The Biggest Con Man in History?

This week I decided to base my blog on the Madoff Hustle. A documentary that focussed on the life of Bernard (Bernie) Madoff and how he was able to con so much money out of so many people! I have to say the documentary did not live up to much; however the subject of Bernard Madoff and his con was fascinating.

So how did he do it? How could one man con (a claimed) $64bn out of people’s pockets? Well he played the oldest trick in the book when it comes to investment fraud. He used a Ponzi scheme! A ponzi scheme is a fraudulent investment operation where the operator, an individual or organization, pays returns to its investors from new capital paid to the operators by new investors, rather than from profit earned by the operator. So in short he was simply paying investors interests with other investor’s money. One wonders why he thought that this would be a valid way of conning people, as after a certain amount of time the money in a ponzi scheme always runs out so there was always going to become a point where he was found out! Perhaps this was just arrogance at the thought that he could not get caught and that he was beating the system? Who knows...

It’s one thing to con someone, but how did he manage to persuade so many people to join his elaborate scheme? Well firstly he offered consistent returns on their investment; nothing stupidly high, but enough for it to be very appealing to potential investors. Secondly (and I believe this is the main reason behind his success) was that he made it very exclusive to be an investor in his scheme. So instead of chasing after investors, he had people chasing him and wanting his scheme.

Once he had investors hooked into his ponzi scheme he used to send them false receipts from supposed trades that he had made with their investment, when in fact he hadn’t traded anything apart from their money to another investor.

Of course the dream for Madoff could not go on forever, so in the end his arrest was inevitable. On his arrest he claimed that he was working alone and that no one else knew of his con. Yeah right! Even though it may be very difficult to prove I find it very hard to believe that no one who was working with Madoff failed to realise what was going on. So none of them noticed that they weren’t actually selling or buying or trading at all with investor’s money? I find that very hard to believe!

In some ways Madoff should be applauded for being so successful in one of the most obvious of cons going. However, it truly is sickening how he was able to take people’s hard earned money from them without thinking twice about it!

If you have anything to add on the Madoff Hustle or any subject similar to it please comment....

Mergers and Acquisitions

For this week’s blog I will be discussing the ins and outs of companies merging or acquiring other companies and the reasons behind them.

The term Mergers and Acquisitions is general term used to refer to the consolidation of companies. A merger is a combination of two companies to form a new company, while an acquisition is the purchase of one company by another in which no new company is formed.

There are several different reasons why a company may want to merge with another and these can all be categorised into 4 sub categories: Synergy, Superior Management, Managerial Motives and Third Party Motives.

The term synergy refers to when the value of a completed merger or takeover is larger than the sum of the two companies when separate. Value is created from a merger or takeover when the transaction costs are lower than gain made.

Market power is one example of a synergy through a merger or takeover. With companies merging to gain market power and possibly become part of an oligopoly or monopoly in the market place, it allows them to have a lot more control over the price that they set for products. However there are regulations that are in place to stop companies that have a lot of market power from setting too high a price tag. In my opinion this is highly necessary! Especially in industries such as the phone industry, where the likes of Orange and T-Mobile have merged to make EE. With there being only a few phone companies, it would be very easy for them to set as high a price as they wish and consumers would have very little choice other than to pay it. So in this case it is very important that they are regulated on what prices they are allowed to charge.

There is also the fact that a company would benefit from economies of scale if they were to merge with another company. This is due to larger companies generally having lower cost per unit output. This comes about as the company does not need to share the central services that both companies will have had, such as the human resources department.

Mergers and Acquisitions do not always occur for the benefit of a company! Like so many other things managerial agreed has been the main driving force behind it! From a manager’s perspective if they acquire or merge with a smaller company, it gives them the opportunity to give themselves a larger salary, as they are seen to have a lot more power and status!

A merger or acquisition driven my managerial greed seems ridiculous in my opinion. If the merger does not create any synergy then surely there is no point in it, as only a few individuals will benefit and the company would incur unnecessary costs!

It is often the case that there is a smaller company involved in the movement of an acquisition and they do not always want to be bought out, which can lead to a hostile takeover. One way that a company is able to defend itself is by selling off its assets that the hostile company want to purchase, so that it leads the attention away from them. However, this may not be feasible if the assets are too large for a company to sell without it becoming financially unstable.

This is just a brief overview of why mergers and acquisitions occur and in my opinion why they seem so appealing for some companies.

If you can think of any other motivations behind a merger or takeover or have anything else to add, please comment.

Until next time fellow bloggers...

Margin Call

Before viewing Margin Call (2011) I had mixed feelings as I had never heard of it before, however once I saw who was in the cast I knew that it would be a good watch with the likes of Kevin Spacey and Zachary Quinto performing.

The basis of the film is following the main people in an investment bank for a 24 hour period whilst they attempt to deal with the early stages of the financial crisis. It became very apparent towards the end of the film that this unnamed company were in a very similar position to what Lehman Brothers found themselves in; a company that had overwhelming amounts of debt (overleveraged) that realised that the only way to survive would be to sell all of its toxic assets. The only difference in this case was the company in the film managed to sell theirs, unlike Lehman Brothers!

It all starts when a junior risk analyst (Zachary Quinto) discovers that the volatility levels of the firms portfolio (made up of mortgage backed securities) has already breached the historical volatility levels that the company bases its whole investment policy on. With this in mind, if the company’s assets were to fall by 25% in value then this would be a loss that was larger than the entire market value of the unnamed company!

At this point in the film we have a great insight into the minds of the people at the top of a major organisation, where they have a decision to make: To save themselves? Do the right and moral thing?

Hmmm, let’s think about it for a minute... Of course they decide to try and save themselves and try to sell all of their toxic assets to their usual buying companies with the full knowledge that they are worth absolutely nothing. To give some credit where credit’s due, in the film they do manage to sell the majority of the toxic assets before the buying companies have fully acknowledged what is happening.

Was this decision a surprising one? Definitely not! Corporate greed was most likely the reason for the company being in the position that it was, so it only made sense for the people at the top to save themselves.

When I look back at the 2007 financial crisis in hindsight, it almost seems moronic that massive organisations thought they could continue operating in the way that they were with no repercussions. Especially with historic events such as the Wall Street Crash in 1929 And Black Monday in 1987!

However, was it just the investment banks to blame? Or was there anything that the government could have done to prevent such a crisis? In the case of the collapse of Lehman Brothers I believe that the government should have bailed them out despite the massive costs that it would have involved. The fallout caused due to the collapse of such a massive firm was so much larger than what the costs would have been for a bailout! On the other hand, in Margin Call, the CEO claims that if they were saved another company would fail after them and if they were saved then another company would fail, etc. So according to Margin Call it was inevitable that a crisis would occur!

Please feel free to comment fellow bloggers...

To Dividend or not to Dividend!?

This week I am discussing the hot topic of dividends and whether or not it is beneficial for a shareholder to receive dividends or not.

It seems that there are two simple options that a shareholder has when deciding if they would like to be paid dividends or not: Would I like to receive payments twice a year regardless of share price movements? Or would I like to be guaranteed that my shares will increase in value over time continually, with no payments made?  In the end all of this can be summarised using divided relevance theory and dividend irrelevance theory.

Just the same as last week (capital structure blog) Modigliani and Miller have a rather different and controversial approach to dividend payments. In their 1961 paper M&M argued the case of “Dividend Irrelevance” and claimed that a rational investor should be indifferent to receiving dividends or increasing wealth through capital gains. They argued the case that the best way to maximise market value is through a company’s investment policy and investing in positive NPV projects. In turn this should theoretically increase positive NPV cash flow, which should increase the share price and finally increase the shareholder wealth. Modigliani and Miller made it clear that they do not discourage companies from giving shareholders dividends, however it should only be the residual money after all possible NPV projects have been invested in.

However, once again good old M&M have made some very major assumptions. Surprise, surprise! Just like they did on their 1958 paper on capital structure they have made the assumptions that there are perfect capital markets with no transaction costs involved and that there are no tax implications regarding dividend payments or on capital gains. To me this is majorly alarming that they have not considered the implications that tax would have on the shareholder. One reason being that if a dividend payment to the shareholder took them into the next tax bracket than they would have been in ordinarily, it would make the shareholder worse off than if they had increased in wealth through increased share price and through capital gain!

 There is also the “bird in the hand” theory (also known as dividend relevance theory), which is discussed by Linter (1956) and Gordon (1959-1962). This is the idea that shareholders see dividends as more desirable than capital gains, mainly because of uncertainty. This uncertainty lies in the fact that future gains are not guaranteed and shareholders would much rather have money paid in the present than have to worry about their investment being tied up in an uncertain investment. From a personal point of view I know that I would much rather have dividend payments than have to wait and see what the outcome of investments are, as I am generally not a risk taker and I am certainly not patient. But maybe that’s just me? 

                                        

The payment of dividends can also act as a “signalling effect” for investors, as high dividend payments can represent good news and low dividends represent bad news. So it could be beneficial for a company to pay out higher dividends even if they are not performing greatly in a financial sense, as it could entice potential investors to invest, which would in turn increase the share price. Personally I see this method of increasing market value very short sited as it would not take long for investors and shareholders to realise how the company is actually performing and the share price would decrease back to the correct level.

On the flip side investors may see high dividends as a negative, as they may believe that this is due to there not being many future investments and no room for growth in the future!

From a personal point of view if I was a shareholder or a company then I would always rather have dividend payments than increased wealth through the share price of a company. Maybe this is just because I am a student and current finances are not brilliant, but I have always had the attitude that having current cash is more beneficial than having slightly more down the line.

From a company’s perspective, I agree with Modigliani and Miller to some extent that it does not matter what the dividend policy is, however I believe that complete transparency with the shareholders is key to increasing the market value!

Feel free to leave any comments fellow bloggers!... 

Debt or Equity?

The idea of having an optimal capital structure is one that is sought after by many organisations; however is this possible, or simply an unachievable theoretical vision?  To achieve an optimal capital structure a company must finance itself using the perfect ratio of debt and equity in order to maximise a company’s market value and the company’s overall Weighted Average Cost of Capital (WACC).

In the overall scheme of things debt is a cheaper and less risky option of finance for a company and financing through equity is high in risk, which in turn, demands higher returns. One reason behind debt being cheaper than equity is due to the fact that lenders generally require a lower rate of return than shareholders do for securities or collateral. Also debt interest can be offset against pre-tax profits before the calculation of the corporate tax will, which reduces the overall tax paid. Transaction costs are also much lower when financing with debt, as the costs of issuing and trading shares are much higher than the costs of servicing and raising debt. So with all of this considered, debt appears to be a much more appealing source of increasing capital than equity does, however is this actually the case?

In theory the more a company borrows and has high levels of debt and high gearing, the lower the overall cost of finance would be. So does it make sense for a company to just raise capital using as much debt as possible? Probably not! Not only does a high gearing level decrease the overall financial costs, but it also increases the chances of a company becoming financially distressed! This could lead to: lawyers’ fees, accountants’ fees, court fees and a waste in management’s time.

 A different and rather controversial view on capital structure is Modigliani and Miller’s (M&M) in their 1958 paper. Their argument was that it does not matter how a company structures it capital, as it does not impact on the WACC. They make the point that a business’ market value depends purely on risk and what a company’s investment policy is. However with this view Modigliani and Miller have made some massive and undeniable assumptions! The main two being that there is no taxation involved and that all markets are strong form efficient. Obviously this is never going to be the case! With these assumptions in mind I do not see how this theory can be relevant, as there is never going to be a situation in business where there is no taxation or there is perfect market efficiency. I almost find this theory of Modigliani and Millers’ irrelevant and somewhat amusing that it is held in such high regard when it holds no genuine substance.

In conclusion to whether or not it is better to finance using debt or equity, I have decided that the optimal structure for a company depends on what industry they are in and how they are able to handle their debts. Obviously financing using debt has it perks, but eventually it does need paying and too much debt can lead to financial distress. So it is essential for companies to find the ideal debt to equity ratio, however this is obviously not an easy thing to achieve!

Feel free to leave any comments…