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Corporate Governance and Financial Health

16414033-abstract-word-cloud-for-corporate-governance-with-related-tags-and-termsThree years ago I did some work for an independent credit rating agency utilizing a quantitative methodology to determine financial health of corporations.  Dr. Patrick Caragata founder of the firm conducted a study of 200 TSX listed firms with high CGI ratings (Governance Metrics International).   Dr. Caragata was seeking to determine the correlation of Corporate Governance (CG) and financial health.  His findings revealed that “CG ratings failed to indicate when a company was in poor health 75% of the time.  In fact, they wrongly identified 32% of weak companies as being highly rated on GMI.”

Dr. Caragata also extended his model to use financial health score as an early warning signal for a listed company’s share price.  KMV, established ratings agencies, Altman’s Z Score were also determined as lagging predictors of share price.  Dr. Caragata’s research on bond pricing and CDS where better predictors of financial health momentum and ultimate predictors of share price but still failed to correlate financial health score as an early warning signal for share prices.  The problem that the model continually encountered was that valuation always exhibited a bias towards share price (market momentum)  not financial health score.  The determination of a “fair value” based on historical spreads of financial health score and share price was overly and overtly price sensitive. Perhaps a signal of an inefficient market?  This was particularly true for bubble stock anomalies and commodity sensitive equities.

Purveyors of Business Process Management (BPM) suggest that listed practitioner’s of BPM trade at a 15% premium to non-practitioners.  I wonder if its marketing boast.  Though BPM is not CG;  it does speak to having CG excellence in the corporate DNA.   A cultural commitment   to sound practices create valuation premiums and sustainable business models.  That’s the message well managed companies consistently deliver as a central theme of their value proposition.  Integrating sound practices and CG excellence into the corporate culture does create valuation premiums because it suggests an intentionality of business process deeply wedded to the enterprise mission.

I believe the radical reconfiguration of Wall Street offers a telling example of incongruity of good CG practitioners and financial health.  It was always a self evident truth that Wall Street firms that folded or transformed into commercial banks were probably some of the best rated CG enterprises.  CG excellence can do nothing to save an enterprise with a structurally flawed business model.  Though CG excellence does presuppose a board of directors in tune with the vicissitudes of the market; who would have thought that we would be looking at the extinction of the global investment banking business?  Merrill Lynch, Morgan Stanley, Lehman Brothers, Bear Stearns and the mighty Goldman Sachs were walking dinosaurs with flawed unsustainable business models?  All either folded, were acquired or became FDIC insured commercial banks.  I still can’t believe it but it’s true.  The world is being turned upside down.

Sum2 is a firm believer in coupling quantitative and qualitative risk measures to maintain operational excellence to build a healthy sustainable enterprise.  Effective CG alone cannot assure financial health.  It  must be a critical pillar of the governance, risk and compliance (GRC) triad.

When we speak about the principles of good governance, how about the original dissertation on the ideal of governance excellence.  Seemingly an insistence on an honest evaluation of reality to determine what is good is all it takes.  Its really that simple.

Visit the blog Risk Rap and the Allegory of the Cave post on FAS 157:

Sum2 welcomes the opportunity to speak with partners who share our passion for GRC excellence.

originally published 6/12/13

June 12, 2013 Posted by | Bear Stearns, business continuity, credit crisis, Credit Redi, culture, FASB, operations, risk management, sound practices, sustainability | , , , , , , , , , , , , , , , , , | Leave a comment

Goldman Sachs as Social Entrepreneur

Goldman Sachs’ CEO Lloyd Blankfein and his largest investor, The Wizard of Omaha, Warren Buffett , descended from the mystical heights of Valhalla with some startling news.  They were bearing a new mythical golden ring.  As they held the ring aloft they made a bold proclamation.  They would embark on one of the grandest social entrepreneurial programs of all time by offering some of the rings precious power, about $500 million worth, to capital starved small and mid-size enterprises (SMEs).  The 10,000 Small Businesses Initiative will distribute $100 million per year over the next five years to SMEs through Community Development Financial Institutions.

These lords of commerce have heard the cries from endangered SMEs.  In their infinite wisdom Blankfein and Buffet understand that the real economy needs to resuscitate and incubate the critical SME segment as an absolute prerequisite to a vibrant economic recovery.    The buzz about this news in the marketplace ranged from cynical suspicion at one extreme to puzzled bemusement and  ecstatic aplomb at the other.

What motivated Goldman to announce this initiative is an interesting question.  Was it guilt, greed or a sense of corporate social responsibility?  Some suggest it is a master PR move to counter a growing public perception that Goldman Sachs,  the poster child of government favoritism and bailout largess,  has leveraged its unfair advantage to achieve historic levels of profitability.  Thus enabling management to pay obscene bonuses to company employees.  But capital has no psyche,  and half a billion dollars is a tall bill to underwrite absolution for some phantom form of guilt.  True to its nature, capital always  seeks a place where it will find its greatest return.  Goldman and Buffett are casting some major bread on the receding waters of a distressed economy.  As its foretold in the Good Book , doing God’s work will produce a tenfold return.  If the Bible’s math is correct, thats a lot of manna that will rain down from heaven for the shareholders of Goldman Sachs and Berkshire Hathaway.  Looks like our modern day version of Moses and Aaron have done it again.  Leading their investors across the dangerous waters of the global economy to live in the promised land of happy shareholders.

As one of the world’s preeminent investment banks and purveyor of capitalist virtues,  company shareholders must be questioning how Goldman’s managers will realize a return on this investment?  Has management examined the potential corporate and societal moral hazards surrounding the program?  Surely shareholders have asked when they expect to be compensated for this significant outlay of capital.   The desire to realize gain is a more plausible motivator and makes more sense for an enterprise like Goldman and the storied investment Wizard from Omaha.

Its wise to ascribe the best intentions and virtuous motivations to actions that we may not fully understand.  This program should be viewed as a seminal event in the history of corporate social responsibility and social entrepreneurship.  Its important to understand that institutions that practice corporate social responsibility do not engage it solely as a philanthropic  endeavor.  Indeed, the benefits of good corporate citizenship pays multidimensional dividends.  All ultimately accrue to the benefit of company shareholders and the larger community of corporate stakeholders.

Goldman’s  move to walk the point of a capital formation initiative for SMEs seeks to mitigate macroeconomic risk factors that are prolonging the recession and pressuring Goldman’s business.   Goldman needs a vibrant US economy if it is to sustain its profitability,  long term growth and global competitiveness.  Goldman needs a strong regional and local banking sector to support its securitization, investment banking and corporate finance business units.   Healthy SMEs are a critical component to a healthy commercial banking sector.  Goldman recent chartering as an FDIC bank holding company may also be a factor to consider.  This SME lending initiative will provide interesting insights into the dynamics of a market space and potential lines of business that are relatively new to Goldman Sachs.  This initiative might presage a community banking acquisition program by Goldman.  At the very least the community banking sector is plagued with over capacity is in dire need of rationalization.  Goldman’s crack team of corporate finance and M&A professionals expertise would be put to good use here.

Goldman’s action to finance SMEs will also serve to incubate a new class of High Net Worth (HNW) investors.  Flush with cash from successful entrepreneurial endeavors, the nouveau riche will be eager to deploy excess capital into equities and bonds, hedge funds and private equity partnerships.  Healthy equity markets and a growing Alternative Investment Management  market is key to a healthy Goldman business franchise.

Community banks, principal lenders to SMEs are  still reeling from the credit crisis are concerned about troubled assets on their balance sheets.  Bankers can’t afford more write downs on non-performing loans and remain highly risk adverse to credit default exposures.  Local banks have responded by drastically reducing credit risk to SMEs by curtailing new lending activity.  The strain of a two-year recession and limited credit access has taking its toll on SMEs.  The recession has hurt sales growth across all market segments causing SMEs to layoff employees or shut down driving unemployment rates ever higher.  Access to this sector would boost Goldman’s securitization and restructuring advisory businesses positioning it to deepen its participation in the PPIP and TALF programs.

The financial condition of commercial and regional banks are expected to remain stressed for the foreseeable future.  Community banks have large credit exposures to SME and local commercial real estate.  Consumer credit woes and high unemployment rates will generate continued losses from credit cards and auto loans.  Losses from commercial real estate loans due to high vacancy rates are expected to create significant losses for the sector.

Reduced revenue, protracted softness in the business cycle and closed credit channels are creating perfect storm conditions for SME’s. Bank’s reluctance to lend and the high cost of capital from other alternative credit channels coupled with weak cash flows from declining sales are creating liquidity problems for many SMEs.   Its a growing contagion of financial distress.  This contagion could infect Goldman and would have a profound impact on the company’s financial health.

The 10,000 Businesses  initiative will strengthen the free flow of investment capital to finance national economic development and empower SMEs.  It strengthens free market capitalism and has the potential to pool, unleash and focus investment capital into a strategic market segment that has no access to public equity and curtailed lines of traditional bank credit. The 10,000 Businesses initiative  will encourage wider participation by banking and private equity funds.  In the aggregate, this will help to achieve strategic objectives, build wealth and realize broader goals to assure sustainable growth and global competitiveness.  All to the benefit of Goldman Sachs’ shareholders and it global investment banking franchise.

Goldman Sach’s has always been a market leader.  We salute Goldman Sachs’ initiative and welcome its success.

In  September of 2008,  Sum2 announced The Hamilton Plan calling for the founding of an SME Development Bank (SDB).  The SDB would serve as an aggregator of capital from numerous stakeholders to focus capital investment for SME manufactures.   More on the Hamilton Plan can be read here: SME Development Bank.

Risk:  SME, bank, recession, unemployment, credit, private equity

You Tube Music: 10,000 Manaics, Natalie Merchant: Dust Bowl

November 19, 2009 Posted by | banking, credit, economics, FDIC, private equity | , , , , , , , , , , , , , , , , , , , , , , , , , , | 2 Comments

A Taxing Situation

irs-and-capitol1President Obama announced his intention to curb the use of offshore tax havens for multinational corporations.  The Treasury Department is looking to raise tax revenues and believes that by closing the use of offshore tax shelters it will be able to raise over $200 bn over the next ten years.  According to the New York Times,  firms like Citibank, Morgan Stanley, GE and Proctor and Gamble utilize hundreds of these type structures to shelter revenue from being taxed by the IRS.  It has effectively driven down the tax rates these companies pay and has been a key driver in maintaining corporate profitability.

This move should come as a surprise to no one.  The Treasury Department needs to find sources of tax revenues to cover the massive spending programs necessitated by the credit crisis and the global economic meltdown.  The TARP program designed to revitalize banks has  expenditures that amounted to $700 bn.  Amounts pledged for economic recovery through EESA, PPIP and ARRA will push Treasury Department expenditures targeting economic stimulus projects and programs to approximately $2 tn.  These amounts are over and above routine federal budget expenditures that is running significant deficits as well.

The planned move by the Treasury Department to rewrite the tax code may be an intentional effort to close budget deficits but it also represents a significant rise in tax audit risk.   For the past two years the IRS has been developing a practice strategy and organizational assets to more effectively enforce existing tax laws.  Private sector expertise, practices and resource has significantly out gunned the IRS’s ability to detect and develop a regulatory comprehension of the tax implications of the sophisticated multidomiciled structured transactions flowing through highly stratified and dispersed corporate structures.  The IRS is looking to level the playing field by adding to its arsenal of resources required to engage the high powered legal and accounting expertise that corporate entities employ.

The IRS has hired hundreds of new agents  and has developed risk based audit assessment guidelines for field agents when examining corporations with sophisticated structures and business models.  As such investment partnerships, global multinational corporations and companies utilizing offshore structures can expect to receive more attention from IRS examiners.

The IRS had developed Industry Focus Issues (IFI) to be used as an examination framework to guide audit engagements for sophisticated investment partnerships and  Large and Mid-size Businesses (LSMB).  The IFI for LSMB has developed three tiers of examination risk.  Each tier has comprises about 12 examination issues that will help examiners focus attention of audit resource on areas the agency considers as high probability for non-compliance.  Clearly the audit risk factors risk

To respond to this challenge, Sum2 developed an audit risk assessment program to assist CFO’s, tax managers, accountants and attorneys conduct a through IFI risk assessment.  The IRS Audit Risk Program (IARP) is a mitigation and management tool designed to temper the threat of tax audit risk.   A recent survey commissioned by Sum2 to measure industry awareness of IFI risk awareness indicated extremely low awareness of tax audit risk factors.

Sum2’s IARP helps corporate management and tax planners score exposure to each IFI risk factor.  It allows risk managers to score the severity of each exposure, mitigation capabilities, mitigation initiatives required to address risk factor, responsible parties and mitigation expenses. The IARP allows corporate boards and company management to make informed decisions on tax exposure risk, audit remediation strategies, arbitration preparation and tax controversy defense preparation.

The IARP links to all pertinent IRS documentation and information on each tax statute and IFI audit tier.  The IARP links to pertinent forms and allows for easy information retrieval and search capabilities of the vast IRS document libraries.  The IARP also has links to FASB to have instant access to latest information on accounting and valuation treatments for structured instruments.

The IARP is the newest risk application in the Profit|Optimizer product series.  The Profit|Optimizer is a enterprise risk management tool used by SME’s and industry service providers.

The IARP is available in two versions.

The IRS Audit Risk Program for investment partnerships (IARP)

Buy it on Amazon here: IARP

The Corporate Audit Risk Program (CARP)

Buy it on Amazon here: CARP

Sum2’s Audit Risk Survey results are here: IFI Audit Risk Survey

You Tube Video: Chairman of the Board, Pay to the Piper

May 6, 2009 Posted by | business, CPA, EESA, FASB, hedge funds, IARP, IRS, NP, private equity, risk management, Sum2, Tax, Treasury | , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , | Leave a comment

Level Three Sinks Lower at GS

Interesting piece at CFO Magazine concerning fair value deterioration of Level Three Assets at Goldman Sachs during the month of August. Goldman Sachs reports that valuation of Level Three Assets dropped by 13%. It would be interesting to understand the impact of this collateral erosion had on GS’s largest counter-party AIG?

Was this the trigger that precursors the radical interventionist moves by the Treasury to purchase a controlling stake in AIG?

This insight will become most constructive as the Treasury begins its purchase program of toxic level three assets. Hammering Hank has hired Neel Kashkari one of his mentees from GS to head up the repurchase program. Mr. Kashkari is said to be a quantitative wiz kid and a real life rocket scientist to buy Level Three Assets from GS and other banks and create and manage a portfolio of toxic assets on behalf of the American taxpayers.

The CFO article can be viewed here.

You Tube Video: Goof Troop Level Three

Risk: collateral valuation, counter-party default,

October 8, 2008 Posted by | banking, credit crisis, EESA, FASB, TARP, Treasury | , , , , , , , , , | Leave a comment