The Princeton Financier: Spring 2012

The Princeton

Financier SPRING 2012 Volume 1 | Issue 2

EDITOR-IN-CHIEF Luke Cheng ‘14

MANAGING EDITORS Hannah Rajeshwar ‘14 Jingwen Du ‘13

DESIGN & LAYOUT Russell Morton ‘14 Valentin Hernandez ‘15

STUDENT CONTRIBUTORS Julian He ‘14 Sunny Jeon ‘14 Tanoy Mandal ‘14 Jason Nong ‘15 Oladoyin Phillips ‘14

PCFC Board SPRING 2012

PRESIDENT Zara Mannan ’13

CLUB MANAGEMENT Hannah Rajeshwar ’14

EDUCATION Anastasia Auber ’13

MENTORSHIP Miguel Tejeda ‘13

MARKETING Luke Cheng ’14

MEDIA & TECH Cosmo Zheng ‘13

INDUSTRY INSIGHT Alex Seyferth ‘14 Julian He ‘14 Jingwen Du ‘13

Letter from the E ditor This issue of The Princeton Financier reflects the growing need to understand financial activity on an international level. During the course of the school year, the Industry Insight Teams within the Princeton Corporate Finance Club put a tremendous amount of effort into publishing weekly newsletters that update members on current events in the global corporate finance world, especially news items concerning leveraged buyouts, mergers and acquisitions, and initial public offerings. Each officer in the Industry Insight Teams is responsible for covering a specific geographic region. The debut issue of The Princeton Financier focused on interviews and articles by professors and industry professionals, including Nobel Laureate Christopher Sims. However, in planning this current issue, the magazine team decided it would be a waste not to showcase our Industry Insight Teams’ expertise and knowledge of corporate finance activity around the world. Furthermore, in this issue, The Princeton Financier also proudly presents an article by Professor Emeritus Burton Malkiel, the famous proponent of the efficient market hypothesis and author of A Random Walk Down Wall Street. This issue was also fortunate enough to feature interviews with Professor J.C. de Swaan of Cornwall Capital as well as Joshua Rosenbaum and Joshua Pearl, co-authors of the best-selling book Investment Banking: Valuation, Leveraged Buyouts, and Mergers and Acquisitions.

Over a year has passed since the inception of the Princeton Corporate Finance Club, and in that year the club

has not only grown, but also continued to accomplish the mission of the organization. The education team has done a phenomenal job organizing our seminars, from the Food+Finance dinner series to the Occupy Wall Street forum to the firsthand account from insider trader Garrett Bauer. The mentorship team has worked tirelessly implementing two mentorship programs, one which paired underclassmen with upperclassmen who had been fortunate enough to gain experience in the industry and one which paired undergraduates with professionals who are currently working in the field of finance. In addition to their weekly newsletters and contribution to The Princeton Financier, the Industry Insight Teams just hosted their first of many MarketWatch events, which serves to give the undergraduate body an overview of the most important finance events that are occurring around the globe. Lastly, our Marketing, Media & Tech, and Finance teams have ensured the seamless execution of our events through their advertising and funding initiatives. It is only at the close of this year with the release of the second issue of The Princeton Financier that we, the PCFC family, can reflect on the success and growth of our organization. However, it is undeniable that without the enthusiasm of the Princeton undergraduate community, it would have been impossible to fully realize the aspirations of this organization.

Therefore the Princeton Corporate Finance Club thanks all of the students, both on and off the Board, who turned our endeavors into success and our hopes into reality.

FINANCE Ani Deshmukh ’13

-Luke Cheng ‘14

ALL CORRESPONDENCE MAY BE DIRECTED TO: The Princeton Financier 2818 Frist Center Princeton, NJ 08544 pcfc@princeton.edu www.princetoncfc.com

INTERESTED IN GETTING INVOLVED? Send an email to pcfc@princeton.edu

The Princeton

Financier 4 6 8 12 14 18 21 22 ABOUT PCFC

INSIDE: Investment Banking : Interview with Joshua Rosenbaum and Joshua Pearl The Glencore Xstrata Megadeal

by Julian He Investing in the East: Interview with J.C. de Swaan Interview by Luke Cheng and Eric Wang China’s Energy

by Sunny Jeon The Random Walk at Forty

by Burton Malkiel The Great Air War

by Tanoy Mandal Interest in No Interest: Banking in Indonesia

by Jason Nong Investment Banking in Nigeria

by Oladoyin Phillips

The mission of the Princeton Corporate Finance Club is to provide an educational and networking platform for Princeton students interested in investment banking, private equity, venture capital, and the field of corporate finance at large.

Established in March 2011, the Princeton Corporate Finance Club has quickly become a prominent club on the Princeton campus with over 300 student members and 20 officers working in six divisions: Education, Mentorship, Industry Insight, Finance, Marketing, and Communication & Technology.

Our core values are fraternity, entrepreneurship, leadership, responsibility, integrity, professionalism, and mutual respect.

INVESTMENT BANKING: Interview with CO-AUTHORS Joshua Rosenbaum and Joshua Pearl The Princeton Financier sits down with the authors of the best-selling valuation book Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions for an exclusive interview to hear insights about their book and recruiting on Wall Street‌ Recruiting on Wall Street has always been very competitive, even more so during the past several years. What advice would you give to a college junior/senior interviewing for Wall Street jobs in banking?

First and foremost your resume needs to be in pristine shape. Candidates must have strong grades, leadership experience and other indicators of high achievement. Having a strong resume is needed to at least get invited to interview.

We have recruited and conducted interviews on-campus for many years and what truly distinguishes students in interviews is knowledge of financial markets and technical skills. Interviewers are always impressed if a student knows the complexities of valuing and modeling companies and is able to articulate them in a concise manner. Technical questions are extremely common and mastery of them is usually what separates the tens of thousands of students who interview on Wall Street.

Could you describe a typical day in investment banking?

There is no typical day in investment banking. It could include anything from creating pitchbooks to detailed modeling

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to accompanying a management team on a roadshow. An analyst working in a coverage group (financial institutions, industrials, media, etc.) has the opportunity to work on various products, including M&A, LBOs, and debt / equity offerings. Day to day responsibilities can change dramatically depending on client needs or deal process deadlines.

An analyst working in a product group (leveraged finance, equity capital markets, M&A etc.) has the opportunity to work across various coverage groups. As a result, these analysts need to gain a mastery of different sectors quickly. As anyone seriously considering entering investment banking knows, the hours are very demanding. This is definitely not a myth.

Why do you believe an investment banking job is desirable for those who have just graduated from college?

Any advice on selecting one bank over another?

If you are interested in a career in finance, we would argue that an investment banking analyst position is the best career choice you can make for your first two years out of college. After only a few months on the job, an analyst is given tremendous responsibility and those responsibilities continue to increase based on merit. The skill set developed in an investment banking program is extremely valuable and include: accounting, advanced financial modeling and valuation, as well as communication and presentations skills. In addition, an analyst position can be the gateway to alternative career paths, including private equity and hedge fund jobs.

At the analyst level, whether you select a bulge bracket bank or boutique, the skill set learned is nearly the same. The key differentiator should be the people – in our view, it is important to select a bank where mentoring is strongly encouraged.

During the recruiting process, you will have the opportunity to meet numerous firms and bankers. This is the time to network and develop initial relationships.

After meeting several bankers from the same firm, you will begin to see patterns in attitudes and behaviors that should be indicative of their firm’s culture. In addition, speak with friends and alumni at the various banks as they can provide you with a more comprehensive overview of the firm and its culture.

What inspired or motivated you to write a book about investment banking? How is Investment Banking different from other finance books on the market?

We both went through the recruiting process at our respective schools, and even though we were fortunate enough to land jobs, we realized that a lot of the knowledge required for the interviewing process (and eventually on the job) was not easily accessible in books or even in the classroom. All of the finance books we read for interviewing and preparing for our full-time Wall Street positions were written by professors or former finance practitioners and centered on theory. Although these books gave us a solid foundation in finance, they lacked a practical approach, and thus were far less applicable to how finance is actually practiced in investment banks. From our own classroom experience, we witnessed firsthand the disconnect between theory and practice. Universities and other

finance books provide a great foundation but lack the real-world applications that are needed to understand the highly specialized world of investment banking.

The need for a book on the practical aspects of banking written by current bankers motivated us to undertake the herculean effort to write our book.

Throughout the process, we consulted with top bankers, private equity investors, hedge fund professionals, corporate lawyers, accountants, and business school professors. In short, Investment Banking is the book we wish we had when we were interviewing and starting on Wall Street.

firms, corporate law firms, and over 100 undergraduate and MBA programs around the world. In addition, we were featured in the Wall Street Journal, and several Wall Street legends have recommended our book, including Joseph Perella, David Rubenstein, Thomas H. Lee, and Josh Harris. Professor Josh Lerner from Harvard Business School and Professor Roger Ibbotson from Yale School of Management have also praised the book. Since its publication in May 2009, the book has been, and continues to be, the best-selling valuation book in the world.

The book you wrote is approaching its three year anniversary. How has the feedback been since its publication?

Do you plan to continue writing other books on finance?

The feedback we have received has been incredible. Our book is currently being used by numerous bulge bracket investment banks, private equity firms, hedge funds, management consulting

We certainly hope so! The acclaim and popularity of Investment Banking has exceeded our expectations and we look forward to potentially writing future editions or authoring different titles in the future.

The Princeton Financier | 5

On February 7, 2012, mining giants Glencore International and Xstrata agreed to a $90 billion merger deal. For the past several months, most of the M&A spotlights have been on this blockbuster merger. This merger, combining the world’s largest commodities trading company and one of the world’s largest mining companies, has the potential to change the game and permanently reshape the mining industry.

Let us begin with a brief description of both companies. Glencore is a mining and commodities trading company giant.

As the world’s largest commodities trading company, Glencore holds major market shares in a variety of internationally tradeable commodities markets. Xstrata is the world’s fifth largest mining company by market capitalization, with its Xstrata Alloys unit being the world’s largest producer of ferrochrome, an alloy popularly used in the production of stainless steel. Both companies are headquartered in Switzerland and listed on the FTSE 100 Index. Before the merger, Glencore already had a 34% stake in Xstrata, making the mining giant the biggest investor in Xstrata. Glencore and Xstrata, knowing that they their coexistence as two separate entities will not be sustaintable, have been eyeing a merger for a long time.

In this article, we will relive the drama and go through the numbers behind this colossal deal. Then we will examine the potential impact this deal has and the challenges it faces.

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The relationship between Glencore CEO Ivan Glasenberg and Xstrata CEO Mick Davis has always been a tricky one. In October 2001, Gasenberg appointed Davis, a Glencore employee, as Xstrata’s chief executive before the mining company went public. Now, ten years later, Glasenberg and Davis are going back and forth on the negotiating table since Davis is repeatedly rebuffing Glasenberg’s offers. After the merger proposal was accepted, another big hurdle emerged: who will head the combined entity? Sources have indicated that under proposed terms, Davis would be in charge of the new company while Glasenberg would serve as deputy CEO. However, can Glasenberg, the man who gave Davis power 10 years ago, play second fiddle to Davis for long?

The majority of the problems with the deal has been generated by Glencore and Xstrata’s disagreement on premium terms.

Xstrata investors arethreatening to block the deal, because they believe that Xstrata’s growth potential will be much more substantial than Glencore’s over the next 10 years. Xstrata investors are convinced that the lack of a hefty premium would be severely against their interests.

“If people think that major shareholders can just be railroaded into a cosy deal, then they should think twice,” Schroders, the 13th-biggest investor in Xstrata, said.

To appease Xstrata investors, Glencore tried to sweeten other parts of the merger terms. According to the Wall Street Journal, it is likely that structuring the

deal as a merger of equals, rather than a takeover of Xstrata, brought Davis back to deal talks after he originally rejected Glasenberg’s previous offers. In addition, Glencore proposed to populate the new board with Xstrata executives, offering Xstrata’s Trevor Reid the CFO position, John Bond the chairman position, and Mick Davis the CEO position of the would be merged entity, Glencore Xstrata International.

Still, Xstrata investors were not satisfied.

“Putting Mick up as chief executive is not going to do the deal for us. We won’t be appeased like this.” One investor said.

Glasenberg, on the other hand, insisted that the premium was fair. “This is a merger of equals. Xstrata has got most of the senior jobs. Most previous mergers of equals were done at a ratio of equals - this deal ... has been done at a premium,” Mr. Glasenberg told Reuters. “We believe it is a fair deal, fair to all shareholders.”

Current deal terms have Glencore offering 2.8 Glencore shares for each Xstrata share. Even though the vote is due in May, Glasenberg has started his campaign to woo Xstrata investors.

Analyst Nik Stanojevic with Brewie Dolphin Investment said that it would be too early for Glencore to increase its premium and he expected the bid to be raised to a ratio close to three as the voting approaches in May. With all the focus on premium terms and market capitalization, let’s go over the valuation numbers behind this

momentous deal. As of March 20, Glencore has a $48 billion market cap while Xstrata’s market cap stands at $56.6 billion. Considering Xstrata’s significant size, Glencore wants a merger, which will save Glencore the takeover premium. On the other hand, Xstrata wants a takeover, citing the fact that Glencore already owns a 34% Xstrata stake and a hefty takeover premium is justified by Xstrata’s significant growth prospects.

Do Xstrata’s growth prospects justify a 20% premium that Xstrata shareholders are demanding? From the interests of a shareholder, such a premium is indeed justified. In addition to Glencore’s 34% stake in Xstrata, the merger will give Glencore shareholders approximately 58% control of the merged company.

Thus, it is reasonable that Xstrata investors complain that the currently structured deal hurts their interests. In addition, Xstrata investors are correct in saying that Xstrata has the better quality assets and earnings than Glencore.

However, from a value standpoint, a 20% premium is not justified. According to Credit Suisse, channeling Xstrata’s production through Glencore’s marketing arm would produce a capitalized value of around $4.8 billion, which would justify a premium of approximately 16%.

Premium argument aside, the colossal mining company created by the merger surely looks intimidating. Credit Suisse estimates that the new company will have revenue of $211.3 billion, EBITDA of $15.8 billion and net profit of $7.5 billion.

Mining would comprise 83% of the total revenue. In contrast, BHP Billiton, the largest mining company by revenue, had revenue of $72 billion in 2011, while Vale, the second largest mining company, posted revenue of $60.4 billion.

Although Glencore Xstrata International is targeting a market cap of $59.3 billion, they will still fall behind BHP Billiton ($104.6 billion) and Vale ($118.8 billion) in market capitalization, according to Yahoo! Finance. Glencore Xstrata International, created by the largest mining deal in history, will have a huge impact on the company itself, its mining

rivals, and the mining industry as a whole.

Since Xstrata will specialize in mining production and Glencore will focus on other areas of the business such as marketing and trading, the merger will create a vertically integrated mining giant that combines production, sales and trading. Furthermore, since Glencore also has mining operations around the world, the merger can also be considered a horizontal integration. This unique model of vertical and horizontal integration will provide the merged company more flexible control over inputs and improved supply chain coordination and increased market power.

“It would be a unique business model.

Glencore provides the marketing and Xstrata the operational base. It could be a new model for the industry although it would be difficult to replicate by others.

This is quite a unique circumstance,” said one long-term industry observer.

However, a vertical integration in the mining industry is unprecedented. In other words, Glencore and Xstrata are trying to succeed in where others have failed before. Their main obstacle will be the relatively low earnings from trading compared to that from mining production.

As for the mining industry, this deal has the potential to be a game changer.

Competitors have to rethink their game plan to rival this newly created giant.

They will either have to stick to their plan of generating organic growth or seek quick growth and expansion through mergers and acquisitions. If GlencoreXstrata’s vertical integration is successful, competitors might have to consider following the model. On the other hand, midsize mining firms will likely be forced to either merge with firms of comparable size or be acquired by larger companies since it is now even more difficult for them to compete. “The long anticipated merger of Glencore and Xstrata could set off a new round of consolidation in the mining industry,” TD Securities analyst Greg Barnes said.

Some analysts, citing Glencore and Xstrata’s shared relationship, see the

merger as a non-event in the mining industry. “The analogy is they’ve been dating for several years and now they’ve announced their engagement,” said analyst John Hughes of Desjardins Securities. “It doesn’t mean everyone else is going to get married.”

Nonetheless, Glencore Xstrata International will be the world’s fifth largest mining company by market value, behind BHP Billiton, Vale, Rio Tinto and China Shenhua Energy. Its unique model and colossal size cannot be underestimated. With two dealhungry CEO’s always looking for M&A opportunities, the new mining giant will only become a larger and more dangerous player in the mining industry.

The main challenges the merger deal faced were from Xstrata investors and European Union regulators. For the angry Xstrata investors, Glasenberg and Davis have to explain what advantages Glencore’s low-margin trading arm brings to the combined entity. The difficult challenge of settling on an appropriate premium will be a major roadblock for the merger deal.

Other than the challenges Glencore faces from Xstrata investors, the merger is also expected to face headwind from the European Union regulators. The EU, which blocked BHP Billiton’s takeover attempt of Rio Tinto due to antitrust concerns, is known as the most powerful antitrust regulator in the world. However, it might be easier for Glencore because it already owns a little more than a third of Xstrata’s stake.

With a colossal deal comes two colossal obstacles. Analysts think it will take quite a long time for Glencore to clear all the hurdles.“If they can get the deal done by next March 1sr, that’s a good outcome,” says Sigurd Mareels, director of mining research for McKinsey & Co. “It could take two or three years.” It remains to be seen how the megadeal will fare against Xstrata investors and regulators. However, it is certain that this deal, if successful, will create a dangerous mining predator and reshape the mining industry.

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INVESTING IN CHINA : INTE RVIE W WITH J.C . DE SWA AN

J.C. de Swaan is a lecturer in the economics department at Princeton University and a Principal at Cornwall Capital, a global macro and special situations hedge fund based in New York. He also teaches at the University of Cambridge and has previously taught at Yale University and Cheung Kong Business School in Beijing. Prior to Cornwall, he was an adviser to the CIO and Chief Economist of Caxton Associates, a global macro fund, and a Principal at Sansar Capital, an Asia-dedicated hedge fund. After graduate school, J.C. spent five years at McKinsey & Company in the New York and Singapore offices. He received his B.A. from Yale University in Political Science, an MPhil in International Relations from the University of Cambridge, and a Masters in Public Policy from Harvard University’s Kennedy School of Government. He is a member of the Council on Foreign Relations.

The Princeton Financier: You spent five years in McKinsey’s Corporate Finance Strategy Practice; what did you learn from your time there, and why did you decide to switch to investing in Asian capital markets?

JCdS: McKinsey is a wonderful place to start a career regardless of what you ultimately want to do. I went there having in mind that I’d spend a couple of years and ended up spending five years, based in New York, with a long stint in Asia. McKinsey provided me an opportunity to learn a broad set of skills in an environment that is obsessively focused on skill development and improvement. Most of all, I met a lot of interesting and thoughtful people. I was particularly interested in finance, and the corporate finance practice gave me exposure to a wide range of projects that had a finance component—for instance, helping a private equity firm think through a potential acquisition or helping a company optimize its portfolio of businesses.

My original interest was economic development—that’s what I studied in school—and over time, I became interested in investing in emerging markets as an expression of that interest.

And so I left McKinsey to join an Asiafocused long/short equity fund that had a very bottoms-up, fundamental approach to investing. I was able to make that switch because some of the skills I acquired at McKinsey were well suited to doing fundamental investment analysis. I was always interested in broad macroeconomic trends, and since then I’ve used a bottomsup approach to identify macro and special situation investment opportunities.

I started teaching four years ago, first at Yale for a semester and since then at Princeton. In conjunction with that, I’m part of a fund called Cornwall Capital. Cornwall Capital doesn’t fit

neatly into any of the traditional hedge fund buckets. We look for asymmetric situations by trying to identify market inefficiencies across all asset classes. That usually involves buying options though at times we buy outright equities that have option-like characteristics.

What are some difficulties that you face as a Westerner trying to understand Chinese companies? How do you know you are getting accurate information?

JCdS: It’s an unusual transition, because most people who end up working in hedge funds are folks who are obsessed with markets and were so from a very early stage in their career. That just wasn’t the case with me. I came to investing from a very structured decision-making process that led me to want to become an investor focused on emerging markets.

It so happened that I had some skills that were transferrable and allowed me to get a foot in the door. I switched to investing relatively late. I wouldn’t necessarily recommend that path; it wasn’t a path that I deliberately took in order to become an investor. I just developed that interest over time.

JCdS: The challenge in knowing whether you’re getting accurate information is very real, and I’ve learned that the hard way. Perhaps you’ve read about the headline corporate governance blow-ups that occurred in 2011, which involved companies that had been vetted by some of the top PE firms in China. Those PE firms employed sophisticated native Mandarin investment professionals and had deployed a fair amount of resources in their due diligence, and they still weren’t able to get it right. It’s hard to say with conviction that you can catch accounting issues systematically in China. You can’t rely solely on what management says and what the auditors sign off on; you have to triangulate in all sorts of ways by talking to competitors, and when possible customers and suppliers, and by going on the ground to check whether, say, the factories are working at capacity or the stores are busy.

Do you plan to stay in the investment world for the time being?

Are there a lot of corporate governance issues with Chinese companies?

JCdS: Yes though it’s hard for me to imagine doing it without teaching as teaching is very complementary—it allows me to step back and try to be more thoughtful about trends and dynamics I observe. One of the things I like about investing, particularly in global fundamental investments, is staying on top of political and economic news for what I do professionally, and that’s exciting for somebody that is curious about the world.

At McKinsey, I could spend six months on a project being embedded deep in the business unit of our client addressing a specific business issue, and I could be oblivious to what was happening in the world, at least professionally.

JCdS: Yes, the corporate governance issues related to small and mid-sized companies in China typically have to do with CEOs treating the listed company they manage as their own private company and treating the company’s assets as their own. The CEOs of small and mid-caps are typically founders. They’re very successful entrepreneurs that at some point decided to raise capital by listing their company but haven’t had much experience in dealing with capital markets. Corporate governance issues are extremely prevalent among these companies. Now this being said, I’m optimistic about the ability of Chinese companies to improve on their corporate governance issues. The research

Was it a difficult transition to go from management consulting to investing?

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shows that there’s a correlation between the level of development of a financial system and a country’s overall level of corporate governance. China ranks very low globally but it’s tracking along where you would expect it to be. As capital markets develop and a greater proportion of funding comes from bond and equity issuance, the tougher it is to mask an egregious transgression as so many more financial actors end up doing due diligence on the company. And you compare that with a situation where you’re getting most of your funding through a bank loan, where you’re dealing with a loan officer as opposed to dozens or hundreds of financial analysts that are scrutinizing you. By contrast, I’m quite pessimistic about Japan—Japan has very different

of poison pills, for instance, to defend themselves against takeovers, even in situations where that might clearly benefit the shareholders.

Do you still go to China yourself to do bottoms-up analysis?

JCdS: My model is that I typically have conference calls with Chinese companies every week. It’s the same set of management teams that I talk to on either a monthly basis or every couple of months. Because I’ve talked to these companies for years, it allows me to get a better sense for when there’s an inflection point. These companies might be leaders in various sectors of the economy, so from these ground level micro data points, I

I typically have conference calls with Chinese companies every week. It’s the same set of management teams that I talk to on either a monthly basis or every couple of months. Because I’ve talked to these companies for years, it allows me to get a better sense for when there’s an inflection point.

types of corporate governance issues, yet it ranks as low as China in international rankings despite already having fairly sophisticated capital markets. I’ve been involved in Japan for some years now, and I am less comfortable with the type of corporate governance issues that you find there versus those that you find in China.

try to tease out some macro trends. In addition, I go to China several times a year and do my due diligence there, where I’ll meet a lot of companies and government officials. I also teach in China, and I learn more from my students than they learn from me.

Can you specify what kind of corporate government issues occur with Japanese companies?

JCdS: I do not, but I have in the past worked with colleagues that do. My contacts tend to be CFOs, CEOs or IR officers of listed companies and they typically speak English. For deep due diligence I definitely need to work with Mandarin speakers.

JCdS: They typically come down to mechanisms that prop up the status quo and favor incumbent companies over challengers. There’s a big premium on keeping things as they are, which means it’s hard for anyone to effect change.

The market for corporate control is not dynamic as a result, and you see examples of situations where local courts favor companies that employ egregious forms

But you don’t speak Mandarin, correct?

Many investors right now are worried that growth in China is slowing. Combined with worries about decreasing exports to Europe and contracting manufacturing activity, the picture painted by the media is quite glum. What are your thoughts

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on future prospects for China’s economic growth?

JCdS: China has had an extraordinary run but now it needs to rebalance the economy and smooth the path toward slower, more sustainable growth. So far we haven’t seen signs yet that they’re making progress in having consumption become a greater driver of growth. The near term challenge is that they’re constrained in their ability to stimulate the economy as there’s a significant overhang of NPLs (non performing loans) from the flood of liquidity that was unleashed on the economy in 2009. Another significant challenge is the property market which the government is struggling to micromanage in order to compensate for the bubble-inducing distortions of its capital controls.

How did the global financial crisis affect long short equity firms that invested in China?

JCdS: A lot of hedge funds were formed during the big bull market of the mid 2000s. That made bottoms up investment in Asia more challenging because many more funds were looking for the same opportunities, so it pushed them to invest in less and less liquid companies whose valuation hadn’t shot up yet. The challenge is that many funds ended up being leveraged beta vehicles rather than pure alpha seeking funds, and when the global financial crisis hit they found themselves very long the market and on top of that, they were long illiquid companies and short the most liquid ones, exposing themselves to a mismatch.

A relatively high proportion of funds that were launched in the 2000s ended up being deeply under their high watermark and many of them are still below it now or have folded at this point. Your average Asia-focused long-short equity fund was down 29% in 2008. That means on average they have had to generate more than 40% of gains on average just to start earnings incentive fees again (because they’re supposed to make up for all of their losses), a daunting task.

In a recent dinnertime talk on campus, you mentioned that firms similar to Tiger Asia and Sansar Capital proliferated between 2005 and 2008, and competition increased significantly during that time. Is the same thing going to happen in the upcoming years as we recover from the global financial crisis?

JCdS: The dynamics are different now.

We have been seeing new launches in the Asian space, some of them large ($1 billion in AUM or more). The difference between the new batch of funds that are being launched and the ones that were launched up to the global financial crisis is that most of the larger funds were being launched out of New York and London whereas now most of the larger Asia-dedicated funds are being launched out of Asia, generally Hong Kong and Singapore. It’s much harder now to try to raise money for an Asia-focused fund and justify being based in New York or London.

Where do you see the Chinese housing market heading in the near future? How do Chinese government policies come into play?

JCdS: The challenge with the housing market in China is that it’s fundamentally distorted because of capital controls that China has maintained over the years.

Chinese households basically only have three channels to invest their savings.

It’s either low yield deposit and savings accounts, which have generated negative real yields for some time now, the onshore (A share) equity market, or real estate.

Real estate is the only asset class that has consistently made money in China.

The reason they only have these three channels is because they’re not allowed to invest overseas except through controlled programs that have tight quotas. So there’s been a huge demand for real estate as an investment class. Because of the distortion in the market, there has been a natural propensity for bubbles to form.

What the government has done is to control that bubble by micro-managing cycles. When property prices go up too quickly, the government introduces new measures to dampen demand, typically creating administrative constraints on

purchasing a second or third apartment, raising the deposit requirement, making it harder to get a mortgage, and so on.

They reverse these measures once prices have come in. And that’s worked for the last few years, but it’s not clear that it’s working in this current cycle. The government started imposing measures two years ago but it’s still not comfortable with where prices are, and in fact Premier Wen at the conclusion of the NPC (National Party Congress) said that property prices were still far, far away from where they should be. We’ve seen volumes collapse since mid October.

While prices have gone down by single digit percentages on average, and a bit more in Tier 1 cities. We’re seeing 25 – 30% declines but it’s usually in suburban areas away from city centers. Developers have held on to their inventories for such a long period of time, assuming that the government was going to relax measures after Chinese New Year, and that is not happening so developers are going to need to clear out a lot of inventory, which could create a dislocation in the market.

be the case, including the public listing of many of the top investment banks that used to be partnerships as well as the short term horizon of most compensation on Wall Street. I also suspect that the short term focus of incentives tends to create a greater risk of “bounded awareness” (a behavioral ethics concept). If you take for instance a financial professional working in an investment bank, that professional is so deeply embedded in a complex web of short term incentives and daily institutional pressure that he/she may not even be aware or become oblivious to the ethical dimension of decisions they make on a day to day basis.

Why is this cycle different from previous ones?

What do you think of the Occupy Wall Street movement? The Occupy Princeton Movement?

JCdS: Inherently, the government is trying to compensate for distortions in the system. The more it applies bandaids through these temporary measures, the more the fundamental bubble will continue forming. An added challenge is that there was an enormous amount of liquidity that was injected in the system in 2009 coming out of the global financial crisis and a lot of that liquidity found its way into the real estate sector.

As a professor teaching a course on ethics in the finance industry, what do you think about the moral issues raised by the financial crisis? Is the current state of ethics on Wall Street on the decline?

JCdS: It’s hard to say whether there is a higher prevalence of ethical transgressions but there’s definitely a sense that financial institutions tend to be more short-term focused than in the past, and that has a tendency to create greater conflicts of interest. One could point to many different structural reasons why that might

Regarding the moral issues raised by the financial crisis—there is a fundamental question of fairness tied to the fact that financial institutions have increased their risks and returns over the last decades through higher leverage but that while the returns have largely accrued to managers and to a lesser extent shareholders, the downside risks have been borne by society.

JCdS: The Occupy Movement certainly resonated with me. It’s hard not to feel that there’s something amiss in the system, and more generally, there’s a lack of fairness. It’s disappointing that the movement hasn’t coalesced around a set of very actionable targeted demands, but that could still happen eventually.

Lastly, what is your favorite news source?

What is your favorite news source for keeping up with the Chinese market?

JCdS: Like every market practitioner, I’m generally glued to my Bloomberg screen though if I had to pick only one source to look at I’d probably stick to a generalist publication, the Economist.

My favorite news source for keeping up with the Chinese market is Caijing (english.caijing.com.cn) which does solid investigative work.

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CHINA’S ENERGY

By Sunny Jeon The second half of the 20th century spurred an unprecedented shift in China’s energy sector. Post WWII-China plunged into Soviet-style industrialization, moving away from agriculture to energyintensive industries based in steel and cement. These industries grew to occupy nearly half of China’s overall economic output. Yet China’s full potential was only unleashed after 1978, when the country slowly loosened its stringent command-and-control approach to allow for limited free market aspects. By 2001, additional factors—such as falling trade barriers facilitating the acquisition of energy efficient technology—had raised China’s energy demand to 10% of global energy demand.

The first decade of the 21st century brought even faster changes, with Chinese energy consumption growing four times faster than predicted and rising to over 15% of overall global demand. China’s present growth is largely explained by the rise of energy-intensive heavy industry, although a significant driver has and continues to be consumption-driven energy demand and transportation. Still, the industrial demand remains the most important, accounting for 70% of total Chinese energy consumption.

China’s surge as an international energy player in its own right cannot be understated. Until recently, the Chinese energy industry’s major players— including PetroChina, Sinopec and CNNOC—focused on politically volatile regions, such as Iran, Sudan or Venezuela.

However, an increase in deals such as PetroChina’s 2011 purchase of a 50% stake in a Canadian gas venture for $5.4 million signaled a radical transformation in the Chinese energy industry’s M&A strategies, and a fundamental shift in China’s relationship with the United States. Since 2010, Chinese companies have invested over $17 billion in American and Canadian oil and gas deals.

These deals represent an increased interest from Chinese corporations in gaining a foothold in regions characterized by their innovative drilling techniques. Most deals have involved the Chinese firms’ upfront payment for a stake in a gas or oil field, thus providing a nonthreatening joint venture, joining the technologyrich Canadian companies with capital from less technologically avadanced Chineese firms. Examples of past deals include a 2010 deal by Sinopec for a 9% stake in Alberta’s Syncrude oilsands project for $4.65 billion, one of Canada’s largest energy projects. Overall, the goal of Chinese companies has been

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to further their current knowledge and investment in international opportunities in order to begin developing and deploying their own technological advancements in the near future.

China’s surpassing of the United States as the world’s largest energy consumer reflected a new energy era; the energyhungry dragon dethroned the position the U.S. had held since the early 1900s.

The change came at a breakneck pace.

China’s energy needs were at barely half of that of the United States’ in the 1990s, but China’s double-digit growth rates had propelled it to number one.

Yet the rise to the top was not without its hurdles, including an equally pressing and growing need to switch to more sustainable energy sources, as well as a constant evolution in the Chinese approach to the world’s energy markets.

Chinese corporations quickly realized the necessity of learning the rules of a game they had recently entered. In 2005, CNOOC’s $18.5 billion bid for a takeover of Unocal Corp. taught Chinese corporations a new lesson: they would have to invest in overseas ventures and minority stakes, rather than takeovers or majority stakes, to gain global energy resources.

Yet this move has not been without its drawbacks. Along with its acquisition of breakneck growth, China has acquired the energy problems—particularly oil addiction—of the developed nations that are its investment partners. This change has raised fears that even China’s current efforts to curb unsustainable energy growth through massive investments in renewable energy, such as wind turbines and solar energy experimentation, will reach the country too late. For example, a particular problem is a Chinese car consumption culture that rivals that of the United States’, which has fueled an increasingly unsustainable Chinese dependence upon oil. Continued increases in Chinese oil prices to $4.42 a gallon in late March of this year—a 7% hike over earlier prices—exemplify efforts to battle the country’s insatiable oil appetite.

The costs of growth have continued to accumulate, and one of the most visibly negative effects has been the proliferation of Chinese pollution. Shrouded in their ubiquitous gray cloak, only 1% of China’s 560 million city dwellers have air deemed safe by the European Union.

Just as China’s rise as an influential economic powerhouse has no historical precedent, so have its environmental problems proceeded without precedent, challenging both the Chinese public and government to control its economic beast.

As of now, Chinese citizens are being paradoxically harmed by the spillover of China’s economic growth; pollution has become China’s leading cause of death.

Yet this is not a problem that be confined to China alone—by virtue of its vast scale and size, China’s problem has become the world’s problem as well. China is now the world’s leading producer of greenhouses gases, overtaking the United States, the former holder of that title.

This awareness of the devastating costs of development has given rise to an environmentally conscious energy sector, which asks the question: can China go green? China’s 12th five-year plan, made in 2010, places particular emphasis on reducing coal reliance and increasing substantial research into new technologies. In implementing tougher regulations for its most energy-intensive industries within steel and textile manufacturing, China has made its goals clear. However, its efforts to reduce its carbon footprint and its dependence upon fossil fuels come with a refusal to agree to targets set by multinational agreements. Instead, China has opted to adjust its energy policies and practice a voluntary, self-enforced program.

While the future seems relatively optimistic as China continues to manifest a vested interest in cleaner energy technologies, the truth is that China has struggled to meet its past goals. Half of the country’s self-imposed 2011 targets for clean air and water, such as sulfur dioxide emissions and water pollutions, were not met.

Zhang Ping, head of China’s National Development and Reform Commission, acknowledged the country’s failure, citing

“complicated reasons for failing to meet the targets”, with the largest rationale being an incompletely transformed economic development model. A 2% drop in 2011 of China’s energy consumption per unit of GDP—significantly less than the targeted 3.5%—provides evidence for the continued frustration of China’s plans.

China’s failure to meet energy targets have formed the basis for international conflicts concerning China’s attempts at pollution reduction. A substantial part of the problem has been the historical practices of Chinese enterprises, which have found it cheaper to simply pollute and pay fines, rather than invest in preventative measures through modern, cleaner technology.

What, precisely, are the renewable energy deals that give hope to a cleaner energy future for China? Perhaps most symbolically, the wind-swept desert of Gansu—China’s first oilfield and notorious for its environmental abuse— has begun undergoing changes. The construction of wind turbines, with their three-pronged arms stretching out into the landscape, has given the project hope for potentially becoming the world’s largest wind farm by 2015. It is a representation of the dichotomy of the current Chinese energy industry. China currently emits the most CO2 of any country in the world, yet is building 36 wind turbines every day and is on the road to supplying 15% of the country’s energy needs by 2020. This energy will primarily come from nuclear and hydropower sources, but there has been extensive research done into the potential of wind and solar energy.

In addition, China’s needs have pushed ahead the frontiers of sustainable environmental technology. Because of this dire need to satisfy a growing thirst for energy consumption, China has invested in clean-tech projects that have yet to even be attempted in the United States. For example, a $1.25 billion deal between China Wanxiang Holdings and GreatPoint Energy in February of this year will take mined coal in the Gobi desert and change it to natural gas to be transported to the country’s expanding urban cities. By 2015, the partnership is projected to provide 0.5% of China’s

energy needs. Solar energy, in particular, represents a vehicle for change and is evidence of China’s vested interest in renewable energy. China’s remarkable commitment to becoming the dominant player in green energy, particular solar power, has made Chinese companies the lead players in solar panel production.

Suntech Power Holdings, China’s largest solar panel manufacturer, has already implemented efforts to build on its current market share by selling solar panels in the American market for a smaller price than the cost of even acquiring the raw materials. Strong government support has aided Chinese corporations, allowing them to bypass the United States’ legislation aimed at protecting their domestic industry by building Chinese assembly plants within the United States. Suntech’s particular progress mirrors the overall trajectory for China’s solar power industry—it now only needs to surpass Arizona’s First Solar in order to become the world’s largest supplier of photovoltaic cells. However, in its current state, solar energy is not a failproof solution to China’s energy problems. One particularly formidable obstacle is that solar energy technology has not lived up to its potential in aiding Chinese energy needs, since 98% of Suntech’s energy production goes overseas. In addition, Chinese companies have experience significant backlash from American companies, a sentiment that is also reflected by the Obama administration’s efforts, such as a $2.3 billion tax credit to equipment manufacturers of clean energy. For China, it will be an uphill battle for green energy, even as its potential continues to motivate efforts to harness it.

China’s position as the world’s dominant energy consumer continues to present challenges for the future. Yet Chinese policies have made substantial progress in beginning to address renewable energy needs, and if done correctly, the future seems cautiously optimistic for sustainable policies. Ultimately, the continued prosperity of one of the world’s largest economic success stories will be hinged upon responsibly developing the driver of its industrial heart: energy.

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Burton Malkiel is Chemical Bank Chairman’s Professor of Economics Emeritius and celebrated author of the investment management classic A Random Walk Down Wall Street which is now in its tenth edition.

Malkiel has been a member of the Princeton faculty since 1960 with the exception of 1981 – 1988 and has twice chaired the Department of Economics and the Financial Research Center. Among his numerous distinguished positions, he served as a member of the U.S. President’s Council of Economic Advisers (1975 and 1977), president of the American Finance Association (1978), and dean of the Yale School of Management (1981 – 1988). His bibliography dated November 2009 includes 12 books and 174 articles not including his numerous OpEd pieces for The Wall Street Journal and other publications. Prior to his academic career, he spent 28 years as director of the Vanguard Group. Burton Malkiel received his bachelor’s degree and MBA from Harvard University and his doctorate from Princeton University.

It has now been 40 years since the first edition of A Random Walk Down Wall Street was published. The book, now in its 10th edition, had a very simple message. Our financial markets are really remarkably efficient. When information arises about the prospects for individual companies or for the stock market as a whole, that information gets quickly incorporated into stock market prices as legions of professional investors make purchases or sales that ensure that no opportunities for unusual profits remain unexploited. Stock prices may not always be correct (the stock market can

sometimes be egregiously wrong), but at any point in time no one knows if they are too high or too low.

This notion of informational efficiency has two important implications for investors. First, it suggests that stock prices will fluctuate randomly. Stock prices will change on the receipt of good or bad news. News of a new oil discovery or approval of a new drug will tend to make the stock price of the company involved go up. News of an oil spill or harmful side effects for an existing drug will lead to a price decline. But true news

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is random, that is, it cannot be predicted on the basis of past information. Hence, stock prices are likely to be unpredictable and neither past stock charts nor the “fundamental analysis” of accounting data, company strategy, etc. will enable either professionals or amateurs to consistently predict future stock prices.

Stock prices will evolve much like a mathematical “random walk” where future prices are unrelated to those existing in the past.

The second implication for investors is that the market is virtually impossible

to beat. Active portfolio management, where purchases and sales are made in an attempt to find “undervalued” or “overvalued” securities, will prove to be useless. It will result in added transactions costs, possibly higher taxes, and larger management fees for investors who buy actively-managed mutual funds. In 1973 I recommended that the best strategy for investors was to buy a so-called “index fund” that bought and held a portfolio of all the stocks in the market.

Unfortunately, in 1973 index funds did not exist. I wrote in the first edition: “It’s about time they did”.

This paper takes an in-depth look at the message of Random Walk and whether the basic advice it offered is still relevant today. It also reviews the vast changes in our securities markets over the past forty years. My conclusion is simple: The thesis of the book has held up remarkably well since its original publication, and changes in securities markets have made the implementation of the recommended investment strategy available to all investors—no matter how modest their assets might be .

Changes in Financial Markets: 1973-2012 Participants in financial markets during 1973 would hardly recognize the instruments and institutions that characterize the financial landscape in 2012. When Random Walk was first

published we did not have money market funds, tax-exempt funds, emergingmarket investment instruments, targetdate funds, or real estate investment trusts (REITS), to name a few of the alternatives available to individual investors today. Similarly, new kinds of investment instruments have appeared, among them asset backed securities, zerocoupon bonds, exchange-trade financial and commodity options, and volatility derivatives. Roth IRAs and 529 college savings plans have provided new ways for investors to minimize their taxes, and the end of fixed brokerage commissions and new trading techniques such as high frequency trading have fundamentally altered the investment landscape.

But as far as readers of early editions of this book are concerned, perhaps the biggest change began in 1976, when the Vanguard Group of Investment Companies offered

the first equity index fund. Today, index funds are available to the general public with minimal annual expense charges of seven basis points—0.07 of 1%—or less.

And the ETF (exchange traded fund) cousins of index funds can be purchased by individual investors with zero commissions at some discount brokers.

Not all financial innovations have been unambiguously helpful to investors and to the economy. But the creation of low cost index funds (which now account for over a quarter of all equity mutual fund assets) and ETFs have dramatically improved the options available to individual investors.

Today, investors can easily implement the investment strategies recommended in A Random Walk Down Wall Street.

How well has the advice given in Random Walk held up over time?

The true test of any hypothesis is whether its predictions work out in practice. Similarly, the true test of the investment advice I offered in 1973 is whether an investor following that advice would have fared better than she would following conventional wisdom. Is it true that professional investors fail to beat the market? Is it true that the investor who simply buys and holds a broad-based index fund would have enjoyed a better economic outcome than the investor who used conventional professionally-managed (actively-managed) mutual funds? I believe the answer to both questions is an undeniable “yes”.

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Exhibit 1 compares the performance of all actively-managed mutual funds specializing in large-capitalization stocks with the (large-cap) Standard & Poor’s 500 stock index (which contains a bit less than three-quarters of the total capitalization of the United States stock market). In 2011, 83% of active professional managers were outperformed by the unmanaged S&P 500 Index. To be sure, 2011 was an unusually favorable year for indexing. In most years the typical percentage of active managers who fail to beat the market is about two-thirds, as is shown in the 10and 20-year data in the exhibit. But while around one-third of professional managers do beat the market in a typical year, the third that do so in one year are not the same as the ones who are “winners” the next year. There is little or no persistence in the ability of managers to outperform the market.

Exhibit 2 presents data for the past five years. It compares professionally managed funds against a relevant set of benchmarks. Professional managers who specialize in investing in smaller companies are compared with a smallcap index. Managers who specialize in international equities are compared with an international index. Interestingly, 86% of emerging-market managers are beaten by an emerging markets index.

Supposedly, emerging markets are less efficient than the U.S. market. But because emerging-market managers charge higher management fees and because trading costs are higher, indexing appears to be an even better strategy than it is in domestic markets.

Of course, there are always some managers who seem to be winners year after year. Yet, even then, “consistent” outperformers eventually revert to the mean. Exhibit 3 presents an article that appeared in The Wall Street Journal during 2009. The Journal looked at 14 funds that had beaten the market for nine consecutive years. They then followed the same funds in year 10 and found that only one of the fourteen managed to beat the market in year 10.

Moreover, many of the funds did so poorly in the tenth year that they lost The Princeton Financier | 16

Concluding Comments The evidence strongly supports the thesis outlined in the first edition of A Random Walk Down Wall Street. Indexing does not imply “guaranteed mediocrity”, as critics of indexing frequently argue. Indexing is a superior strategy producing larger returns than those available from the average professionally-managed portfolio.

Efficient markets, in the sense that I have always used the term, does not imply that market prices are always “correct”. In fact, market prices are always “wrong”. What the efficient-market hypothesis says is that no one knows for sure whether they are “too high” or “too low”. There is no evidence that professionals are any better than amateurs in spotting mispricings.

The market is extremely hard to beat.

Indexing has proved itself to be an aboveaverage investment strategy.

As was mentioned above, there are now low-cost ways to implement the strategy outlined in Random Walk. Competition has forced down the annual expense ratios for indexed mutual funds to 0.07 of 1% or less. And Exchange Traded (Index) Funds (ETFs) are available at similarly low fees. Index Funds and ETFs should comprise at least the core of everyone’s investment portfolio.

whatever excess returns they had earned in the previous years.

Over the long run, the results are even more devastating to active managers, even when only surviving funds are considered.

One can count on the fingers of one hand the number of professional portfolio managers who have managed to beat the market by any significant amount, as is shown in Exhibit 4. And you can be sure the nonsurviving funds did even worse. The record of professionals does not suggest that sufficient predictability exists in the stock market or that there are enough recognizable irrationalities to produce exploitable opportunities to earn excess returns over the market average.

Exhibit 5 presents a comparison between active bond managers and a variety of bond indexes. In the bond market as well as the stock market, indexing has proved itself to be an optimal investment strategy.

Exhibit 6 shows the average returns over the 20 years ending December 31, 2001 for a variety of indexes relative to the average actively managed funds. Whether the manager focuses on large-cap or small-cap equities or even fixed income investments the investor who purchases index funds earns above average returns.

Active managers underperform their benchmark indices by approximately the amount of the extra expenses they impose on investors.

Today index funds comprise between 25 and 30% of all portfolio products available to the public. People frequently ask me, as an evangelist for index funds over a 40-year period, if I am disappointed that indexing’s share of the total is so low.

I am not disappointed at all. The fact that an idea that started in the academy has gained so much traction has delighted me. Would I like to see index funds have a larger share of the investor’s funds?

Indeed I would, since it would mean that more investors would avail themselves of a superior way to invest and would therefore be able to enjoy a more comfortable retirement. But I know that the share of indexing has been growing and I expect it will continue to grow.

And I am very proud of the role that Random Walk may have played in the acceptance of indexing as an optimal investment strategy.

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THE GREAT AIR WAR

Back in the Golden Age of Aviation, between WWI and WWII, it was commonplace to take a flight not knowing exactly what type of aircraft you were on, and even less so what company had made it. How come? First of all, it did not matter to most passengers: you would have simply been happy that you were one of the people fortunate enough to be able to afford air travel. Secondly, at the time, there were many manufacturers who made aircraft of similar quality, and no particular company stood out among the rest. However, in the past several decades, that all has changed. Because of increased barriers to entry, the switch many companies made to purely military aircraft, and the ensuing domination of the market by a few companies, the world today is left with two behemoth aircraft manufacturers, the names of which you are probably already familiar with: Boeing and Airbus. Today, the two firms are locked in a battle of epic proportions, each pinning their fate on their own beautifully designed and luxuriously equipped aircraft: the Boeing 787 Dreamliner and the Airbus A380.

The success of one over the other could lead to one of two possible outcomes: the established supremacy of Boeing in conjunction with the downfall of Airbus, or alternatively, a larger market share and a more even playing field for Airbus.

First, however, a little history might shed some light on why this current situation

is so important to the two companies and indeed the entire commercial aviation market.

A Storied History Boeing was founded in 1916 by William E. Boeing and has existed almost since the start of the aircraft era. Throughout the years it has survived all the trials of the 20th and 21st centuries, and has always been present in both the military and the civilian markets. Interestingly, back before the Air Mail Act of 1934, Boeing made its own propellers and engines, built its own aircrafts, and flew the planes under its subsidiary operations known to the public as “United Airlines”.

This activity was seen as monopolistic behavior, and due to the Air Mail Act, Boeing split into three separate companies: United Aircraft Corporation (engines and propellers), Boeing (aircraft manufacturer) and United Airlines (airlines). Boeing began to take over the commercial market with its revolutionary Boeing 707 in the 1950s, the first in a long line of superior quality large commercial aircraft marked by worldrenowned aircraft such as the Boeing 777 and the Boeing 747. With these aircraft, Boeing grew in size, acquired a few of its competitors, and became the largest player in the commercial aviation market.

Its market share peaked in 1985 – 1986 at a whopping 90% of the market.

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BY TANOY MANDAL ‘14 Currently however, Boeing accounts for less than 50% of the market.

The Successful Competitor At the time of Airbus’s inception, the United States dominated the world market in the form of three corporations, namely Boeing, Lockheed Martin, and McDonnell Douglas. Airbus was developed in 1970 as a collaboration between France, Germany, and the UK to compete with the big three and hopefully make a substantial impact on the market. For the first 10 years of its existence, Airbus had little to no effect on the market. However, in 1981 it finally succeeded in creating the Airbus A320, which became the first commercial aircraft to offer a fly-by-wire (electronic) flight control system instead of the old manual controls, which were still used in the American manufacturers’ planes. Airbus had established itself as a major player and was ready to take on Boeing. Finally, in 2001, the unthinkable happened: Airbus took over as the dominant player in the commercial aircraft market and for the past 10 years has held slightly over 50% market share. How did this happen?

Here is where the controversy started.

Under the Table Since Airbus was developed not by entrepreneurs or businessmen but rather

by politicians of three separate European countries, Airbus was founded not with private money, but with public “launch aid” and various subsidies which have supported the corporation over the years. This money is a major source of contention between Airbus and Boeing and even between the United States and Europe. The debate over whether these huge subsidies should be allowed has intensified in the past decade with the introduction of the world’s largest commercial airliner, the Airbus A380.

At the time, Boeing considered making a similarly sized airliner, but the projected development cost of $15 billion was too high, and it was estimated that the cost could not be covered by the order size. Airbus had no such problem because of heavy subsidies from European governments. Incidentally, the turnaround in market share coincides perfectly with the introduction of the A380 in 2001, something that would have been impossible without those very subsidies. Thus began the bitter feud for market share and the massive effort

by Boeing to find a suitable response to the jet that could have meant the demise of Boeing as the premier standard in commercial aviation.

Struggles

if the EU stands by its law it will have effectively killed its own brainchild’s chance for dominance in the aviation market which would be a reversal of the current trend. Other nations protesting the law might also pressure their national airlines to drop orders for the expensive jet and instead opt for the Boeing jet since it features a superior cost-benefit ratio in light of the law.

The production of the Airbus A380 began in 2004, and therefore this aircraft has a larger presence in aviation than does the 787 which is not necessarily beneficial.

The jet has made headlines by proving too difficult for some airports to handle since it requires three jetways to board and unboard its two levels. It was also involved in the famous incident at New York’s JFK airport in October of 2011, when an Air France A380 that was taxiing

The second problem Airbus faces is the physical manufacturing defects. Lately, it has been discovered that the large jet is predisposed to crack in the wings, which is a highly unsettling prospect for all potential fliers and simultaneously devastating for potential buyers of the jet. Unfortunately, the only way to check for damage is to remove each jet from service for a minimum period of 24 hours but if cracks are found, the repairs

shares, whoever chooses the correct answer will viably capture a substantial majority of the market and rule the air for at least the next twenty years. All of that, however, is contingent upon both programs being run smoothly and without the various problems that have plagued both since their start.

Given the current closeness of the market shares, whoever chooses the correct answer will viably capture a substantial majority of the market and rule the air for at least the next twenty years.

Pinning Hopes on a Dream Boeing launched two simultaneous projects in the wake of the A380’s success: the Boeing 747-800 and the Boeing 787 Dreamliner, which would later become the A380’s main competitor. The 747800 received a mild response, since it was nearly identical to the 747, apart from a few changes, one of which made it the longest passenger aircraft in the world.

The Dreamliner on the other hand piqued a lot of interest as it severely cut operating costs, became the most fuel-efficient jet in the world, and was the first to be made primarily of composite materials.

It is now apparent that the dilemma is between increasing size (which would mean more passengers per flight with increased profits and decreased operating costs) or increasing fuel efficiency (which would greatly reduce operating costs in a world where jet fuel prices are uncertain).

Given the current closeness of the market

onto a runway clipped the tail of a smaller Delta aircraft with its enormous wing which sent the smaller aircraft spinning.

Currently, there are two problems that are plaguing the A380 and Airbus’s hopes for market domination. The first problem, which is less troubling but has the potential to have severe ramifications in the future, centers on the execution of the order for ten A380s that was placed

by Hong Kong Airlines. Since the EU has passed a carbon emissions payment law, which China and several other nations are opposed to, China is pressuring Hong Kong airlines to discontinue the order for the A380 aircrafts. This would result in a loss of up to $3.8 billion dollars for Airbus. If the order is dropped, then the future for Airbus looks grim. Because the 787 has a higher fuel efficiency and lower carbon footprint than the A380,

will undoubtedly take longer. Although Airbus claims to have a solution to the problem, current airlines with A380s are unhappy with the profit losses especially in the current state of the economy, and these current consumers as well as other potential buyers will be wary of future purchases of this aircraft. If either of these problems occur, Boeing has a very good opportunity to re-establish its dominance over Airbus in the commercial aviation market and reverse the decline it witnessed over the past decade.

The reason Boeing will once again be able to establish its superiority over Airbus if these problems occur is because Boeing has never struggled with producing good quality jets. The only problems they experience are delays leading up to the final production of the The Princeton Financier | 19

jet. Boeing has faced numerous delays (such as the worker strike in the primary production facility and the discovery of manufacturing faults during assembly) during the production of the 787. Thus the main advantage Boeing holds over Airbus is that it has been in the industry longer and so it checks every system until it is satisfied with the products before they are shipped to consumers in order to ensure that consumers are happy with their product. All these delays and obstacles only indicate that Boeing has a larger economic hurdle to overcome than Airbus. Although Boeing shied away from developing an A380 sized airline because the development costs were predicted to be $15 billion, Boeing invested over double that amount ($32 billion) in the 787 Dreamliner. Since the 787 has only started being delivered in 2011, Boeing has only delivered seven total aircraft to date as opposed to Airbus’s 71 deliveries.

However, the order numbers tell a different story. Airbus has 253 orders for its A380, whereas Boeing already

has almost four times the orders with 873 orders for its 787. The 787 is priced around $200 million which is a little more than half the price of the A380. It seems that currently fuel efficiency is increasing the number of passengers per flight and that airlines are more worried about the operating costs per flight rather than the profit per flight. It is fortunate that Boeing did not pursue a project similar to the A380, because its response to the A380 was a smarter gamble that seems to be paying off. The math clearly indicates that Boeing will emerge victorious from this battle, yet such a victory is still contingent on several other factors.

Who Will Win This War? Aside from the mathematical support for Boeing, the logical outcome seems to be that Boeing will recapture the market due to the problems Airbus is encountering. However, there are a lot of important factors that have not been taken into consideration in determining

the real winner of the war. For example, the 787 might have 873 orders, but what about the amount of orders for the 737, 757, and 767 that the 787 is supposed to replace? Will 777 and 747 orders be affected? For Airbus, does the lack of orders for the A380 mask an increase in the order numbers for the steadfast A320? Furthermore, because the 787 has only been in production since last year versus the Airbus in 2004, it is only in 2011 that the serious problems began to emerge for the program, which were mainly due to the manufacturing defect and the EU law. However, laws can be erased, and for all we know, seven years from 2011, Boeing will find some manufacturing defect it could never have predicted at this time that will cause it to ground planes as well. Still, unless a huge surplus of jet fuel is discovered, that cost will rise and the 787 will continue to look like the better choice. Thus in theory, the risk aversion of Boeing will allow it to recapture the market with its 787, but in reality only time will tell. 

Airbus A380 525 seats 9600 mi range Mach .85 (560 mph) crusing speed First displayed Jan. 2005 11 billion euro development cost

Boeing 787 250-290 seats 9780 mi range March .85 (560 mph) crusing speed First displayed July 2007 32 billion dollar program cost

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INTEREST IN NO INTEREST Banking in Indonesia

By Jason Nong ‘15

Indonesia is the world’s fourth most populous country at 238 million inhabitants and has enjoyed recent GDP growth of around 6%, yet it is often not at the forefront of the stage when examining the financial services industry. Given the immensity of its economy, Indonesia’s financial services sector is without a doubt underdeveloped. Indonesia has shown itself to provide great opportunities for financial services firms, albeit with a few problems.

Indonesia’s banking sector shows strong potential for growth. Recently, Indonesian banks’ credit ratings have gone up while the rest of the world has seen its ratings fall. Although the grade received by Indonesian banks varies depending on the rating service used, there has been a general increase in the ratings of Indonesian banks, regardless of the rating service. This coincides not only with an increase in Indonesia’s sovereign rating but also with a real improvement in the banks themselves. Indeed, the banks are much stronger than they were after the Asian financial crisis of 1997, when GDP growth fell from 7.64% in 1996 to 13.13% in 1998. Strong economic growth has meant strong capital and strong earnings for the banks. The nonperforming loan ratio, which is the ratio of non-performing loans to total loans, has also fallen from 49% in 1998 to below 3% as of recently.

The quality of loans and liquidity remain main risks to Indonesia’s banking industry.

Threats to loan quality are a result of Indonesia’s quick growth, and liquidity has tightened, especially in foreign currency loans. On the other hand, unlike most banks today, Indonesia’s are some of the most insulated from European banks and will be affected the least by European debt issues. In addition, there is also much room for further growth and expansion

in the financial services, especially in the banking industry. Compared to China’s 120% lending to GDP ratio and India’s 50% ratio, Indonesia’s 30% lending to GDP ratio suggests that it has some catching up to do in terms of credit to the private sector and to households.

The need for Indonesian companies to raise capital has led to a great amount of overseas borrowing and capital raising exercises. To help address this issue, the government and central bank are urging all banks, especially state-owned ones, to lend more. Loans are expected to grow by 15 – 20% this year.

One issue that many Indonesian banks face is the fact that few Indonesians save money. Mistrust and low interest rates, among other reasons, have led to a decline in banking assets and deposits as a percentage of GDP. Bank credit was approximately 60% of GDP in 1997 but now is only at around 30%. However, the lack of enthusiasm for saving money may stem from other issues as well. For example, the very geography of Indonesia as an archipelago makes it difficult for banks to boost coverage and savings, and for consumers to obtain a loan.

Bank Negara Indonesia (BNI), a stateowned bank, is looking to try microbanking to address this issue despite its current inability to do so. In addition, it has seen a great deal of growth in the area of Sharia banking. Sharia banking, or Islamic banking, may prove to be a big help to the banking industry. Indonesia has nearly 240 million Muslims, and Islamic law prohibits lending money out on interest.

To get around this rule, Islamic banking uses other ways to make money, such as profit sharing, joint ventures, or leasing.

While Islamic banking was introduced much earlier in other countries, Islamic banking laws were not passed until 2008 in Indonesia. This may explain why

Islamic banking accounts for 20% of the Malaysian banking sector while it is only around 3% for Indonesia. Recent regulation changes in Indonesia have resulted in Islamic banking becoming one of the fastest-growing banking strategies in the country, and everything from state banks to foreign banks now have Islamic banking branches.

Islamic bonds, or sukuks, also account for a significant part of the Islamic finance industry. Laws regulating sukuks in Indonesia, however, are still incredibly complex and hinder its widespread use.

Although a law passed in 2008 facilitated the issuance of sukuks, many companies are reluctant to issue them due to the slow and complicated process. However, great potential still exists in the sukuk market in Indonesia, and Malaysia’s success in Islamic finance serves as a good guide for the Indonesian financial services industry.

Similar to the way in which Islamic banking is successfully rising in Indonesia’s banking industry, Islamic insurance, or takaful, is also a rapidly growing area in Indonesia’s insurance market. The Islamic insurance market has been growing at around 30% for the last five years, while both the demand for insurance products in general and the size of the insurance market are once again surprisingly small.

Islamic insurance products only account for about 3% of all insurance premiums, due in part to its late entrance into the market, its lack of government incentives, and its poor regulations. However, recent and projected future growth in this underdeveloped market provides excellent opportunities. Syarikat Takaful Malaysia Berhad, a Malaysian company with operations in Indonesia, currently only derives 5% of its total revenue from Indonesia, but it expects Indonesia to make up for more than half of its revenue in the next five years.

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mark a substantial increase from its current size of 200. There are definitely prospects for growth in the Nigerian capital markets and corporate finance industry, but as mentioned earlier, this article’s focus is on the present challenges facing businesses in the Nigerian investment banking industry.

This is where the story begins.

If the investment banking industries of developed countries are adults, then that of the Nigerian industry is a toddler, running unsteadily in her quest to catch up. This is not an exaggeration. As of December 2011, the NYSE Euronext recorded a market capitalization of $14.2 trillion. On the other hand, the market capitalization of the Nigerian Stock Exchange (NSE) was only $63 billion, which is more than 200 times smaller. This figure is not only small in absolute terms, but also in terms of the stock market’s significance in the nation’s economy. If we compare the NSE with the Johannesburg Stock Exchange, the conclusion stays the same. The South African market capitalization was 278.4% of GDP in 2010, whereas Nigeria’s was only 26.3%. Even so, Nigeria has the third largest stock exchange in Africa and is the leader in the western region of the continent. While it may be a toddler, it is growing quickly and is far above the level of its African peers.

African countries are no strangers to the notion of ‘potential’; there are countless articles outlining Nigeria’s prospects for growth. However, I am more interested in taking a break from fantasizing about the bright future ahead for my country’s investment banking industry and instead, examining the present. This article will focus on the situation investment bankers in Nigeria currently face, focusing specifically on the challenges they experience while working in the industry.

Investment banking activities in Nigeria

consist of the usual M&A advisory services, capital markets, project finance, and structured finance, albeit on a less sophisticated level than its more developed counterparts.

Excluding the lending businesses, the Nigerian Securities and Exchange Commission (SEC) regulates these components of investment banking and the Nigerian Stock Exchange (NSE), the nation’s bourse, on which almost 200 companies representing eight different sectors are listed. The eight sectors represented on the NSE include: healthcare, information and communications technology, industrial goods, oil and gas, services, construction/ real estate, consumer goods and financial services. The NSE is mainly an equity stock market, with about 198 equities trading in it. However, trading activity in fixed income securities and Exchange Traded Funds (ETFs) have been on the rise following the 2008 market crash and the consequent reduction of investor confidence in the equity stock market.

Subsequently, there has been an increased need for the NSE to be revamped. In response to this need, the NSE recently named ten market makers and will soon complete a refurbishment that will: relax restrictions on price swings, adopt the Nasdaq platform, open during U.S. trading hours, and allow short selling.

Furthermore, it plans to begin trading futures and other derivatives. These changes will hopefully help the NSE reach its target of 1000 companies, which would

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I wanted to get authentic answers to my questions and the Internet did not do justice to my cause. I knew it would be more interesting and informative to speak with the individuals that have to face these challenges on a daily basis.

My journey of discovery involved a fair amount of phone tag and long email chains, but the high phone bills were worth it in the end. I was able to speak with two top executives in the field, and they were gracious enough to give detailed explanations of their experiences as investment bankers in Nigeria.

One of the biggest challenges facing investment banks in Nigeria today is a limited pool of skilled individuals, a relevation by Mr. Folasope Aiyesimoju of Stanbic IBTC that I found quite surprising. The deficiency in the quality of human resource capital can be primarily attributed to the current state of the Nigerian educational system.

Banks struggle to find a wide-enough pool of graduates with the necessary analytical and problem-solving skills.

However, the problem also lies within the banks themselves since they are still in the developing stages and consequently have not begun to invest in training and recruiting the way larger American banks do. In Nigeria, you hardly hear of an oncampus recruiting information session or summer internship opportunities with investment banks. Even the top tier banks in the country do not invest nearly as much effort and resources as the American bulge bracket banks in their recruitment processes. In addition to new analysts lacking the required skills there is also a limited number of experienced professionals in the industry. This results from the Nigerian industry’s low level of development in comparison to the West.

The minimal level of talent in the industry is an important problem, and one that is

often listed as one of the causes of the 2008 Nigerian capital market crash that reduced the market capital by more than 50%. However, there is also a wave of recent graduates from top universities in the United Kingdom and the United States that have had some experience in most of the bulge brackets and are now seeking to move permanently to Nigeria.

This trend presents an opportunity for the investment banks and smaller boutique firms to improve the quality of their employee base. One can see that the lack of talent is a problem that is not only linked to a lack of education and poor governance in Nigeria but also to the development stage of the investment banks themselves. Consequently, it is a problem that can and will be overcome with time.

Aside from the human resource problems, banks also struggle with limited amounts of data, research material and information.

This problem often presents itself during the valuation process. When doing a comparable base valuation, banks often struggle to find enough listed companies or even a sufficient amount of historical comparable transactions. The bankers then usually need to resort to data from other emerging markets, or even the West, which are usually not directly comparable.

So while someone in the United States could do a regression analysis using data from the past 60 years, in Nigeria, one struggles to find even two decades worth of data. This problem can be quite frustrating since it gets in the way of both the speed and efficiency of the job. However, sites such as Bloomberg and Reuters have taken an increasing interest in the Nigerian capital markets and so this data is slowly becoming more available.

Another frustration Nigerian investment bankers face concerns the regulatory framework because it is often unclear.

Even Mr. Aiyesimoju mentioned that the relevant laws are so confusing that sometimes even the SEC officials struggle with interpreting them. However, this is a reality faced by Nigerian investment bankers. One pertinent example of illdefined laws occurs when one company bids for another. It is unclear whether it is

mandatory to make the bid for the whole company, or if the bidding firm is allowed to bid for just a part of it. In the U.S., for example, it is clear that when surpassing a certain percentage of a company, the bidder must bid for the whole company. In addition, until quite recently, the Nigerian government provided clear laws for mergers but no clear rules for acquisitions.

This proved frustrating at times since they are two different transactions. Despite these difficulties, the banks are playing an active role in improving the situation by having top executives in the industry contribute when laws are being drafted.

There are also efforts made to organize forums for the regulators in order to facilitate better communication.

The structure of the Nigerian economy also plays a part in the limitations found in the investment banking industry. One key aspect affected by the state of the economy is capital raising transactions.

As Mr. Bolaji Lawal of Guaranty Trust Bank explained, there is a large volume of finished and service goods being imported and when one has these manufactured goods imported, there is little chance for local growth. It follows logically that if there were a reduction in imports and a consequent demand for more factories, there will be an increased need for financial advisory services in the form of capital raising transactions. This is where the potential for increased transactions for investment banks is lost. The equation is pretty simple—a small amount of new companies means a reduced need for capital raising transactions.

In addition to the importation issues within Nigeria, the agricultural sector also presents some key problems. The sector contributes about 40% to the nation’s GDP and employs 60 – 70% of the Nigerian population. However, it is still on a subsistence level and so is not heavily represented on the capital market, nor does it engage in corporate action. Consequently, we have a situation in which the biggest non-oil contributor to the country’s GDP is not featured in investment banking activities, which is another huge loss of potential deals for the industry. Nonetheless, the current

administration appears to be making more of an effort to increase the development of these sectors; all one can do is wait and see how it plays out.

Oil revenue is another big feature of the Nigeria economy. The oil and gas sector constitutes about 20% of the economy. The oil revenue accounts for roughly 90% or more of the nation’s foreign earnings and is thus a major component in the budgetary revenues. However, the oil majors who dominate the oil and gas industry hardly make use of the local financial advisory services. Their investment banking needs are largely serviced off-shore because they have relationships with the investment banks in their home countries, which makes it a bit challenging for Nigerian investment banks to go into business with them. However, there have been some recent projects in which Nigerian banks have taken part; this goes to show that as the industry continues developing, more avenues for growth open.

After my discussions with these investment bankers, I realized that despite all these challenges and limitations, business still moves on. Just as a child would mature, the industry is definitely growing and becoming more sophisticated every single day. Although Nigerian investment bankers face many obstacles, they have not been deterred from their jobs. They simply find a way around these problems and work toward improvement. Therefore, if one views the current situation from the investment banker’s perspective, the investment banking industry in Nigeria is quite proactive. There is definitely an energy that is present in the field, despite these day-to-day setbacks in addition to the many overarching ones. The onus is on the Nigerian government to make bold and strategic moves that will increase the depth of the capital market. However, I would say that the investment banking industry in Nigeria is one industry of many in the country that is being held back by the lack of commitment and dedication of the Nigerian government. At this juncture, I will return to “fantasizing about the future” and say that a strong and positive growth for the industry is definitely on the horizon.

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