Archive for the 'Securities Regulation' Category

The Structure of Private Equity Funds

Private equity funds are typically structured as limited partnerships or limited liability corporations (LLCs). There are a number of reasons for this preference.

  • No double taxation (profits taxed at limited partner or shareholder level)
  • No liability beyond the initial investment

Typically private equity funds will be structured to have a 7-10 year life, with options to extend this for an additional 1-5 years. The objective is to realize the full value of investments by the liquidation date. Rather than manage pools of uninvested capital, private equity managers typically require commitments that are drawn down as the funds are needed to make investments or cover expenses.

Fees for private equity managers typically include a management fee of 1.5% – 2.0% of assets under management, plus an incentive fee of 15%-20% of the profits retained after capital is returned to the limited partners. The incentive fee may include a hurdle rate of return that must be met before the fee is earned, and also may include a claw-back provision in case later investments do poorly.

Posted on 27th August 2008
Under: Active Management, Alternative Assets, Institutional Investing, Investing in Private Equity, Portfolio Management, Securities Regulation | No Comments »

Margin Transactions

Investors have the option to invest borrowed money, leveraging the return on their transactions. Brokers provide margin funds for this purpose.

In a margin transaction, the investor posts a portion of the cash needed to buy a security and borrows the rest. The stock or security purchased serves as collateral on the loan.

The Federal Reserve Board determines the margin requirement, or maximum portion of any transaction that can be made using margin. A lower margin requirement permits higher borrowing levels. Currently the margin requirement is 50%, meaning investors can borrow up to half the funds for a transaction.

Using margins exaggerates the return on an investment. For example, buying 100 shares of stock for $100 per share at 50% margin, the investor uses only $5,000 cash. The investor’s cash is also called the “equity” in the transaction.

If the stock rises to $110, the shares are worth $11,000 but the investor would still only owe $5,000 (plus some interest.) The equity has increased to $6,000 – which is a 20% gain even though the stock itself rose only 10%.

Of course, the same phenomenon works in reverse. If the stock falls 10% to $90, there is only $4,000 of equity and the investor loses 20% when the stock has lost just 10%.

Posted on 1st May 2008
Under: Investing in Stocks, Securities Regulation, Security Selection, Trading Execution | No Comments »

American Depositary Receipts (ADRs)

An American Depositary Receipt, or ADR, is a security that represents shares of a foreign company. Shares of the foreign firm are deposited with a bank, which issues the ADRs in the foreign company’s name. An ADR may reflect one share of the foreign firm, multiple shares or even a partial share.

ADRs can be issued with or without the involvement of the foreign company. However, unsponsored ADRs can trade only on the over-the-counter market or pink sheets. When the ADR is sponsored, it can be classified into one of three levels:

  1. A Level I ADR does not comply with SEC regulations and reporting requirements. The shares can only be traded over the counter. They can raise capital only through private placements to qualified investors.
  2. Level II ADRs are registered with the SEC and comply with SEC reporting requirements. They can be listed on exchanges or the NASDAQ market.
  3. Level III ADRs meet the criteria of a Level II ADR and can raise money in the U.S. through public offerings.

ADRs offer the advantage of easy and direct investment in foreign firms, particularly for retail investors. Large investors often find it more efficient to invest directly in the firm by trading on its home market exchange. Not all foreign firms offer ADRs, so investors who limit their foreign investments to ADRs are limiting their options to a narrow subset of the available international securities.

Posted on 2nd December 2007
Under: International Investing, Investing in Stocks, Securities Regulation | No Comments »

Why Sell Short?

Some investors believe the market for short selling is less efficient than the market for long holdings, and that there are more opportunities to find mispriced securities. A number of points support this theory:

  • there are fewer investors participating in the short sale market, and additional rules surrounding short selling.
  • many short sellers seek companies that are using aggressive accounting practices to artificially improve financial measures. Presumably few management teams will purposely make their performance look poor by choosing overly conservative accounting methods.
  • sell-side analysts typically rate more stocks “buy” than “sell.”
  • conflicts of interest may encourage analysts to rate stocks more favorably than they might otherwise.

Posted on 18th July 2007
Under: Accounting, FInancial Planning, Fundamental Analysis, Investing in Stocks, Investment Returns, Portfolio Management, Securities Regulation | No Comments »

How Transparency Affects Stock Valuation

Cheng, Collins and Huang published an article in the September 2006 Review of Quanititative Finance and Accounting that considered the effects of shareholder rights and financial disclosure on the cost of equity capital.

Prior research has shown that the cost of capital is reduced when shareholders have strong rights and the company operates in a transparent manner with full financial disclosure. This article studies interactions between rights and transparency, as well as the resulting impact on cost of capital.

Consistent with prior research, both shareholder rights and transparency individually serve to increase value by reducing the cost of equity capital. Furthermore, the authors find that poor scores on either measure can offset strong scores in the other, and that the greatest benefit is accrued by companies that offer both strong shareholder rights and high financial transparency.

Posted on 6th June 2007
Under: Corporate Governance, Governance, Research, Securities Regulation, Valuation | No Comments »

Proxy Battles: A Motorola Case Study

Motorola (MOT) had the usual start to its recently filed Proxy statement:

Dear fellow stockholder:

You are cordially invited to attend Motorola’s 2007 Annual Stockholders Meeting. The meeting will be held on Monday, May 7, 2007 at 4:30 p.m., local time, in the Rubloff Auditorium at The Art Institute of Chicago, 230 South Columbus Drive, Chicago, Illinois 60603.

At this year’s Annual Meeting, in addition to electing your entire 11 member board, we are asking stockholders to approve an amendment to the Motorola Employee Stock Purchase Plan of 1999 (the “MOTshare Plan”) to make 50 million additional shares available for purchase by employees. The MOTshare Plan encourages employees to own more shares of Motorola and thereby further aligns their interests with those of all Motorola stockholders.

I encourage each of you to vote your shares through one of the three convenient methods described in the enclosed Proxy Statement, and if your schedule permits, to attend the meeting. I would appreciate your support of the nominated directors and the proposed amendment to the MOTshare Plan. Your vote is important, so please act at your first opportunity.

On behalf of your Board of Directors, thank you for your continued support of Motorola.

The problem (for Motorola) is that there has been another proxy statement filed, this one by dissident shareholder Carl Icahn. Icahn has some different ideas as to how the shareholders should vote on the matters before them. Let’s take a look at each one.

The candidates nominated by the company as directors include the 10 current directors and David Dorman, retired chairman of AT&T. Icahn has nominated himself. Those 11 receiving the most votes will win, and only those votes cast in favor of a candidate will be counted.

According to Motorola’s filing, the compensation of directors is fairly favorable, though the company is large and it is unlikely any of the nominees “needs” the money.

During 2006, the annual retainer fee paid to each non-employee director was $100,000. In addition, (1) the chairs of the Audit and Legal and Compensation and Leadership Committees each received an additional annual fee of $15,000, (2) the chairs of the other committees each received an additional annual fee of $10,000, and (3) the members of the Audit and Legal Committee, other than the chair, each received an additional annual fee of $5,000. The Company also reimburses its directors, and in certain circumstances spouses who accompany directors, for travel, lodging and related expenses they incur in attending Board and committee meetings.

Including stock and other awards, most of the directors took home about a quarter-million dollars in 2006.

The next proposal is to increase the shares authorized for issuance as employee compensation:

The Board of Directors believes it is in the best interests of the Company to encourage stock ownership by employees of the Company. Accordingly, the Motorola Employee Stock Purchase Plan of 1999 (the “MOTshare Plan” or the “Plan”) was initially adopted in 1999 and authorized the sale to employees of up to an aggregate of 54.3 million shares of Common Stock issued under the Plan. In 2002, both the Board of Directors and the stockholders approved amending the Plan to increase the aggregate number of shares of Common Stock available for sale to employees by 50 million shares.

Having already approved the plan, the Board recommends voting in favor, while Icahn’s proxy makes no recommendation.

Proposal #3 would require a shareholder vote on management compensation plans. The Board does not like this plan, Icahn’s group does.

Proposal #4 seeks to amend the bylaws so that incentive compensation earned by managers could be taken back if it was later determined that the appropriate targets were not met. The Board opposes, and Icahn’s group has no opinion on the matter.

Posted on 27th March 2007
Under: Accounting, Securities Regulation | No Comments »

The Cash Method of Accounting

Many small businesses operate on a cash accounting basis. They simply keep track of cash received and cash paid out. This is known as the cash method of accounting. Under this method it can sometimes be difficult to match expenses with their associated revenues. For example, if a company purchases inventory in one year and sells it in the next, the expense will be reported in year one while the revenue will be reported in year two.

Publicly traded companies are not permitted to use the cash method under either U.S. GAAP or International Accounting Standards. However, they must present a statement of cash flows under both standards. The cash flow statement allows investors and others to compare accruals with the timing of cash flows.

Posted on 25th March 2007
Under: Accounting, Financial Statement Analysis, Fundamental Analysis, Securities Regulation | No Comments »

Revenue Recognition from Barter Transactions

One earnings quality issue arises from barter transactions. A good example of this is provided in Financial Statement Analysis : A Global Perspective and excerpted below.

Internet companies often exchange rights to place advertisements on each other’s Websites (that is, barter). Should the company record the revenue based on the fair market value of the space and a related expense of the same amount? Or should both be ignored since they offset each other? The net result has no impact on earnings, but early stage companies are often valued based on revenues rather than earnings or cash flow (often because they have no earnings or cash flow). Companies could inflate their values by recording barter transactions as “revenue” even if these arrangements did not produce earnings or cash flow for the respective entities.

In 1999, the FASB Emerging Issues Task Force (EITF) declared that revenue from such barter transactions should be reported only if the fair value of the advertising surrendered in the transaction is determinable based on the entity’s own historical practice of receiving cash, marketable securities, or other consideration that is readily convertible to a known amount of cash for similar advertising from buyers unrelated to the counterparty to the barter transaction.

Analysts may go further, and consider whether other transactions between companies are barter-like and whether the financial statements should be adjusted to treat them as such.

Posted on 28th February 2007
Under: Adjusting Reported Financial Statements, Financial Statement Analysis, Fundamental Analysis, Securities Regulation | No Comments »

Analyzing the Auditor’s Statement: An Unqualified Opinion

Securities regulations require the company’s auditors to provide a report stating whether investors can rely on the information presented. Such reports can take several forms:

In most cases, the auditor will provide an unqualified opinion, essentially saying “yes, investors can rely on the information in this report.” An example can be found in the 20F (the annual report for a foreign company) for Sony. The key line is:

In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Sony Corporation and its subsidiaries (“the Company”) at March 31, 2004 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended March 31, 2005, in conformity with accounting principles generally accepted in the United States of America.

These statements assure investors that they can rely on the financial statements presented.

Posted on 13th February 2007
Under: Financial Statement Analysis, Fundamental Analysis, Securities Regulation | 1 Comment »

Analyzing the Auditor’s Statement: Adverse Opinion

Securities regulations require the company’s auditors to provide a report stating whether investors can rely on the information presented. Such reports can take several forms:

In an adverse opinion, the auditor will state that the financial statements “do not present fairly, in all material respects, the financial position” of the company.

It is rare that investors will see such an opinion, but when they do they should proceed with caution.

Posted on 13th February 2007
Under: Financial Statement Analysis, Fundamental Analysis, Investing in Stocks, Securities Regulation | No Comments »