Leaders of successful businesses build long-term relationships with customers, suppliers, employees, and shareholders. They make farsighted investments to support and develop their core competencies. They act quickly to ensure that short-term obstacles do not disrupt their long-term strategies. In conceiving and implementing corporate strategies, managers have always drawn on the skills of many specialists, from marketers to production experts. Now a small but growing number of senior managers have found that practitioners of a new technical specialty—financial engineering—can help them achieve their companies’ strategic objectives. They have found that, like other technological breakthroughs such as cheap computing power, financial engineering has the potential not only to reduce the cost of existing activities but also to make possible the development of new products, services, and markets.
The notion that financial engineering—the use of derivatives to manage risk and create customized financial instruments—can advance a company’s strategic goals might contradict the impression one gets from recent stories in the press. In many of these tales, traders within the finance staff use derivatives to speculate on the steepness of the yield curve or on movements of exchange rates. It appears that these bets have not been driven by the company’s business strategy and that senior managers have been unaware of choices made deep within their finance organizations. When misguided wagers backfire, companies lose millions and executives lose their jobs. Managers who seek to avoid disasters certainly must pay careful attention to these cautionary tales. Nevertheless, these accounts could easily give the impression that financial engineering is not used, and indeed should not be used, by nonfinancial companies to advance core business goals. That impression would be wrong.
It is well to recognize the pitfalls of new technologies, but failure to appreciate their true competitive value can be shortsighted and ultimately hazardous. Forward-looking managers need to keep abreast of their rivals’ successful uses of promising breakthroughs like financial engineering. Unfortunately, those are the stories that remain untold. Were they to be told, managers would learn of leading organizations that have used financial engineering to solve classic and vexing business problems. These are not narrow finance problems that involve shaving a few basis points off financing costs or shedding transaction exposures arising from sales abroad. Rather, they are broad strategic problems—in marketing, production, human resources, investor relations, and strategic restructuring—for which advanced financial techniques have offered new solutions. This article presents five case studies that illustrate innovative applications of financial engineering and offers managers guidance for determining when such techniques are appropriate.
Managers need to keep abreast of their rivals’ successful uses of financial engineering.
The cases highlight five corporations—three headquartered in the United States, one in France, and one in Mexico—that produce and market gas, electricity, chemicals, cement, or oil. Although the companies faced different management challenges, their goals were clear and their opportunities well defined. Traditional approaches toward achieving their objectives, however, seemed inadequate—either the costs or the risks appeared to be too high. The outline of a new, nontraditional solution was not hard to discern. But the innovative approach required that the companies commit themselves to bearing risks that their customers, employees, or counterparties sought to shed. Without a means of structuring, valuing, and mitigating those risks, the strategic initiatives that management pursued seemed doomed to failure. In the end, the innovative approach was made possible by the concepts, tools, and markets of financial engineers.
The cases demonstrate that close collaboration between general managers and financial engineers can help create a competitive edge in a variety of ways: by differentiating products through enhanced price and delivery options, by increasing production capacity with flexible alternatives to capital investment, by changing the risk characteristics of holding stock, or by keeping strategic mergers on track through the creation of win-win situations. The underlying aim of the cases is to follow the eye of the financial engineer who thinks like a strategist (or the strategist who thinks like a financial engineer). That means “following the risk” through the process of identifying the sources of risk, evaluating the strategic advantage of bearing risk, creating financial instruments to transfer risk, and using financial markets to value and shed risk.
Controlling Volatility: Enron Capital & Trade Resources
Producers and distributors of regulated commodity products, such as natural gas or electricity, have not generally been known for their sophisticated marketing programs. Before deregulation, there was little need or incentive to differentiate their products. But price decontrols, open distribution systems, and market economics have changed all that. How, then, can a commodity producer succeed in a competitive environment? Elementary strategy suggests that the company must either be the lowest-cost provider or distinguish its product from the competition. And yet it would seem almost senseless for a company to establish a brand name for a product like methane, which can be fully described as one molecule of carbon attached to four molecules of hydrogen.
How can a producer of a commodity like natural gas differentiate its product?
This was the challenge confronting Enron Capital & Trade Resources (ECT), a subsidiary of Enron Corporation of Houston, Texas—a diversified natural gas company that explores for and produces gas, operates pipelines, and builds and operates power plants around the world. ECT’s recent success in the natural gas business can be attributed in part to its ability to create a line of product and service options by using financial engineering. As Jeffrey K. Skilling, chairman and CEO of ECT, puts it, “Selling natural gas is getting to be a real business, like selling washing machines. We’re taking the simplest commodity there is, a methane molecule, and we’re packaging and delivering it under a brand name, the way General Electric does.”
ECT’s managers had learned from a decade of instability in the natural gas market that their product was about more than carbon and hydrogen and that users of natural gas cared very much about such characteristics as reliable delivery and predictable prices. From 1938 to 1978, the price of natural gas had been under regulatory control, and buyers and sellers had known that prices would be fairly predictable. In the early 1970s, price controls together with the oil embargo in the Middle East led to severe gas shortages and precipitated the industry’s deregulation from the wellhead to the end user. A series of legal rulings and market developments abrogated the standard industry contracts, which presold fixed quantities of gas at fixed prices. By 1990, more than three-fourths of all gas sales were at spot prices. Natural gas prices were more volatile than oil prices and, on occasion, four times as volatile as the Standard & Poor’s 500 index.
In the late 1980s, ECT’s managers sensed a market opportunity. Their vision was to create a “gas bank” that would serve as an intermediary between buyers and sellers, allowing both to shed their unwanted risks. Focusing on buyers, ECT’s marketers reasoned that bundling methane molecules, reliable delivery, and predictable prices into a single package would define a clear product line and communicate the company’s unique skills. Further, by giving the package a distinctive name, they could perform the seemingly impossible trick of creating a brand name for methane.
Accordingly, ECT developed a family of products called EnFolio Gas Resource Agreements—gas-supply contracts that could be customized according to the quantity, time period, price index, and settlement terms specified. One local gas utility could buy EnFolio GasBank and be assured of a fixed volume at a fixed price. Another might prefer EnFolio Index, which offered a fixed volume at a price tied to a natural gas index. A third might choose EnFolio GasCap, which delivered a fixed volume at a price tied to a natural gas index and capped at a previously determined level. Given the range of variables, each product could be sold under a nearly infinite set of specific conditions. ECT’s marketing strategy, which stressed the company’s ability to help gas consumers avoid unpredictable prices, included an amusing advertising campaign that featured a large black dot called Spot, representing the spot price of gas. In one ad, Spot was in a hospital bed. An erratic chart tracked its vital signs, and the caption read, “See Spot. See Spot having problems long-term.”
ECT’s crucial insight was that the extraordinary volatility of natural gas prices and the fluctuations in supply offered the company the opportunity to distinguish its product and to profit by managing the risks of uncertainty experienced by gas producers and consumers. Buyers and sellers would, in effect, pass their risk on to ECT. But ECT realized that it would have to manage the gas bank’s long-term contracts carefully to avoid falling into the trap that had plagued the savings and loan industry, in which fixed-rate, long-term mortgages were funded by short-term interest rates paid to depositors. That mismatch of assets and liabilities had nearly bankrupted an entire industry when interest rates rose. ECT’s risk managers have clear instructions to develop a hedging strategy that minimizes net gas exposures, and the company has invested millions of dollars in hardware, software, and hundreds of highly trained personnel to eliminate mismatches and ensure that fluctuations in gas prices do not jeopardize the company’s existence.
Understanding customers’ needs and developing a supporting marketing strategy did not require any knowledge of financial engineering. But creating the contracts and ensuring that the company did not expose itself to excessive risks were classic exercises in financial engineering. ECT’s success—measured by both market share and profits—illustrates how financial engineers, working with marketers and strategists, can differentiate a commodity product without taking on undue risk.
Adding Capacity with Virtual Bricks and Mortar: TVA
Senior managers facing projections of increased demand have to confront difficult decisions about whether to make or buy production capacity to meet that demand. The problem can be particularly vexing when building new capacity entails large-scale capital financing that may limit precious flexibility in a rapidly changing market. Costly production assets with projected useful lives of several decades could be rendered obsolete almost overnight. For the managers of Tennessee Valley Authority, the problem was even more acute because government policy limited their ability to finance new projects, and their industry was in a period of unprecedented upheaval. How could TVA meet its customers’ needs without exposing itself either to market uncertainties or to large investments?
Founded in 1933, TVA was set up by Congress to manage the waters of the Tennessee River to produce electricity for the southeastern United States. At first, TVA built hydroelectric dams, and in later years, coal-fired-steam and nuclear power plants. Throughout its history, TVA met the increased demand for power by turning to its engineers, who transformed bricks, mortar, turbines, and reactors into energy. By mid-1994, TVA’s demand forecasts indicated that for all but its lowest projections, it would have to continue to add capacity; for its highest projections, additional peak capacity would be required as soon as 1997.
But building new capacity is not inexpensive. One estimate puts the cost of TVA’s nuclear power program over its 28-year history at $25 billion. In mid-1994, the capital expenditures necessary for TVA to meet its forecasted demand by the year 2000 were projected to be about $1.7 billion per year for the next six years. Numbers like these were putting pressure on TVA’s capital budget.
Two other factors complicated TVA’s ability to meet increasing demand. First, by setting TVA’s debt ceiling at $30 billion, Congress limited the company’s ability to finance new projects. In 1994, TVA’s debt already stood at $26 billion, and its own board had set an internal cap approximately 10% below that imposed by Congress. Second, the deregulation of the electric power industry had begun, and the electricity market was in a state of flux. In the new market for power, electricity could be bought and sold for spot or future delivery. In the United Kingdom, brokers of power already could trade primitive futures contracts. In the western United States, the Western Systems Power Pool operated as a power exchange for its members. And the New York Mercantile Exchange was actively discussing the specifications of an exchange-traded futures contract on electric power. By the end of 1994, 80 entities had applied to the Federal Energy Regulatory Commission to become over-the-counter brokers or marketers of power in what was thought to be the beginning of one of the nation’s biggest emerging markets.
The evolving markets for power clearly offered TVA a way to meet increasing demand by buying power rather than making it with bricks and mortar. Buying long-term fixed-price and fixed-quantity contracts might require a smaller up-front capital investment than would building new generating plants. But that strategy wouldn’t necessarily solve the problem of uncertain demand—the question of when and how much to buy. TVA could vary the amount of energy its power plants produced in a matter of minutes; and because electricity is not easily stored, that flexibility was a critical aspect of the business. Given the volatility of prices in the emerging power markets, flexibility was becoming even more important. Thus for buying power to be an adequate substitute for making power, it would have to give TVA the same flexibility that the company’s power plants could. It looked as though long-term contracts that locked in fixed amounts at fixed prices would not fit the bill.
In early 1994, members of the Customer Planning Group at TVA, all engineers by training, began to discuss a new idea. Why couldn’t TVA purchase call options on power that would give it the right, but not the obligation, to buy power from other utilities? By purchasing call options on electricity, TVA could buy additional power as needed. The call options could create a virtual power plant for TVA that acted like the real options that the company had in its bricks-and-mortar plants. Just as TVA could decide the level at which to operate a particular generating source—sometimes on a daily basis, based on market demand and prices—so it could choose whether to exercise its options to buy power. If the company’s low energy forecasts were borne out, it might choose to buy less additional power, but if the demand for energy was strong, it could exercise all its options. Similarly, it could choose whether to exercise its options on the basis of prevailing energy prices.
A number of questions remained: How could TVA ensure that its power counterparties would perform both technically and financially on their contracts? How should the option contracts be structured? How would TVA evaluate and price the various contracts? Through the spring and summer of 1994, the TVA team hammered out the mechanism for soliciting market prices from potential sellers of options. In July 1994, it issued a request for proposal for option purchase agreements (OPAs), formally seeking quotations on electricity options. By December 1994, it had received 138 separate bids totaling nearly 22,000 megawatts of power. During the winter and spring of 1995, the team evaluated the proposals, created a shortlist, and began to negotiate with potential counterparties.
Concepts drawn from financial markets will help TVA manage the risk of an options portfolio.
The insight that TVA needed flexibility in acquiring new capacity did not require any financial engineering skills, but the implementation of the option purchase plan did. Concepts borrowed from the financial markets will help TVA value its OPAs, compare them with the traditional alternative (building plants), and manage the risk of an options portfolio. The financial engineers who structure, value, and manage these portfolios of option contracts may someday prove to be as valuable to a utility’s future as the engineers who design hydroelectric, coal, and nuclear power plants. Perhaps as important, the information that electric power markets will provide to both producers and consumers will allow managers to make better investment decisions, even about traditional bricks-and-mortar projects.
Reducing Stockholders’ Risks: Rhône-Poulenc and Cemex
When investors shy away from a stock, it is probably because they think that the risks of investment are too high relative to the likely return. The managers whose stocks are avoided, however, may believe that such judgments are unwarranted or ill informed. They may want to educate investors and communicate confidence in their company’s stock, especially when the potential investors are their own employees. Many managers and scholars agree that workers tend to be most productive when their financial interests are aligned with those of the company’s shareholders. One way to achieve this community of interests and to motivate workers is to tie compensation to stock price performance through executive stock ownership or employee stock ownership plans. Although companies can, of course, give stock to employees, they obviously would prefer that employees purchase shares. But they may find it difficult to persuade them to buy, especially when the prevailing business culture has made workers risk averse and there is no tradition of employee stock ownership in any form.
That was the problem confronting officials of the French government and managers of Rhône-Poulenc, the leading French life sciences and chemical company. Rhône-Poulenc had been nationalized in 1982, but more than a decade later a new regime sought to return the organization to private ownership, and a massive equity offering was planned to sell shares to global investors. Government officials and Rhône-Poulenc managers, deeming that broad participation by employees was critical to the private entity’s long-term success, were excited by the prospect of employees having a direct interest in the value of its stock. When, in early 1993, an initial block of Rhône-Poulenc shares was sold in a partial privatization, both the government and the company took measures to encourage employees to buy shares. The state granted employees a 10% discount off the market price of the shares, and Rhône-Poulenc sweetened the deal by giving them an extra 15% discount in addition to the right to pay for the stock over 12 months. Despite those incentives, the employees’ response was disappointing: Only 20% chose to participate, and only three-fourths of the employee allotment was sold.
As full privatization approached in late 1993, managers of Rhône-Poulenc and their counterparts at the French Treasury considered even more aggressive traditional incentives, such as further discounts, free shares, and interest-free loans. These sweeteners, however, had two problems: First, they might prove very costly both to the government and to Rhône-Poulenc. Second, the Treasury and the managers suspected that even these measures would be insufficient because they failed to address the employees’ fundamental fear of holding stock—the fear of losing their entire investment. The managers and the government worried that employees, whose economic well-being was already largely dependent on Rhône-Poulenc, would not take on a greater stake in the company; they needed a solution that would reduce or eliminate the risks of stock ownership for employees and avoid prohibitive costs or risks to themselves. How could they meet both those goals?
Rhône-Poulenc needed to reduce the risks of stock ownership for employees and avoid prohibitive risks of its own.
This was another classic opportunity for financial engineering, and the company’s financial advisers at Bankers Trust offered the following solution: Why not provide employees with a guaranteed minimum return on their investments, which could be paid for by forgoing a part of their interest in the stock if it appreciated? In simple terms, employees could be offered a stock investment in Rhône-Poulenc that gave them voting rights and guaranteed a minimum return of 25% over four and a half years plus two-thirds of the appreciation of the stock over its initial level. If the company performed poorly, employees would not suffer any loss, and if it did well, they would gain, although not as much as they would have had they held regular shares. Thus the agreement would address the employees’ fear of losing their money, as was amply demonstrated by their overwhelming acceptance of the plan. The proposed guaranteed shares, described in information sessions and on videotapes, turned out to be a successful portion of Rhône-Poulenc’s oversubscribed offering.
But what about the costs to Rhône-Poulenc and the French government? Neither wanted to bear the risk of the guarantees if share prices fell. Here, too, they turned to their financial intermediaries, who assumed responsibility for managing the risk of the employee portfolio in financial markets. The financial engineers who structured the deal and managed the portfolio profited from the transaction while attracting praise and new business with their novel proposal. More important, by using the tools of risk management, they supported a well-conceived human resources policy that was an integral part of the company’s strategy. And, thanks to financial engineering, Rhône-Poulenc’s innovative approach had a net cost that was no higher than it would have been had the company used any of the traditional sweeteners. Management’s insight that guaranteeing a minimum return on employee stock ownership would alleviate workers’ concerns did not require any special knowledge of finance. Nor did the rank and file have to understand that they were financing the purchase of a put option by selling calls. But the skills of financial engineers were essential to ensure that Rhône-Poulenc kept the promises it made to employees.
Rhône-Poulenc’s need to communicate confidence in its stock highlights a common management concern. Virtually every manager at one time or another believes that his or her stock is undervalued. If a company is using its stock to acquire other companies or if executive compensation is based on stock-price appreciation, undervaluation may be especially troublesome. Consider the case of Cemex, the largest cement producer in the Americas and the second-largest industrial company in Mexico. In 1992, when Cemex announced its strategic acquisition of two Spanish cement manufacturers, its stock fell dramatically in response. The market undervaluation was both extreme and crippling. What could Cemex do to communicate its confidence to investors?
The managers’ first line of defense, meeting with investors and analysts, apparently failed, and the second “normal” solution, a stock buyback, was complicated by Mexican law. Cemex’s financial advisers at J.P. Morgan then suggested an alternative that would comply with Mexican law while achieving the same purpose as a buyback: Instead of buying its stock, Cemex could sell investors an option (the right but not the obligation) to sell their stock back at any time over the next year for a fixed price. In the financial engineers’ terminology, Cemex could issue a put on its own stock. In effect, it would commit to buy back its shares, guaranteeing a minimum price to any investor who bought the put. Whereas companies sometimes quietly sell (or write) puts in conjunction with their stock-buy-back programs, J.P. Morgan was recommending a well-publicized sale of puts to communicate Cemex’s conviction that its share price was too low.
Cemex had publicly committed to bearing a large portion of its investors’ risks, but there was one remaining problem: If the company’s share price plummeted, Cemex would not have the resources to honor its guarantees. The company’s advisers at J.P. Morgan, however, were willing to issue and back the securities, called equity buyback obligation rights (EBORs), themselves. The proposal was a classic example of financial engineering: The specialists could price the EBORs and manage their risks in the financial markets.
Cemex’s puts were a close cousin of the guarantees that Rhône-Poulenc offered its employees and apparently were just as effective. Between the time of the board meeting at which the EBORs were discussed and the actual offering, the company’s stock recovered nearly half of its earlier decline. It is impossible to tell whether the response was caused by the public signal sent by Cemex, the trust implied by J.P. Morgan’s issuance of the securities, or unrelated movements in the stock’s price. Regardless of the cause, financial engineering (in this case, the sale of puts) offered a viable alternative to communicating confidence in stock through press releases and straight buybacks.
Bridging the Gap Between Buyer and Seller: MW Petroleum Corporation
For the thousands of mergers and acquisitions consummated in a given year, there are probably thousands more that never get completed. Although some of those deals fail because of big differences in the perceptions of buyer and seller, others fail even though the gaps between the two parties are quite small. Given the right technical resources, skilled negotiators often can find ways to close the gaps, removing impediments to the fulfillment of their company’s strategic plans.
In early 1991, a proposed transaction that would help both Amoco Corporation and Apache Corporation achieve their strategic goals looked as if it might bust. Amoco, an integrated petroleum and chemical corporation with sales of more than $28 billion, had emerged from a long-term, multiyear strategic assessment of its business with the conclusion that, given the company’s cost structure, it should dispose of marginal oil and gas properties. So it created a new organization, MW Petroleum Corporation, as a freestanding exploration and development entity with working interests in 9,500 wells in more than 300 producing fields. Among Amoco’s options was the ability to sell MW Petroleum as a midsize independent petroleum company. Amoco and its financial adviser, Morgan Stanley Group, then marketed MW Petroleum to potential international and domestic buyers. Among them, Apache Corporation, an independent oil and gas company with revenues of $270 million, showed the most serious interest. Apache was an aggressive acquirer of oil and gas properties whose strategy was to acquire properties that majors like Amoco believed were marginal and then use its expertise and low-cost operations to achieve substantially higher profits. According to Apache’s chairman and CEO, Raymond Plank, the strategy “is a bit like a pig following a cow through the cornfield. The scraps are pretty good for someone with our particular mission.” The MW Petroleum deal was an attractive set of scraps.
The sale of MW Petroleum to Apache looked like a strategic win-win for both companies—if they could find an acceptable price. In the spring of 1991, however, the oil and gas markets had just passed through a tumultuous period. Iraq’s invasion of Kuwait had not only pushed oil prices to historic highs but also increased uncertainty about their direction. In this environment, Amoco was bullish and Apache bearish about future oil prices. So although Amoco and Apache agreed on most of the technical characteristics of MW Petroleum, their differences over oil prices set a roadblock to the deal. More important, Apache’s bankers, who would fund the acquisition, were very conservative about future oil prices and based their proposed loan on worst-case scenarios. With the gap between buyer and seller equaling perhaps 10% of the transaction value, the deal appeared to be dead. Strategic goals are fine, but only if they can be accomplished at a reasonable price.
That might have been the end of the story—another set of discussions derailed by a failure to agree, with neither party willing to take the risk of a compromise. In this case, however, the disagreement was about future commodity prices, not about the inherent characteristics of the business being bought and sold. Although both parties were committed to their forecasts, they eventually realized they could find common ground by sharing the risk of future oil price movements while at the same time addressing the concerns of the bankers financing the deal. The solution hinged on a remarkably simple piece of financial engineering.
Amoco, which was more optimistic about oil and gas prices, could write Apache a capped price-support guarantee. Under the guarantee, if oil prices fell below a designated “price support” level in the first two years after the sale, Amoco would make compensating payments to Apache. With this support in hand, Apache would see short-term revenues and profits bolstered were oil and gas prices to soften. In turn, its lenders would be assured of sufficient cash flow to make the required debt service. In return for the guarantee, Apache would pay Amoco if oil or gas prices exceeded a designated “price sharing” level over the next five to eight years. Although Apache would end up paying more for MW Petroleum if oil or gas prices rose, the corresponding rise in revenues would provide the means to make the payments. By forgoing some of the upside, Apache could insure itself against the downside. The agreement was a win-win solution because each party would get the price it had forecast if that forecast was right—so both parties felt that they got the better deal.
By the same token, either company might regret having structured the transaction as it did. Nevertheless, by using a simple piece of financial engineering, both could accomplish their strategic goals in an environment of great uncertainty about future commodity prices. They found a way of sharing risks that made the chief executives and boards of both companies comfortable with the transaction. It did not take financial engineering skills to recognize that the risks of this deal could be shared. Nor did the buyer and seller have to understand that they had created a collar—a combination of a call option and a put option. Financial engineers, however, could value the collar by using actual data and financial models. Moreover, their pricing exercise was not merely theoretical. After the deal was closed, both sides were approached to sell off their positions and thus had the choice of monetizing the options and closing their risk exposures.
Applying Financial Engineering
All the case studies presented here show how financial engineering can offer solutions to intractable problems. Although the cases differ in many respects, managers in each one recognized the need, for the sake of their own strategic goals, to help others bear risks. Financial engineers were then able to structure, value, and manage the transfer of those risks. Further similarities among the cases raise a number of questions that managers should consider when deciding whether it is appropriate to apply financial engineering techniques.
Is your ability to commit to bearing additional risk critical to your strategic success?
The use of financial engineering in these five cases contrasts with traditional forms of risk management, in which financial managers, seemingly divorced from the rest of the organization, inherit a set of exposures and manage their risk. Business leaders in these five cases knowingly took on risks to satisfy their customers, employees, stockholders, or negotiation counterparties. They did not seek to take on risk for risk’s sake but, rather, risk for strategy’s sake. The anticipated value of their transactions would come primarily from the strategic gains made possible by them. Although ECT, for example, sold fixed-price gas contracts, its primary goal was not to gain when gas prices rose or fell but rather to profit over the long term by differentiating its product. Similarly, Rhône-Poulenc’s primary purpose was not to profit from movements in its stock value but to benefit from the increased personal investment and productivity of its employees.
Is there an existing or potential market for the kinds of risks you need to bear?
Financial engineers are experts in transforming the risk-and-return characteristics of investments, and they are assisted by deep markets with low transaction costs. The more closely they can correlate the risk they seek to modify to a traded market with established contract forms, the more likely they are to find a feasible solution. Some risks, such as a potential rise or fall in a broad stock index, are very common, and claims on these risks are actively traded in public and private markets. Other risks are more idiosyncratic. But even a risk as personal as the potential property loss due to an auto accident can be mitigated—not in a market but through the risk sharing of property insurance. Financial engineering has proved to be most useful in protecting against potential failures caused by or related to movements in financial or commodity markets—in the present cases, the stock markets for Rhône-Poulenc and Cemex, and the commodity markets for the others.
Financial markets offer the opportunity to exchange risks at reasonably low transaction costs. Managers and academics should recognize that an efficient market, being essentially a zero-sum game, makes it difficult if not impossible to profit by taking on fairly priced risks. And they should be skeptical about whether companies should assume those risks. But again, it should be remembered that the five companies used financial engineering, in large measure, to shed the risks they took on. To the extent that they accepted risk, the “profits” they sought were not in the financial markets but rather in the product “market” for reliable gas, the labor “market” for committed French employees, or the acquisition and divestiture “market” for marginal oil properties. In an important sense, the companies were arbitraging risks between efficient financial markets and less efficient nonfinancial markets.
What is remarkable about these companies is their willingness to pursue financial engineering even though the relevant markets they faced were not very deep or well developed. None of them could find a premade derivative contract at an exchange that would answer their needs. Yet the importance of their problems and the lack of traditional business solutions motivated them to construct tailor-made solutions. While these tailored solutions may have been expensive, they were less expensive and more effective than the alternatives.
Can you structure a contract that transfers the risk at a reasonable price without forcing you to incur unacceptable risks?
Financial engineering, of course, is not free, and transactions that transfer risk characteristically require cash payments or entail other contingent risks owing to the nature of the transactions. Managers who use financial engineering must understand those costs or new risks.
Managers obviously need to consider the cash costs of selling risks. For example, the owner of a stock portfolio might pay cash for a put option that gives him or her the right to sell the portfolio for a fixed price at some future time, thereby setting a floor value on the stock-and-option package. Cemex’s EBORs and TVA’s proposed purchase of call options both involve such up-front cash payments. Furthermore, when companies use financial engineering to obtain flexibility, they should understand and allow for the additional cash costs they may incur if they later change their plans.
Often, the price of shedding risk is taking on another risk or giving up some of the upside potential of a future transaction or rate movement. That is how Apache, Rhône-Poulenc’s employees, and the purchasers of EnFolio GasBank products protected themselves against adverse movements in the price of oil, stock, or gas. In these forms of risk barter, the terms of trade were explicit and understood by all parties, but the allegations surrounding some recent cases of leveraged swaps underscore the need to make such understandings very clear.
In addition to these explicit costs or risks, managers using financial engineering should be mindful of other contingencies that are harder to quantify. As in other corporate transactions, there is some degree of credit risk because financially engineered solutions generally involve fallible counterparties. Financial engineers have devised various ways to mitigate credit risk, from collateralization agreements to AAA-rated derivative subsidiaries. Nevertheless, when you buy a commodity contract from a financial institution, you often are trading price risk for counterparty risk. A closely related problem arises from performance risk, or the risk that the counterparty in a commodity market will not be able to produce or deliver the product as specified in the contract. Clearly, if TVA’s proposed option contracts are to work as planned, its counter-parties must be able to deliver power.
Another contingency is basis risk, which you encounter when you cannot find a market that trades precisely the kind of risk you want to shed, and you have to use a close substitute that behaves similarly. ECT, Apache, and Amoco wrote contracts tied to specific grades of gas or oil, delivered at particular locations; users of these types of contracts may have to contend with differences between their individual exposure and the benchmarks in the industry. Other contracts might entail liquidity risks. For example, if a company uses short-term contracts to hedge long-term risks, the consequence may be sudden and unexpected cash-flow requirements. If so, a strategy intended to protect company value may turn out to be worse than no strategy at all. Perhaps the most troublesome risks that parties bear arise from legal, tax, and regulatory uncertainties. Courts, commissions, legislatures, and politicians may suddenly change the rules or simply abrogate existing contracts. As a result, it is not uncommon for “legal engineers” to work alongside financial engineers to ensure the reliability of their agreements.
Making the Decision on Risk and Return
When a business decision is about to be made, it is always useful to repeat the mantra “risk and return.” The two concepts are simple, but the cases presented here emphasize that a full understanding of how they are related often requires the collaboration of financial engineers and general strategists. Financial engineers can help to measure and moderate risks by answering such questions as, Based on the current market, what’s a fair price for shedding oil-price risk? How much upside must I surrender to buy downside protection on a stock price? But ultimately, the most significant returns on transactions can be understood and valued only by the general manager, who must answer such questions as, What is it worth for the company to have its employees own stock? Will divesting a large part of our business allow us to make significant gains elsewhere? Each party has some of the relevant risk-and-return information. Working alone, neither the financial engineer nor the general manager has enough information to make a prudent decision. Working together, they may. What is most interesting about these five cases is not their technical virtuosity; to the contrary, the financial engineering employed was quite simple. Rather, the cases are exciting because they demonstrate that collaboration between financial engineers and general strategists can produce concepts and insights capable of meeting complex challenges.
The potential for this kind of collaboration will vary from company to company and from situation to situation. But the cases presented here should suggest that the possibilities are broader than might at first be imagined. Equity derivatives that address employees’ concerns or signal confidence in a company’s stock can be applied widely, as long as the company has traded common stock. The use of derivatives in an acquisition can be beneficial if the contract is structured around the subsequent accounting or stock market performance of the unit being sold. The use of futures markets and indices in commodity settings can also be applied much more broadly—for example, there are new real estate indices, as well as new derivative contracts on the indices. By using these contracts, a real estate brokerage could differentiate its services from those of its rivals by protecting a home seller or buyer against marketwide moves in prices between the time of listing and the time of sale or purchase.
Surely not all experiments in financial engineering will be successful. Some returns may be smaller than anticipated, some risks larger than expected. New technologies like computing or financial engineering usually produce winners and losers. In the case of computing, we remember the survivors—companies made richer by capitalizing on low-cost technology. Yet if we think back a decade or two, we also will remember companies whose experiments failed. Similarly, there are companies whose experiments with financial technology have been uninspiring. The debacles reported in the headlines represent our generation’s technological washouts. What they seem to have in common is a degree of myopia on the part of senior management. We often learn that the specifications, design, execution, and oversight of these programs were all performed by the same technicians, without strategic direction and review. Facing a new specialty, senior managers sometimes throw their hands up and abdicate responsibility. The results are not surprising: An advanced financial program designed without reference to the business and its strategy, like a computer system built without input from end users, runs the risk of missing the mark.
The financial engineering used in these cases was simple, but it solved complex problems.
The companies studied here adopted financial solutions as integral parts of their core business processes. The financial engineering used in these cases was remarkably simple, but it was able to solve complex managerial problems. Furthermore, these experiments with financial wizardry promise to accomplish the objectives that management established: capturing market share and profit with minimal risk, developing new production capacity, persuading employees and shareholders to buy stock, and bringing an important acquisition to completion. Although such success stories produce blander headlines than do dramatic tales of derivatives disasters, they should be more suggestive and inspiring to forward-thinking leaders.