Technofile Europe

Death, taxes and financial regulation

As the global banking sector convulses with the most comprehensive restructuring in memory, voices on both sides of the Atlantic are calling for tighter banking regulation in order to prevent a future meltdown.  Heads had to roll and a number of senior executives have lost their jobs, while others find themselves inadvertently turned into civil servants operating state-owned banks. 

Relatively speaking, that was the easy part.  The question now is: how to regulate the industry better without stifling financial innovation?

There is no shortage of ideas coming from European and US regulators, many bad (executive pay caps, short sale bans), some good (clearinghouses for private financial contracts).  The only thing we can say for certain is that there will be amendments to existing Basel II and Mifid regulations, as well as new initiatives to increase disclosure and fiddle with capital adequacy rules.

As a participant on the margins of financial markets, I hope regulators err on the side of improving the transparency and liquidity of existing financial innovations, rather than try to constrain the complex financial products whose reckless distribution got us into this mess.  

The fact is that every link in the chain of this financial crisis -- subprime mortgages, credit default swaps, counterparty defaults, off-balance sheet investment vehicles -- was beset by the same fundamental problem:

insufficient information to
(a) gauge value, and
(b) understand dependencies.

This was an information crisis.  The new financial instruments and their markets simply got ahead of risk managers', CEOs' and regulators' ability to keep track of them.  And this is in spite of all the technical tools to manage this information being readily available.

We have a vested interest in this problem, through our investment in FRSglobal.  Until this year, FRS provided necessary but unexciting solutions to banks to calculate risk and to automate regulatory reporting.  Today, FRS is talking to regulators all over the world about how to improve everyone's visibility of risks and interdependencies among banks.  FRS CEO Steve Husk blogs about these issues here. 

The crisis is the catalyst that is finally bringing together risk management, business analytics and reporting -- a 3-way marriage software vendors and consultants have talked about for a decade, but which no one has yet consummated.  It's time for CFOs to have a single view of risk exposure, and to report on that view to both their boards and the regulators. 

To this end, FRS has made two acquisitions in the past 3 months: Swiss-based vendor of integrated risk management solutions IRIS (see Gartner's take here), and SAP/Business Objects subsidiary SECAM+, a specialist in regulatory reporting for the UK securities industry. 

Traditional ERP and even banking systems vendors acknowledge that the new paradigm of risk management and reporting is a highly specialised activity, requiring purpose-built analytical tools and extensive banking domain knowledge.  For this reason, incumbents like SAP and Temenos are partnering with FRS to deliver unified risk management to their clients.

It's only the beginning of the consolidation in this market and a lot of uncertainty remains.  But to death and taxes, we can undoubtedly add 'more regulation' to the list of certainties.

What does the crisis mean for growth capital and VC?

A lot of people have been asking me what impact the global financial crisis has on the business of venture capital and growth equity.  The short answer to this question is: not much.  The slightly longer answer is: not much, yet.

Let me explain.

If you are currently raising a venture capital or growth capital fund, the paralysis of investors worldwide means slower decision-making and a longer fund-raising cycle.  You may even lose some previously committed investors who are now conserving cash to cover losses in other asset classes.  If you have recently raised a fund then you are in good shape.  As banks, non-bank companies and consumers are rapidly finding out, when credit is tight cash is king.

But what about the impact on our business of investing in businesses?  Our existing portfolio companies will feel the crisis on two fronts: commercial performance and exit horizon. 

First, a prolonged recession will make it harder to land customers and grow revenues.  This means that business plans will take longer to achieve.  The exception may be in countercyclical or recession-proof segments, such low-priced entertainment (eg, games), discount retail (eCommerce), cost-reduction tools (eSourcing, supply chain optimisation), and products that address the current crisis directly (like compliance software, or trading platforms for previously 'hidden' financial assets). More on the latter category in a future post.

Second, as the IPO window remains shut for longer and M&A activity slows, there will be fewer buyers for companies and acquisition prices will be depressed.  We already saw throughout 2008 a flight to quality: companies with strong topline growth and high profitability are still being acquired and achieving good valuations.  The companies best able to survive this environment are those with strong 'operating leverage' -- that's VC-speak for high gross margins.  High margins reduce the effect of slower revenue growth and give companies more flexibility to reduce their cost structure as the market slows.

For investors, the key is to be able to wait for the right time to sell a company. This means both the internal timing (strong operations, good growth, a clean balance sheet) and external timing (market interest).  Companies that are profitable or close to profitability have a huge advantage in this market.

The impact on the private equity industry will vary drastically.  At the top end, LBO funds have already seen a huge increase in their equity cost as they refinance debt packages with equity, while their companies' earnings decline.  This is a continuation of the shake-out that started a year ago.

The second most affected category will be early-stage VC.  Most VC-backed companies are loss-making and were valued at the time of investment on the basis of aggressive growth forecasts, or expected strategic value on exit, or both.   Slower growth and a longer-time-to-exit means they will need to raise more capital, probably on worse terms.  This increases the equity cost of their investors and extends their investment horizon, depressing rates of return. 

Already we are seeing VC firms increase the follow-on reserves for existing portfolio companies, which will mean less capital available for new investments.  In the last downturn, many shifted their focus to later-stage investments, leading to a funding drought for pre-revenue companies.  More on the dilemma for early-stage companies on Fred Wilson's blog here, and Jason Calacanis' here.

The least affected, in my view, will be growth equity and midmarket buyout firms.  Growth equity portfolio companies typically have little or no debt financing and are cash-generative (or can get there quickly).  This means they can adapt their operations to slower market conditions, invest in discrete growth opportunities, and wait for the right time to exit.  The best ones will be acquired for the quality of their earnings by savvy buyers even during the downturn.  Growth equity investors can focus these businesses on improving the quality of the business and finding pockets of higher growth while positioning the business with potential acquirers.

Lastly, the more unpredictable effect is on the making of new investments in the technology markets.  In the 2001-2003 downturn (which was heavily weighted toward the technology industry) few entrepreneurs felt confident enough to write aggressive growth plans, and as a result it was difficult to find quality companies to invest in.  But I think this one is going to be different.  Here's why:

First, this recession is going to be more generalised, similar to the banking-led industrial downturn of 1980-82, with a correspondingly smaller effect on the technology industry itself. 

Second, the European investment eco-system is far deeper and more mature than it was in 2001.  Back then, a nascent VC and entrepreneurship market was nearly wiped out by the collapse in stock market values.  Today, we are tracking thousands of European technology companies that have shown more than 5 years of continuous growth, are profitable and in many cases geographically diversified.  This represents a very deep pool of potential investments, which are supported by a broad universe of specialised lawyers, bankers, recruiters, and angel investors.  So, I think that for investors with funds, good research capability and a broad network of sources for dealflow, there will be no shortage of investment opportunities.  Equally, for entrepreneurs with capital-efficient businesses, that have demonstrated an ability to prosper in good times and bad, there will be no shortage of investment capital.

Let's see how it plays out.

FRSGlobal acquires IRIS

Among the few segments of the technology industry actually benefiting from the crisis roiling the financial markets are risk management and compliance.  As shareholders scrutinise banks' risk management practices and regulators debate new reporting requirements, financial institutions of all sizes are having to review how they assess and report on risk. 

Earlier this year I wrote about the need for a more comprehensive approach to risk management to take account of off-balance sheet assets and more correlated financial markets.  In particular, I made the point that the bank CFO needs to have a holistic view of risk that is independent from the risk management systems used by individual trading desks. 

In response to increasing demand for end-to-end risk systems under the CFO's control, we announced today the acquisition of IRIS Integrated Risk Management by our portfolio company FRSGlobal.  Iris is known for having one of the most sophisticated platforms for managing complex risks in a single, integrated application.  About 230 financial institutions worldwide use its products. 

FRSGlobal will combine Iris' financial analysis capabilty with its ability to generate regulatory reports in over 30 countries to become the world's only one-stop shop for risk management and regulatory reporting for banks.

As you can tell, I'm pretty excited about this deal, because it (a) makes a lot of strategic sense and has a the support of FRSGlobal's and Iris's existing customers; and (b) it's always satisfying to find a market segment that is counter-cyclical as we head into uncertain economic waters.

Picture credit: Van Gelder Insurance.

What's in a name?

If nothing else the Carlyle Capital debacle is a good lesson in where to draw the line in extending your brand.  The Carlyle Group's partners owned only 15% of the fund, and yet they had lent it their prestigious name.  As a result the hedge fund's collapse has become a PR nightmare for Carlyle, when it could have been the disappearance of just another over-leveraged hedge fund, and little more than a (painful) personal investment loss for Carlyle's partners.  A lesson to remember for the next cycle.

Time for risk management 2.0

The unrelenting waves of bad news coming out of the financial services industry these days all seem to wash ashore at the same place -- on the desk of the CFO and his compliance team.  Financial risk management just isn't what it used to be.  Or rather, the risks themselves have moved so significantly in the past 10 years that banks have not managed to keep up (except, perhaps, the whiz kids at Goldman). 

Time for a change, or as Steve Husk of FRSGlobal suggests in his new blog, banks need to decide whether they want to be Southampton FC or Real Madrid (really!).  It's time for a two-dot-oh look at risk management.

In my view 3 main factors have contributed to an exponential increase in the scope and complexity of risk.  First came an acceleration of innovation in financial instruments, with investment banks churning out weekly new spins on the securitisation concept to ensure they had something to sell to clients, something to trade in and out of to generate fees, and -- in many cases -- something for their prop trading desks to buy.  The sophistication of these products have come a long way from Bowie bonds to a finely-graded slice of sub-prime mortgage risk.

Second, the entrance of new market participants, including hedge funds, corporate treasurers and commodities offices, the banks' own SIVs, and -- finally -- consumers egged on by retail bank 'consultants', created greater liquidity but also volatility in the market.  The behaviour of many of these market participants was not predictable and their reaction in a crisis untested.

Third, capital moves at higher speed through many more jurisdictions today than ever before.  There is no such thing as a domestic or European or American capital market today.  The effects of US subprime mortgage defaults are being felt in every corner of the globe, much to the surprise, no doubt, of the poor souls who are actually defaulting.

And yet the risk management approach used by most banks is based on legislative concepts that were  developed decades ago, in a simpler world of capital offsetting measurable liabilities on balance sheets (Basel I, Basel II).  The IT systems on which these risk management processes run tend to be local financial accounting systems, perhaps even instrument- or business line- specific, with little integration with the global exposures of the bank.

Now that banks know their real exposure is much greater than previously thought, and with the threat of increasing regulation if they don't find a way to regulate themselves, it's time to dust off those formerly Utopian plans to develop a single view of risk within the bank.

For both banks and corporates the era of keeping multiple sets of books is drawing to a close.  There is simply too much risk in not having a single, accurate, reportable view of the financial position.  The board will want to see the same report as the regulator is reviewing.  And when the regulator calls, the CFO wants to make sure his reporting is fully transparent and auditable.

It's no longer good enough to delegate local regulatory reporting to country managers. Regulators from different countries are talking to each other and are likely to exchange information and continue to harmonise their requirements.  For a bank operating across the world, this means local financial reporting needs to be in synch.  For the CFO, it means reducing risk of local error, while increasing global visibility of the numbers. 

So while general IT spending by banks will likely tail off this year, spending on compliance processes and risk management will continue, benefting firms like Riskmetrics (which is going public today), Algorithmics, and FRSGlobal (disclosure: Kennet company).  It is likely to take banks years to consolidate their financial systems and arrive at a single, global view of risk and an ability to report on it.  The good news is that this is more a process problem than a technology problem.  Recent technical innovations, including all that Web 2.0 stuff, make it notionally easier than ever.  Time to get started.