Breakingviews

What hedge funds share with rock’n'roll festivals

By Rob Cox The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

At first sight, hedge funds don’t share a lot with rock music festivals. But both are subject to the law of large numbers. Festivals like Pickathon, a three-day concert taking place outside Portland this weekend, are limiting entry to make the experience less mundane. And the likes of Moore Capital Management’s Louis Bacon are seeking better-than-average returns by shrinking, too.

Connecticut-based Bacon, whose fund firm invests some $15 billion of his own and clients’ money, is much more likely to be found on his Scottish estate or the slopes of Aspen than in the Oregon woods. But he might find some common ground with Pickathon’s organizers. He just decided to hand back $2 billion of the money his firm oversees to investors. He felt he wasn’t able to make big enough returns in the current environment.

The difficulty of maintaining better-than-normal returns, festival experiences or growth as a concern gets larger is a widespread phenomenon. It’s the same for giant companies like Apple and burgeoning economies like China’s. It’s arguably a narrower problem for hedge funds and festivals, though. Hedgies have a finite number of strong investment ideas and a limited universe of securities in which to deploy their cash. And concert promoters can only book so many bands at a time.

At a certain point, the alternative to becoming run-of-the-mill is to shrink. Bacon hopes to deliver better percentage performance with less money to put to work. He’s not alone in the investing world. Howard Marks of Oaktree Capital has long had only a limited appetite for new money. Stanley Druckenmiller in 2010 decided to stop managing money other than his own, saying $10 billion was about his limit. Brevan Howard, a London-based fund firm, returned some cash to investors last year and other hedgies, including Paul Tudor Jones, Steven Cohen and Daniel Loeb have stopped taking new investment.

For Pickathon, shrinking is more about exclusivity. The event’s organizers cap the number of tickets sold at around 3,600 daily so that artists and fans alike can mingle and take in 50 eclectic musical acts on six stages. The limit on attendance keeps the experience special, explains co-founder Zale Schoenborn, an Intel microprocessor architect by day. Capping the number of tickets has allowed Pickathon to raise the cost of a three-day pass by about a third to $200.

It’s far from a direct analogy with a hedge fund like Bacon’s. But the lesson is similar: For businesses that want to stand out, whether in finance or rock music, less can be more.

Shale writedown tarnishes BHP’s street cred

By Kevin Allison

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Marius Kloppers is right to take his lumps. The BHP Billiton chief executive has waived his 2012 bonus after the mining giant took a $2.8 billion writedown on some of its U.S. shale gas acreage. The hit looks small when compared with BHP’s $170 billion market cap, and wasn’t unexpected. But BHP paid almost $5 billion for the asset just 18 months ago. That’s embarrassing for a company that trades on its reputation as a canny operator.

In February last year, BHP’s purchase of 487,000 acres of Fayetteville shale reserves from Chesapeake Energy was seen as a breakthrough after a string of failed mega-deals. BHP is one of the few big miners to own a substantial petroleum business. Gaining a foothold in the U.S. shale revolution seemed to make good strategic sense.

But the $4.75 billion price tag looked stretched from the outset. When the deal was announced it was already clear that booming shale production was creating a gas glut that would threaten the profitability of wells that mainly produce gas. At the time, U.S. gas prices stood at about $4.50 per million British Thermal Units, down by a quarter from 2010 highs. They plunged to below $2 per mbtu earlier this year. Even at today’s price of about $3 per mbtu, drillers are still losing money.

BHP’s decision to write down the Chesapeake assets suggests it doesn’t see the glut easing anytime soon. Like other gas drillers, it is shifting its focus to the more oil-rich shale deposits it acquired when it bought U.S. driller Petrohawk for $12 billion in July last year. That bigger, more ambitious purchase is not affected by the writedowns.

BHP is hardly the only company to fess up to overpaying for shale. Shell, BG and Encana Energy all took impairments in the second quarter. The 1.9 percent rise in BHP’s London-listed shares following the announcement suggests investors expected Kloppers to bite the bullet.

Knight shows that next creative loss is never far

By Richard Beales The author is a Reuters Breakingviews columnist. The opinions expressed are his own. Knight Capital’s “technology issue” turned out to be a monster, not just a bug. A software update that sent erroneous orders and rocked 150 or so New York Stock Exchange issuers on Wednesday has cost the market-maker $440 million. The coding error that caused it proves that investors can never be too imaginative about the ways in which financial firms will lose money.

Knight handles massive volume for customers. Its market-making business traded $19.5 billion of equities a day on average in June. Yet as an intermediary, it wasn’t supposed to be massively exposed at any given time. So losses equal to almost a third of the company’s $1.5 billion of book equity at the end of June are a shock. Investors slammed Knight’s stock, knocking two-thirds off its $1 billion market value earlier in the week. The company is seeking cash to shore up its finances – or maybe a buyer.

The aftermath of the Facebook initial public offering sprung other surprises. Nasdaq messed up trading on the social network’s market debut and has so far offered $62 million to affected firms, including Knight, to make amends. But the biggest bombshell came from UBS, which wasn’t even an underwriter on the deal but still managed to lose about 350 million Swiss francs ($354 million) on the botched IPO.

That seems to have been the result of UBS repeating customer trades multiple times while Nasdaq was offline and being stuck with huge positions it hadn’t wanted. But the whole chain of events – also involving automated systems to some extent – is another that would take creative scenario planning to identify in advance as a possible source of concern.

Such turns of events prove that risk can’t be regulated away, however fervently politicians and watchdogs still reeling from the 2008 crisis may wish it. Financial institutions make bets of all sorts and can lose – and lose big. JPMorgan’s $6 billion Whale loss is another recent case in point. All investors can do is press corporate bosses to explain how they manage their risks. These days, that includes computer code along with human and financial assets. And even then, the next creative loss will never be far away.

Investors may be happy to ride on renovated JAL

By Wayne Arnold

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Japan Airlines’ plans to raise roughly $8.5 billion in an IPO may seem a heavy lift amid weak global markets and a perennially limping aviation industry. But big funds will likely clamor for seats on a flight fueled by a mix of government largesse and one of Japan’s most promising turnaround stories.

Like PanAm and TWA, JAL prospered in aviation’s salad days but was not suited for a more competitive era. Cabin crew were given jet-set lifestyles, including company-paid taxis for the roughly $300 ride into Tokyo from the international airport. In 2010, with $25.6 billion in debt, JAL declared bankruptcy, a rare step in a stock market littered with zombie companies.

The JAL emerging from government-supervised restructuring has been re-tooled: its 50,000 employees reduced by a third, pensions slashed, non-core units sold, fleet trimmed and international routes cut. All that, plus $4.5 billion of taxpayer money and cost-cutting efforts by Kazuo Inamori, the Kyocera founder enlisted by the government, have turned JAL into the biggest earnings generator in the industry, with $2.4 billion in profits.

Participants in the 61-year-old carrier’s IPO will likely appreciate its new-plane smell. It still has roughly $2.7 billion in debt and is forecasting a 30 percent decline in profits in the year ending next March as global aviation lurches, but it can still count on $4.6 billion in tax credits, enough to create at least two years of almost tax-free earnings.

JAL’s underwriters at Daiwa are suggesting a price of 3,790 yen a share. That would make it the third largest airline by market capitalization, after Singapore Airlines and Air China. But at about 5 times the company’s projected earnings, the proposed valuation looks conservative. Rival All Nippon Airways trades near the regional median of 12 times.

Man Utd counts on investors behaving like fanatics

By Jeffrey Goldfarb The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Manchester United is counting on investors to behave like soccer fanatics. The English club’s committed supporters expect nothing short of greatness, an ethos that carries through to Man Utd’s initial public offering. Though devotees of the Red Devils are rarely disappointed, buyers of the stock at the mooted price probably will be.

After dallying with a listing in Asia, Man Utd found an even more hospitable venue for its lopsided governance in the United States. Billionaire Malcolm Glazer and his family will retain control after the New York IPO with their more powerful Class B shares. There’s also no plan to pay any dividends to the Class A shares on offer and the company’s Cayman Islands home will make keeping official tabs on the board difficult.

Man Utd’s finances give further pause. Though the club just signed a fresh sponsorship deal with General Motors and foresees long-term growth in digital and mobile, revenue is expected to fall by as much 5 percent in the year to June 30. That’s because failure to qualify for the knockout stages of the Champions League in the most recent season cost the club at least 10 million pounds of broadcasting revenue.

What’s more, despite winning 12 Premier League Championships in the last 20 years, Man Utd was edged out by rival Manchester City last season. That has led to fears that Man Utd’s legendary manager, 70 year-old Alex Ferguson, and his squad are past their best. The club may also struggle to compete with the deep pockets of Man City’s owner, Abu Dhabi Sheikh Mansour, when attracting the best players.

And yet Man Utd reckons it should command a premier price. At the top end of its $16-$20-a-share range, the company’s equity would be worth some $3.3 billion – almost three times what the Glazer family paid in 2005. Add net debt of some $500 million, after IPO proceeds are used to pay off a big slug, and the enterprise value is about $3.8 billion. That’s 22 times EBITDA.

By comparison, MSG, which owns the New York Knicks and Rangers as well as Madison Square Garden, a stadium on par with vaunted Old Trafford, trades at a multiple of just under 11. Man Utd may be considered a trophy asset, but at the valuation on offer it’s no prize.

Loser Citi lawsuit sends SEC back to drawing board

By Reynolds Holding The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

A loser lawsuit against a Citigroup banker should send the U.S. Securities and Exchange Commission back to the drawing board. A federal jury cleared Brian Stoker of misleading CDO investors, while also urging the watchdog to bring more financial fraud charges. But quantity isn’t the issue. The SEC has filed over 100 crisis-related suits. What’s too often lacking, as with the Citi example, is a solid case.

No one may have wanted this trial more than the judge, Jed Rakoff. Last year, he bounced Citi’s $285 million settlement over the same hybrid CDO-squared, saying he couldn’t judge the deal’s fairness without an admission of wrongdoing. At the beginning of Stoker’s case, he bubbled about finally getting the chance “to find out what the truth is.”

As it turns out, there was probably no misconduct. Jurors rejected SEC charges that Stoker should have known offering materials he prepared didn’t disclose that the bank had helped pick the risky mortgage securities behind the collateralized debt obligation and then bet against it. In fact, Stoker argued, Ambac Financial Group and other investors were clearly told Citi might short the deal. Banks also typically help select at least some assets underlying a CDO.

In an unusual move, jurors included with their verdict a note encouraging the SEC to keep pursuing the financial industry. The surprising missive reflects public frustration over the failure to hold Wall Street accountable.

The SEC is aware of the sentiment. It has touted the $2.2 billion extracted so far from alleged fraudsters behind the crisis. That amount, though, comes largely from settlements with Bank of America and other institutions that never admitted wrongdoing. And the agency has been equally eager to publicize Florida pump-and-dump schemes and insider trading actions against sports stars.

So it’s understandable that the SEC would try to make hay with a high-profile trial against a banker. By overreaching, though, it has cost Stoker a small fortune in legal fees while leaving serious egg on the watchdog’s face. Pursuing miscreants more aggressively won’t help until the SEC gets smarter about the fights it picks.

StanChart finds buffer against Asia slowdown risk

By George Hay

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Standard Chartered has found a new way to exploit an old advantage. Since the 2008 financial crisis, the emerging markets lender has made considerable hay trumpeting strong growth in its Asian markets. But even investors worried about a slowdown can take comfort from the fact that StanChart is taking a bigger slice of the cake.

StanChart’s first half contained something for both bulls and bears. The bank’s supporters can point to nine percent growth in both operating income and pre-tax profit, and the fact that chief executive Peter Sands reaffirmed that he expects double-digit top line growth for 2012. Importantly, operating income growth is outstripping cost growth. And in terms of liquidity and capital – where StanChart’s core Tier 1 ratio is likely to be 11 percent even after including all Basel III reforms – the bank is way ahead of the pack.

Yet detractors will worry about bad debt provisions, which spiked up by 42 percent year-on-year, albeit off a low base. For now, these seem focused on a number of wholesale clients in the United Arab Emirates and India, and from StanChart’s decision to gradually expand the amount of riskier unsecured consumer lending it does from 17 percent of its loan book back towards the pre-crisis level of 20 percent. Given the uncertain economic climate, how and when to take more risk remains a critical judgement call for Sands and the board.

Yet even if economic growth does slow, it has a fallback. As harassed euro zone banks retreat to domestic markets, StanChart and its UK peer HSBC are stepping in. The British duo accounted for almost three-quarters of the three percent uptick in European loans to Asia outside Japan between the start of the year and April, according to Morgan Stanley. Helping Western firms sell their wares in Asia allowed StanChart to boost wholesale revenue in the Americas, the United Kingdom and Europe by 25 percent year-on-year.

StanChart should be wary of becoming overly dependent on less predictable wholesale banking activities. But investors will be cheered that the bank remains capable of finding itself in the right place at the right time.

Facebook costs UBS some of its new friends

By Peter Thal Larsen

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

UBS is making a habit of springing nasty second-half surprises. Eleven months ago, the Swiss bank shocked investors with a 2 billion Swiss franc rogue trading loss. Now it has fessed up to dropping 350 million francs on Facebook’s bungled initial public offering. In an already tough second quarter, it’s the last thing UBS’s slimmed-down investment bank needed.

For months, rivals have wondered how UBS could have stubbed its toe on Facebook despite not being selected as a bookrunner on the much-hyped offering. According to the bank, its equities arm received many orders for Facebook stock from fund managers and wealthy clients. Due to trading glitches at the Nasdaq exchange, it repeated orders multiple times, only to be left with large amounts of unwanted stock. Assuming UBS paid an average price of $40 per share and subsequently sold at an average of $31, that implies the bank ended up with almost 40 million Facebook shares – or roughly 10 percent of the company’s freely traded stock.

UBS says it will take legal action against Nasdaq for what it describes as the exchange’s “gross mishandling” of the IPO. Nevertheless, the debacle overshadowed a second quarter already marred by weak trading volumes and reduced corporate finance activity: as a result, UBS’s investment bank slipped back into the red.

In other areas, however, UBS actually performed rather well. Assuming the full implementation of Basel III rules, the bank’s core Tier 1 capital ratio improved by more than a percentage point to 8.8 percent, aided by ongoing deleveraging. There are also signs that UBS is recovering its status as a safe haven for the world’s wealthy: its private banking arm attracted 9.5 billion francs of net new money in the quarter. The flipside is that risk-averse clients tend to hoard cash. As a result, the private bank’s gross margin slipped by 4 basis points to 89 basis points.

UBS continues to shrink its investment bank: the unit’s target for risk-weighted assets by 2016 has been shaved to 135 billion francs, from 170 billion francs today. But as long as UBS remains capable of producing unwelcome shocks, investors will remain wary.

HSBC held back by developed-world headaches

By Peter Thal Larsen

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

HSBC can’t leave its developed-world headaches behind. More than a year after new Chief Executive Stuart Gulliver sketched out plans to focus on growth in emerging markets, the bank has set aside $2 billion for mis-selling in the United Kingdom and money-laundering in the United States. The setback will only reinforce HSBC’s strategic shift.

The lender is strong enough to absorb the blow: with the help of some gains on disposals, pre-tax profit in the first half of the year was $12.7 billion. After tax and dividends, there was enough left over to lift the bank’s core Tier 1 capital ratio by more than a percentage point to 11.3 percent.

The results also broadly underscored HSBC’s new strategy. Hong Kong and the rest of Asia generated two-thirds of the bank’s pre-tax profit. Much of the growth came from commercial banking and from HSBC’s investment banking arm, which bucked the industry trend by generating roughly the same amount of income as in the first half of last year.

However, HSBC cannot simply shrug off its problems in the West. Its $1.3 billion charge for mis-selling products to UK consumers and small businesses was bigger than rival Barclays. Meanwhile, the $700 million charge for money-laundering is only a guess at the size of fine that the U.S. Department of Justice may choose to impose. Then there is the risk of litigation related to the bank’s role in setting the London interbank offered rate (Libor), which HSBC hasn’t even tried to estimate.

The embarrassment should strengthen Gulliver’s hand as he shifts HSBC away from the United States and parts of Europe. It may also give extra force to his drive to centralise decision-making in a bank that has traditionally operated as a federation of far-flung national subsidiaries. However, such centralisation appears at odds with the UK’s attempts to introduce ring-fencing, which aims to give domestic banking operations greater autonomy and make them easier to separate in a crisis. HSBC’s reputation for caution and solidity means it still enjoys the benefit of the doubt from investors. Further regulatory embarrassments could prompt that view to change.

China’s insider culture stains CNOOC foreign bid

By Wei Gu

The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Chinese companies call for fairer treatment from foreigners. China’s critics say that these companies still don’t play by the accepted global rules of capital markets. The accusation of insider trading around the $15 billion bid by Chinese oil major CNOOC for the Canadian producer Nexen supports the critics.

The U.S. Securities and Exchange Commission filed a complaint on Friday against a Hong Kong vehicle controlled by Zhang Zhirong, China’s 26th richest man as ranked by the country’s New Fortune Magazine. The American regulator said that a purchase of 14.3 million Nexen shares only four days before the CNOOC bid provided an unrealized gain of $7.2 million. Zhang’s ship-building empire has a longstanding strategic cooperation agreement with CNOOC. In response to the accusation, share prices of the shipbuilder, and a property company also controlled by him, fell by double digit percentages in Hong Kong.

When capital markets are relatively unsophisticated, high-level insider trading hardly seems scandalous to those involved. French politicians and businessmen were genuinely surprised at the furore raised by their 1988 gains from buying cheap shares of a target of aluminium producer Pechiney. There was not even much indignation in Italy in 1995, when an executive at Italian glasses-maker Luxottica bought shares in an acquisition target.

Standards for propriety are higher now in Europe and in some Asian countries. In Japan, Nomura’s weak response to insider trading at the firm just cost the chief executive his job. But Chinese authorities will find it harder to reach such a high level of indignation.

In China, insider trading is just one manifestation of a widely accepted insider culture. The powerful, and their families, often use positions and connections for personal gain. The Chinese securities regulator is trying to crack down on insider trading, but a few prosecutions aren’t likely to change the culture.