The Blog

To be Advized or not to be Advized

1. Situation

Over the past 50 years, the role of the Chief Financial Officer (CFO) has evolved from that of an accountant to that of strategist and business partner who focuses on the creation of shareholder wealth. No longer only acting as the guardian of the books, the CFO’s role is fluid and complex, compelling individuals to use skills, technologies and management techniques that did not exist twenty years ago. Already struggling to manage the broadening scope of demands on the financial function, CFOs now also have to address core corporate initiatives like business process optimisation, stakeholder management and strategy formulation in an increasingly competitive global environment.

Even though they are responsible for both the organisation’s internal and external reporting, which necessitates them remaining informed about a raft of constantly transforming International Financial Reporting Standards (IFRS) and the accompanying information technology systems needed to manage the resulting data, CFOs must still ensure that their companies remain compliant with ever-changing legislative, regulatory and corporate governance requirements. The additional burden of increasing strategic corporate demands being placed upon the finance function means that CFOs also have to operate at a greater level of intricacy in other areas such as corporate restructuring, capital structure optimisation and treasury management. This has triggered the growth of compartmentalised functions which rely on increasingly specialised skills and resources.

In recent research, the South African Institute of Chartered Accountants (SAICA) polled 40 CFOs from top JSE-listed companies about their changing role. No less than 94% of respondents agreed that their role has changed in the last three years, and they expect it change further in the next three years.

Asked how they managed their time, respondents said that they spent most of their time on strategic planning, advice and management. They also spent a great deal of time on attracting and retaining skills; coaching and mentoring staff; investor, stakeholder and market liaison and communication; and merger and acquisition activities. They spent less time on information management; information technology maintenance and management; or on sustainable development, sustainability reporting and the triple bottom line. In five years’ time, these same CFOs expect to spend more time on strategic planning; giving advice and management; risk identification, assessment and management; and performance management and benchmarking.

In summary, the focus on planning and strategy is clear, and so is the explosive growth in the multitude of different tasks that now comprise the CFO’s role. Accordingly CFOs are time-poor and under huge pressure and need to remain very agile. In addition, they face all the challenges of having to make informed and accurate decisions in increasingly diverse and broadening areas where they often do not have the benefit of a granular level of detail. Consequently, they are experiencing a growing need to rely on specialists to plug the gaps created by a scarcity of time and the lack of necessary specialised skills.

2. Complications

The constant evolution of financial markets provides CFOs with a sophisticated, diverse and effective toolkit to manage aspects of the financial function. However, these tools can also complicate and confuse. In 2002, Nabisco CFO Angela Holtham predicted that the CFO’s role in risk management would grow in importance by 2010: ”There will be more and more sophisticated instruments out there. The CFO has to understand what they can all do so that they can be employed without increasing the risk to the company.” Holtham said CFOs would need to understand the risk potential of pension fund investment, hedging in both commodities and financial markets, and the multitude of different products offered by investment banks in order to make informed decisions.

Additionally, as a result of the banking crisis, global regulators are looking to increase banking capital adequacy and liquidity requirements, which in turn will create more pressure on the banks to earn higher fees and margins so that they can maintain the returns that shareholders demand. One of the unwelcome side-effects of these industry-wide changes is that banks are already increasing both the cost and complexity of their products and services and speeding up the product development cycle, all of which further compounds the CFO’s problem.

However, despite the broadening scope of activity CFOs, still need to keep their eye on the details. In order to remain effective, they have to understand highly technical financial products and structures, and the resultant solutions. To adequately do this they need direct market access, appropriate product and market knowledge and a working comprehension of the reporting, legal, tax and regulatory issues associated with the utilisation of these financial products and services. In short, they require a large amount of highly specialised knowledge, relevant and accurate information, and high quality people networks.

Consequently, two of the key questions that CFOs must ask themselves are, firstly; whether the opportunity cost of the time spent acquiring and maintaining so much detailed knowledge has not become too high, and secondly; having acknowledged that it is no longer optimal for them to attempt to be specialists in every aspect of their rapidly expanding domains, whether they would not be better off co-opting experts to perform some of these tasks for them? If they choose to bolster their specialised financial capabilities, they can either grow their existing in-house teams or hire external advisors, or settle on some combination of these two options.

Adding global markets skills to in-house teams can be very expensive, since this type of expertise tends to gravitate to the investment banks, where it is more economically scalable. Primary research conducted with leading financial services recruitment agencies indicates that the cost-to-company to hire either a chartered accountant or lawyer with five years of investment banking experience ranges from $250,000 to $400,000 per annum. And because the attraction of large bonuses makes it harder to lure these skills away from the banks, the available talent pool for corporate recruitment is limited. On the other hand, outsourcing to a specialist consultancy can significantly reduce these employee-related costs and at the same time improve both the breadth and depth of the services on offer. One of the most cost effective approaches to solving this problem is to temporarily supplement the organisation’s existing in-house skills by bringing in the specialised skills required for the particular circumstances at hand. However, when retaining external consultants, care should be taken to appoint advisors that are truly independent, thereby reducing the potential for conflicts of interest to arise, such as can happen when investment banks provide advice about the products they sell.  

Tuch explains that these types of conflict of interest typically arise as a result of the multiple services offered by investment banks, the different capacities in which they act, and their broad customer base. [1] The complex relationship between an investment bank and its client can become so intertwined that the only way to resolve it is in court, as in the 2007 Australian case of Asic vs Citigroup. The court found that the investment bank had no fiduciary duty towards its client (to whom it was providing advisory services in relation to a takeover bid). According to Hanrahan, had it been the case that a fiduciary duty did in fact exist, the international investment banking community would have had to address its widespread practice of combining advisory businesses with equities trading businesses.[2]

Furthermore, although it may be argued that the investment banking division of a bank is able to provide its clients with ‘independent’ corporate restructuring advice, it is simply not possible for a bank to offer independent global markets advice for any transaction. This is because the global markets divisions of investment banks consist of structuring, sales and trading teams that are mandated to sell their products. Hence, potential conflicts of interests are inherently part of the overall offering. And history has shown us time and time again that the implementation of policies such as ‘Chinese walls’ and ‘wall-crossing’ does nothing to resolve the conflicts that inevitably occur when banks gain access to non-public information.

This potential for conflicts of interests to arise is further exacerbated whenever a firm mandates an investment bank to provide it with corporate restructuring advice. Currently the banks insist that any global markets execution required for a corporate restructuring transaction will be handled by the same bank that provides the investment banking advisory services. The banks are highly incentivised to promote this particular practice because more often than not a significant portion of their overall transaction profits come from the global markets execution component. In fact, the profits from transaction execution often dwarf the fees earned by the mandated bank for the advisory work. Therefore, in addition to mandating them to provide the advice for a transaction, banks also encourage their clients to appoint them to execute the transaction. It is well known that senior management within the banks overtly discourage their corporate restructuring divisions from introducing any competition for the global markets execution portion of the transaction into the process, even when this best for the client, as it almost always is. Employees are made well aware of the fact that reducing the advising bank’s wallet share in this way would be akin to committing internal political suicide, so they never do so. Accordingly, as a pre-condition of the awarding of any investment banking advisory mandate a client should insist on retaining the right to award the transaction execution component to the most appropriate execution provider(s), even if this means going beyond the successful bidder’s global markets division to the competition.

Even if these deficiencies in the present model were not present, investment banking divisions typically lack the time, knowledge and expertise to competently manage the global markets aspects of most transactions, and so the addition of independent specialist markets advisors to the deal team becomes all the more crucial for establishing feasibility of the proposed solution, achieving structural integrity, optimising execution and minimising the overall costs of the transaction. The way that investment banks currently attempt to address this problem is by setting up ‘Chinese walls’ and then ‘wall-crossing’ traders, structurers and/or sales people from the relevant global markets division(s) to join the M&A deal team. However, this means that traders then have direct access to price sensitive non-public information that can be used in a way detrimental to their clients. To overcome the challenges posed by this inherently flawed model, independent global markets advisors should be included in the deal process from inception, thereby eliminating the need for any employee from the global markets division of an advising bank to participate until the very last moment possible. This would guarantee that the necessary skills are available throughout the transaction to independently test any markets-related assumptions, identify preferred product providers and negotiate the pricing parameters for execution purposes, whilst simultaneously reducing the risk of information leaks and related abusive trading. And taking this argument to its natural conclusion means that corporates should strongly consider the option of appointing independent (non-bank) corporate restructuring and global markets advisors to make up the transaction deal team, and then only use the banks for their execution capabilities.

Another complication with the status quo is that optimally fulfilling a client’s needs often ideally requires a bundle of global markets products, each needing to be individually sourced from different divisions within the banks. However, the tendency of internal divisions within the banks to operate with a ‘silo mentality’ almost always results in a reduced number of possible solutions being offered to the client. Destructive inter-divisional turf wars can further limit client choice, which also detracts from the optimality of the final solution. Since it is reasonable to assume that increased competition at both the industry and divisional level will lead to higher quality and lower cost deals, what is required is a mechanism to ensure that the appropriate division within the correct bank is chosen to execute the relevant part of the transaction. This is another compelling reason why we recommend that our clients appoint independent global markets advisors, since these professionals understand the complex organisational structures, internal operating policies and processes, and behavioural dynamics of the investment banks well, and can help their clients to identify and source the best transaction execution providers for each situation. In this way our they can ensure that they will be exposed to a fuller set of possibilities than if they had just relied on the mandated division to dictate the composition of the global markets component of the deal team, thereby only including participants from their own bank.  This is one of the most effective ways available to either reduce or eliminate any super profits that would otherwise have been earned by the bank, unbeknownst to the client.

Another challenge that CFOs need to overcome is their reliance on banks for providing them with access to the relevant global markets information. Regardless of the commoditisation of many products, banks still benefit immensely from the information asymmetries that arise as a result of their direct participation in the financial markets. Banks use their specialist knowledge, priority access to market information and other informational asymmetries to extract maximum value from selling their products. By appointing independent global markets advisors, our clients should be able to significantly reduce these information asymmetries, which in turn will lead to significant cost savings.

Appointing external advisors is also prudent from a corporate executive’s perspective because if things go wrong, they can point to the fact that they have taken the necessary steps to obtain an independent expert’s opinion on the issue. This additional layer of comfort is becoming increasingly important in the context of burgeoning regulatory and corporate governance requirements.

3. Implications

The CFO is therefore best served by retaining an independent advisory firm to provide him with a complete set of the possible global markets solutions available for any identified need, whether it is part of a corporate restructuring, day-to-day treasury, valuation or capital raising process. The primary functions of such an advisor are to critically evaluate any banking proposals which are designed to address the problem, procure transaction-specific market data and intelligence, test the feasibility of any proposed solutions, provide an insider’s perspective of each participating bank’s view of the transaction, make strategic and tactical recommendations about transaction execution and ensure that the most efficient pricing levels are achieved. The advisor should also assist the CFO to resolve the ‘silo’ problem, by facilitating co-operative interaction between the relevant divisions within the selected execution bank(s). By appointing an independent global markets advisor the CFO can directly address some of the deficiencies inherent in the current investment banking model.

Appointing an independent global markets advisor is also the only realistic way to attain an integrated investment banking and global markets advisory capability that has been immunised to any conflicts of interest. The good news is that this can be achieved regardless of whether the corporate restructuring advisory work is performed by an investment bank or an independent boutique. The inclusion of independent, non-banking global markets specialists in the deal team inevitably leads to a more cost effective solution, not only because the necessary global markets skills are available throughout the process, but also due to the fact that the traders are only introduced at the last possible moment.

CFOs should ensure that they only appoint global markets advisors who have the necessary specialised banking skills, broad transactional experience, deep financial product knowledge, relevant relationships and complete independence from the banking sector. Each employee working for the advisor should be trustworthy, discrete, professional, intelligent and committed to continuously building on his knowledge. By appointing advisors with these characteristics, CFOs will ensure that they receive the best advice at all times. 

[1] Tuch, Investment Banks as Fiduciaries Implications for Conflicts of Interest, pg 15

[2] Hanrahan, Asic vs Citigroup Investment Banks Conflicts of Interest and Chinese Walls, pg 2

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