An Introduction to Investment Banks, Hedge Funds, and Private Equity The New Paradigm Companion Web Site Ancillary materials are available online at: www.elsevierdirect.com/companions/9780123745033 An Introduction to Investment Banks, Hedge Funds, and Private Equity The New Paradigm David P. Stowell Kellogg School of Management Northwestern University AMSTERDAM • BOSTON (cid:129) HEIDELBERG (cid:129) LONDON NEW YORK (cid:129) OXFORD (cid:129) PARIS (cid:129) SAN DIEGO SAN FRANCISCO (cid:129) SINGAPORE (cid:129) SYDNEY (cid:129) TOKYO Academic Press is an imprint of Elsevier AcademicPressisanimprintofElsevier 30CorporateDrive,Suite400,Burlington,MA01803,USA 525BStreet,Suite1900,SanDiego,California92101–4495,USA 84Theobald’sRoad,LondonWC1X8RR,UK Copyright#2010,ElsevierInc.Allrightsreserved. AllCaseStudiesarecopyright#KelloggSchoolofMangement.Torequestpermissionforthese,please [email protected]. Nopartofthispublicationmaybereproducedortransmittedinanyformorbyanymeans,electronic ormechanical,includingphotocopy,recording,oranyinformationstorageandretrievalsystem, withoutpermissioninwritingfromthepublisher. PermissionsmaybesoughtdirectlyfromElsevier’sScience&TechnologyRightsDepartmentinOxford, UK:phone:(þ44)1865843830,fax:(þ44)1865853333,E-mail:[email protected]. YoumayalsocompleteyourrequestonlineviatheElsevierhomepage(http://elsevier.com),byselecting “Support&Contact”then“CopyrightandPermission”andthen“ObtainingPermissions.” LibraryofCongressCataloging-in-PublicationData Stowell,David. Anintroductiontoinvestmentbanks,hedgefunds,and privateequity:thenewparadigm/DavidStowell. p.cm. Includesbibliographicalreferencesandindex. ISBN978-0-12-374503-3(casebound:alk.paper) 1.Investmentbanking.2.Hedgefunds.3.Privateequity. 4.Finance–History–21stcentury.I.Title. HG4534.S762010 332.66–dc22 2009050831 BritishLibraryCataloguing-in-PublicationData AcataloguerecordforthisbookisavailablefromtheBritishLibrary. ISBN:978-0-12-374503-3 ForinformationonallAcademicPresspublications visitourWebsiteatwww.elsevierdirect.com PrintedintheUnitedStatesofAmerica 10 11 12 9 8 7 6 5 4 3 2 1 For Janet, Paul, Lauren, Audrey, Julia and Peter Contents Preface ix Acknowledgments xiii Section I. Investment Banking 1 1. Overview of Investment Banking 3 2. Regulation of the Securities Industry 21 3. Financings 41 4. Mergers and Acquisitions 63 5. Trading 97 6. Asset Management, Wealth Management, and Research 115 7. Credit Rating Agencies, Exchanges, and Clearing and Settlement 125 8. International Banking 137 9. Convertible Securities and Wall Street Innovation 155 10. Investment Banking Careers, Opportunities, and Issues 173 Section II. Hedge Funds and Private Equity 197 11. Overview of Hedge Funds 199 12. Hedge Fund Investment Strategies 219 13. Shareholder Activism and Impact on Corporations 241 14. Risk, Regulation, and Organizational Structure 257 15. Hedge Fund Issues and Performance 269 16. Overview of Private Equity 283 17. LBO Financial Model 307 18. Private Equity Impact on Corporations 325 19. Organization, Compensation, Regulation, and Limited Partners 347 20. Private Equity Issues and Opportunities 361 vii viii CONTENTS Section III. Case Studies 381 1. Investment Banking in 2008 (A): Rise and Fall of the Bear 383 2. Investment Banking in 2008 (B): A Brave New World 403 3. Freeport-McMoRan: Financing an Acquisition 419 4. The Best Deal Gillette Could Get?: Procter and Gamble’s Acquisition of Gillette 435 5. A Tale of Two Hedge Funds: Magnetar and Peloton 451 6. Kmart, Sears, and ESL: How a Hedge Fund Became One of the World’s Largest Retailers 469 7. McDonald’s, Wendy’s, and Hedge Funds: Hamburger Hedging? Hedge Fund Activism and Impact on Corporate Governance 489 8. Porsche, Volkswagen and CSX: Cars, Trains, and Derivatives 511 9. The Toys “R” Us LBO 521 10. Cerberus and the U.S. Auto Industry 539 Sources List 553 Reading List 559 References 561 Index 563 Preface The world of finance has experienced a paradigm shift following the global financial meltdown of 2007–2009.Marketparticipantshavebeensignificantlyimpactedandattitudesaboutrisk,transparency, regulationandcompensationhavechanged.Investmentbanks,hedgefundsandprivateequityfirmsare attheepicenterofatransformedfinanciallandscape,forgingnewrolesandseekingnewwaystocreate valueinanenvironmentoflowerriskandgreaterregulation.Thisbookprovidesanoverviewofinvest- ment banks,hedgefundsand private equityfirms anddescribesthe relationships betweenthese organi- zations: how they simultaneously compete with and provide important services to each other, and the significant impact they have on corporations, governments, institutional investors and individuals. Together, they have reshaped global financing and investing patterns, attracting envy and awe but also criticism and concern. They dominate the headlines of the financial press and create wealth for many of their managers and investing clients. This book enables readers to better understand these heavily interconnected organizations, their impact on the global financial market, principal activities, regulatory environment,historical development,and risks andopportunitiesinthe post-crisis world. Ultimately, the objective of this book is to demystify investment banks, hedge funds and private equity firms, revealing their key functions, compensation systems, unique role in wealth creation and risk management and their epic battle for investor funds and corporate influence. After reading this book,thereadershouldbetterunderstandfinancialpressheadlinesthatheraldmassivecorporatetake- overs,corporateshareholderactivism,largecapitalmarketfinancingsandthemyriadstrategies,risks, and conflicts in the financial market landscape. The inclusion of case studies and spreadsheet models provides an analytical framework that allows the reader to apply the book’s lessons to real-world financing, investing and advisory activities. Target Audience The target audience for this book includes MBA, MSF and Executive MBA students, and upper-level undergraduates who are focused on finance and investments. Investment banking classes can use this bookasaprimarytextandcorporatefinanceandinvestmentsclassescanusethebookeitherasasec- ondarytextorasaprincipaltexttofocusonhedgefundsandprivateequity.Inaddition,professionals workingatinvestmentbanks,hedgefundsandprivateequityfirmscanusethebooktobroadenunder- standing of their industry and competitors. Finally, professionals at law firms, accounting firms and other firms that advise investment banks, hedge funds and private equity firms should find this book useful as a resource to better understand and assist their clients. ix