Wharton Finance1
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Corporate FinanCe
VoL. 1
Wharton on
Finance
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From dealing with new accounting rules to selecting investment vehicles,
finance executives are simultaneously pressured to keep their firms’ books inline while also taking advantage of new and rapidly multiplying opportunities for
revenue growth. Meanwhile, these opportunities often expose companies to new
forms of risk— so much so that financial risk management has become a critical
concern for most organizations. In this collection of articles, Knowledge@Wharton
looks at financial risk in the context of private equity investing, venture capital, and
the use of derivatives, as well as the less obvious risks executives should take
into account when making decisions about business process outsourcing. Also,
Wharton faculty offer insight on how recent accounting regulations will impact
executive compensation.
Corporate Finance
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Private Equity Is on a Roll, but Are Investors in for a Let-Down? 4
With private equity investors of all types flush with cash, private financing hit record levels in 2006 and islikely to remain strong in 2007, according to Wharton faculty and industry analysts. Nearly a third of the dollar
value of all U.S. acquisitions last year involved private equity firms, up from 3 percent 5 years ago. But just
how long can this boom continue, and what changes may be in store for private equity models?
Will It Pay Off, or Become a Writeoff? Managing Risk in Venture Capital Investing 8
Risk is part of the landscape when investing in startup firms, and venture capitalists need to approach this
peril across a range of dimensions, including geography, industry, and the timing of investments in the
product development cycle, according to speakers at a Wharton conference entitled Innovation and Organic
Growth: Balancing Risk and Reward , hosted by the Mack Center for Technological Innovation.
How New Accounting Rules Are Changing the Way CEOs Get Paid 12
When a well-known compensation consulting firm predicted in April 2006 that new accounting rules wouldn’t
have any impact on the use of options as compensation for corporate executives, Wharton Accounting
Professor Mary Ellen Carter was ready to disagree. “That’s just not true,” she says. “Options will be cut, and
directors will be switching to restricted stock for executive compensation.” Carter’s response is the result of
her research into the role of accounting in the design of CEO equity compensation, which is also the title of a
recent paper she coauthored.
Finding Value for BPO Through Revenue Distance 16
Evaluating and ranking each business process for its contribution to creating value for customers and the
company is a central part of a new model to help finance executives make outsourcing decisions, developedby Ravi Aron, senior fellow at Wharton’s Mack Center for Technological Innovation. Called the Revenue Distance
model—since it measures the distance between a process and revenue creation—the tool offers a simple way
for executives to put a comparative valuation on each business process that is a candidate for outsourcing.
The Role of Derivatives in Corporate Finances: Are Firms Betting the Ranch? 19
Many American corporations use derivatives to offset risks from fluctuating currency and interest rates. But
some have run into serious financial trouble using derivatives in a more dangerous fashion— to speculate. Are
shareholders in for ugly surprises if executives’ derivatives bets go sour? To get a better picture of derivatives’
role in corporate finances, Wharton Finance Professors Christopher C. Geczy and Catherine Schrand and
Bernadette A. Minton of Ohio State University reexamined confidential responses from an earlier study that
focused in part on derivatives.
Contents
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with private equity investors of all types
flush with cash— from venture capitalists and
hedge funds to large leveraged buyout (LBO)
firms such as The Blackstone Group and The
Carlyle Group— private financing hit record
levels in 2006 and is likely to remain strong in
2007, according to Wharton faculty and industry
analysts. Nearly a third of the dollar value of
all U.S. acquisitions last year involved private
equity firms, up from just 3 percent 5 years
ago, according to U.K.-based Dealogic, which
tracks the investment industry.
General Electric reportedly has invited private
equity firms to bid for its plastic divisions in adeal that could be worth more than $10 billion.
The nation’s largest casino operator, Harrah’s
Entertainment, is weighing a $15.5 billion
bid from a team of private equity players. In
November, shareholders of hospital company
HCA approved a $33 billion private equity
buyout, topping the prior record of $31.3 billion
paid for RJR Nabisco in 1989. The RJR Nabisco
deal, chronicled in The Barbarians at the Gate ,
has come to symbolize the 1980s buyout era
that ended with the crash of highly visible junk
bond deals.
With $660 billion in corporate buyouts last
year and a war chest of $750 billion still to
deploy, private equity investors are on a roll, but
concerns about the sector’s ability to deliver
sizeable returns are also welling up. Angel
investor Rob Weber’s first reaction was surprise
when a hedge fund swooped in a few weeks
ago to snap up the entire $10 million second-
round financing of a life sciences startup he
owns. He flashed back to the high-tech boom
that went bust in 2000. “A warning flag went up
in my head,” he says. “I hope we’re not in for a
repeat of the bubble era.”
Wharton Finance Professor Pavel Savor echoes
the note of caution. “Everything is very peachy
now, and maybe the only way to go is down,
but I would say that nothing is imminent,” he
says. “Last year was the best on record by size,
and 2007 in all likelihood will be even better in
terms of activity. Whether it will be a good year
for investors is an open question.”
Savor says lenders remain eager to accommodate
buyout firms, and debt ratios are nowhere near
the alarming levels that led to the junk-bond
collapse following the buyout binge in the late
1980s. “A couple of high-profile bankruptcies
could change that,” he warns, “but for now, the
buyout shops have a little space to breathe.”
Much of the investment in private equity has
been concentrated at the industry’s largest and
best-known firms, Savor points out, noting that
investors are eager to place investments with
the top firms because they tend to get better
terms than with smaller companies. And, in
order to preserve their reputations for future
deals, the big players are also less likely tolet firms they control go bankrupt. “They have
career concerns and do not want to default,”
Savor says.
New Roles for Private Equity
According to Wharton Management Professor
Saikat Chaudhuri, the rush to fund private equity
is blurring some of the lines that were once
drawn between venture investment, hedge
funds, and leveraged buyout companies. Hedge
funds, which once focused mainly on publiccompanies and had a short-term horizon, are
now also delving into privately held firms and
even small venture-type investments that may
require patience. Private equity firms, often
working together in teams, are now going
after increasingly large deals that once were
considered so big only the public markets could
provide financing. “Private equity firms are no
Private Equity Is on a Roll, but Are Investors in
for a Let-Down?
The rush to fund private equity
is blurring some of the lines that
were once drawn between ventureinvestment, hedge funds, and
leveraged buyout companies.
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longer spreading themselves thin in a lot of
investments,” says Chaudhuri. “Now they are
going after more mature investments even if
there is a smaller return, but that’s better than
just parking the money or not doing much with it.”
As buyout deals grow larger, firms may find
that simple financial engineering techniques will
not create enough new value to generate the
kind of above-average returns that many privateequity investors have come to expect, adds
Chaudhuri. Typically, buyout firms come into a
new company and can quickly create value with
a new financial structure, simple operational
fixes, or big cuts in the workforce. “As you start
to get into these large deals— in the double-digit
billions— that’s going to require management
expertise in the field and probably also holding
the company for a longer period of t ime.”
Wharton Finance Professor Andrew Metrick says
there should be little concern that shareholders
are being shortchanged in the large buyout
deals. In the wake of public scrutiny following
the scandal at Enron and the 2002 Sarbanes-
Oxley Act, operating a public company has
become more difficult and potentially less
efficient for many managers. “There are
executives who believe their companies are
worth more and would function better in the
hands of pr ivate owners,” says Metrick.
In the past, he adds, private ownership was
considered less efficient than a public structure
because it tended to concentrate equity in thehands of just a few owners. Now, however,
large buyout firms spread ownership widely
because most of their partners are often big
investors, such as pension funds.
He also points out that the major LBO firms
that have been generating a lot of publicity
are growing but are still dwarfed by the
public equity markets. He estimates that after
leveraging their capital, private equity firms
would be able to target $2 trillion in U.S.
investment. By comparison, the public equitymarkets are valued at $13 trillion. “Private
equity was historically a niche industry,” says
Metrick. “It got a lot of press in the 1980s
when it first emerged but throughout most
of the 1990s was small relative to the public
markets. Now it’s become noticeable again.”
Harry W. Clark, managing partner of Stanwich
Group LLC, a Greenwich, CT, consulting firm,
says it is unlikely that a large private equity
buyout firm will ever make a hostile bid for a
public company. “You may see more actively
hostile actions by hedge funds, but for the
serious, mature players in the large private
equity sector, the nature of their business lies
in a relationship with management.” Major
investment banks, however, may begin to carve
out new business as consultants to public
companies that want to develop strategies tocompete with the private equity funds, he adds.
Chaudhuri suggests that the rise of private
equity buyouts is putting pressure on public
company management but that it may also
be a transitional phase as the economy
rebounds from the weakness that began with
the technology investment crash of 2000.
Companies that fall under the control of private
equity firms, he argues, will ultimately wind
up in the arms of strategic buyers in their
own industries. Those transactions will bring
firms to the next level of business innovation
and productivity. “After the boom, there was a
slowdown, and a lot of firms were struggling.
As they are rebuilding themselves in a growing
economy, the strategic buyers are not yet in
a position to consolidate,” Chaudhuri says.
“The private equity firms are coming in and
streamlining some of the companies. Eventually,
in my view, they will be sold to strategic buyers
once again.”
Too Much Money, Too Few DealsIn the venture investment sphere, Raphael
Amit, Wharton professor of entrepreneurship
and management, says the picture is mixed. On
the positive side, activity is strong, and even
large investment firms are willing to take on
small, seed and first-round financing. “That’s
very good news for innovation in the United
States. These top-tier firms used to not want to
do small deals. Now they are willing to do them
just to get their foot in the door.”
On the downside, he says, returns are, onaverage, close to those of the S&P 500, with
only the best-known firms generating returns of
30 percent to 40 percent. “The top-tier firms are
completely oversubscribed. If you want to [get
into] the sector, you should only invest in them,
but they’re not taking in any new investors.”
Amit points to Sevin Rosen, a prominent venture
firm with offices in Silicon Valley and Dallas that
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raised more than $200 million from investors
last year. This fall, Sevin Rosen sent the money
back, saying it could not invest the cash
productively because there were already “too
many deals funded in almost every conceivable
space.” Sevin Rosen also cited a weak exit
environment for private investors hoping to cash
out through an initial public offering (IPO).
Amit says liquidity events, such as an IPO or asale to strategic buyers in the same industry,
are now taking much longer than they once
did. In 1999, it took less than 2 years for
investors to cash out of an investment through
an IPO, but in 2006 it took more than 5 years,
he notes. The timeframe has also expanded
in the other chief form of private equity
exit— merger and acquisition deals. In 2001,
it took an average of about 18 months to do a
sale or merger, but by 2006 the timeframe had
stretched to more than 5 years.
Savor points out that private equity firms mayshift toward a completely new model in which
funds hold companies longer and repay their
investors through dividends. “In the past, IPOs
were the preferred exit, and I would say they
will remain so in the future,” he says. “But if
for some reason they do not, private equity
shops will find other ways to monetize their
investment— as long as there is something to
monetize.” While U.S. public offerings have
been limited, Amit points out that exchanges in
London, Hong Kong, and elsewhere have been
sponsoring a healthy number of new listings.According to Metrick, private equity firms may
also cash out of investments by selling to other
private equity firms.
Wharton Management Professor Mauro Guillén
says private equity will continue to play an
important role in Europe, where companies
are still undergoing restructuring related to
the creation of a single European market and
the subsequent expansion of that market into
new countries. “I don’t think there’s been
enough M&A and LBO activity. Private equity
is a part of this whole story in Europe. I don’t
think we’re anywhere near the end of this,”
says Guillén. “The adjustment by business in
terms of the restructuring and consolidation of
industries has been lagging behind the great
progress made in expanding the size of the
market and removing barriers. I think it’s going
to keep going for a long t ime.”
Guillén is less optimistic about continued private
equity strength in Latin America following
moves in several countries toward more
populist policies. He points to Venezuela, where
newly reelected President Hugo Chavez has
vowed to nationalize the nation’s power and
telecommunications sectors. In Asia, China
continues to be a draw for all forms of capital,
including private equity, says Guillén. India, too,
presents opportunities. While India has somemodern, highly-efficient industries, such as
software development and business services,
many sectors are in dire need of the kind of
restructuring that attracts private equity investors.
The boom in private equity finance has drawn
the attention of regulators. In Britain, the
Financial Securities Agency (FSA), which
oversees financial markets, issued a report
in November stating concerns that the U.K.
private equity market is overextended. The U.S.
Department of Justice this fall sent letters of
inquiry to several major private equity firms.
The focus of the probe appears to be on large
consortium, or so-called “club” deals— in which
private equity firms combine to take on large
transactions— and on whether the firms may
have collaborated in some way to reduce the
price of the bid.
Chaudhuri says increased regulation in the
United States is not likely unless a major deal
goes sour. “I do think some pressure will come,
so this free rein is no longer going to be there.
If one of the largest deals doesn’t do so well
under private equity, that’s when [we will see]
some regulatory pressure.”
Weber, the angel investor who is also
chief executive of Intellifit, a startup that
markets guaranteed-fit technology for online
apparel shopping, says he had been hearing
about hedge funds moving into traditional private
venture investing. “It seemed illogical to me,” he
says. “Then suddenly i t was in my own backyard.”
Weber says today’s buyout environment is less
perilous than in the era of Gordon Gekko, the
Private equity rms may shift toward a
completely new model in which funds
hold companies longer and repay their
investors through dividends.
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buyout artist portrayed by actor Michael Douglas
in the film Wall Street , who famously proclaimed
that “Greed is Good.” In those days, Weber
says, the use of junk-rated debt fueled the
excess. Still, he finds it worrisome when hedge
funds get involved with startups because they
may not have enough experience in the volatile
venture world to help make their investments
succeed. “Everybody’s happy when things are
up, but when they are bad, I’m not sure howprepared a hedge fund will be to navigate the
rough waters of an entrepreneurial startup.”
Weber is also concerned about the risk that
private equity firms themselves are engaged in
a sort of ponzi scheme in which buyout firms
sell companies to one another at increasingly
high prices that ultimately will crash. “Having
lived through the bubble era, when I see
irrational exuberance, or signs of it, I get a bit
concerned because the venture industry has
worked hard to return to sanity and an era of
logic,” says Weber. “I was start ing to feel goodagain about the work we do. I still do, but now I
have this flag that has gone up which is causing
me to be a little bit worried.” ■
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risk is part oF the landscape when
investing in startup firms, and venture
capitalists need to approach this peril across
a range of dimensions, including geography,
industry, and the timing of investments in
the product development cycle, according to
speakers at a Wharton conference entitled
Innovation and Organic Growth: Balancing Risk
and Reward , hosted by the Mack Center for
Technological Innovation. “We have generated a
lot of wealth for people and also created our fair
share of losses,” Spencer Hoffman, a pr incipal
at Safeguard Scientifics, noted during a panel
discussion entitled, Financial Perspectives on
Managing Risks.
Hoffman and his fellow panelists from the venture
capital industry discussed how firms determine
which new technologies— whether from the
energy, high-tech, or health care sectors— are
good investments and what strategies they
employ to manage and mitigate risk.
Prior to the discussion, Wharton Finance
Professor Andrew Metrick explained how
financial economists view risk by citing
two hypothetical companies— Box Co., anestablished manufacturer of corrugated boxes,
and Drug Co., a biopharmaceuticals company.
Box Co.’s returns rise and fall with the overall
economy, while Drug Co. is working on a cure
for a host of diseases but has little probability
of success. Assuming both companies have
the same expected cash flow, which company
would be expected to generate higher returns
for investors? Metrick asked.
He explained that while the drug company
has a high level of individual, or idiosyncratic,
risk, the box company should offer a premium
to investors willing to back it in bad times as
well as good. “The box company does well
when people are already doing well. It has poor
returns when the economy is poor and people
are hungry,” Metrick noted. “If someone says,
‘I will hold Box Co., which will not pay much
exactly when I am most hungry,’ then they need
to be compensated.”
Investors in the drug company could mitigate
their risk by buying up shares of many drug
companies, hoping at least one will come up with
a hit product to justify the overall investment.
More widespread risk may be difficult to insure
against— such as a sudden hike in the cost of
natural resources— but companies need to take
steps against this type of threat if it begins
to erode operations. He used the example of
a well-run airline company facing a sudden oil
price hike beyond its control. Shareholders in
the firm could hedge against an oil shock by
creating a portfolio that benefits from higher oil
prices. But as owners of the airline, they also
need to be concerned that the oil shock will
impact sales and will result “in distress costs
at the airline.” One strategy is using a collar
on the price paid to limit exposure to severe,
operational risk without attempting to insure
against all risk at any price, Metrick said.
He also explained why small venture capital
firms take on so much more risk in backing long-
shots than do large corporations that have more
resources or appear to have the ability to absorb
Will It Pay Off, or Become a Writeoff?
Managing Risk in Venture Capital Investing
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a swing and a miss. Executives and employees
at a large company all share in the downside of
problems when problems arise at the targeted
firm, he said, but the benefits of hitting a home
run with a new technology investment are
diluted. He noted that even the largest venture
capital firms have very few partners, allowing
each to win big if a high-risk investment pays
off. “These are small organizations. When they
get too big, the incentives for any one personaren’t so clear,” said Metrick. “If someone is
better than their partner, then they leave and
start their own firm.”
Panelist Michael DeRosa, managing director
of the DFJ Element Fund, an affiliated fund of
Draper Fisher Jurvetson in Menlo Park, CA,
agreed. “It’s not just that venture capital firms
have more incentives to invest, but that large
corporations have less,” he said, adding that
he was surprised recently when a large public
company came to his firm offering an ownership
stake in an attractive new technology. The
company wanted to reduce its own stake to
less than 20 percent to get the development
costs off its books where they were cutting into
quarterly earnings. “This [technology] looks like
a huge home run, but right now it’s a hit to their
earnings, and they don’t like that.”
The DFJ Element Fund is focused on
technology, particularly in energy and other
heavy industries, and on companies that
are developing solutions to old economy
problems, he said. “The theme is to take the
venture capital method that works in high-techinformation technology and biotech and apply it
to growth opportunities in the real core sectors
of our economy,” said DeRosa, who added that
rising petroleum prices are generating interest
in the DFJ Element Fund’s strategy.
According to DeRosa, his firm approaches
risk management on two levels. The first is
at the portfolio strategy level, which calls
for diversification across industries. He
acknowledged that is not as easy for a fund
with a specific strategy like DFJ Element, as it
would be for a general technology investment
fund that, for example, can invest in both
biotech and software.
To combat that problem, DeRosa said the firm
shifts from a risk-management approach tobuilding expertise and networks in its own
specialty. Investors can then select the best
venture capital firm in each area of technology
to build their own diversified portfolios.
DeRosa added that the firm has tried to
construct mathematical models to guard against
putting too much money in one investment in
case something goes wrong, such as a change
in government regulation. He said the firm at
one point was overly dependent on the pace of
deregulation in the utility sector, which occurred
slower than expected. Another influencing
factor is the tolerance for risk in the public
markets, which was high in the late 1990s and
in 2000, but dried up in 2001 through 2003 with
the collapse of technology stocks.
The firm’s second level of risk management
entails making investments within the venture
company. To diminish the risk of a technology
firm failing, he said, DFJ Element installs good
management and financial systems. “Then if
the technology works, you’re golden.”
He added that fund managers look for a product
or technology that works but is not living up to
its promise because it is locked in a company
with operational problems.
The notion of risk in emerging technology is
fundamentally different than with an established
company, DeRosa said. “I think of risk as
something you have and lose. We work with
companies that don’t have anything yet, and we
work to get it there.”
Investing in Health Care
Panelist Asish Xavier, a principal in Johnson &
Johnson Development Corp., said the health
care company’s 33-year-old venture group
“[keeps] an eye out there for new technology.”
Excluding early-stage seed investments, the
fund’s managers view risk in two buckets:
one is technology risk, and the other involves
More widespread risk may be
difcult to insure against—such as
a sudden hike in the cost of naturalresources—but companies need to
take steps against this type of threat
if it begins to erode operations.
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business issues, such as potential legal,
financial, and management problems.
Xavier’s firm also looks at long-term
investments across several dimensions. First,
the company is a global investor with holdings
in Europe, Israel, and Canada. During the recent
bubble, European nations offered subsidies in
biotech firms, but many of them are struggling
since the market has cooled. Those firms arenow rationalizing and merging, creating new
opportunity for JJDC. “We’re not a fund tied by
geographic ability to invest, so we can invest
more broadly and manage our portfolio” with
more flexibility.
The fund also invests across three major
health care sectors— biopharmaceuticals,
biotechnology, and medical diagnostics— and
builds its portfolio across different phases of
product development, from the early preclinical
stage through drug discovery and finally into
clinical testing. Since the fund is not primarily
driven by its internal rate of return, JJDC can
invest in technologies that are out of favor, said
Xavier. He noted that biotech products typically
take 10 years to develop, while most venture
funds have a shorter time horizon than that.
After the bust in biotech (following a boom
based on the promise of genomics), health care
has not been generating much interest among
investors. However, he pointed out, health care
technology companies are beginning to show
some strength. A big trend driving the industryis an effort to reduce the time it takes to develop
a new drug— from 7 to 10 years down to 3 to
5 years. Reducing the time to market allows
companies to take more advantage of the time a
new product remains protected by patents.
Another major trend bolstering pharmaceuticals
and biotech venture investing is the repositioning
of compounds. Companies eager to fill weak
drug pipelines are going back into product
portfolios to test old drugs for new uses.
Since the products have already been provensafe, the development time and costs are
reduced. Companies are also looking abroad
for successful compounds that could be
introduced in the U.S. market. And the industry
is benefiting from the increase in outsourcing of
research to countries where costs are lower. He
said firms are looking to move chemistry labs to
Eastern Europe and clinical trials to India.
Health care venture investors are also active
in looking for spin-outs of products, or parts
of companies that could fare better on their
own. In addition, medical devices are gaining
new attention from health care investors,
following the biotech bust. “The larger funds
are diversifying into medical devices to hedge
their port folio,” he said, adding that health care
investors are pulling back from early-stage
investments to focus on compounds that havebeen proven safe in the short term and are in
Phase 2 studies to determine whether they
actually work against targeted diseases. “We
know the returns will be capped, that there is
a higher chance of giving up a home-run, but
there is greater certainty.”
Liquidity and Diversification
Spencer Hoffman, a principal at Safeguard
Scientifics, presented another take on venture
investing and risk from the viewpoint of hiscompany, a publicly traded investment firm
specializing in information technology and
health care.
Safeguard has had its share of success,
Hoffman said, such as its investment in
Cambridge Technology Partners, which was
acquired by another Safeguard startup, Novell
Inc., in 2001. Yet it has also suffered with other
firms, notably the well-publicized collapse
of Internet Capital Group in 2000. “We have
generated a lot of wealth for people and also
created our fair share of losses.” As a public
company, Safeguard provides investors with
liquidity, he said. “If you like what we have to
say, you can go out and buy Safeguard. If you
don’t, you can short Safeguard or change either
way in an hour.”
Most of Safeguard’s shareholders are
individuals, not the large insurers or pension
funds, or qualified investors that can participate
in elite venture funds. “Our model is providing
a liquid and transparent way for people to
participate in alternative asset classes and getdiversification that way,” Hoffman said.
Safeguard’s model is to mitigate risk and
create above-average returns by selecting
the right companies in areas where the
firm has expertise. Then, using Safeguard
partners or networks, the company uses its
own entrepreneurial experience to help build
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or improve the businesses. “What we try to
do is bring a little bit of the buyout model
to the growth equity space and look for
opportunities venture capitalists won’t touch
because management isn’t perfect or some
element of the execution isn’t there.” Hoffman
stressed that a key to reducing risk is to pay
the right price and structure the terms of the
deal correctly in the first place. “The real way
venture capitalists mitigate risk is with theterms,” he said.
Furthermore, in designing compensation for the
founders and managers of venture companies,
many funds have a bias against allowing
management to cash out much of its equity in
order to keep as much capital as possible in
the business. Hoffman joked that this results in
founders with bruises on their heads inflicted
by spouses who see a lot of wealth on paper,
but have been waiting years to buy a summer
house or are concerned about how the family
will finance its children’s education.
Safeguard is more inclined than other firms to let
founders have some money early on, according to
Hoffman. As long as a big chunk of their wealth
is still in the company, he said, founders who
have been able to tap into some of their equity
are likely to be better managers. He argued theyare less concerned about the downside if they
have been able to profit to some extent from
their entrepreneurial risk. “Actually I’m surprised
more firms don’t do this,” he said. “If the owners
of the firm are not concerned about paying for
their children’s education, either they are total
risk seekers or independently wealthy with no
commitment. Those are the people you want to
run away from.” ■
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when a well-known compensation consulting
firm predicted in April 2006 that new accounting
rules wouldn’t have any impact on the useof options as compensation for corporate
executives, Wharton Accounting Professor Mary
Ellen Carter was ready to disagree. “That’s just
not true,” she says. “Options will be cut, and
directors will be switching to restricted stock
for executive compensation.”
Carter’s response is the result of her research
into the role of accounting in the design of
CEO equity compensation, specifically as it
relates to the use of options and restricted
stock. Her study coincides with a recent ruling,implemented by the Financial Accounting
Standards Board (FASB), requiring all firms to
expense the value of employee stock options.
Specifically, Carter looks at the accounting
practices of 1,500 firms from 1995 to 2001,
before many large companies began expensing
stock options but during the years when
the FASB began pushing the reform. Carter
corroborates the findings of her study by
examining changes in CEO compensation within
firms that voluntarily began to expense options
in 2002 and 2003.
In a paper on this topic entitled “The Role
of Accounting in the Design of CEO EquityCompensation,” Carter concludes that CEO
compensation will change now that companies
are required to subtract the expense of stock
options from their earnings, just as they are
required to account for salaries and other costs.
And Carter predicts that as a result, firms will
switch from options to restricted stock as a
preferred compensation option.
“By eliminating the financial reporting benefits
of stock options, firms expensing stock
options no longer have an ability to avoid
recording expenses with any form of equity
compensation,” writes Carter, who authored
the study with Luann J. Lynch, a professor
at the Darden Graduate School of Business
Administration, and Wharton Accounting
Professor Irem Tuna.
“We found that companies prior to the rule
changes granted more options because of
favorable financial reporting. Results suggest
that favorable accounting treatment for stock
options led to a higher use of options and loweruse of restricted stock than would have been
the case absent accounting considerations. Our
findings confirm the role of accounting in equity
compensation design.”
Leveling the Playing Field
The timing of Carter’s report could hardly
be better.
This past year, a revised FASB rule took effect
that requires companies to expense the value
of stock options given to employees. Most
public companies are required to expense
options for fiscal years beginning after June
15, 2005. Since most companies operate on a
calendar basis, this means expensing options
by March 31, 2006. Known as SFAS 123(R), the
new accounting standard was developed by the
FASB to create a more level playing field when
it came to management incentive compensation
and its impact on a company’s bottom line.
Before SFAS 123(R), companies that gave out
stock options did not have to report the “fair
value of the option”— that is, they did not have
to claim the options as an expense, which in
turn would result in a reduction in net income at
the end of the fiscal year. However, companies
that relied on cash bonuses or restricted stock
for equity compensation have always had to
report or “expense” the value amount, an
accounting requirement that reduced corporate
net income at year’s end.
How New Accounting Rules Are Changing the
Way CEOs Get Paid
The new accounting standard was
developed by the FASB to create
a more level playing field when it
came to management incentive
compensation and its impact on a
company’s bottom line.
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The FASB first proposed changing the
accounting standard in 1991. At the time, the
move was strenuously opposed, particularly by
many high-tech firms and startup businesses
that relied heavily on stock options as an
incentive to recruit and motivate employees
to work for companies that reported little or
no income. As nearly everyone knows, stock
options are perks given to employees that
allow them to buy company stock in the futureat a set price. If the stock rises before the
options are exercised, the employee can buy
the stock at the lower predetermined price
and then sell it at the higher price and quickly
realize the difference.
During the dot-com boom, the use of stock
options skyrocketed. According to the National
Center for Employee Ownership, up to 10
million employees held stock options by
2002. “Stock options were always seen as
an incentive, a way of tying employee or
executive action and company performance
to compensation,” says Carter. “In other
words, ‘You will get something if you get the
stock price to go up.’ It was a way of aligning
employees’ and executives’ interests with those
of the shareholders.”
But from the beginning, companies balked
at putting a numerical value on options and
expensing them, arguing that doing so would
result in a negative impact on their stock price.
After intense lobbying, the FASB backed off
the proposal in the early 1990s, but issueda compromise, known then as SFAS 123:
Companies had to disclose the use of stock
options and their fair value in the footnotes of
their financial reports or proxy statements.
Nearly 10 years later— in the wake of the
volatile post-Enron era, when improper and
unethical accounting practices were widely
exposed in one corporate scandal after
another— the FASB returned to the concept of
expensing stock options. At the time, corporate
institutions like Global Crossing and WorldCom,in addition to Enron, had became synonymous
with corporate greed, and anyone who followed
their downfalls quickly understood how
company executives who held substantial stock
options were motivated to artificially inflate
stock prices for their own financial gain.
In an effort to distance themselves from
companies that routinely “cooked the books,”
many corporations wanted to showcase their
ethical financial practices. So they began to
voluntarily expense options in their proxy
statements, a step above and beyond the
footnote citation already required by the FASB.
In 2002, General Electric, Bank One Corp.,
Coca-Cola, The Washington Post Co., Procter
& Gamble, and General Motors announced
that they would expense options, along with
Amazon.com and Computer Associates. Somecompanies— like Papa John’s International, USA
Interactive, and Microsoft— announced that they
were doing away with options altogether.
The push for corporate accountability and
more transparent financial accounting
practices received an undisputed boost
with the Sarbanes-Oxley Act of 2002, which
required that executives and auditors evaluate
internal financial controls and be accountable
for financial statements. In turn, the FASB
responded in early 2004 by presenting therevised draft of its accounting standard related
to options expensing, or SFAS 123(R). This
time, there was little protest, primarily because
companies had already responded to the
suggested changes and were resigned to the
practice of expensing options.
As BusinessWeek reported on April 1, 2004:
“Like an approaching hurricane that generates
more advance warnings than damaging
winds, FASB’s proposed rule probably won’t
cause a lot of additional change. Some 500
publicly traded companies have already started
expensing options, or said they will. Many
have begun shifting toward other nonoption-
based pay schemes that are likely to deliver
more motivational bang for their compensation
bucks. And investors, who can already look up
option costs in the footnotes of companies’
quarterly financial reports, seem to have grown
accustomed to factoring the values of options
into what stocks are worth.”
What, then, was the impact of accounting
practices in the compensation choices
for CEOs? Noting that “prior literature is
inconclusive,” Carter set out to determine
whether favorable accounting for stock options
had motivated the use of options, deterred
the use of restricted stock, and led to higher
overall executive compensation. Carter and
her fellow researchers focused on the use
of options in CEO compensation before the
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new accounting standards went into effect—
through either voluntary or required measures.
They studied 6,242 executive compensation
packages from 1995 to 2001, using information
from ExecuComp, a database of executive
compensation information that covers the
S&P 1500.
Carter’s study found that the “method of
accounting for options has affected decisions
regarding their use.” Among the findings:
Between 1995 and 2001, approximately80 percent of the ExecuComp firms were
granting options to CEOs, while only
approximately 20 percent of these firms were
granting restricted stock to their CEOs.
The use of stock options increased steadily
throughout the sample period. Specifically,
the percent of sample firms granting options
to CEOs increased from 76.5 percent in 1995
to 82.3 percent in 2001.
Firms in the sample used very little restricted
stock compared with options. However, the
use of restricted stock to compensate CEOs
increased steadily throughout the study
period, from 18 percent of firms in 1995 to
21.6 percent in 2001.
Notes Carter, “We find that firms that are
more concerned about the earnings they
report used more stock options in their equity
compensation, due to the favorable accounting
treatment for options, and that once firms
start expensing stock options, they shift into
restricted stock. Our analysis provides insightinto what changes are likely to occur in CEO
equity compensation now that the FASB has
made stock option expensing mandatory.
While we may not see an overall decrease in
CEO compensation, we anticipate a decline in
stock option use and an increase in the use of
restricted stock.”
■
■
■
Testing the Hypotheses
To corroborate these findings in her report,
Carter also studied 206 firms from the same
ExecuComp database that began to expense
stock options in 2002 or 2003. Carter’s goal
was to determine “whether firms that expense
stock options alter CEO equity compensation
packages in response to the decision to
expense options.” Based on these firms’experiences, “we examine changes in the
structure of CEO pay packages concurrent with
and after the decision to expense options,”
Carter says. “Using this sample, we are able to
test our hypotheses without having to rely on
a proxy for firms’ financial reporting concerns.
Our findings confirm the role of accounting in
equity compensation design. We find that firms
expensing options decrease compensation
from options and increase compensation
from restricted stock, even after controlling
for standard economic determinants ofcompensation and general economic trends.”
For instance, Carter found that before
expensing options, 88.7 percent of the firms
in this subgroup were granting options as part
of a CEO’s compensation; during the year the
firm first expensed options, the number of
firms granting options dropped 18.6 percent,
down to 68.9 percent; the year after expensing
for the first time, the number of firms granting
options dropped further to 64.3 percent for
a total decrease of 23.7 percent. In contrast,
the number of firms granting restricted stock
to CEOs grew from 42.8 percent in the year
before expensing options to 55 percent the year
after expensing, an increase of 12.2 percent.
During an interview, Carter pointed to proxy
statements from the following two corporations
to illustrate how companies shifted from options
to restricted stock for CEO compensation:
From Liberty Property Trust, proxy statement
filed on March 26, 2004: In making long-term
incentive compensation awards with respect to2003, the Compensation Committee, as it did
with respect to 2002, placed greater emphasis
on restricted shares and less emphasis on
options as compared to past awards of long-term
incentive compensation…. In part, this change is
a reflection of the Trust’s determination to begin
in 2003 to record options as an expense at the
time of issuance. Additionally, greater reliance
The researchers set out to determinewhether favorable accounting for
stock options had motivated the
use of options, deterred the use of
restricted stock, and led to higher
overall executive compensation.
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on restricted shares reduces the potential
dilutive impact from option grants. This change
is intended to provide appropriate long-term
incentive to Named Executive Officers that is
competitive and consistent with the interests
of shareholders.
From FBL Financial Group, proxy statement filed
on March 31, 2004: For 2004 we have included
grants of performance-based restricted stock tothe executive group. This change is partially in
response to our expensing of stock option costs,
and partially to create more performance-based
incentives for this key group. We traditionally
grant stock options to executives and other key
employees each January 15. For the 2004 grant,
we have determined a target level of incentive
awards to this group, then divided it by value,
50 percent in stock options and 50 percent in
performance-based restricted stock.
And what, if anything, happened to the amount
of executive pay packages? Carter found “no
evidence of a decrease in total compensation”
to CEOs once companies expensed options.
The fact that executive pay did not decrease
led Carter to one of two conclusions: Either
the favorable accounting treatment for stock
options did not lead to higher levels of
executive compensation “or firms find it difficult
to downsize the large executive pay packages
that resulted from the favorable accounting
treatment for stock options,” Carter writes.
In summary, Carter concluded, the fact that“firms are granting fewer options and more
restricted stock suggests that these firms are
shifting towards restricted stock [in order to]
provide longer-term performance incentives
and that there will likely be changes in CEO
compensation now that SFAS 123(R) is
effective. Though firms may have appeared to
favor options, under a regime of mandatory
expensing, the role of options in executive
compensation may be restricted.”
Like an asterisk at the bottom of a key
paragraph, Carter and many others who studied
the ramifications of options expensing admitthat the drop in granting stock options is
something of an “unintended consequence”
of the new FASB requirement. Why? Because
the financial markets have proven to be
relatively efficient; the accounting change to
options expensing has actually not resulted in
a significant drop in corporate stock prices, a
byproduct once feared by companies opposed to
the change. In 2004, a study by compensation
consultant Towers Perrin of 335 companies that
voluntarily began to expense options found
no impact on their stock prices; another study
by Bear, Stearns & Co in 2004 predicted that
the options expensing change would reduce
reported earnings of S&P 500 companies by less
than 3 percent, according to BusinessWeek.
“There really shouldn’t be a problem,”
Carter says. “The value of the options was
in the footnotes. Anyone who is a hard-core
market efficiency person would say that any
information that is public is already included
in the stock valuation. So expensing options
shouldn’t be making any difference at all. But
it is. Companies are cutting back on options
because they believe that there is an impact to
expensing, but there really shouldn’t be.” ■
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in the last decade, companies have
discovered that outsourcing some tasks
to cheaper locations is one way to deliverefficiencies and cut costs. But the simple
act of outsourcing to a lower cost base has
evolved into a complex process that can
inflict considerable damage if not dealt with
in a sophisticated and scientific manner. The
damage can range f rom not achieving the
expected cost savings to losing control to a
third party, particularly when a company’s more
essential processes are outsourced.
Questions concerning which business
processes should be outsourced and whetherthe outsourcing should be done onshore or
offshore require careful financial and strategic
consideration, says Ravi Aron, senior fellow
at Wharton’s Mack Center for Technological
Innovation. According to Aron, most
companies— about 60 percent of those who
outsource— focus only on cost savings, and
many fail to achieve those savings in addition to
not taking into account other opportunities that
outsourcing offers.
Linking Outsourcing to RevenueAs with everything that is complex, the best way
to ensure successful outsourcing is to ask the
right questions, Aron says. Before outsourcing
a business process, an executive should ask,
“How much does this process— compared to
other processes— contribute to our product’s
being better than the competition’s product?”
Evaluating and ranking each business process
for its contribution to creating value for
customers and to capturing that value for the
company is a central part of a model developed
by Aron to help finance executives make
outsourcing decisions. Called the Revenue
Distance model— since it measures the distance
between a process and revenue creation— the
tool offers a simple way for executives to put a
comparative valuation on each business process
that is a candidate for outsourcing.
In other words, Revenue Distance captures
the importance of a business process to the
company. Those that are ranked high are
critical for revenue generation and thus are
best held close to home; and those that have
low rankings could be, and perhaps should be,
outsourced, explains Aron.
A finance executive following the Revenue
Distance method should first rank every
process that is a candidate for outsourcing on
a 1 to 10 scale as though only one question
existed— How much does this process
contribute to creating value for my customer?
(One is most important; 10 is least.) Next, rank
the process for its contribution to capturing
that value for the company. Add up the two
ranks, and the resulting number is the Revenue
Distance of that process.
Finding Value for BPO Through Revenue Distance
Revenue Distance captures the
importance of a business process to
the company.
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“The smaller the number, the lower is the
distance of the process from the point where
money is made— that is, the smaller the number,
the more critical the process, and it should not be
outsourced,” Aron says. “We say that processes
with moderate to large revenue distance are very
beneficial to outsourcing,” he adds.
The Revenue Distance model also recognizes
that the relative importance of value creationand value capture will be different for different
industries. For instance, a company in a nascent
industry would rank processes that help in value
creation very high. For mature industries such
as retail, banking, and hospitality, however,
value capture will be more important than value
creation. Apple Computer’s iPod, for example,
depends on the success of value creation, says
Aron. The company is good at product design
and, as such, will not consider outsourcing any of
its design processes. However, it can outsource
its value capture processes, such as retail and
distribution management. On the other hand, for
a company like Dell, whose competitive edge is
the way it manages its supply chain, outsourcing
distribution is not a good idea, he points out.
To accommodate business processes that rank
disproportionately high in value creation and not
in value capture, or vice versa, Aron says the
values for the disproportionate side should be
weighted to prevent a skew in results.
Keeping It In-House at a High Cost
Not only will this exercise allow finance
executives to determine what should be
outsourced, but it will also reveal those
processes that a company keeps in-house at
a very high cost. Some of these processes
enable the creation of value but are not crucial
to beating the competition, Aron notes. For
instance, in a financial services company
that originates home loans, such processes
as documentation and loan servicing are
necessary parts of the business but are not the
differentiators that help it achieve a competitive
edge. Therefore, such processes could be
outsourced, explains Aron.
Very often, the Revenue Distance exercise
reveals that more than 50 percent of business
processes in a corporation are responsible for
creating less than 25 percent of value and that a
handful of processes create a high percentage of
value, he says. Thus, by keeping the majority of
the low-value processes in-house, the company
could be leaving a lot of money on the table as
well as wasting managerial time and talent.
Aron gives the example of a large financial
services company that had been outsourcing
without going through the Revenue Distance
exercise. It found that some processes were
working out well, while others were prone
to repeated and costly breakdown. However,after applying the Revenue Distance model,
the company discovered that 3 out of the 10
processes they were outsourcing abroad were
not good candidates for outsourcing. Also,
the company also found a number of other
processes that should have been outsourced and
have since reworked their outsourcing strategy.
The Need for a Disciplined Approach
Using sophisticated tools such as Revenue
Distance has become critical as companies
now outsource not only information technology-
related processes but also business processes.
In fact, the most important trend in business
process outsourcing in the last 5 years is that
corporations have realized it is not a practical
operations decision, but a highly strategic
decision, he notes. “Depending on the scope
and nature of the engagement, there are
several different people involved in the decision
making. Very often it is at the highest level—
the chief financial officer or even the chief
executive off icer.”
The trend has emerged for a number of reasons,
including the recognition that outsourcing can
now have a direct impact on business line
objective. The strategic intent behind outsourcing
has changed too. It used to be cost savings, but
there are other virtues that companies try to
harvest from outsourcing, including increased
operational flexibility, says Aron. Also, there
is the cost-quality frontier, which favors one
location more than the other: If a retail bank, for
instance, is looking to lower transaction errors,
it will be more cost effective to set up a shop in
By keeping the majority of low-value
processes in-house, a company could
be leaving a lot of money on the table
as well as wasting managerial time
and talent.
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India, China, or the Philippines where it could be
staffed by workers with master’s degrees and
financial or accounting backgrounds more easily
than in the U.S.
Despite the increasing critical nature of
outsourcing, only in the last 2 years have some
discipline and formal rigor been brought into the
process, Aron notes. The most common metric
used is called a “zero one” approach, whicheliminates a process from outsourcing that
could potentially cause the company to lose
significant revenues if something were to go
wrong. This model, however, results in several
necessary but noncritical processes being kept
in-house, leading to a big waste of managerial
time and talent. The Revenue Distance model
provides a concrete methodology for not only
identifying what business processes can be
outsourced but also what the cost is of keeping
them in-house, he notes. ■
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many american corporations use
derivatives conservatively, to offset risks from
fluctuating currency and interest rates. But overthe years, companies such as Procter & Gamble
and Gibson Greetings have run into serious
financial trouble using derivatives in a more
dangerous fashion— to speculate.
Is high-risk behavior common? Are shareholders
in for ugly surprises if executives’ derivatives
bets go sour?
That has long been nearly impossible to
determine, says Wharton Finance Professor
Christopher C. Geczy. “It’s not well disclosed
in the financial [statements]. It could be
widespread, but it’s hard to say.”
To get a better picture of derivatives’ role in
corporate finances, Geczy, Wharton Accounting
Professor Catherine Schrand, and their co-author,
Bernadette A. Minton of Ohio State University,
reexamined confidential responses collected
in an earlier Wharton study that focused on
341 corporate respondents, 186 of which used
derivatives. The companies studied were not
concentrated in any one industry, but were part
of a broad sample of U.S. public, nonfinancialfirms. The researchers report their findings
in a paper entitled Taking a View: Corporate
Speculation, Governance, and Compensation.
“We found that there are corporations out
there, some of them very large, which have
speculated, or are speculating,” Geczy says.
Companies reporting that they frequently
“actively take positions” in currency or interest-
rate derivatives on the basis of likely market
movements were defined as speculators. The
researchers then looked at the nature of those
companies. They concluded that companies
typically speculate in hopes of adding to
profits but not to “bet the ranch” to get out of
financial difficulties or to hit it big. Executives
who conduct the speculation typically are not
renegades but instead are encouraged to do
so by their superiors and board. Furthermore,
firms that engage in speculation generally have
oversight and monitoring procedures to prevent
abuse. Finally, executives’ compensation was
often tied in some way to their success in
derivatives speculation.
“The main findings are that firms take positions
based on a view [of market conditions] when
they believe they have an information advantage
to predict rates, which is consistent with a
profit-making motive for speculation,” the
researchers write.
Derivatives are contracts whose values are
tied to price changes of underlying securities.
A typical currency derivative gives its owner
the right or obligation to buy or sell a block
of dollars, yen, or other currency over a given
period at a set exchange rate. Interest-rate
derivatives are like insurance policies that pay
off if rates move up or down a specified amount
during the time covered.
In one important use, derivatives can neutralize
risks. An American company that must
exchange dollars for yen to buy goods from
Japan could use a currency derivative to make
up the difference if the dollar falls and Japanese
goods become more expensive. Essentially,
the contract would allow the company to lock
in today’s exchange rate for a given period. The
American company would lose money on the
derivative contract if the dollar got stronger
instead of weaker, but that would be offset bythe lower cost of Japanese goods as dollars
were exchanged for yen.
A company could, however, use the same
currency contract to speculate, by simply
buying a contract in hopes it becomes more
valuable as exchange rates change. Since
the change in the contract’s value would
not be counterbalanced by a gain or loss
The Role of Derivatives in Corporate Finances:
Are Firms Betting the Ranch?
“We found that there are corporations
out there, some of them very large,
which have speculated, or arespeculating,” Geczy says.
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in the purchase of Japanese goods, the
company would suffer a net loss if the dollar
strengthened and the contract loses value. This
is speculation.
In the 1990s, Procter & Gamble lost $157
million in a currency bet involving dollars and
German marks; Gibson Greetings lost $20
million; and Long-Term Capital Management,
a hedge fund, lost $4 billion with currency andinterest-rate derivatives.
“Shooting for the Moon”
Over the years, various theories have attempted
to explain why firms would speculate with
derivatives. One theory suggests it is practiced
at troubled firms “betting the ranch” to recover.
But Geczy and his colleagues concluded this is
unlikely, as the speculating firms tended to have
access to low-cost outside financing, which
made betting the ranch unnecessary.
In most cases, firms that speculate are
using types of derivatives they have gained
experience with through safer hedging
strategies. Those that speculate with currency
derivatives, for instance, typically operate in
international markets. As the authors write,
companies that speculate with foreign currency
derivatives “have a greater percentage of
operating revenues and costs denominated in
foreign currency relative to firms that never or
sometimes actively take positions.”
Executives in charge of derivatives speculation
tend to feel they have some unique insight into
currency and interest-rate markets, even though
their firm’s main business may be entirely
different, Geczy says. “They really believe they
can make money. They feel like they can identify
opportunities and/or trade with the advantage
of low costs of leverage.”
Another theory is that executives use
derivatives to “shoot for the moon”— trying
to push up the company’s earnings to boost
the stock price and thus the value of their
own holdings. But according to Geczy, the
goal appears to be more modest— just to
make some extra profit when they think the
opportunity arises. “On average, they do not
appear to be trying to make the firm really risky
to make big payoffs.”
At the same time, says Geczy, “just because
speculating firm managers do not appearto be shooting for the moon, so to speak,
doesn’t mean that there aren’t dangers or that
speculating firms cannot suffer large losses.
What makes our research interesting is that
these managers can, in fact, suffer large losses
even if speculation is rational and profit oriented.”
Generally, firms that speculate have structures
that give executives significant authority and
freedom. They may be well-insulated from
shareholder pressure by poison-pill anti-takeover
defenses, for example. As Geczy notes, “The
companies that speculate seem to be ones
where shareholders don’t have as much power.
It’s basically stronger managers…stronger,
confident management that thinks it can make
money. However, this in no way means they
are successful.”
As to whether there is more speculation going
on now than in years past, “this is quite hard to
say,” notes Geczy. “We actually did a followup
survey of respondents from the first survey and
found that some firms moved from speculating
to not speculating at all and, in fact, remarkedthat they didn’t feel speculation added much
value net of its risk. Others went from not
speculating to speculating with the expectation
of making a profit. So we see transitions in
both directions.”
The original survey did not ask companies to
report how much they earned or lost through
derivatives speculation. Geczy and his colleges
conducted followup interviews with some
of the companies’ executives but could not
determine how successful the speculation was.“It’s been fairly hard to track down whether
they actually do make money,” he says.
But Geczy questions whether these executives,
who typically speculate as a sideline to their
main duties, can effectively compete with
professionals who do it full-time. “It’s hard to
believe, frankly, that corporate treasurers know
more than the financial markets about what
In the 1990s, Procter & Gamblelost $157 million in a currency bet
involving dollars and German marks,and Long-Term Capital Management
lost $4 billion with currency and
interest-rate derivatives.
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foreign currency or interest rates are going to
do,” he said, adding, “We haven’t been able
to identify reliably positive results of using a
perceived information advantage” enjoyed by
executives who speculate.
What is clear, however, is that shareholders
are generally in the dark about derivatives
speculat ion. “An important aspect of this study
is that we are able to assess whether investors,using publicly available data, could identify the
firms that admit to speculation in a confidential
survey,” Geczy and his colleagues write. “The
answer is that they could not.”
In the followup interviews, a number of firms
reported speculation was extensive enough
to potentially have a significant, or “material,”
effect on financial results. “In some cases, this
can be big,” Geczy said. But as the study notes,
the lack of financial statement transparency
about these activities is “not necessarily
evidence of accounting fraud, because actively
taking positions based on a market view may
not always meet the requirements for reporting
under generally accepted accounting principles
(GAAP). Nonetheless, irrespective of whether
opaqueness results because the accounting
rules do not require disclosure of speculative
activities or because firms do not implement
the rules properly, the end result is that the
financial statements do not provide an accurate
picture of the firm’s speculative activities.” ■