The Operating Returns to Acquired Intangible Assets

Accounting rule makers have long debated whether companies should recognize intangible assets on their balance sheets. At the heart of this debate is whether recognized values can predict future income and cash flows, or whether the high degree of measurement uncertainty embedded in intangible asset values precludes such predictive ability. While many agree intangibles like patents, trademarks, and goodwill contribute significantly to value creation and profitability, separately identifying and reliably measuring intangibles is costly. In fact, due to measurement-related concerns, accounting rules generally do not allow companies to recognize internally generated intangibles on their balance sheets. Intangibles acquired externally in … Read more

Investor-Paid Credit Ratings and Conflicts of Interest

Credit ratings provide information regarding a company’s default probability.  Ratings are relied upon extensively in regulation and private contracting and play a crucial role in the functioning of the capital markets.  However, since the major credit rating agencies (CRAs) operate under a business model whereby they are paid by their issuers, there is reason to believe that issuer-paid ratings are inflated.  Many market observers view this conflict of interest as a contributing factor of the global recession of 2008-2009.  This indictment has also allowed for the emergence of several CRAs that operate under an alternative “investor-pays” business model, which some … Read more

The Identity Challenge in Finance

Identity is fundamental in finance. At a time when huge TechFins like Amazon are making inroads into the financial services industry, major questions are arising as to the most effective methods of customer identification and meeting Know Your Customer obligations (KYC). Does the solution lie in redefining identity, in the methodology of retrieving identification, in some mix of the two, or in other ways? We have recently explored these issues, here.

To date, forms of analogue and digitized identity (i.e paper documents and scanned ID documents respectively) have been relied upon to prove an individual’s identity to, say, a … Read more

Do Public and Private Firms Invest Differently?

Equity markets are an important source of capital financing for firms, particularly in the United States. These large, liquid markets channel capital from savers to firms and facilitate corporate investment by distributing risks among many smaller investors. There is concern, however, that along with these benefits, equity financing has significant costs. One of the most prominent criticisms of the public ownership of firms is that investor pressure over short-term stock market performance causes public firms to forgo profitable, long-term investments.

This criticism has prompted such notable corporate leaders as Jamie Dimon of J.P. Morgan Chase and Warren Buffett of Berkshire … Read more

Paul Weiss Discusses New Trends in Private Equity Transactions

The private equity market is more competitive than ever.  Target company multiples have skyrocketed due to both a robust strategic acquisition market, and stiff competition from PE buyers as they vie with one another to deploy $1 trillion in dry powder that remains from the $3 trillion raised in the past five years.[1]  As traditional investment strategies become more challenging, PE firms are adopting innovative strategies to adapt.

In this issue of the Private Equity Digest, we look at four methods PE firms have used to adapt to the current competitive environment – (i) engaging in more buy-and-build approaches … Read more

Split Derivatives: Inside the World’s Most Misunderstood Contract

Derivatives are the “bad boys” of modern finance: exciting, dangerous, and fundamentally misunderstood.  Their supporters defend them as important instruments for measuring, managing, and transferring risk, enhancing both the efficiency and resilience of the financial system.  Their critics label them everything from “socially useless” to “financial weapons of mass destruction” to “the crystal meth of finance.”  They have been singled out by policymakers as one of the catalysts of the global financial crisis.  They have even been condemned by the Pope.  Indeed, in the wake of the crisis, it often seems like everyone who is anyone has an opinion about … Read more

Debevoise Discusses OCC Efforts to Modernize Community Reinvestment Act Regulations

On August 28, 2018, the Office of the Comptroller of the Currency (“OCC”) published an advance notice of proposed rulemaking (“ANPR”) inviting public comment on ideas for modernizing the regulatory framework for the Community Reinvestment Act of 1977 (“CRA”).[1] Comments must be received by November 19, 2018.

The ANPR addresses concerns from banks, community groups, academics and other stakeholders that CRA regulations have become ineffective because they no longer reflect the banking activities of many banks or consumers, given the dramatic growth of digital banking and technologies that have allowed banks to become active in communities where they do … Read more

Did Deregulation End the “Quiet Period” of Low-Risk Banking?

From the New Deal until the 1970s, banks were on a tight leash. Regulators controlled the rate of interest they could pay on deposits. Banks could not underwrite or deal in corporate securities. With some exceptions, they could not expand geographically.

These restrictions were gradually eliminated beginning in the 1970s. Simultaneously, banking grew riskier. From the end of World War II to 1970, bank failures were virtually nonexistent. From that time on, the U.S. experienced waves of bank distress culminating in the financial crisis of 2007-09.

It is tempting to conclude that the deregulation caused the instability. I believe, however, … Read more

The Deregulation Debate: The Challenge of Using Static Rules to Govern a Dynamic System

In their lively disagreement about the role of deregulation in contributing to the 2007-2009 financial crisis, professors Arthur Wilmarth and Paul Mahoney inadvertently illuminate why the processes through which finance is regulated are so ill-suited to that purpose.  Finance is dynamic.  Today’s financial system bears only a coarse resemblance to the financial system of the 1950s.  Tomorrow, the system will evolve yet further and in ways we may not be able to imagine today.   In contrast, the legal regime is designed to stagnate. Frictions make statutes and regulations difficult to change, even when market changes have already altered the substantive … Read more

Do Investors Care Who Did the Audit?

In 2008, the U.S. Department of the Treasury’s Advisory Committee on the Auditing Profession called for a “standard-setting initiative to consider mandating the engagement partner’s signature on the auditor’s report” as a way to increase audit transparency.[1] The Public Company Accounting Oversight Board (PCAOB) considered this call, weighing investor benefits (e.g., increased transparency) against potential costs to the audit profession (e.g., increased litigation risk and administrative costs). After considerable discussion with registrants, investors, and audit firms, the PCAOB responded in December 2015 by enacting Rule 3211, Auditor Reporting of Certain Audit Participants.

The new rule mandates that auditors … Read more

Lehman Brothers: How Good Policy Can Make Bad Law

As we approach the 10-year anniversary of the failure of Lehman Brothers, the news is again awash in a debate about whether policymakers could have saved the investment bank.  That the issue remains so deeply contested reflects how fundamentally flawed the current legal regime is.  Although embodying ideas that are sensible in the abstract, the regime makes the authority to act contingent on facts that policy makers cannot readily discern during periods of systemic distress.  Making matters worse, subsequent events, including other actions by those same policy makers, can further skew the critical facts on which legal authority rests.  This … Read more

A Retrospective on the Demise of Long-Term Capital Management

The 10th anniversary of the harrowing financial events of September 2008 is nearly upon us.  The anniversary will undoubtedly be marked by various retrospectives analyzing those events.  For a longer-term perspective, though, it may be helpful to consider another anniversary that will be observed in September 2018:  the near failure of Long-Term Capital Management, L.P. and its fund, Long-Term Capital Portfolio, L.P. (collectively “LTCM”) 20 years ago.  LTCM was the largest hedge fund operating in the United States and its brush with death provided a preview of some of the forces that would contribute to the near collapse of the … Read more

Why Do Firms Go Public Through Debt Instead of Equity?

Private firms can gain access to capital markets in several ways. The most well-known approach is through an initial public offering (IPO) of equity, and high-profile firms typically attract a large amount of attention from the popular press when they go public. However, a less publicized approach is going public through an initial public debt offering (IPDO), an alternative option for tapping public markets. One example of an IPDO firm that issued public debt (through a private subsidiary) before issuing public equity is United Parcel Service Inc. The company was founded in 1907, filed its IPO S-1 registration statement on … Read more

How Markets Learn to Value the Financial Performance of Socially Responsible Firms

Market reactions to a company’s performance on environmental and other social issues are ambiguous, because it is difficult to measure social and financial performance and how they affect each other. We, however, create a virtual value-weighted portfolio based on the list of “100 Best CSR companies in the world” published by Reputation Institute and show that investing in this portfolio could provide investors annual abnormal returns of between 1.98 percent and 2.74 percent.

Corporate social responsibility (CSR) facilitates the integration of business operations with values so that the interests of all stakeholders—including customers, suppliers, employees, communities, governments, society, and the … Read more

Buy-Side Analysts and Earnings Conference Calls

The role of sell-side equity analysts in the capital markets has been researched extensively by academics over the past several decades. In contrast, due to data limitations, there has been little research on buy-side analysts. Buy-side analysts work for institutional investment firms and have different incentives and responsibilities than do their sell-side counterparts working at brokerage firms. That makes buy-side analysts not only worthy of study in their own right, but also makes it unclear whether the inferences and conclusions from the sell-side analyst literature also apply to buy-side analysts. While it is widely assumed that buy-side analysts conduct fundamental … Read more

Hidden Holdouts and the Puzzling Pricing of Collective Rights: An Analysis of the Venezuelan Debt Crisis

The emergence of “activist” investors across a range of markets has been one of the most interesting phenomena of the past few decades (see here, here and here). These investment funds seek to capture rents from their investments by “actively” enforcing their rights.  Activist investors pursue this strategy in markets in which the majority of investors are passive. Much of the discussion of this development in both the financial press and the academic literature has focused on activists acquiring equity positions in order to influence a firm’s management policies (see here and here). Our focus, however, is … Read more

Debevoise & Plimpton Discusses a Turning Point for FinTech

On July 31, 2018 the Office of the Comptroller of the Currency (“OCC”) announced it will begin accepting applications from non-depository FinTech companies for a special purpose national bank charter. [1] This announcement caps a years-long and much anticipated initiative by the agency to make federal banking charters available to FinTech firms (see our prior analysis, here and here describing previous developments).

The OCC’s action came on the same day that the Treasury Department released the fourth report (the “Report”) mandated by Executive Order 13772, setting forth the Trump administration’s “core principles” for regulating the U.S. financial system.[2]  The … Read more

The Role of Relationships and Informal Norms in Entrepreneurial Finance

Contracting parties in an on-going relationship often rely on informal norms to resolve disputes and reduce transaction costs.  Known as “relational contracting,” this concept is typically studied in the context of procurement contracts between manufacturers and suppliers,[1] but it also applies in finance.[2]  A pre-existing relationship between an external investor and an entrepreneur can reduce monitoring costs, limit opportunistic behavior, and lower the initial cost of capital.

Despite the benefits of a relational contract, investors seeking to fund startups may need to look beyond their existing networks to find an entrepreneur with an innovative business plan.  Consistent with … Read more

The Role of Artificial Intelligence and Machine Learning in Risk Management

Lending in China is a risky proposition. When a U.S. bank needs to decide whether to approve a loan to a U.S. customer, it simply accesses the customer’s credit report, which is often the deciding factor. The bank can thus reasonably manage its credit risks based on the historic default rates for the lending categories it specializes in.

In China, however, about 80 percent of potential borrowers have no credit record. That has left lenders with two approaches to credit risk: concentrate on lending to the highly sought-after 20 percent of borrowers with credit records and live with less profitable … Read more