, but also attends monthly meetings with chairs of other chapters, which are a main source of inter-chapter communication, sharing of ideas and solutions.

The Future It is often hard to increase business efficiency when the resources for a company are solely dependent upon philanthropy. Reality shows that funds are needed, as well as specialized counselors for high tech companies and restaurants. The restrictions of a non-profit firm may decelerate SCORE’s overall growth, efficiency, and flexibility. While it is vital for a nonprofit to adhere to its core values, SCORE would benefit immensely from more financial freedom which in turn would allow it to function more smoothly and efficiently. In order to continue offering its philanthropic consulting services to those small business owners who need it the most, SCORE must refocus on actively engaging in financially fruitful partnerships with for-profit companies like banks and law firms.

Winter 43 Winter 2006 2006 || HARVARD HARVARD COLLEGE COLLEGE INVESTMENT CONSULTING MAGAZINE MAGAZINE 43

fi l es d esi g n w r ite r Moneyworldbusiness nonpCONSULTINGrofit investmentfirmpro filesdesi?gnwriter M o ne y w o r l d busi nessn o n p r o fitin JOIN vest m entfi r m p r o fi l es d esi g n w r ite r M o ne y w o r l d busi nessn o n p r o fitin INTERESTED IN

HCCm We are looking for writers and designers with an interest in the world of business and consulting. The next comp process begins soon. For more information, contact hccm@harvardinvestmentmagazine.org

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

rs Mortgages business- Real estateâ&#x20AC;&#x2122;s delinquent sibling fitT ors busi fitin ors busi fitin By Henry Foo

he real estate market has once again

become popular fodder for conversation and

publications, mainly due to the property appreciation

seen in much of the world. From Thailand to South Africa, it seems that everyone has something to say about the

increasing property prices in their country. However, in some countries, like Australia and Great Britain, which have already seen decreases in home values,

Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

Investing Today

the attitude is less buoyant. For many in the United States, that same lack of enthusiasm regarding the real estate market is growing. Perhaps the greater risk to the economy is posed not by the decreased consumer sentiment or decreased perceived wealth due to the housing market, but by a high number of mortgage defaults.

Current Condition of the U.S. Market

The most recent data regarding housing have certainly been disappointing. The builders are becoming less optimistic—the National Association of Home Builders’ Housing Market Index shows a continuing halt to a low of around 30 by the end of 2006. The neutral outlook point in the index is usually 50, with anything below that denoting a pessimistic builder outlook. Existing home sales data from the National Association of Realtors shows a pause in the continuing decrease from the beginning of 2006, with an increase in September of about 30,000 extra homes sold as compared to last year’s seasonal data. This pause may be attributed to the West Census Region’s increase in activity, since the rest of the country appears relatively unchanged. Because of the aberrational regional increase, there is unfortunately no sign that the national slide in existing home sales will stop for certain at the end of 2006. With housing prices in the United States now leveling off or dropping in certain markets, the question is whether the United States housing market as a whole can find the discipline to resist damaging speculative pressures. Seemingly distant now, Hurricane Katrina may still cause disruptive influences in the future; after it hit, speculators rushed to buy “bargain” homes in damaged areas, since the bidders knew that many owners would want to sell and could not possibly charge full price. This illustrates, from the perspective of the Southern market, the damages that a negative price movement would cause for 46

speculators; a fall in housing prices would mean a lower, and perhaps even negative, return on initial investment.

In Come the Mortgages

Contributing to a negative return is the fact that, at some point during the purchasing process, the average buyer probably took out a loan to pay for a new house. If prices are driven up by speculators, then the amount of money received from selling that house a few years down the road conceivably could be less than the cost of a similar house in another regional market. Since the previous mortgage has to be paid back, a greater mortgage must be taken out to pay for the new purchase,

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

The real problem from housing is the amount of future personal

wealth being tied up in a potentially depreciating asset.

Investing Today

unless one wishes to downgrade. The real problem from housing is the amount of future personal wealth being tied up in a potentially depreciating asset. The bad news is that if housing slows down considerably, the American economy will suffer. The worse news is that the bad news has been old news for quite some time. In a research report written back in 2005, Merrill Lynch estimated that a leveling off in home prices, not even a decrease, would decrease GDP by almost one percent that year and would decrease the consumption of durable goods. This estimate has proven to be in the ballpark—recent Federal Reserve Board press releases have mentioned the potential of a decrease of a percentage point in GDP in the end of 2006 and into the

beginning of 2007. The main idea is clear: for a country that has largely relied on the growth of housing-related industries, the United States must realize the implications of an end to the continued upward trend in home price appreciation. With respect to future personal wealth and the future national economy, the largest threat will be the debt burdens. The National Association of Realtors (NAR), an organization in favor of home-buying activities, has found the growth in monthly mortgage payments by 11.5 percent over the past year troubling. The NAR’s polls indicate growing concern among American consumers that the increased mortgage payments, combined with higher energy costs, will force them to sell their houses

and buy cheaper ones. In Australia, The Reserve Bank of Australia faces a more advanced version of the United States’ situation: property prices continue to increase at auction, many people have stretched themselves financially because of mortgages, and the economy requires some slowing by interest rate increases. Without getting too much into monetary policy, suffice it is to say that debt problems arising from mortgages have already begun. Credit quality deterioration and mortgage delinquency have also already begun. With adjustable rate mortgages suddenly becoming more of an issue— especially since the Federal Reserve Bank had recently increased the Federal Funds Rate incrementally to 5.25%—many individuals may feel the need to refinance. At this current state of the market, the refinancing rate is not as good as that of a year ago, but it is a requisite step to preventing too much credit-related problems. As the Mortgage Bankers Association’s Mortgage Applications Index shows, refinancing activity has been trending upward since the summer of 2006, while mortgage purchases have continued their downward trend from the beginning of this year, though end of the year data seems to indicate a slight reversal in the trend. This is certainly in line with the notion that homebuyers should refinance, but the real question is whether the refinancing was for a better mortgage payment schedule or for a mortgage equity withdrawal earmarked for consumption and spending. With the data available at the beginning of December, it appears that consumer spending is weaker than ideal, though the holiday season may prove that incorrect. Also, since credit is only starting to change as a result of more limited mortgage equity withdrawal, the data is beginning to suggest worrisome credit deterioration. Also very noteworthy is that mortgage credit quality is already slipping, and banks involved in the American mortgage market are beginning to see deterioration in mortgage credit quality because of decreasing home prices. The credit problem can be expected to become more pronounced going into 2007.

A Closing Word on Interest Rates

Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

Investing Today For much of the fourth quarter, members of the Federal Reserve have been referencing levels of core inflation that are still quite high and require additional caution. With a high level of inflation present in the economy, maintaining—if not increasing—the current Federal Funds Rate of 5.25% is a pretty sensible policy, especially considering the GDP numbers for the end of November. However, factoring in economy-wide data—housing prices (including construction), slipping manufacturing, lackluster employment, and more stabilized oil—the risk of interest rate decreases appears larger. The magnitude of decrease remains to be seen, but the drop in the 10-year Treasury yield is enough indication of market expectations. At the beginning of December, inflation does not appear to be weak enough for a continued decrease in the Federal Funds Rate. Hypothetically, though, a large enough drop in the Federal Funds Rate and the resulting drop in home mortgage rates may allow homeowners who switched out of adjustable-

As the conditions of the economy grow less favorable and require more monetary action, the housing and mortgage markets may

drag the economy down, with the worst case scenario being a serious depression.

rate mortgages to find a more favorable rate. This would be beneficial in easing the increased mortgage pressures from the latter half of 2006. One may only hope that lower mortgage rates will not spur another round of real estate accumulation on an aggregate level. Future rate changes aside, the potential effects of prolonged trouble in the housing and mortgage markets may spark instability that would severely stunt recent economic growth; however, evidence suggests that even intervention in those markets is not effective enough by itself. By far the greatest problem remaining is the repercussions of mortgage defaults in a country with a negative savings rate. Fortunately so far, the United States is seeing a leveling off in the decrease in the prices and the growth of the housing market. On the other hand, as the conditions of the economy grow less favorable and require more monetary action, the housing and mortgage markets may drag the economy down, with the worst case scenario being a serious depression.

Bain Capital is one of the world's leading private investment firms, managing more than $38 billion of leveraged buyout, public equity and credit funds. Sankaty Advisors, the credit products and debt hedge fund business of Bain Capital, is a world-class team of over 40 investment professionals with extensive experience analyzing and managing high-yield investments. Representatives from Sankaty Advisors will be visiting campus throughout the year, speaking with undergraduate students about internships and full-time positions that will put your education to work on global, multi-million dollar investment decisions. Please look for us on campus in the coming months to learn more about the great opportunities we offer.

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

For information visit us at www.baincapital.com or www.sankaty.com

Investing Today The Private Equity Allure

The

Private Equity

Explosion

By Alex Bayers and Robert Andrew DaviS

o judge the success of an investment, look no further than its

profit yielded. The 1990’s served as an investor’s paradise. During that decade, the Dow Jones Industrial Average (DJIA) rose

by 309 percent, the NASDAQ surged by 786 percent, and the S&P 500 increased by 308 percent. Mutual funds took advantage of the Technology Bubble as annual gains of 15 to 20 percent from these

funds came to be expected. However, the end of the technology bubble in 2000 and the recession that followed in 2001 greatly diminished the investment returns seen during the 1990’s. Compared to that

era, returns since 2000 have been minimal at best. Gone with the

rapid returns of the stock indexes from the 1990’s are the 15 to 20

percent annual returns from mutual funds. Due to the recent meager returns of mutual funds, highly-capitalized investors have turned to

private equity to earn profits. Private equity funds have thus replaced mutual funds as the source of market out-performance. This has led to larger and larger sources of capital for these funds. With larger

sources of capital for private equity funds comes the ability to purchase bigger companies. However, these larger capital pools may also have unforeseen consequences for the world economy.

Private equity entails any investment in an asset whose equity is not freely tradable on a public stock market. The main purpose of private equity is to increase the value of a privately owned company in order to reap the profits. Private equity can take many forms, including leveraged buyouts, venture capital, and angel investments, among others. The basic strategy of a private equity fund is to either purchase part or all of an undervalued company. The partners of the private equity fund will then do one of two things. In some cases they will maintain the company’s current management but change the strategy or infrastructure of the company so the managers can more effectively run the company. In other cases the fund partners will hire a new management team and take the company in a new direction. In either case, the end purpose is to increase the company’s value. Profits are then obtained through one of several methods. One is to take the company public through an initial public offering (IPO), upon which the partners can profit by selling their shares. A second option is to sell the company to other investors or another company for a profit. The third option is to conduct a recapitalization of the company and distribute a dividend. Since the goal of private equity firms is to improve an already existing company, private equity requires long-term commitments from investors. Also, increasing the value of a purchased company is far from being assured. Returns can be tremendous, but considerable losses occur as well. As a result, private equity partners only accept money from certain types of clients, which most often include extremely wealthy individuals, pension funds, university endowments, and other trust funds. Also, whereas investments in mutual funds can be of any amount and can be redeemed at any time, investments in private equity funds usually require at least $1 million (in some cases the minimum is $10 million) and do not come with a certain time frame for redemption. The most noticeable distinction between private equity funds and mutual funds are the managerial fees. To begin with, private equity fund managers charge a 1 to 2 percent fee on all capital invested in the fund, regardless of results. If the fund is profitable, then the fund managers receive 20 percent of all profits.

Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

This fee’s purpose is to align the interests of the managers with those of the investors. These fees are quite controversial because many economists consider them excessive, especially since they can potentially make private equity fund managers tremendously wealthy for doing little more than holding onto a large sum of investors’ money.

Boundless Private Equity

Private equity funds have easily outperformed mutual funds during the current decade. This has led to a rapid increase in the amount of money invested in private equity funds. According to Private Equity Analyst, an online database offering market trend analysis, through October, private equity funds had raised $177.89 billion during 2006, setting a new record for the amount of private equity capital raised during a single year. Since the amount of private

leveraged buyout funds. This transition can be explained by the changes in market conditions. During 2000, internet start-ups were the fad and venture capital funds were popular because they invested in these internet companies. The current popularity of leveraged buyout funds is due to the easy credit markets. After the recession in 2001, the Federal Reserve responded by decreasing the Federal Funds Rate to a low of one percent. Even now, the Federal Funds Rate stands at 5.25 percent, which is still historically low. Since the Federal Funds Rate is what banks pay for overnight loans, it means that a lower Federal Funds Rate will lead to lower interest rates for companies borrowing from banks. Leveraged buyouts involve investing a little bit of capital in a company and buying the rest of the company with debt, so easy credit markets have made these types of buyouts increasingly profitable.

funds have not become reckless with their money. Blackstone Group has promised that it will only spend 40 percent of its $20 billion in capital per year in order to protect against market fluctuations. The increasingly large private equity capital pools allow these funds to purchase larger companies. Through the end of October 2006, the funds had paid $421 billion to buy companies, well above the $253 billion spent during 2005. Much of this $421 billion has been due to large purchases. During 2006, eight of the nine largest private equity buyouts ever took place. Of these mammoth buyouts, the pinnacle was the buyout of the hospital operator HCA, Inc. Including debt, the buyout of HCA, Inc. cost $33 billion, which tops KKR’s buyout of RJR Nabisco as the largest private equity leveraged buyout in history. (While the proposed buyout of Equity Office Properties Trust by Blackstone for $36 billion is

$177.89

Private equity funds had raised billion equity capital raised through nine months of 2006 is greater than the amount raised during the entirety of any previous year, it is clear that private equity has become increasingly popular. Furthermore, private equity researchers claim that 75 percent of existing funds are oversubscribed, meaning that the funds have more money than they originally desired. However, what really changed between 2000 and 2006 is how private equity capital is allocated. In 2000, the majority of private equity capital was invested in venture capital funds. Through the first nine months of 2006, 66 percent of the private equity capital raised went towards

The high level of capital invested in private equity has not led to more private equity funds, but instead to the increased amount of capital that each private equity fund controls. During 2006, Blackstone Group raised $20 billion, the most capital ever for a private equity fund. Others are following suit. Carlyle Group is attempting to raise a $15 billion fund, Kohlberg Kravis Roberts & Co. (KKR) is attempting to raise $25 billion during the next year to divide over several separate funds, and Texas Pacific Group has created a $15.2 billion fund. Only a few years ago, private equity funds with more than $10 billion of capital were unheard of. Nonetheless, these new large

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

larger, it has yet to be completed.) What might be most noticeable about the HCA acquisition is the amount of debt included: $11.7 billion. With private equity funds growing larger and larger and with low interest rates allowing large amounts of debt to be funded, it has become possible for almost any company to be bought out. Analysts predict that a $40 billion buyout may not be far off. Companies such as Texas Instruments, Home Depot, Dell, and Vivendi have been named as possible takeover candidates. If companies of this magnitude are possible buyout candidates, the economy as a whole will benefit because these mega-corporations will

be forced to improve their efficiency to prevent takeover-. A report by the Federal Reserve Bank of Chicago states that the ability to purchase any company will help the efficiency of the private equity market, as funds become more wary of which companies they choose to invest in.

The Resulting Impact

As private equity funds grow larger, there are some reasons to fear their growth. One accusation is that private equity groups are participating in anticompetitive behavior. The Department of Justice has begun sending letters to some of the most known private equity firms, including KKR, Carlyle Group, Merrill Lynch Global Private Equity, Silver Lake Partners,and Clayton,Dubilier,& Rice Inc. It is believed that this probe involves the â&#x20AC;&#x153;clubâ&#x20AC;? deals that have recently occurred, in which several private equity firms combine their capital to complete a given takeover.

increase their profits. The U.S. and British tax authorities raised concerns that the growth of private equity funds could lead to the loss of tax transparency, which would negatively affect corporate governance. Experts feel that the tax authorities are overreacting. They argue that highly aggressive tax practices are not beneficial for private equity firms because they need bank funding for their leveraged buyouts, and banks look sorely upon aggressive tax planning. If this opinion is true, then the growth of private equity funds should not negatively impact corporate governance or the amount of tax revenue that governments receive from corporations that are bought out. In comparison to the reported damage that the growth of private equity funds is causing, the rewards from the growth of private equity seem to be much more substantial. One of the most common criticisms of private equity funds has

equity helps to benefit the countries where it is practiced. For example, studies conducted by the German Private Equity and Venture Capital Association show that private equity financed companies grow faster, invest more funds, and create more jobs than companies that are not financed by private equity. Just as the growth of private equity has led to improved economic conditions in Germany, the same has occurred in China and India. As those two countries have been some of the fastest growing economies during the past few years, the amount of private equity capital has surged in those areas. During the first half of 2006, the amount of U.S. capital invested in both countries doubled from the year before, which has clearly benefited both of their economies. Private equity capital pools have grown to record sizes as a result of their performance. Private equity funds have outperformed mutual funds and stock

during 2006, setting a new record for the amount of private equity capital raised during a single year. When private equity firms cooperate in a club deal, they may theoretically depress prices for the companies being bought out because there are fewer competitors in the bidding process. However, the private equity firms claim that club deals do not lead to collusion. If competing bidders shared information about their bids or agreed that the loser could join the winning bidders, it would be collusion. Instead, private equity managers claim they are only sharing the risk of investing in an outside company. Another concern regarding private equity is that some funds are piling on so much debt in their deals that they are encouraged to file incorrect tax reports to

been that they are too exclusive. Since the minimum investment is often $1 million or more, the general public cannot be part of the oversized returns that private equity funds are known to generate. This is no longer the case as KKR has instituted the practice of listing shares for one of its funds on the Euronext stock exchange in Amsterdam. The name of this $5 billion fund is the KKR Private Equity Investors LP, which allows investors to buy a part of the KKR portfolio for under $25 a share. This fund is not the first of its kind to be listed on a stock exchange but it is the first to be listed by as prominent a company as KKR. Studies have also shown that private

market indexes consistently since 2000. Now, with the listing of KKR Private Equity Investors LP, regular investors can be a part of these private equity gains and not be burdened by oversized fees. As the growth of private equity continues, economies will improve as the result of increased investment in startups. Furthermore, as the ability of private equity funds to purchase large companies increases, large companies will be forced to improve their efficiency in order to not be threatened by the private equity funds. Thus as long as private equity investment continues to grow, it signals a healthy future for economies fortunate enough to reap the benefit.

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Investing Today

The Future of

European Private Equity T

he European Private Equity (PE) market remains highly attractive with strong potential for growth—especially because PE funds may help the Eastern European restructuring process. Compared to the U.S., Europe is a newcomer on the PE scene. Europe saw a few buyout efforts in the 1940’s, but they only began in earnest in the early 1980’s. There was a very dramatic increase in activity in the 1980’s, followed by a decline in activity for much of the early 1990’s, with a gradual recovery during the mid-1990’s.

By Mate Pencz

The German PE market in particular is growing solidly with buy-outs essentially determining the rate of growth. Germany has attracted a relatively large number of foreign PE firms that have undertaken large takeovers in the recent past. In 2005, Germany witnessed buy-outs worth over EUR 22.5 billion. A prime example of this trend was provided in late 2006 when Kohlberg Kravis Roberts & Co. and Goldman Sachs’s PE unit agreed to buy the Kion forklift division of Linde Group for EUR 4 billion (approximately U.S.

HARVARD COLLEGE INVESTMENT MAGAZINE | Winter 2006

$5.1 billion) in Germany’s biggest takeover by a leveraged buyout firm. The takeover came amidst PE firms announcing a record $173 billion of deals in 2006 in Europe, up from $93 billion in the parallel period from 2005. However, in Germany as in other markets, PE firms face some opposition and distrust. German Labor Minister Franz Muentefering branded foreign hedge funds and PE firms as “a swarm of locusts, destroying everything and moving on.” Still, attitudes may be changing as buyout funds provide a new source of cash for investment, particularly for family-owned companies with aging owners. Many European business segments remain largely fragmented with familytype establishments, in particular lending themselves to consolidation. The current environment creates many opportunities for PE, which may be the most appropriate form of financing transition and a critical means of support for growth, restructuring, and change. Relatively low interest rates should encourage continuing investment and can be most supportive of financial and equity restructuring efforts. Especially in Eastern Europe, PE and venture capital is an essential part of the modernization and development process. Private Equity emerges as the most appropriate and often the only available form of financing the rapid reconstruction of the capital base in the area. Moreover, the lack of management history calls for a more hands-on, active role which is very often best achieved by private equity firms. Experienced management and proven products can help reduce the risk of venturing in Eastern Europe. As the European PE market becomes increasingly crowded,more and more firms will look for creative ways to deploy capital, keep returns high, and minimize auction situations. As a result, funds will increasingly shift to the middle market sector, for companies worth less than EUR 300 Million. Most European PE participants are confident that the industry will continue to expand steadily and perform well over the long term.

Real Opportunities in

Real Estate

Why developing and renting in Central Europe will bring you money.

hether or not to make your money work for you is never the question – the real dilemma is how, where, and when to do it. Recently, real estate has offered an attractive investment option in an uncertain economy, with significant potential upside and a relatively low risk to reward tradeoff compared to the various asset classes. In a low interest rate environment, compounded with rising consumerism among the rich driving up property prices, legions of investors have aggressively pursued the markets of rentable land and buildings. The resurgence of the global real estate markets, particularly the recovering properties in Central Europe, has instigated commentaries on the opportunities that lie abroad. Now, the most pertinent questions in real estate investing are how much of it is hype and how much is reality. The answers lay in analyzing the responses of two different groups: individuals and corporate investors. Each group has different needs, goals, and resources which shape their motivations and investment approach when entering the Central European real estate market.

Individuals

Why would an individual want to invest in real estate? The reasons are manifold, ranging from long-term guarantees to diversification of one’s assets to an interest in above-average profits. Within Europe, investors are startlingly optimistic about the real estate market in Central Europe, where

By Jan Zilinsky

property has appreciated dramatically with the rapid development of apartments and offices complexes. CE Invest Group, a real estate investment group in Slovakia, recommends that investors buy an apartment in towns of rising importance, such as Bratislava and Budapest and simply rent it out as its value rises dramatically over the next few years. Several apartment properties have risen in value by 20-40% since 2004. Prior to purchasing an apartment, however, an investor must bear in mind maintenance costs, which vary from an average of €200 to €400 per month. Due to compounding vacancy and opportunity costs, it is important to find a renter quickly, even if it means settling for rates which are slightly lower than market rent. An alternative is buying an apartment that needs to be renovated. Such buildings are readily available and commonly undervalued in Central and Eastern Europe. Despite the additional investment required for refurbishment, in the long run, older, historical buildings often prove their intrinsic worth. House prices can be found from €110,000 to €770,000 in the Central European region, although there is a lot of variation between the rural areas and the cities. Property is often disproportionately more expensive in the capital cities than in smaller towns. Many locals own smaller houses in the countryside that are used for recreation. Increasingly, this option is being discovered by Western Europeans, especially those who live in nearby

Winter 2006 | HARVARD COLLEGE INVESTMENT MAGAZINE

Investing Today countries such as Austria and Germany. move before prices skyrocket. laborer worked 623 more hours in 2004 Exchange rates also play an important Despite the appeal of fast growing than a Norwegian. This suggests that a role in determining the appropriate timing markets in Central Europe, foreign real typical Norwegian would need to work of purchasing property. For example, an estate companies should be pragmatic a full 24 hours for almost a month - 26 apartment bought in Budapest for €89,000, about the timeframe of their investments. days - to catch up with a typical Czech. In will cost €96,000 two years later solely Instead of quick turnarounds, the general terms of education, children in the Central because of an appreciation in the exchange macroeconomic environment bodes well European countries scored on average 2.5% rate. Nevertheless, it would be difficult and for longer-term property investments higher in science than children in Norway, unwise to base one’s investment strategies in Central Europe. As the economies of Germany, Austria, and the U.S. according on the unpredictable Central Europe regenerate, to the OECD 2006 Factbook. Within Europe, nature of exchange rate higher GDP’s and higher movements. consumption rates will lead investors are startlingly to increased demand in Hype vs. Reality the real estate industry. In Investing in foreign real estate optimistic about the Corporate Investors Slovakia alone, according may seem intimidating in light of its high Most corporations to forecasts from The demands on time, resources, and legal real estate market in operating in the U.S. Economist Intelligence consultations, but these issues are offset Central Europe, where Unit, a leading provider by the potential profitability through and Western Europe have yet to seriously real-time statistics from the appreciation of the investments. For property has appreciated of consider expanding Central Europe, private individuals who want to make their money into the emerging dramatically with the consumption will grow work but are unimpressed with the lower economies of Central by 16% between 2005 yielding certificate of deposit interest and Eastern Europe. This rapid development of and 2008, a jump from rates offered by most banks, wary of stock acknowledged hesitancy approximately $248 to market’s volatility, and willing to sacrifice apartments and office $287 billion U.S. dollars. some liquidity, buying property in Central to open offices in Central Europe is largely due This rate is a stark contrast Europe is now a very attractive option. complexes. to concerns regarding a to the more modest annual lack of infrastructural support, uncertain increase of 2% in neighboring Austria. The growth prospects, and restrictive labor and Czech koruna appreciated by 5.8% against business regulations. It would certainly be the euro last year and has demonstrated imprudent to move into unfamiliar markets unprecedented stability a n d without the necessary due diligence. strength in the past One of the few companies which few years. The Czech has recognized the opportunities which Republic has also lie beyond Germany’s eastern border is maintained strong McKinsey & Company. McKinsey recently GDP growth opened offices in Prague and Bratislava in ranging from order to help, in their own words, “shape 5.7% to 7.4% a new business era.” While corporate annually, which investors have paid the bulk of their is on aggregate, attention to the economies of Western three times the rate Europe, there is a movement to take of GDP growth of its advantage of the potentially lucrative real Western counterparts. estate markets of countries like the Czech Labor and talent Republic and Slovakia. In Bratislava, the markets in Central price range for offices is €1200- €2000/ Europe are also highly Experts predict that this is an opm2. Office space in Prague can be found attractive to foreign portune time for investors hoping for €2700/m2. Infrastructure in Prague investors. OECD is constantly improving; thus, real estate calculations reveal that to break into the Central European prices have begun rising at fast rates. This the populations of markets to make their move before trend is representative of the whole region Central Europe work and is bound to continue in the future. astonishingly long hours prices skyrocket. Experts predict that this is an opportune relative to workers in time for investors hoping to break into the richer countries. For Central European markets to make their example, a typical Czech

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