Burnham's Beat

2008 Software M&A: Year in Review

Unlike the Internet M&A space, the public software company M&A market was actually fairly robust in 2008 with 33 deals worth over $40BN closing.  That's actually up from 2007 when 28 deals worth $18.5BN closed.  That said, most of the increase has to do with several large, complex deals announced in 2007, including Nokia's purchase of Navteq and TomTom's purchase of Teleatlas, taking almost a year to close, but it remains that despite the terrible market, public software company was actually fairly robust in 2008.

2008 continues the long term trend of increased public software company M&A.  As the graph below makes clear, software M&A has been in a solid uptrend since 2004. 

# of Public Software Company M&A Deals

As outlined initially in a post several years ago on the incredibly shirking software industry there are a number of trends driving increasd M&A in the software space and these trends appear to accelerating.  The total number of public software companies decreased 11.5% in 2008 vs. 11.2% in 2007 and 11.1% in 2006.  Total market cap of the software sector is now $618 BN, down 25% from 12/31/03.  Good lord.

One interesting observation is that this consolidation does not appear to be driven from the "top down".  Despite significant M&A activity on the part of the "Big Four" software companies (Microsoft, IBM, Oracle, and SAP) over the past five years, their share of the software sector's market cap has actually decreased from 70% to 68% over the past 5 years. I wouldn't have believed them if somebody told me this before today, but it's true.  Granted, most of this decrease has to do with a 27% decline in Microsoft's market cap in the last 5 years (16% if you exclude their $3 special dividend).  Of the Big Four only Oracle has seen it's share price and market cap increase in the last 5 years. What this suggests is that consolidation within the software industry is taking place at all levels and that the largest software companies are ultimately not really taking share from the market.   Pretty much counter intuative to conventional wisdom within the software space, but right now that's what the numbers say.

Click on this link for a complete list of all the public company software M&A deals in 2008.

2008 Public Internet M&A: Year In Review

2008 will not be remembered as the "Year of the Deal" in the Internet sector.  In fact, it is a year virtually all companies and investment bankers would prefer to forget.

There were a grand total of 9 public Internet companies acquired in 2008 and the largest of those deals, CBS's acquisition of CNET, was only $1.8 BN, hardly big enough to generate sufficient fees to keep Wallsteet's finest attired in bespoke suits.

The biggest news in the Internet M&A space was, of course, the deal that never happened: MIcrosoft's proposed offer to buy Yahoo!.   In the wake of this failed engagement there may be some big deals in 2009 as both Microsoft and Yahoo pursue other options, but for now 2008 will go down as one of the quietest, perhaps the quietest, years for M&A in the Internet sector ever.

           2008 Acquisitions of Public Internet Companies

Closed	Target		Acquirer		$ Size
1/17/08	Visual Sciences	VSCN	Omniture	OMTR	$394
2/4/08	Traffix	TRFX	New Motion	NWMO	$159
3/18/08	Audible	ADBL	Amazon.com	AMZN	$300
4/16/08	Varsity Group	VSTY	Follett Group		$4
6/30/08	CNET	CNET	CBS	CBS	$1,800
8/6/08	Hostopia	H.TO	Deluxe	DLX	$124
10/15/08	Greenfields Online	SRVY	Microsoft	MSFT	$486
10/30/08	Napster	NAPS	Best Buy	BBY	$121

For a complete list of public Internet M&A deals as well as some private deals see this list of Internet M&A deals.

2008 Software IPOs: Year in Review

While the Software sector did not fare as poorly as the Internet sector when it comes to IPOs in 2008, it did not do much better.  In fact it did just 1 better; as in 1 IPO for all of 2008. This is obviously the smallest # of Software IPOs since we began compiling a list of them 5 years ago.

Who was the lucky winner?  It was a security software company called ArcSight (ARST).  ArcSight managed to get public on Valentines Day, 2/14/2008, at a price of $9.00/share.  Things were looking grim for ARST in mid November with the stock trading close to $4/share, but they fortuitously reported a "beat and raise" quarter in early December and the stock rallied furiously.  So much so that Arcsight closed the year at $8.01, off only 11% from its IPO price.

Other than Arcsight, the Software IPO space was a quiet as a country mouse and based on the paucity of recent S1 registrations it will be awhile before there are any more Software IPOs to speak of.

2008 Internet IPOs: Year in Review

This is going to be an easy review.  That's because 2008 will likely go down as the first year in the modern "web" era of the Internet that there wasn't a single Internet related IPO in the major US stock markets.  That's right, not a single one, zippo, nada.  There were a few spin-offs and a couple cross listings but as for brand new spanking public Internet companies there wasn't a single one.  It's enough to make a make a grown VC cry.

As it stands, the last IPO of an Internet focused company was arguably NetSuite, which went public on 12/20/08 at a price of $26/share and closed today at $8.44.  And that 68% price decline, ladies and gentlemen, is all you need to know on why there hasn't been an Internet IPO since then.

That makes it 377 days without an Internet IPO.  I modestly suggest that Sand Hill VCs should tie a ribbon made of $100 bills around a Redwood tree outside their offices until such time that the market stops holding their late stage deals hostage.

Granted there were only 30 IPOs in the entire market in 2008, but you'd think that what is supposedly one of the fastest growing, highest technology sectors in our economy would be able to contribute at least one good IPO.  Oh well, maybe next year.

Madoff Madness: Seven Things You Might Not Know

When I was a Wall Street analyst I got to know Bernie Madoff by reputation because I covered the whole online/electronic trading industry and Madoff was a big actor in that space due to his market making operations and his constant fights with the NYSE.

Given this experience as well as the fact that I currently manage a hedge fund, I can’t resist making a couple of points that I don’t think have been widely discussed in the media so far:

1. Madoff’s investment firm was not a hedge fund, it was what’s called a “managed accounts” business in which each investor had their own separate account that was supposedly managed by Madoff.  That’s why press reports indicate the investor’s got statements that listed individual trades in their account (something you don’t get with a hedge fund).  The reason why this is important is that, like many managed accounts, Madoff only charged a relatively small flat management fee (1.5% a year according to reports) compared to hedge funds which typically charge at least a 2% management fee plus 20% of the profits.  This fee structure made Madoff’s fund very attractive to fund-of-funds because it made their “double fee, double carry” structure look a lot less onerous.  If you are wondering why so many fund-of-funds bet the farm on Madoff’s fund, look no further than this.
2. Madoff was not only the investment adviser to these managed accounts, he was also the broker, custodian, and administrator.  This is a huge red flag that anyone with even a basic understanding of investment management should have noticed immediately.  A firm structured like this is essentially a closed loop with almost no external checks and balances.  Even an outside auditor would find it difficult to uncover fraud because there’s no independent entity to verify trades, assets, etc.  It’s amazing that this kind of structure didn’t raise more alarm bells at places such as the SEC and the fund-of-funds.
3. What makes this fraud truly genius is that everyone on the street, including I suspect most of his investors, assumed all along that Madoff was a crook, in fact that’s why they invested with him in the first place!  The rumor was always that he made his money by front running the order flow from his market making business so if things didn’t add up people must have just figured, “Well of course they don’t add up, wink wink nudge nudge, because we all know this whole split strike strategy is just a lie to cover up the fact he is screwing his order flow customers”.
4. The fund-of-fund managers who invested heavily in this fund should probably go to jail before Madoff.  Not only did they invest in a firm with a operating structure that should have raised just about every due diligence red flag in the book, but it delivered amazing returns at fees that were “too good to be true”. 
5. It’s highly ironic that people are shocked a market maker would be doing something illegal.  Market makers, including Madoff, conspired for years to rig spreads on the NASDAQ market before they were caught (by two professors, not the SEC!).  To this day market makers continue to front run their customers on a massive scale (why else would they pay for order flow?).  Why anyone would trust such firms with their investments is beyond me.
6. Making the rather generous assumption that it didn’t start out as a fraud, it will be very interesting to learn just when and why the scheme crossed over from investment fund to ponzi scheme.  I am guessing that the advent of decimalization plus electronic trading (both on the equity and options exchanges) plus the rapid expansion in funds under management took most of the juice out of the original model and ultimately led to the collapse of the fund’s strategy.  If that’s the case it will be highly ironic that some of the market “improvements” that Madoff help champion ultimately undermined his firm.
7. Finally, I am sure that the government will enact all kinds of new regulations as a result of this fraud but the truth is that this could all have been prevented if investors had insisted on the most basic of check and balances including an independent broker, an external custodian, a third party administrator, and a reputable auditor.  These simple, common sense controls would have easily prevented this fraud from ever taking place.

Buffet Makes It Official: Even Goldman Sachs is Junk

Lots of press this afternoon on Warren Buffet's investment in Goldman Sachs.  For $5BN it looks like he will receive $5BN face value in perpetual preferred with a 10% coupon callable at 110, plus 5 year warrants on another $5BN worth of stock @ $115/share (which equates roughly to warrants on about 43.5 million shares @ $115/share).

I am not an options guy, but if you take the take the implied volatility on Goldman 120 Jan-2011 calls and apply that out to 5 years (which I realize is a generous leap of faith), it looks like the warrants are worth in the neighborhood of $50-$55/share depending on your assumptions (options pros please correct me if I am way off here) which means the 43.5M in warrants are worth around $2.2BN to $2.4BN at issue.  That means that Buffet is really investing only about $2.8 to $2.6BN at a yield to maturity (assuming 5 years) of around 27% to 29.5% and that's not even counting the 10% preferred redemption premium. With the 110 call on the preferred and the upfront warrant coverage, the YTMs are even higher if Goldman decides to call the preferred earlier.

Obviously, Buffet is getting a healthy discount because he's the ultimate in smart money, but still, when Goldman, the Gold standard in investment banks, is selling perpetual preferred at theoretical yields to maturity of 25%+ you have to wonder what the market rates really are for your average investment or commercial bank.

I assume the market will heartily applaud this deal, but I don't know if I should be excited that Buffet thinks it is finally a good time to buy or scared to death that the best global franchise in investment banking has to raise money at interest rates that would make a sub-prime credit card issuer blush.

Fannie Mae Is Saved! It's Shareholders ... Not So Much.

As I chronicled in my last post about Fannie Mae's Golden Goose, the struggles of Fannie Mae and Freddie Mac were clearly putting to the test the bond market's long held assumption that both companies had the implicit backing of the US Government and were "too big to fail".

With tonight's announcements from the US Treasury and the Federal Reserve, it looks like the bond market was right all along and much more credible that the consistent denials of Washington's politicians (imagine that!).  After tonight's action there's nothing implicit about the government's guarantee of Fannie and Freddie's debt; you might as well print in on the legend of their bond certificates and take it to the bank (or perhaps the Fed).

Be Careful What You Celebrate
There are probably a lot of cheers going through halls of Fannie Mae's Georgian-style mansion on Wisconsin Avenue tonight, but before they crack open the bubbly, they might want to read fine print of today's press releases, because while Fannie and Freddie will indeed survive to live another day, they will be living in a very different world.

Specifically, as part of getting the Fed to sign off on this rescue package, the Treasury and OFHEO have (undoubtedly at the Fed's insistence) agreed to give the Fed "a consultative role" in "setting capital requirements and other prudential standards".  For anyone who has followed the Fed's view of the GSE's over the past 15 years, this means the party's over for Fannie Mae and Freddie Mac.

Payback Is A Bitch
The upper echelons of the Federal Reserve, including almost its entire Board of Governors are typically populated by very serious economists, almost all of whom have PhDs and illustrious academic careers.   Fed economists tend to be very smart, very logical, and very cynical.  Thus they have for some time understood the huge moral hazard inherent in the basic structure of Fannie and Freddie.   This is why both Bernanke, and Greenspan before him, have been one the few voices in Washington DC consistently almost literally begging politicians to reign in both agencies.   Up until now, those pleas have largely fallen on deaf ears thanks to the masterful political coalitions built by both Fannie and Freddie.  That Fannie Mae and Freddie Mac fended off the Fed, arguably most Washington's most powerful independent institution, for so long is a true testament to the power of the political coalitions that they built.

Unfortunately, for Fannie and Freddie, those political coalitions are currently collapsing at light speed as politicians run as fast as they can from ground zero before Fannie and/or Freddie go super-critical. Fannie and Freddie now not only find themselves without their vaunted political air cover, but at the mercy of one pissed-off Fed.  Economists are generally not prone to anger, there's very little utility in that, but my guess is that there's a fair amount of anger going around Fed these days.  Anger that none of the politicians listened to them, anger that Fannie and Freddie consistently thumbed their noses at them, and anger above all else that they are currently stuck cleaning up a mess they warned everyone who would listen would one day come their way.

So how might the Fed translate this anger into policy now that it has officially been given, at least partial, control of Fannie and Freddie's regulatory leash?  To get some insight into that one need only to read a speech about Fannie and Freddie from Chairman Bernanke just over a year ago.  Indeed, the final paragraph gives good sense of what the future has in store for Fannie and Freddie:

Legislation to strengthen the regulation and supervision of GSEs is highly desirable, both to ensure that these companies pose fewer risks to the financial system and to direct them toward activities that provide important social benefits.  Financial safety and soundness can be enhanced by giving the GSE regulator capital powers comparable to those of bank supervisors and by creating a clear and credible receivership process that leads debt holders to recognize that they would suffer financial losses should a GSE fail.  Finally, the Federal Reserve Board believes that the GSEs’ investment portfolios should be firmly anchored to a measurable public purpose, such as the promotion of affordable housing.  I believe that this approach provides a reasonable balance of social costs and benefits for the GSE portfolios. In particular, this approach would re-focus the GSEs on the affordable housing objectives given to them by the Congress.

Before you react to this, consider that this speech was made over a year ago when Fannie Mae's stock price was 5 times higher and its powerful political coalitions were still fully intact making any attempt at criticism a rare, brave, and largely futile endeavor.  Once one gets past the obligatory genuflections to "affordable housing", the Fed's prescription in this speech is clear:  they want to kill Fannie and Freddie Golden Gooses, i.e. they want to dramatically reduce their $1.5TR mortgage portfolios to a small fraction of their current size and return both companies to their original mission as a conduit and guarantor with maybe a few "investment" dollars thrown in to grease the skids of the only the most politically sacrosanct areas of the mortgage market.  In short, the Fed intends to replace Fannie and Freddie's regulatory leash with choke chain and then proceed to pull it ... very hard.

Say Goodbye To The Golden Years
For taxpayers, this is largely good news as it will likely result in far smaller balance sheets at Fannie Mae and Freddie Mac with far lower potential for a (another) costly bail-out.  For consumers this is probably slightly negative news as the absence of the agency's "risk free" buying binges will probably lead to slightly higher mortgage rates. For Fannie and Freddie shareholders, beyond Monday's likely relief rally, this is long term bad news because it means that the government is killing off the agencies golden gooses and therefore the companies are never likely to return to the halcyon days when their biggest concern was making too much money.

All that said, given Fannie and Freddie's prior political and economic comebacks it's entirely conceivable that they will be able to weather the storm and then refashion a political consensus that allows them to get back to the good old days (up until Friday they were doing pretty well).  But even politicians are once bitten are twice shy, so it may be awhile before Washington DC forgets enough of today's pain to let the GSE's take another free-ride on the government guarantee express, and if the Fed has its way, that train will never leave the station again.

I currently have no investment position, long or short, in Fannie Mae or Freddie Mac.  This is not investment advice. Please see my disclaimer at the bottom of this page for further details.

Fannie Mae's Golden Goose: A Lesson In Moral Hazard

In the mid 1990’s I spent over a year as part of a team consulting to Fannie Mae.  Given that they have been in the news a bit over the last few days, I thought it might be interesting to pass along a few observations that initially crystallized during my time there.

The World’s Biggest Mortgage Bank
For those of you that don’t know Fannie Mae, it is one of the largest financial institutions in the county with over $880BN in assets.  It is almost exclusively focused on buying, selling, and guaranteeing single family residential mortgages.  Fannie Mae was originally a US government agency, but became a public company in the 1970s.  Despite being a public company, Fannie Mae has remained a quasi-government agency subject to federal oversight and regulation.  This government regulation, combined with a few perks such a direct credit line from the US Treasury as well as its overwhelming size and importance to the US housing market has resulted in what amounts to an implicit US government guarantee that Fannie Mae (and its cousin brother Freddie Mac) will never default on their debt. There is no law or regulation to that effect, just an assumption by the market that Fannie Mae is too big, too close and too important to the government for the government to ever let Fannie Mae fail.  With the mortgage market in massive turmoil and Fannie Mae’s stock down 85% in the last year, that assumption is currently being heavily tested.

I don’t know exactly what the future holds for Fannie Mae, but I think I can shed some light on how it got in this position in the first place.    The seeds of Fannie Mae’s current crisis were actually sown in the recovery from its last crisis.  In the mid-1980s Fannie Mae almost went out of business thanks in large part to some very poor and rather unsophisticated asset and liability management practices.   What basically happened is that the aggregate cost of Fannie Mae’s debt exceeded the income it was deriving from its (then relatively modest) mortgage portfolio.  This never should have happened given the instruments and strategies available to Fannie Mae’s finance team, but they had become somewhat complacent and had failed to keep up with the state of the art in portfolio and treasury management.

Creating the Golden Goose
A new team of people took over the finance side of Fannie Mae and implemented a series a relatively sophisticated and ultimately incredibly profitable Asset and Liability Management (ALM) strategies.  One of the key innovations was issuing debt instruments, specifically callable debt instruments, that enabled Fannie Mae to much more closely match both the duration and pre-payment characteristics of its Assets (primary residential mortgage securities) with its debt (primarily Fannie Mae corporate debt).  Normally, callable debt is quite expensive (much more expensive than residential mortgage debt), because bond holders want to be compensated for selling the call option to the issuer, but thanks to Fannie Mae’s quasi-government status it was able to issue this callable debt at yields that were only marginally above straight treasury yields.  This debt combined with a more sophisticated overall ALM approach, not only reduced Fannie Mae’s borrowing costs significantly, but enabled it to very quickly adjust its portfolio in the event of rapid changes in pre-payments.

With this strategy in hand, not only could Fannie Mae buy mortgage securities for less than the cost of its debt (and thus earn a nice spread), but it could almost entirely contain pre-payment risk effectively making the purchase of mortgage securities “risk free” except for credit risk, which itself was very low thanks to Fannie Mae’s strong underwriting guidelines.  Fannie Mae had discovered the equivalent of a financial golden goose.

Let’s Get This Party Started
With its golden goose in hand, Fannie Mae almost immediately began buying a lot more mortgage securities.  Who did it buy these securities from?  Why none other than Fannie Mae itself.  You see Fannie Mae’s original role was to buy mortgages from individual banks, package them up into securities, guarantee those securities against loss, and then sell them to other financial institutions.  However once Fannie Mae realized that the “golden goose” allowed them to buy those same securities for its own portfolio and lock-in “risk free” profits, Fannie became a major buyer of its own securities.  Fannie Mae was thus in the rather bizarre position of guaranteeing an ever increasing portion of its own assets against default. 

By the time I showed up in the mid-1990’s, Fannie Mae had become one of the largest buyers of its own securities.  Its stock was up over 40X from it’s 1980s nadir and it seemed as though the single biggest problem it had was deciding on how much money it wanted to make.  This was a bigger problem than you might imagine because as a quasi-government agency, and a constant political football, Fannie Mae realized it couldn’t be seen to be abusing its market position.  So rather than go crazy and buy every mortgage security in sight, Fannie Mae just settled on charting a nice predictable upward growth in earnings fueled largely by buying an ever increasing share of its own securities.

Now a normal private company could not pursue this strategy because as it issued more and more debt to fund the golden goose, the yields on the incremental debt would start to increase to the point where the strategy no longer made sense.  But Fannie Mae was different.  Because of the implicit government guarantee of its debt, Fannie could issue incremental debt with little or no regard to its existing debt load because everyone assumed the federal government would backstop the debt.

Fannie Mae’s only significant problem thus became that the supply of mortgage securities would prove insufficient to fund its projected earnings growth (which was well above the projected growth in mortgage debt).  As a result Fannie began a series of largely successful political campaigns to increase the volume of mortgage securities available to fund their habit.   Theoretically, the easiest way to increase the supply of mortgage securities was to get the federal government to increase the size limit of mortgages that Fannie could buy and guarantee, but this was a very difficult political fight for Fannie to win because commercial and investment banks dominated the so-called “jumbo” mortgage market and, already smarting from Fannie’s dominance of the so-called “conforming” market, they had drawn a line in the sand in the jumbo market and committed most their lobbying resources to keeping Fannie’s size limit as low as possible.

Moral Hazard vs. Mo’ Money
While Fannie still fought to increase its size limits, it quickly found another, much more politically palatable, way to increase the pool of mortgages it could buy: it dropped underwriting standards under the guise of increasing “home ownership” and “affordability”.  Traditionally, Fannie had required the mortgages it purchased to be so-called 80/20 mortgages wherein the borrower puts at least a 20% down payment on the mortgage. This was a requirement because residential mortgages in the US are a “no-recourse” loan in which the borrow can generally “walk away” from the loan with no recourse to the lender other than seizing the house and reporting the default to a credit agency.  A 20% down payment was generally thought to be enough to dramatically limit the moral hazard of borrowers “walking away” because housing values would have to decline 20%+ for the borrower to be underwater and even then the borrower would still face the prospect of losing their own sunk capital which makes walking away even more difficult from a psychological perspective

The problem with a 20% down payment is for many people it was very hard to come up with that big a down payment and thus it limited the total size of the mortgage market which in turn limited the volume of mortgage securities that Fannie Mae could purchase for its golden goose.  While the obvious solution to this problem is just to lower the down payment requirement, Fannie couldn’t do this unilaterally because the government unit that regulated it would see such cuts as needlessly raising Fannie Mae’s risk profile.  Far more politically astute that that, Fannie Mae began a campaign to increase “home ownership” and “affordability”.  It created a home ownership “foundation” which opened offices in almost every congressional district and promptly set about mobilizing all the local advocates for “affordable” housing to put pressure on their elected representatives to let Fannie Mae offer “affordable housing programs”.  Of course, “affordable housing problems” was just a euphemism for allowing Fannie Mae to lower its underwriting standards so that more mortgages could be created and the golden goose could thus kick out more golden eggs.

This proved to be a highly effective political coalition for Fannie Mae.  Not only did they build a huge network of grass roots political supporters through their “foundation”, but politicians saw political advantages in supporting the programs because it cast them in the role of trying to help families buy a new home (as opposed to lowering underwriting standards to help a giant corporation keep up its earnings growth by taking a free ride on the US government’s guarantee).  Even commercial banks and investment banks signed on to the program because it at least resulted in higher origination fees and an expanded credit market, even if most of the assets ultimately went to Fannie Mae and Freddie Mac.

A Victim of Its Own Success
Fast forward to the mid-2000’s and Fannie Mae’s financial and political strategy was largely a resounding success.   Fannie was now offering a wide range of mortgages that required less than a 20% down payment including even some that required no down payment at all! These products had dramatically increased the addressable size of the mortgage market.  The increased size of the mortgage market enabled Fannie to purchase a massive amount of its own mortgage securities.  In fact by this point Fannie Mae had become the single largest purchaser of its own securities.  These newly purchased assets in turn enabled Fannie to continue to grow earnings which in turn supported a stock price that continued to trend nicely upward (though at a much more modest rate).

However beneath the seeming calm, the seeds for Fannie’s distress were now firmly planted.  Fannie’s drive to lower underwriting standards had created a pool of mortgage debt with a much higher level of embedded moral hazard risk as well as good old fashioned credit risk.  Fannie’s purchases of mortgage securities were so large that it was getting increasingly difficult to feed the golden goose enough food.  On top of all that, with hundreds of billions of dollars of assets and liabilities to manage, Fannie's ALM strategies had become more and more complex and some of its bread and butter strategies started to become less profitable as the sheer weight of over half a trillion dollars of debt started to compress spreads (it would seem that even an implicit government guarantee has its limits).

It is no coincidence that the current mortgage crisis started in the so-called sub-prime market as that’s the mortgage market with the lowest credit quality and underwriting standards, however as the mortgage crisis has spread it has become increasingly clear that the traditional conventional, conforming mortgage market, long the domain of Fannie Mae and Freddie Mac, shares many more similarities with the sub-prime market than it would like to admit.  While credit and underwriting standards are clearly much higher in the conforming market, they are also undoubtedly much lower than they were 10 or 20 years ago.  What’s more the two biggest insurers against loss in that market now happen to also be the biggest owners in that market thanks to 20 years of purchasing mortgages to fund their government subsidized golden gooses.  Guaranteeing oneself against risk is not insurance, its an exercise in futility.

The Goose Is Not Dead Yet
Despite all of this, I personally don’t expect either company to go out of business.  If recent comments from a slew of politicians are any indication, they are indeed “too big to fail”.

What I find most ironic in all of the current commotion is that rather than trying to address the root causes of Fannie Mae’s precarious state: dramatically lower underwriting standards and a massively levered balance sheet taking a free ride on the government’s back, politicians are doing the exact opposite:  they are dramatically increasing the size of the mortgages that Fannie and Freddie can buy and pressuring them to maintain and even further lower their already un-sustainably low underwriting standards.  I don’t know where this ends, but reinforcing the bad behavior that led to the crisis in the first place can’t end well

UPDATE: See my latest post if you are interested in my take on the Fed/Treasury's recently announced strategies for helping Fannie/Freddie.

 

I currently have no investment position, long or short, in Fannie Mae or Freddie Mac.  This is not investment advice. Please see my disclaimer at the bottom of this page for further details.

Infospace and the Great Shareholder Robbery of 2007

Wow.  Infospace reported earnings today and the stock was off 14%.  But that's not what's making me say "wow".  What's making me say "wow" is that I took this opportunity to take a look at Infospace's 2007 "earnings" report and I have to say I am impressed because it has to go down as one of the great shareholder robberies of all time.  Infospace, as you may recall, was a once high flying internet content company that assembled a motley menagerie of web and mobile based content businesses via 30+ acquisitions over the last 10 years.  They bought everything from Authorize.Net, to Go2Net, to Switchboard.  While there was supposedly a grand strategy driving to all these purchases, arguably what they were left with after 10 years and $1.7BN in paid in capital was just over $1BN in retained losses and a motley collection of business that looked like they were going no where fast.

Anyway, the company's mobile business was held out as the potential savior for a long time but as that too began to implode in 2006 and early 2007 the management team basically threw in the towel and embarked on a process of selling off the company's assets piece meal to the highest bidder.  No doubt a somber occasion given that the sales represented the culmination of a failed strategy that had cost shareholder's a cool $1BN, but at least you have to give the management team and the board credit for doing the honorable thing by admitting they failed and doing their best to salvage something for the shareholders.  Or do you...

On Closer Inspection
Before you give the management team and board any credit for doing the right thing, you might want to know a little something about the a deal they struck for themselves that nicely coincided with their fire sale.  The plan was to sell off the assets and dividend out the cash proceeds to the company's long suffering shareholders, which sounds fair enough.  However, the management team was able to convince the board that they should get paid a "bonus" equivalent to the dollar value of the dividends that would theoretically accrue to any vested or unvested stock options they might have.   So if the company did a $5 dividend of sale proceeds and the stock dropped $5 (which it inevitably would), the management team would get a $5/share bonus for each vested and unvested stock option they owned.

Now on one level that sounds fair enough.  I mean after all, why should the management team and the employees have their options go further underwater simply because they are doing the right thing and trying to get shareholders back some cash.  However the net effect of such a scheme is to basically give the management team a gross cut of whatever they sell an asset for without regard to whether or not the sale was even profitable.   The cynic/economist/anyone with common sense would say that under such a incentive structure management would race out and sell everything and the kitchen sink for whatever price they could get because it was money in their pocket no matter what.

Care to guess what happened?

Everything Must Go!
That's right, Infospace's management team ran out and sold everything they could for whatever price they could get.  The directory business, painstakingly built up over a period of 10 years: sold for $225M to a private equity firm.  The mobile business, which they been acquiring new businesses for less than a year earlier: sold for $135M to a private competitor (who reportedly now mightily regrets the purchase).

And what did they do with all that cash (as well some cash from settling a lawsuit with a former founder who defrauded the company's investors)? Why surprise, surprise, they dividended out all that cash out to their shareholders in two special dividends totaling $15.30/share or over $500M in cold hard cash.

And what, pray tell, what did the management team get for the arduous task of lifting up the phone and calling their bankers?  A cool $90M in special cash bonuses and stock compensation in 2007.  If you are on that management team, the thought that likely came to mind as you cashed your 2007 bonus check was "God Bless America!"

Defending the Indefensible
But wait, defenders of the management team's "golden dividend" might point out that the asset sales generated a combined $149M "gain" and surely the team should at least be entitled to share some of that gain.  But that logic fails to account for that fact that prior to 2007, Infospace had already taken $240M in impairment charges since 2000 which means that the actual "gain" on sale of those assets was likely far lower and might even have been a net loss of over $90M on an original cost basis. (I'd guarantee its a loss, but it's impossible to figure out what impaired assets were sold given how many deals they did.)

One final point of defense might be the stock price.  Defenders might point out that at the beginning of 2007, before management embarked on the asset sale strategy, Infospace's stock price was $20.51, and even though it closed at $10.38 today, when you add back the $15.30 in dividends, you get an adjusted price of $25.68 or about $5.17 higher, so one could argue that despite all the management payouts they still created value.  There are only two problems with that logic:  1.  With 33 million shares outstanding, $5.17/share translates into only $170M in increased "shareholder value" vs. $90M in management comp which equates to a 35% cut for the management team.  M&A bankers would sell their mothers to get a 3% cut of a sale so I shudder think what they'd do for a 35% cut.  2.  If you go back just 3 years, the stock price was at a whopping $47.55 meaning that shareholders have suffered a 46% loss in the last 3 years, but the management team and the board thinks that's an occasion for them to give themselves a windfall payday the size of which would make even an investment banker blush.

Don't Look Now But You've Been Robbed
Let me be clear: I've never owned or shorted (unfortunately) Infospace stock, so I don't really have a dog in this fight.  I am just flabbergasted that none of their shareholders stood up to such a blatant scheme and called it for what it is: highway robbery.  I don't have a problem at all with paying management teams well for creating value,  I just have a huge problem with handing out huge bonuses (i.e. more than 10X the already egregious fees charged by bankers) to people who sell assets for little if any gain when their shareholders are already sitting on $1BN an losses and a 46% stock depreciation since 2005.  Call me crazy, but I have a problem with that even if, inexplicably, Infospace's shareholders don't.  You may also ask why didn't the board, who supposedly represents the shareholders, have problem with that: simple, they cut the same deal for themselves.

As for shareholders, they are now left with a business whose only significant asset is a website called Dog Pile.  If you're like me, the image that pops into your mind when you hear the term "Dog Pile" isn't exactly a pile of money, which at least strikes me as poetic justice if nothing else.

I currently have no investment position, long or short, in Infospace.  This is not investment advice, it is an incredulous rant.  Please see my disclaimer at the bottom of this page for further details.

SkyGrid and the Emergence of Flow-Based Search

GigaOm had a post today on a company called SkyGrid and its official company launch.  As an investor, advisor, and beta-user of the platform, I thought I would chime in with my own self-serving post mostly because I wanted to talk about the advanced technology and architecture behind SkyGrid and why it makes the company such an interesting case study in the evolution of search technology.

Simply put, SkyGrid represents a massive and exciting departure from traditional search architectures and technologies.  If I had to sum it up in a word, I would say that SkyGrid represents what I consider to be one of the first "flow based" search architectures, while traditional search engines are "crawl based" architectures.

Old Search: Crawl/Index/Query
While the technical departure was necessitated by the leading edge demands of investment professionals, it was these needs, and the lack of traditional search's ability to meet them, that exposed some of the most glaring weaknesses of traditional search technology. Specially, traditional search technology and architectures suffer from several glaring weaknesses:

1. Crawl-based: Current search architectures collect information to index primarily by employing massive farms of "crawlers" that systematically crawl IP address spaces. The benefit of crawling is that it is exhaustive, the drawback is that it time consuming and expensive.
2. One-off: Search platforms are designed around rapidly processing one off queries. This makes search engines highly useful and adept at finding "the needle in the haystack" but very cumbersome to use in situations where one just wants to get new results to the same old query.
   
3. Batch-based: Page rank and the other "secret sauce"algorithms behind most search engines today require a very expensive and complicated indexing process to be performed on "snap shots" of data. It can be days or even weeks before newly published content is crawled and properly indexed, meaning that most search engines fail to provide "real time" results for all but the most popular content sources (which they crawl very frequently).
   
4. Unabridged: Search engines are exhaustive in that they return every URL that mentions a string. This is good is you are looking for a needle in the haystack, but bad if you are trying to search on a common term such as "Google" or "Microsoft". While ranking algorithms do a great job of ordering results according to likely relevancy, they don't filter down the number of results. Since most users don't go past the first page of results, this makes it quite easy to miss relevant information that for some reason doesn't rank in the top 10 results.
   
5. Unstructured: Search engines typically present query results as a simple list without context or analytics, beyond say separating them by a simple criteria, such as text and images. While some progress has been made in terms of trying to cluster results or help users filter them, by and large, users still just get an unprocessed, unanalyzed data dump when they do a search.
   
6. Retrospective: Search today is focused on determining what has happened in the past. Who wrote what, who said what, etc. However this does little to help people figure out what will happen in the future.
   

Without giving away the farm, SkyGrid represents an exciting departure from the search technologies and architectures of the past. This change has been made possible by several factors including the widespread deployment and adoption of ping servers and RSS/ATOM feeds, dramatic improvement in several areas of artificial intelligence and unstructured data analytics, and new stream-based methods of database and query design.

SkyGrid Search: Flow/Filter/Analyze
When you put all of these technologies together, along with a laser like focus on solving some of the unique high-end demands of investment professionals, you get a radical new search architecture and technology that not only solves some very pressing and pragmatic problems facing investors, but holds the potential to actually predict the pattern and influence of idea/meme propagation throughout the internet and from there into the financial markets and beyond.  

Specifically, SkyGrid's search architecture differs from traditional search engines in that it is:

1. Flow-based: SkyGrid treats the web as a giant pub-sub system or at least it does to the extent that the rapidly growing RSS/Ping server infrastructure does. It does not crawl the web, but rather the web "flows" to it.
2. Persistent:  SkyGrid persists queries over time so that incremental results are delivered with no additional action by the user. One can easily see how this would be valuable in the case of something like, oh say, a stock, which persists from day to day.
   
3. Real-time: Rather than using batch-based indexing, SkyGrid uses a real-time stream-like query system that queries (and analyzes) new content as it flows into the system. This is particularly useful in situations, such as investing, where a few minutes or seconds, can make a huge economic difference.
   
4. Filtered: Rather than presenting results as a data-dump, SkyGrid uses advanced analytics in the form of entity extraction, meta-data analytics, and rules based AI, to quickly analyze and append additional meta-data to incoming information. This enables users to easily filter data according to number of criteria which greatly lessens the chance of "data overload" and greatly improves the chance of "data discovery".
   
5. Analytical: By applying highly advanced artificial intelligence, such as natural language procession, entity extraction, etc. SkyGrid is able to actually analyze and assess the actual content of a URL, thus enabling it to make determinations such as the sentiment (positive/negative) of information, its "velocity" and its "authority". This goes a step beyond simple meta-data filtering to creating real insights into the content.
   
6. Predictive: SkyGrid's flow based architecture and advanced analytics enable it to view the web as a living breathing, changing entity. By observing the propagation of information over time and across downstream nodes, SkyGrid is in a position to not only assess the "authority" and "influence" of individual nodes, but it should ultimately be able to make reasonable predictions about which information will flow where on the web. By correlating this observed "flow" over time with observed movements in things such as, oh say, stock markets, company sales, etc. it can not only assess the historical sensitivity of changes on the web creating changes in the real world, but it should ultimately be able to theoretically predict, with reasonable accuracy, many of those changes. Yes, I said it: SkyGrid and its new search architecture may ultimately predict the future.

I realize that the last point is at the very least hyperbolic and at worst disingenuous, but as an early beta-user I can tell you first hand that once you see it in action and understand the architecture, predicting the future, in some very specific, limited, yet potentially highly valuable ways, is certainly not something beyond the realm of reason and indeed something that seems quite possible given the progress to date. That said, SkyGrid is still a beta platform and many features have yet to be implemented in part or in full, but the promise and potential is undeniably there.

Google Roadkill?
Why won't SkyGrid simply be put of business by the big players like so many other search oriented start-ups? First and foremost because SkyGrid is delivering a premium product to a group of users that will pay significant sums for something that not only dramatically improves their daily productivity but holds out the promise of providing insightful, market oriented analytics that they simply can't get elsewhere. Second, the existing search engines cannot compete effectively against SkyGrid because to do so would require a reengineering of their basic search architectures to address all of their shortcomings relative to SkyGrid. Moving from a traditional crawl/index/query architecture to a flow/filter/analyze one is a decidedly non-trivial undertaking, one that would require an entire re-architecture of their core services and thus one highly unlikely to be made.  

Well then does that mean that SkyGrid will put the "legacy" search engines out of business? Not at all. The current search engines are optimized to deal incredibly well with the vast majority of queries from the vast majority of users and they will likely continue to do so for some time. Next generation flow-based platforms such as SkyGrid are, by design, tackling a subset of the available queries, but arguably a very valuable subset. Indeed that's why SkyGrid can charge $500/seat/month for its services while the existing search engines must give away their services for fee and make their money on advertising.

Now I can see a lot of people being skeptical after reading this about both my ability to impartially judge SkyGrid's next generation search technology as well as its market potential. To them I would say: just keep your eyes out for some announcements over the next month as I think they will conclusively demonstrate that a number of people far more knowledgeable and accomplished than I see the same potential.