Evolution is Hard Work
UBS Exits Businesses While Blackstone Adapts to the New World Order
UBS AG, Switzerland’s largest bank, has been conducting multiple rounds of job cuts at its securities division in order to to shrink the fixed-income unit after record losses from the global financial crisis, according to Bloomberg and other media sources. The Zurich-based bank will exit its real estate and securitization and exotic structured products businesses. The company had already announced about 6,100 job reductions at the investment bank since October is also quitting municipal bonds, proprietary trading and commodities businesses, excluding precious metals. “These changes will enable us to leverage our core strengths while relying on lower risk and balance sheet utilization,” said Jerker Johansson, head of UBS’s investment bank, in a separate statement. As a result, it is highly likely that UBS’s investment bank is a business entirely focused on equities, equity underwriting, merger advice and foreign exchange.
The announcement sure seems to describe something awfully similar to a static business model, where a typical response to recent losses or an unfavorable market outlook is to scale a business down or exit it altogether. Is there a better response, the one that does not mechanically exit businesses at the bottom only to lose market shares, reopen these same businesses at the top of a cycle, suffer losses, and exit them again? Is there no value in being in real estate and securitization and structured products businesses going forward? Or in municipal bonds, proprietary trading and commodities businesses? The answer to these questions is a resounding “no.” Is retrenching to highly commoditized “red oceans” of equity trading and underwriting, merger advice and foreign exchange trading a better strategic decision? Highly debatable.
Static business models have been at the core of many ills that got financial institutions in trouble in the first place. Following losses, they exited businesses, exposing themselves to loss of market share and opportunity costs. When the perception of the environment turned favorable, abandoned businesses were re-entered and existing businesses were scaled up. Throughout, the risks underlying these businesses always remained the same. Importantly, this latter feature is responsible for yet another highly undesirable and dangerous properly of static business models: the fact that they tend to respond to earnings pressures and low return environments with blind leverage and excessive risk taking. The ongoing financial crisis is, in many ways, a manifestation of static business models in action.
UBS’s response poses a sharp contrast to other financial institutions that seem to be transforming their business models in the spirit of Financial Darwinism. The Blackstone Group, for example, has been using its natural expertise in analyzing and advising companies to shift focus from leveraged buyout to advisory businesses. Note that it is not exiting private equity business altogether; it’s just supplementing it with other sources of revenue in an area where its natural expertise and competitive advantages can be leveraged. As a part if its adaptive evolution, Blackstone has already advised Procter & Gamble Co. on the $4.5 billion sale of its Folgers coffee unit to J.M. Smucker Co. and worked with Microsoft Corp. on its proposed takeover of Yahoo! Inc.
In all, according to Bloomberg, Blackstone earned fees from clients on 18 deals worth $12.3 billion in recentmonths.
The group’s profit almost tripled to $61.1 million in the third quarter of 2008 compared with a year earlier. “The problems at all the major banks and securities firms are causing widespread cutbacks, distraction and personnel defections,” one of the firm’s executives said. “This turmoil at our major competitors is clearly benefiting our advisory business.”
No one claims that organizational change is easy, but firms like Blackstone have shown that the effort can mean not only survival but long-term prosperity. Such actions are clearly a superior alternative to typical knee-jerk behavior of institutions with “static” business models.
The typical bond fund represents a quintessential static business model – always exposed to the same risks, always at the mercy of competitive and market forces, and challenged to effectively react to the rapidly changing financial world. Traditionally a staple of any investment portfolio, they have been a source of reasonably steady – if unspectacular – returns. Fast forward to the new reality: interest rates are at extremely low levels, so even in the best case scenario, future returns for these funds are likely to be lackluster at best. Moreover, the prospect of significant inflationary pressures is real, presenting huge dangers to fixed income holdings that are not dynamically managed.
The reason for the bleak prospects of traditionally managed bond funds in the foreseeable future is their structural exposures to interest rates, which are likely to greatly offset, if not overwhelm, any potential gains should inflation intensify and interest rates rise. Now there are new kinds of bond funds in the works designed to get around this problem.
It’s called the “Go-Anywhere” funds, and the name says it all.
Go-Anywhere funds are an attempt to introduce dynamism into the investment process of fixed income funds, hopefully making their returns less cyclical, market-dependant, and susceptible to inflation risks that plague conventional bond funds. They accomplish this by giving managers wide latitude to invest in bonds from a variety of issuers with varying maturities and credit ratings, including emerging-market bonds and non-U.S. currencies. But all this opportunity comes at a greater risk – and much higher reliance on the market-timing skill of portfolio managers.
So far those financial institutions that have created go-anywhere funds have been generally cautious. Instead of leaping into a range of potentially volatile investments they have kept investments in higher quality instruments and results have been modest at best.
The dynamism of the go-anywhere funds is part of a broader trend toward business model recalibration of financial institutions that is designed to respond to the challenges of today’s global economy and volatile and interconnected financial markets. The intention is the right one – and the available broad universe of asset classes and risks should give skillful portfolio managers an opportunity to create long-term value for their investors. However, it is important to note that this mode of operation is a significant departure from the traditional expertise of most fixed income managers, so results are likely to vary significantly. As always, let the buyer beware.