Chairman's letters

17 September 2012

The Case for Having Investment Boundaries

When I started at Goldmans as a young trader, I never imagined that 30 years later I would be arguing for clear, enforceable and enforced risk management rules. I did not believe such rules were necessary – a view still held by some who should know better.

However, I am not a convert to the idea of detailed regulations and prescriptions aimed at preventing every mistake or misjudgement. Attempts at micro-management strangles enterprise and innovation. Even worse such rules all too often fail to prevent the behaviour they are intended to stop.

This very mistake is currently being made by bank regulators. The detailed regulations and capital ratios disciplines being put in place on both sides of the Atlantic in order to prevent another bank-led crisis are destined to fail because our financial institutions will find a way round them. Their real impact will be to prolong the crisis by making it more difficult for successful businesses and entrepreneurs to borrow the money they need to expand.

Instead, a complete separation of investment and commercial banking is needed to prevent any repeat of the recklessness which brought the global economy, and a whole host of countries, to their knees. That way investment banks will pay the price for mistakes they make while ensuring that the vital role that commercial and retail banks plays in the wider economy is protected. 

Anything less than separation and the banks would have too much incentive to find a way round any restrictions. We need commercial and retail banks to be as safe and dependable as utilities are meant to be. This means they won’t be able to make the huge short-term returns that they got used to.  It is also why international banks have campaigned so aggressively against separation. Their returns have been based on being able to load up their balance sheets with assets which had the stamp of approval from the regulator. This mixing of assets and activities across retail and investment banks has meant that in the good years bankers won…and when things went wrong the shareholders and eventually the public ultimately paid.

When Mervyn King said recently that there had been a break down in the culture in our banks over the Libor crisis he was only partly right. The break-down was caused by importing the much more risky culture of investment banking into our commercial banks and ultimately into our high-streets. Many heads of international banks came originally from proprietary trading – where I began my own career. Leopards cannot change their spots. Moving from a risk-taking investor to fiduciary manager of a Government-backed institution is not something that I believe is possible.

When I first criticised the way banks were being run five years ago, I was forcefully told by the head of a major international bank that ‘it is only through using the money we raise through our retail deposits for our investment banking activities that we can continue to make the returns that justify what we get paid.” He is no longer in his post. But no matter who is in charge, the temptation of making quick profits from investment banking is just too great. We need people in charge who have backgrounds outside investment banking and trading; people who have the strength to stand up to the rest of the firm and protect the bank’s balance sheet and its customers. They are certainly not the risk-taking traders I admired in my early years at Goldmans.

I have seen throughout my career that while micro-management does not work, neither does a free-for-all. Instead banks need a small number of very clear boundaries and limits to behaviour, and then they need to make sure that these are clearly understood and, if broken, the consequences for the individuals will be severe.

It was a lesson I learnt on the trading desks at Goldmans in the 1980s where I saw the dangers of having only a few rather unclear boundaries. On taking over the Eurobond desk in London, I wanted to impose strict limits on the amount each trader could invest and to fire any trader who breached these limits. This was seen as draconian and I was over-ruled by my senior US bosses. 

They argued that traders needed the freedom to increase their positions to increase returns. That freedom appears fine in a healthy market but is disastrous in a crash – as Goldmans discovered when they were left nursing huge losses in both 1989 and 1994.

These boundaries are critical when times are good to ensure that people do not over-reach and can resist the pressures that success brings. This lesson applies to the private equity industry as well as the banks, as many of us learned to our cost.  After Terra Firma’s experience with EMI, there are few better placed to share the lessons than me.

There are two major differences, however, between the fallout that occurred through the behaviour of the banks and the experience of the private equity industry. First, Terra Firma and indeed the whole private equity industry did not need and would not have expected any Government bailout. Secondly, private equity employees typically directly share risk with their investors. Terra Firma and its employees were indeed the biggest investor in EMI.

In the run-up to the 2008 crisis the private equity industry could do no wrong.  The money was pouring in and the pressure was on to find ever larger deals to through which to put that capital to work and get the returns that investors wanted. Even those with plenty of experience found it difficult to resist such pressure.

At Terra Firma we believed that EMI presented a great investment opportunity otherwise we would not have publicly and legally committed to it in May 2007. Nor would we have underwritten such a high exposure to a single deal across two of our funds.  We were confident that we would be able to sell down part of our investment to co-investors. No one knew that credit conditions would change so quickly and disastrously.  While Terra Firma was not the only private equity firm or institution caught out when the market crashed, EMI was a large deal in a colourful sector and it became the poster child for deals caught up in the market chaos.

The irony is that EMI would have been a good deal if the debt and equity market conditions had not changed so dramatically. Our problems stemmed from the timing of the transaction not the strategy. Our view of the music industry’s overall market decline proved to be almost largely correct. As EMI’s subsequent performance has also shown, our plans for transforming its operations were both correct and its only chance of survival as an independent company.  The business moved from negative cash flow of £150 million per year to positive cash flow of £250 million per year under our ownership. At the same time EMI’s market share increased 13%, in an industry that declined by 15%.

The timing of the closing of the deal, in the second half of 2007, meant we were unable to syndicate or re-finance the transaction. Citigroup eventually took over the business by accelerating the maturity of the loan – despite the fact that we were capable of covering our interest payments twice over. Citigroup has now split up and sold the business in order to have their loan repaid early. EMI represented a huge capital issue for them around which they would have got substantial regulatory focus.

Although we kept our investors fully informed of what we were doing and had their full support, the responsibility for what went wrong is mine. I had the chance to veto the deal back in May 2007 but did not. We should have had in place strict rules restricting our exposure to individual deals and preventing cross-fund investment, as we do now. 

It is ironic that someone who had argued for clear rules throughout his career was caught out this way. It demonstrates to me the importance of having firm boundaries in place, irrespective of how many years’ experience you have. Boundaries provide safeguards and discipline. If set correctly, far from stifling creativity, they encourage it by giving freedom to operate within clear limits.

It is not just the financial world which benefits from such rules. I recall a sad story about a family building firm which went bust, at the end of the 1990s, after successfully trading for over 170 years. The mistake they made was to break their own rule: never take on a contract worth more than 10 per cent of annual revenue. Tempted by the biggest contract in their history, they put all their eggs in one basket. When the contract failed to pay up over a dispute about the quality of the work, they went bankrupt and unlike Terra Firma, they never had the chance to apply the lessons learnt.

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