When Tony Hayward took over as Group CEO of BP in May of 2007, he acknowledged BP’s past failings and promised to correct them. He continued plans to make $7 billion in safety improvements. He took personal charge of BP’s group operations risk committee. He expanded the safety audit group and increased safety training.
Much good it did BP or him. When BP’s Macondo well blew, eleven men died, and in the aftermath as much as 7.8 million barrels of oil spewed into the Gulf of Mexico. The disaster will cost BP $32 billion by its own estimate. Hayward lost his job as CEO.
How could this happen? Where did he go wrong? What were the warning signs of problems in risk management at BP?
Hayward brought BP’s accident rate from the worst of the big three oil companies in 2007 to the best in 2009. But there were signs of deep troubles beneath the statistical surface. In 2009, U.S. safety regulators assessed the largest safety fine in U.S. history against BP for “willful and egregious” violations of safety controls and failure to fix hazards at the Texas City refinery dating back to 2005.
BP ended 2009 with the best net margins among the big three as well, but Hayward wanted more. As he said about his company’s results, “BP is performing okay now. We are back in the pack and doing fine. But there is still a gap between us and the best in the industry…So we think there is a long way to run in terms of overall efficiency that we can drive into BP.”
There were strong incentives for Hayward to think that way. Under BP’s bonus plan, top executives received no share awards unless BP ranked at least third place among the oil majors. BP finished last in shareholder returns for 2005 – 2007, and Hayward failed to get a share bonus in 2007.
BP took great pride in being a leader in deepwater drilling. As its head of exploration and production put it, “We don’t do simple things. We are prepared to work at the frontier and manage the risks.” Yet Thunder Horse, the company’s showcase deep field in the Gulf, was delayed for years by a flood of blunders, including faulty welds and improperly installed valves.
Whatever gains BP made against risk at the top, they did not penetrate down to the deepest levels of the company, where simple safety violations get corrected and basic quality checks take place. The pressure to keep up with Exxon and the rest of the majors meant line managers at BP had to make trade-offs between key measures like accident rates and new reserves and “overall efficiency.” They made them poorly at Texas City and Thunder Horse and disastrously at Macondo.
The risk management lesson? It’s hard to make deep, company-wide changes in risk management. It takes more than just a few years. It’s an even harder and longer job when incentives focus on returns and ignore risk.
It’s tragically obvious now that BP has deep problems with operational risk management, but it’s no challenge to identify risks after the fact. For credit analysts the challenge is evaluating risks before they occur and to do it with limited information. Using publicly available information, what could a credit analyst have learned about safety at BP before the April 2010 Deepwater Horizon disaster?
We’ve been studying the safety data that all the major oil companies use to report on safety, and we think you may find it surprising. By most measures, BP has made great progress since an explosion and fire killed 15 people and injured 180 others at its Texas City refinery in 2005. By 2009, BP arguably had become the safest major oil company in the world.
You can see from the first chart how BP’s accident rate fell between 2005 and 2009 and how BP went from being the worst in the industry to closing the gap with long-time safety leader, Exxon.
The next chart shows how BP cut fatalities down to the lowest among the top three oil majors.
The third chart shows how BP reduced spills, an important indicator of process safety, to the lowest level among the industry leaders.
Before the terrible facts of the Deepwater Horizon explosion and the Macondo well spill, BP appeared to be in good control of its operational risks, but of course it wasn’t. So what’s the risk management lesson here? It’s that the conventional measures don’t always capture the complete risks.
That’s true not just for operational risk but for credit and market risk as well. Were there any signs of weakness in risk management at BP? We think there were, and we’ll talk more about it in our next blog post.
The last time we looked, Hovnanian Enterprises was trying for lower financial leverage. We saw signs of progress along those lines, but we were concerned about the company’s financial flexibility. Let’s see if they made any progress in the last six months.
Using cash reserves, the company brought debt down from $2.5 billion in 2008 to $1.8 billion in 2009. But debt was stuck at $1.7 billion in the second quarter of 2010. Cash flow wasn’t strong enough to let Hovnanian pay down more debt, and the company was reluctant use any of its $459 million in cash reserves.
Hovnanian also made big changes in its debt maturity structure between 2008 and 2009, as the chart shows. It cut $1.1 billion of the debt maturing between 2012 and 2015 by targeting prepayments on debt maturing in those years and by refinancing $785 million of old debt with new, senior secured notes due in 2016.
But the company was able to prepay only $100 million of its 2012-2015 maturities in the first half of 2010 — again because of weak cash flow and the need for large cash reserves. Ironically, one reason Hovnanian needed so much cash is that it had no revolving credit to help with liquidity needs. The company was forced to cancel its $300 million revolver to do the $785 million debt issue in 2009.
The lesson is that financial risk can be hard to manage. It involves complex trade-offs among leverage, flexibility, and liquidity. Hovnanian was able to reduce leverage and improve flexibility in 2009, but only by compromising liquidity. And it still has a $1.1 billion mountain of debt to climb in 2016.
For the 7th time in 10 years, Wal-Mart is #1 on the Fortune 500 list (in the other 3 years, it was #2). The company is the largest private employer in the U.S. and accounts for 8% of total retail sales in the US. As big box retailers (including Wal-Mart, Target, The Home Depot and others) have gained market share over their smaller competitors, consumer products companies feel the need to sell to these large retailers in order to grow sales. For some companies, however, selling to the big box retailers has a darker side – what we call “Wal-Mart Risk.”
Customer Concentration Risk
The risk is customer concentration – that a significant portion of a company’s sales are to one company. The dangers of customer concentration include:
1) Credit risk – the risk that the customer will go bankrupt and the company will be unable to collect its receivable.
2) Switching risk – the risk that the company will build capacity to satisfy a large customer, and then the customer switches to another supplier, leaving the company with significant excess capacity (and perhaps unsold inventory).
3) Buyer power – the risk that the customer uses its position as a large buyer to drive down the price it pays the company for goods.
In order to address customer concentration risk, revolving credit agreements that include a borrowing base often exclude accounts receivable from customers above certain concentration limits (say 10% of total receivables). This provision significantly limits revolver availability for some borrowers and does not protect lenders from the main risks of customer concentration – switching risk and buyer power.
How is Wal-Mart Risk different?
How should we look at customer concentration risk differently when the large customer is Wal-Mart or one of the other big box retailers?
1) Credit risk is significantly reduced. It is unlikely that Wal-Mart will go bankrupt and not pay its suppliers.
2) Wal-Mart takes advantage of its buyer power more than most. The downside of selling to big box retailers is that they will demand lower prices, leaving their suppliers with lower margins. In addition, Wal-Mart is well known for setting other strict terms for its suppliers in terms of product quality, inventory levels, distribution and returns.
Can we “structure around” Wal-Mart risk?
So how should lenders address the ever-increasing Wal-Mart risk among their borrowers?
1) Waive concentration limits for receivables from high quality vendors, like Wal-Mart, but consider lower advance rates to account for the higher dilution likely from aggressive return and warranty claims.
2) Consider the impact of the loss of a large customer on the borrower. Does the company have a contingency plan? Will it be able to bring down costs and capacity to match lower sales?
3) Lower leverage! Companies with significant customer concentration have higher business risk than companies with a diverse customer base and should thus have a more conservative financial strategy – that means less debt.
Have you seen companies and/or their lenders address this risk? Tell us how – we welcome your comments.
The problems of the last leveraged buyout bubble are still with us. From 2004 through 2007, the U.S. experienced an unprecedented level of LBO activity. That all ended with the collapse of the debt markets in the summer of 2007 (and the disappearance of the debt markets after the Lehman bankruptcy).
LBOs are funded primarily with debt – somewhere between 60% and 80% of the capital structure. These are the debt products used:
Institutional Term Loans (also know as “Term Loan B” or “TLB”) – often the single biggest tranche of debt, these loans are sold to institutional investors, such as collateralized debt obligations (CDOs) and prime rate funds. They have very little principal amortization and a final maturity of 6-7 years.
Pro-rata Loans (comprised of a revolving credit facility and a Term Loan A) – these loans are sold to banks and typically make up a smaller part of the capital structure than the TLB. Standard terms for a Term Loan A include significant principal amortization and a final maturity of 5 years.
High Yield Bonds – are sold to institutional investors. They have a bullet maturity (i.e. no principal amortization) and a final maturity longer than the Institutional Term Loans, typically 7-10 years.
The Debt is Coming Due!
Starting in 2012, we will see significant amounts of LBO debt coming due. Knowing the typical maturities of the debt products and counting forward from the boom years of 2006 and 2007, first we’ll see large amounts of pro-rata loans come due, then institutional term loans, then high yield bonds, as this chart shows:
What is the solution?
Highly leveraged companies have been working on this problem for some time. Given their earlier maturities, much attention has been focussed on refinancing the loans. Companies have issued new loans (with longer maturities) and high yield bonds in order to repay existing loans and extend their debt maturity profiles. There have also been many “amend and extend” agreements whereby existing lenders extend the maturity of their loans (in exchange for fees, increased interest spreads and other consideration).
Looking out into 2012 and beyond, the question is whether or not there will be capacity in the loan and bond markets to refinance all of the maturing debt. The jury is still out on this question.
We stumbled upon these striking charts in an article in the Financial Times recently. It has interesting implications for credit analysis.
The last decade’s boom in credit has been remarkable, led, of course, by mortgage-backed securities. But debt funding by companies is a close second, if you count “corporates” and “money-markets.”
There are plenty of reasons to believe the surge in corporate debt will continue. Equity’s miserable performance over the last ten years makes it much more expensive than debt, for one thing. And businesses in developing economies are hungry for capital, for another.
Although the article focuses on trading opportunities, debt markets move on a couple of drivers: technicals like changing interest rates and fundamentals like credit quality. After the market seizures of 2008, portfolio managers can’t be so confident they can trade their way out of a poor credit position. That means strong demand for credit analysis at origination and in the after-market.
Corporate loan and bond portfolios did not take the same drubbing as the mortgage-backed markets over the last several years, but doesn’t mean they were risk-free. At the worst, the global default rate on investment-grade bonds was 5.4% in 2009, and on non-investment grade bonds it was 13.0%. Commercial loan delinquencies in the United States were at a 4.5% rate at the end of 2009.
The debt markets got a memorable course of risk-aversion therapy recently, and they’re likely to remain acutely risk-conscious for some time. Regulators doubtless will be especially vigilant about credit risk as well.
Banks, investors, and traders who take credit risk will want to pay close attention to the fundamentals. Analyzing business risk, financial risk, and structural protections may not be glamorous, but it will be more important than ever.
Last post, we argued that Lehman’s Repo 105 balance-sheet-management tactic was not the worst thing Lehman Brothers did on its way to extinction. Volume 8 of Anton Vakulas’s Bankruptcy Examiner’s report details a bunch of blunders with far more serious consequences.
Here are a few of our favorites:
Although management was aware of the growing problems in the mortgage markets as early as 2006, Lehman decided to take on more risk “to pick up ground and improve its competitive position.”
It chose to do that by “making ‘principal’ investments – committing its own capital in commercial real estate, leveraged lending, and private equity investments.”
And it sacrificed liquidity along the way, so that “less liquid assets more than doubled during the same time from $86.9 billion at the end of the fourth quarter of 2006 to $174.6 billion at the end of the first quarter of 2008.”
But in our view, Lehman’s biggest missteps were in risk management. Lehman’s opportunistic push for growth changed into an aggressive push to offset declines in its commercial mortgage business late in 2007 and early in 2008, and that led the company to ignore its own risk controls.
This chart from the Examiner’s Report shows how Lehman’s risk appetite grew through 2007 and into 2008. Risk appetite was Lehman’s estimate of the amount it could lose without jeopardizing employee compensation or shareholder returns.
The chart also shows how in the last two quarters of 2007 the firm exceeded its own risk appetite limit with hardly any restraint, and then in the first quarter of 2008 solved the problem not by reducing risk but by raising the limit.
There are plenty of other instances of management’s undisciplined approach to risk management:
Management played games with key risk measures and “omitted some of the largest risks from its risk usage calculation” until June 2008 and “did not revise its stress testing to address its evolving business strategy.”
“Lehman rewarded its employees based upon revenue with minimal attention to risk factors in setting compensation,” in spite of the fact that managers were supposed to “use risk-weighted metrics such as return on risk equity…to determine compensation.”
After she resisted an increase in the firm’s risk appetite in 2007, Lehman replaced its highly regarded Chief Risk Officer, Madelyn Antoncic, in the third quarter of 2007 with the Chief Financial Officer, Rick O’Meara, who had no risk management experience.
Lehman did not see risk management as a crucial discipline or as a vital safeguard for a company operating with little capital and limited liquidity in troubled markets. For Lehman, risk management was a public relations tool.
It was a show put on to reassure clients, regulators, lenders, and the rating agencies but with no substance or bite. And that misuse of risk management was far more misleading and much more damaging than Repo 105.
A few weeks ago, the world was shocked to learn that Lehman Brothers was guilty of “window dressing” its balance sheet throughout 2007 and 2008. As the New York Times’ Dealbook put it, ”In Lehman’s Demise, Some Shades of Enron.”
The outrage is based on information in the examiner’s report on Lehman’s bankruptcy. We’ve read the report, and we think there is less to be upset about than the press coverage suggests.
The charge against Lehman is that they used accounting tricks to move assets of its books, making leverage ratios seem lower than they really were. The amounts were $38.6 billion in the fourth quarter of 2007, $49.1 billion in the first quarter of 2008, and $50.4 billion in the second quarter of 2008.
These seem like big numbers. They certainly meet the test for materiality set by Lehman’s auditors, Ernst and Young, which was “any item that moves net leverage by 0.1 or more (typically $1.8 billion).”
But let’s look at their impact not from a reporter’s point of view, or even a lawyer’s. Let’s look at this the way a credit risk analyst would.
This chart shows Lehman’s net leverage ratio as reported (without the Repo 105 assets) and as adjusted (with the Repo 105 assets). It was a measure the company emphasized in its public reporting and in its presentations to the rating agencies.
Net leverage is total assets less restricted cash, securities held as collateral, securities held to resell, borrowed securities, and intangible assets divided by stockholders’ equity less intangible assets.
When we analyze financial ratios we like to look at two dimensions of the data: level and trend. Let’s take a look at both for Lehman’s net leverage ratio.
Repo 105 does not make a big difference in the level of Lehman’s leverage. It changes from 12.1x to 13.9x in May 2008, for instance, but that’s not a decisive difference. When the examiner told the rating agencies about Repo 105, none of them said it would have made them change their ratings.
And Repo 105 does not change the trend in the company’s leverage. From November 2007 to May 2008, it fell by 25% with Repo 105 and by 22% without it. Either way, Lehman was cutting its leverage significantly.
Repo 105 makes for exciting headlines and promising legal claims, but it’s just not that big a deal. The public dismay over Lehman’s window dressing is disingenuous: banks and investment banks having been doing it for years.
The fuss reminds us of the police captain in Casablanca who is “ Shocked to find there’s gambling going on in here!” just as he gets his winnings from the croupier. Lehman did plenty wrong, but Repo 105 was not the worst by any means.
What do Calisto Tanzi, Bernie Ebbers, and Edward Groves have in common? Several things, actually.
For one, they all ran major companies. Tanzi was CEO of Parmalat, an Italian food company; Ebbers was CEO of WorldCom, an American telecommunications firm; and Groves was CEO of ABC Learning Centres, an Australian day care provider.
For another, each was a hard-driver who started small and made it very big. Tanzi built a global company from one pasteurization plant. Ebbers turned a rural telephone exchange into the third largest telecommunications company in the United States. Groves began with a single childcare center and grew it into the largest day care company in the world.
Another thing was they all owned professional sports teams. Tanzi had a Serie A football team, Parma F.C.; Ebbers had a minor league hockey team, the Jackson Bandits; and Groves had a basketball team, the Brisbane Bullets.
Yet another common point is that all of them were involved in massive misstatements of their companies’ finances. Tanzi kept enormous amounts of debt off Parmalat’s balance sheet, while Ebbers and Groves kept tremendous amounts of costs off their companies’ income statements.
The final thing they have in common is prison. Tanzi has been sentenced to ten years, and Ebbers is serving a 25-year sentence. Groves has yet to face criminal charges, but he may end up in jail yet.
So what does all this mean? Is owning a professional sports team an early warning sign of financial fraud? Not really. But it does mean Tanzi, Ebbers, and Groves shared traits that led to their misdeeds, and those traits may be useful signals of misconduct in others.
What these three malefactors had in common is some combination of these behaviors, which are based on Sydney Finkelstein’s “Seven Habits of Spectacularly Unsuccessful People” from his book Why Smart Executives Fail.
They were domineering. They resisted any outside control, including accounting rules.
They had no sense of a boundary between their interests and the company’s. What was good for them must be good for the company.
They thought they had all the answers. Since they were always right, they made their own rules.
They eliminated resistance. They quashed dissent and had no one to warn them about the risks they took.
They were the public face of their companies. They reveled in public attention and professional rewards, and they saw financial statements mainly as public relations tools.
They underestimated difficulties. It never occurred to them they eventually would be caught.
They relied on what worked in the past. They were sure that if a little bit of deception worked before more would work even better now.
It’s a truism of credit analysis that character matters, but it doesn’t just matter in small and medium-sized businesses. It’s crucial in big companies too.
Tanzi, Ebbers, and Groves did not set out to create criminal enterprises. But their own flaws pushed them and their companies across the boundary between aggressive reporting and fraud, with grim consequences for shareholders, bondholders, and lenders. And disastrous consequences for at least two of them.
The return investors receive for owning a debt instrument, whether a loan or a bond, is driven by the various risks of owning debt. This Job Aid from Financial Training Partners does a good job in explaining the major risks faced by debt investors.
When Tony Hayward took over as Group CEO of BP in May of 2007, he acknowledged BP’s past failings and promised to correct them. He continued plans to make $7 billion in safety improvements. He took personal charge of BP’s group operations risk committee. He expanded the safety audit group and increased safety training.
Digg This!
The last decade’s boom in credit has been remarkable, led, of course, by mortgage-backed securities. But debt funding by companies is a close second, if you count “corporates” and “money-markets.”
What do Calisto Tanzi, Bernie Ebbers, and Edward Groves have in common? Several things, actually.
Another thing was they all owned professional sports teams. Tanzi had a Serie A football team, Parma F.C.; Ebbers had a minor league hockey team, the Jackson Bandits; and Groves had a basketball team, the Brisbane Bullets.
The final thing they have in common is prison. Tanzi has been sentenced to ten years, and Ebbers is serving a 25-year sentence. Groves has yet to face criminal charges, but he may end up in jail yet.