Capital needs in the '90s.
As the losses sustained by several major companies in the derivatives market over the past few months demonstrate, CEOs confront a new set of issues in today's capital markets--issues that won't be resolved in court or by congressional hearings. Despite all the finger-pointing at "risky" financial products, the fundamental problem lies not in derivatives or any other financing product, but in businesses' financing strategies and tactics.
The simple fact is that the number and sophistication of financing techniques available to companies today have far outpaced many businesspeople's understanding of how to apply them in meeting their operating goals. If the debacles in derivatives prove anything, it is how easily any financing approach, if it's poorly thought-out or its dynamics are misunderstood, can wipe out the benefits of a brilliant operating plan.
The challenge to CEOs is simple to state as well: Find ways to ensure that your company's financing and operating strategies work together in a comprehensive, integrated manner to maintain and enhance shareholder value. The central question then becomes, "Where should CEOs and senior managers turn for guidance?" The answer, I believe, is that the best guidance is increasingly likely to come from what some may view as an unlikely source: their bankers.
I am aware, of course, that some observers believe commercial banks are financial-services dinosaurs. With 25 years in the banking business under my belt, I am also aware that those observers have a point. In a world populated less and less by borrowers and lenders, and more and more by issuers and investors, the need for traditional financial intermediaries that can hold assets on their books is declining. Over the past decade, credit has changed from being a service provided exclusively, and sometimes grudgingly, by banks, factors, and finance companies, to a commodity available from many sources. Access to the capital markets--including commercial paper, mid-term and long-term financing, mezzanine financing, private equity, lease capital, and derivatives--is available to a broader cross section of companies than ever before. Financing tools and techniques once open only to the nation's largest corporations are increasingly available to companies of all sizes from a steadily expanding universe of financial-services providers.
As a result, the criteria CEOs traditionally applied in choosing the financial institutions they wish to deal with are changing rapidly. For most large corporations, in fact--and many so-called middle-market companies--the short list is no longer limited to, and may not even include, commercial banks. For many companies, the factors to be considered no longer focus solely on credit capacity and pricing, but instead include versatility and sophistication.
This fact is reflected in the changing competitive geometry in the banking industry. In the past, companies outgrew their banks' lending capacity and graduated to institutions with larger lending limits. Today, companies are outgrowing their banks' financing versatility and are graduating to institutions with access to more capital-markets alternatives and more sophistication in finding solutions. Far from a homogeneous industry, in which banks offer essentially the same services on different scales, banking is fast becoming a tiered business, in which companies face three basic choices: to deal with (1) a traditional lending institution, (2) a bank that offers a broad array of capital-finding capabilities, or (3) a bank that brings not only money to the table but also expertise in the application of financing techniques and problem-solving power.
Conventional credit, of course, will continue to be a financing mainstay for many companies; senior bank debt always will play a role in the capital structure. But as businesses' access to the capital markets broadens, fewer and fewer companies need traditional financial intermediaries--banks that can hold assets on their balance sheets. More and more companies, on the other hand, need knowledge intermediaries--banks with the willingness and ability to guide them through the capital markets, to help them evaluate financing alternatives, and to select the ones that will do the most in the long run to maintain and enhance the firm's value. Even more than the need for sophisticated financing products, the need for knowledge-based solutions continues to grow. And it is the role of knowledge intermediary that some banks are preparing themselves to fill.
I emphasize some banks for a reason. While many institutions--including Continental--are actively expanding the array of products they bring to the marketplace, relatively few so far have been willing and able to make the changes needed to serve as solution-oriented knowledge intermediaries. That means developing new delivery systems geared not to pushing products through the pipeline, but instead to understanding and addressing the competitive demands clients face in their markets. Interestingly, doing that means building on the very characteristic for which banks and bankers usually are blasted: their culture.
Banks certainly can do without some aspects of that culture, such as bureaucracies, hierarchies, and internal perspectives, to name a few. But one aspect remains extraordinarily valuable to businesses: commercial banks' relationship focus. Unlike almost any other kind of financial institution, commercial banks have never looked on their clients solely as a source of "deal flow"; they have never been particularly interested in one-off transactions. Instead of doing deals, commercial banks' greatest strength always has been their emphasis on relationships, their willingness to serve as long-term partners to their clients.
The term "partnership" is tossed around lightly today, but the fact is that a true relationship focus is difficult to develop. Commercial banks may not become investment banks anytime soon, regardless of how far they extend their product lines. But--and this is the important point--investment banks, with their emphasis on doing deals, never will become commercial banks. The cultural chasm between a transaction-driven business and a relationship-driven one is vast and, I suspect, unbridgeable.
FOSTERING A CLIENT FOCUS
A recent experience with a Continental client bears out that assertion. In this case, the company sought to raise financing for a proposed acquisition. After evaluating the situation and the company's financial position--which was stable--we recommended that the company raise money through a private placement of coupon-only subordinated debt. The client was, to say the least, initially skeptical of our advice. An investment bank, looking to finalize the deal quickly, didn't take the time to truly evaluate the company's financial dynamics or explore investors' needs. It advised management that in order for a subordinated financing to work, the deal would need to provide a 28-percent-to-30-percent internal rate of return to investors. Because we knew the company well, we were confident we could tell its story effectively to investors and deliver financing at a much lower cost: 13.5 percent. In fact, we did deliver, closing the financing within eight weeks of our first discussion with investors.
As that example suggests, commercial banks, far from being the moribund institutions some observers say they are, actually have more opportunities to serve clients today in more capacities than ever before, if they are willing to build on their relationship strengths, becoming more client-focused and solution-oriented, and making their principal goal supporting clients' long-term business objectives.
SHARE OF MIND
As any CEO who has tried to put solutions ahead of sales knows, becoming a fully client-focused organization can be the toughest challenge any business faces. The determination to put clients first means more than tinkering with the mission statement or playing musical chairs with the marketing department. It means radically reshaping an organization and its approach to the market from the ground up.
This, I know firsthand, is a demanding task. Breaking with a product-sales approach may mean, in the short term at least, sacrificing revenues and, potentially, market share. In the long run, however, I believe that in service industries such as banking, share of market, which by nature focuses on a company's product-specific position, is a less important measure of leadership than share of mind, an organization's position in its market as a value-added adviser when issues of strategic significance arise.
Market share always can be bought. In every industry, there are always competitors willing to cut prices to improve market share, and while this approach may work for companies pursuing mass-market strategies, for specialized institutions such as banks, price competition offers few long-term rewards.
Share of mind, on the other hand, must be earned. Achieving it means more than offering an expanded array of products. The evolution of the financing markets has, after all, been toward steadily wider application, less complication, and lower costs. Today, it's a relatively simple matter to structure what once seemed like advanced financing strategies to meet almost any company's needs. Granted, delivering these alternatives calls for a number of strengths that go far beyond relationship focus--substantial corporate-finance capabilities; Section 20 securities powers; and structuring, distribution, and risk-management skills--which many traditional, credit-focused banks are not likely to have. At bottom, however, the relationship remains key.
CEOs and business owners can relate to their bankers as sources of products and efficient transaction execution, or as advisers to whom they turn for guidance in managing the financial aspects of their enterprises. In the long run, the latter, client-focused relationship will be more rewarding, both for companies and for the banks that serve them.
TESTING YOUR BANKERS
How can you tell if your banks and bankers are truly client- and solution-focused--if they are committed to meeting your company's needs rather than just selling their products? Here are some tests CEOs can use to evaluate banks in the 1990s.
Pay attention to approach. Are your bankers focusing on the deal of the day, or on your company's long-term value? Do they discuss financing options in a vacuum, or in a context informed by your:
* Industry and its value-adding dynamics.
* Business strategy, including your competitive position, performance, strengths, and vulnerabilities.
* Financial strategy and objectives, including your asset/liability management approaches, use of leverage, cash-flow adequacy, and need for financial flexibility.
* Operating performance, including your firm's long-term earning power, its cash-flow sources and structures, and an outsider's view of your company.
* Capital-markets alternatives, including your company's access to alternative sources of financing and the relative efficiency of these alternatives in meeting financing goals without compromising your long-range financial strength.
Prepare to be pushed. Knowing clients and their needs is a demanding process, for companies as well as for banks. It means asking senior managers to confront, clearly and objectively, the linkages and disconnections between a company's business strategy and its financial strategy. It means asking senior managers to answer direct and sometimes discomforting questions, such as:
* Where do your best growth opportunities lie?
* How are your customers and their markets changing?
* Who are your emerging competitors, how are their strategies changing, and how are you responding?
* How well do your financing structures support your business objectives?
* Could changes in your capital structure better support your operating strategies?
* What's your view on the trade-offs among financing cost, diversification, and flexibility?
As these questions suggest, dealing with a client-focused, solution-oriented bank won't be easy at first for any company. CEOs are used to hearing bankers say, "Tell us what you want to do, and we'll do it for less." They're not accustomed to being challenged by their bankers. We're taking this approach at Continental, and CEOs have been known to disagree--sometimes strongly--with solutions we propose.
But we are raising issues of strategic importance to our clients. And, we believe, in the process we are raising the bar on bank performance overall.
Ask about access. Does your bank function mainly as a capital provider--a traditional lender--or as a capital finder, offering access to a full range of corporate-finance resources to meet your company's financing needs? While capital products alone won't secure any bank's future, the ability to help you tap global markets through alternatives such as asset securitization, private placement of debt and equity, lease capital, and risk management is critical.
Test the bank's business focus. Is your bank using its resources to enhance your access to the money and capital markets? Banks with a product focus tend to concentrate on larger, high-profile deals. Solution-focused banks subordinate product strategies to client needs and will strive to find ways to make approaches work at all market levels. Of course, some approaches can be used efficiently only by larger corporations, but it's important to understand how your bank allocates resources--by product or by client need.
Look for true teamwork. Is your bank taking steps to break down the cultural barriers that many banks have erected, dismantling bureaucracies, stripping away internal perspectives, de-emphasizing individual business units, and making teams the most important unit in the organization? Is it aligning the organization's objectives around its clients and shifting the focus of appraisals and compensation from product sales to teamwork and idea generation?
One way to tell is by evaluating the coordination of bank calling efforts. If different specialists from different product areas are tripping over each other's feet trying to get through your company's door, the bank is probably product- rather than solution-oriented.
The 1990s will bring new demands for all businesses, and your banker should be prepared to help you address them strategically. Today, and even more in the future, the way to tell if your bankers are doing their job won't be to look at products and prices, but rather to examine the questions they ask. If they're not asking tough ones, if they're not driving you to think about your business and your financing strategies in new ways, they're failing the test.
Successful banks aren't just providing the capital businesses need from their own lending "inventory"; they're helping clients access money and capital worldwide, building solutions around a wide range of financing techniques. Here are some of the capital-raising tools the top business banks offer today.
Asset securitization: With securitization, companies--including lesser-rated and unrated companies--seeking to raise at least $10 million in financing can tap a large, diverse, and growing financing market with a variety of short- and medium-term marketable securities at competitive rates. While securities backed by consumer receivables (charge-card receivables, auto loans, and mortgages) continue to dominate the market, business receivables are catching on fast. Securitized assets have expanded dramatically and now include real estate, natural resources, airline leases, service contracts, royalty and licensing fees, reverse-equity mortgages, and many other types of assets.
Private placements: These are no longer limited to the nation's largest corporations. In today's low-interest-rate environment, investor appetite is growing for paper from lower-rated and unrated companies with sound business fundamentals. Reflecting that, the private-placement market offers an attractive way for even "story" companies to diversify their capital sources, refinance outstanding debt, and strengthen their balance sheets.
Lease capital: Once an alternative to straight cash or debt-financed equipment acquisition, leasing today is a powerful tool that can be used to meet a number of specialized financing requirements. Companies increasingly are using sophisticated structures--such as leveraged leases, synthetic leases, and project financing--to manage tax positions, restructure balance sheets, fund large-scale development projects, and enhance project returns.
Mezzanine finance: Designed to fill the gap between the amount of senior debt lenders are willing to provide and the amount of equity capital a business owner is willing and able to commit, mezzanine finance allows companies to raise long-term capital without seeking equity from outside sources, diluting ownership and control.
Private equity: Many companies need to raise equity but resist going to the public markets for a variety of reasons: the costs and risks of a public offering, a complicated or changing financial record, the potential for illiquidity in the secondary market, or the impact of public-market price swings. Private-equity placements allow businesses to avoid these issues, while raising equity from sophisticated, long-term, institutional holders.
Derivatives: As a stand-alone tool to hedge specific transactions, or as part of an integrated strategy to mitigate overall risk, swaps and other derivatives have become a critical component in many companies' financing structures. Properly structured derivatives approaches can, for example, insulate companies' cash flows from unexpected swings in interest rates, exchange rates, or commodities prices, and can allow them to enter capital markets--such as the market for fixed-rate debt--that otherwise would be closed.
Public markets: The Federal Reserve has granted approximately 30 bank holding companies the power to underwrite commercial paper and asset-backed and municipal-revenue securities. Of these 30, six have been granted the additional power to underwrite corporate debt, and two of the six have the authority to underwrite equities.
Michael J. Murray is the vice chairman and head of Corporate Banking at Chicago-based Continental Bank, a $22 billion bank holding company with subsidiaries engaged in commercial banking, corporate finance, market making, risk management, and specialized financial services.