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VOLUME IV: ISSUE VIII

APRIL 2014

THE ETHICALITY OF STAPLE FINANCING


By Vincent Criscuolo
The Story In March of 2011, RBC served an advising role on Rural/Metro Corp.s acquisition by the private equity firm Warburg Pincus LLC. RBC presented a valuation range of $8.19 to $16.71 to Rural/Metro, down from the $19 valuation decided upon earlier by RBC. Interestingly enough, this valuation range made Warburgs $17.25 offer appear to be a great deal. The ethical dilemma arises from the fact that while RBC was telling Rural/Metro it had a great offer, it was also lobbying Warburg for a role in the financing of the acquisition. Considerable fees can be made financing these deals. In fact, the buy-side financing of this acquisition would generate fees far greater than the sell-side fees RBC would collect from a better deal for Rural/Metro. So, one might presume that RBC had ulterior motives in advising Rural/Metro to take the deal. And in fact, one did so presume. The Decision J. Travis Laster, the Vice Chancellor of the Delaware Court of Chancery, has made clear that he sees unethicality in RBCs position. Additionally, he has made a name for himself in his opposition against M&A bankers in other cases as well. Thus, it was no surprise that Laster found RBC liable for damages on Friday, March 7. RBC is currently considering the options it has, but it is known that the plaintiffs were seeking $172M in damages, the difference between the valuation Rural/Metro believes was appropriate, $24.04, and the value it got for the sale, $17.25. RBCs valuation also got called into question because of its original pitch to Rural/Metro. In this pitch, it
OCR ADVICE FOR UNDERCLASSMEN William Helmold Page 2 ETHICALITY OF STAPLE FINANCING Vincent Criscuolo Page 3

cited two recent deals in which the advised companies sold at 9.4 and 9.5 times earnings before interest, taxes, depreciation, and amortization (EBITDA). Meanwhile, its final valuation of Rural/Metro was about 6.3 times EBITDA. RBC contends that this was a different company in a different industry with few deals to compare to. However, this change in numbers certainly raises some concern. The Motive Fittingly, RBC is in a period of aggressive growth. The firm is attempting to move beyond its advisory and smaller financing role in the industry. That is, RBC hopes to take on larger financing roles in the future, especially

on the sell-side, like many of its competitors, in order to reap the larger fees that are characteristic of these deals. In fact, RBC has moved up from having the fifteenth largest investment banking fees to having the tenth largest, according to analysis by Dealogic. Naturally, RBC is not the only bank that has been engaging in this questionable behavior. These activities have become so common they have a namestaple-finance arrangements. In these dealings, the bank representing the sellers simultaneously offers financing to the Story continued on p. 3, see Staple Financing
PUERTO RICAN DISTRESSED CREDIT Kevin Lai Page 4 MORTGAGE SERVICING INDUSTRY Graham Jordan Page 5

INSIDE THIS ISSUE

WHARTON UNDERGRADUATE FINANCE CLUB

APRIL 2014

ADVICE ON OCR FOR UNDERCLASSMEN


By William Helmold
On Campus Recruiting. OCR. Although those three words are enough to inspire fear in any Penn junior, OCR represents one of the greatest opportunities that undergraduates have here at Penn. While stressful to endure, successfully navigating OCR will land you a terrific summer job, which may even translate into a career after graduation. Typically targeted towards juniors, it seems increasingly common for sophomores and even some freshman to go through OCR. While definitely more difficult, it is not impossible for the underclassman candidate to achieve OCR success. The Hardest Battle As an underclassman, the biggest challenge will be securing an interview. As mentioned above, the vast majority of positions are targeted specifically at juniors because most financial firms use their internship protheir interviewers schedules full. Finally, some larger firms will intentionally tap underclassmen to build loyalty in talented individuals ahead of competing companies. Sadly, these cases are still uncommon on Penn Link. Underclassman must apply early and often in order to secure an interview. The Interview As an underclassman, it will be easier to do well in a first round interview than it will be to secure the interview. Firms recognize that underclassmen lack experience, and are more interested in how prospective applicants would fit with the company. Interview success comes by demonstrating a strong passion for the company and its industry, an excellent attitude, and a great understanding of trends in the macro-economy. A lack of fit will end an applicants candidacy. Moreover, being able to ace behavioral questions can compensate for a dearth of technical finance knowledge. It is strongly recommended that after mastering basic concepts (know, at the least, material from the core classes ACCT 101, ACCT 102, FNCE 100, and FNCE 101), applicants master fit questions before bothering with more advanced technical topics. Conveying passion is easily the most effective way to do well for a fit interview. By showing excitement for a firms business activity (e.g. investing, raising capital, equity research, etc.) or for a general career in finance, an applicant can prove intelligence and showcase personality. This is a non-trivial point; try honestly convincing your next classmate that you enjoy studying the capital structure of a company and see if you are greeted with sarcasm. The easiest way to succeed at conveying passion for a particular industry is to actively cultivate a passion for that industry. Consider joining an industry-specific club on campus, such as the Wharton Undergraduate Finance Club, Wharton Undergraduate Real Estate Club, or the Wharton Private Equity Venture Capital, and performing some of the tasks that you would do were you to have a career in that industry. Being able to talk about a specific case study you looked at through WUFC/WUREC/PEVC during an interview is much more convincing than simply asserting that you are passionate for business. Outside of having an honest passion for finance, remember to prepare for the standard non-finance orien Story continued on p. 6, see OCR Advice
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Conveying passion is easily the most effective way to do well for a fit interview. By showing excitement for a firms business activity or for a general career in finance, an applicant can prove intelligence and showcase personality.
grams to place employees for full-time positions. For many firms, the summer internship represents a significant investment of time, expertise, and money that can only be recovered by retaining interns for full-time employment. Unfortunately, this causes a problem for underclassman applicants. Many firms do not want to invest in an underclassmans skillset, only to have that student go through OCR again as a junior and be poached away by another firm. Despite the above concerns, there is a silver lining for younger candidates. Many smaller firms are willing to take on underclassmen because they are not interested in hiring an intern for full-time employment. In addition, although most Penn Link postings are targeted towards juniors, it is somewhat common for firms to signup strong sophomores as alternative interviewees in order to keep 2

APRIL 2014

WHARTON UNDERGRADUATE FINANCE CLUB

Staple Financing, story continuned from p. 1 He has presided over and will continue to preside over buyers. Thus, the advising banks can reap the benefits of many similar cases in which bankers put themselves into the buy-side and the typically larger benefits of the sell- allegedly unethical positions. side. However, it is important to note the benefits of staple financing, which has become common practice in the Similar Cases mergers and acquisitions field. It expedites the bidding As staple-finance arrangements have grown more process, as buyers do not have to search for financing. That prominent, so have the number of cases that deal with is, the sellers bank presents the buyer with the sellers them. While RBC is the first defendant in one of these offer and the financing proposed by the sellers bank. That cases to go to court, other complaints have been filed and way, the buyer can analyze the deal as a whole and decide settled out of court. First, Del Monte Foods. Co. com- quickly whether or not to go forward with the deal. This plained against Barclays PLC. Barclays allegedly engaged certainty also forces buyers to make the purchase more in unethical activities very similar to those of RBC. Ad- often than not. vising the seller while courting the buyer, Barclays supNonetheless, many institutions are questioning the posedly engaged in illegal activity. However, it settled, ethicality of these activities. The clear incentive is to set paying $23.7M toward a settlement and forfeiting $21M valuations low so that sellers will more often agree to buyin fees. ers offers. As a result, the deal will go through and the adLikewise, Goldman Sachs Group Inc. forfeited vising bank will become the financing bank of the buyer, $20M in fees on the sale of El Paso Corp. to Kinder Mor- generating even greater fees from the financing. gan Inc. Goldman allegedly engaged in similar unethical The solution to this issue is anything but clear. On activities, magnified by the fact that Goldman had a 19% the one hand, regulators could not allow sell-side advisers stake in Kinder Morgan at the time of the sale. Naturally, to offer buy-side financing. But, doing so would likely reneither Barclays nor Goldman admitted any wrongdoing sult in a lack of efficiency and bank returns. On the other during the proceedings. extreme, regulators could ignore the issue and simply Whats more, some cases have seen banks al- allow advisors continue to incorrectly value companies legedly assisting boards in shortchanging investors. Ac- they are advising for the sake of greater buy-side fees. Or, cording to this theory, financial advisors are essentially perhaps there is a middle ground. Perhaps regulators could aiding and abetting a board's failure to get the best price (RBC Ruling Strikes a Blow to Deal-Making The incentive is to set valuations low so Banks). That is, the boards benefit from an expedited sale that sellers will more often agree to of their company because they receive compensation after buyers offers. the sale, while their shareholders are hurt. Here, in theory, the financial advisors help the board by providing a lower valuation, allowing the board members to sell the company find a way to monitor these valuations. Some argue that more quickly at a price that fails to maximize shareholder this could be done through a third-party evaluator. Rather value because they can justify the sale price with the ad- than getting involved directly, regulators could require that visors valuation. For example, Moelis & Co. allegedly as- a third-party advisor with no interest in the matter approve sisted Epicor Software Corp.s board in failing to secure valuations of advisors partaking in staple financing practhe highest possible price in its 2011 acquisition. Similarly, tices. This would do little to slow down efficiency and Jefferies LLC and KeyBanc Capital Markets Inc. allegedly could likely lead to a more self-regulated market. Natuengaged in the same unethical activities regarding the sale rally, this raises the question of what is and what is not a of Morton's Restaurant Group Inc. fair valuation. But clearly, something should be done, and it probably should not be the complete disallowance of staImplications for the Industry ple financing. This decision is another step towards tighter reguThus, there are many benefits and drawbacks to lation of mergers and acquisitions bankers. More and staple financing. It will be up to these institutions and govmore, banks must carefully consider their roles in different erning bodies to decide whether the benefits of expedited deals, making sure that they are not being incentivized to and more frequent deal making exceed the drawbacks of underperform for profit. Meanwhile, this deal only builds questionably ethical valuations, or whether perhaps there on Lasters reputation as a harsh critic of these bankers. is a third option that will resolve the matter entirely.
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WHARTON UNDERGRADUATE FINANCE CLUB

APRIL 2014

IMPLICATIONS OF PUERTO RICOS DISTRESSED CREDIT


By Kevin Luo
What happened to Puerto Rico? In the past five years, the US economy has made a gradual recovery from recession. While equity markets have appreciated spectacularly the past year, the road to economic growth has not been without shocks. In the past year, the US has seen two major municipalities falter, with Detroit filing for bankruptcy last June and Puerto Rico bonds precariously close to default. In this issue we examine the recent developments in Puerto Rico, as well as implications and investment opportunities created by the situation. Recent Economic Background Over the past few years, Puerto Rico has seen its economy shrink, with this past year posting the worst economic deterioration since 1999. Despite a 740M budget deficit in 2004, the commonwealth and its agencies have doubled borrowing levels since 2004. Furthermore, the Puerto Ricos Planning Board recently released projections estimating a further 0.8% decline in FY2014. Earlier this year, Puerto Ricos municipal debt was downgraded to junk status, straining many municipal bond fund managers, who now face heavy redemptions from holding the unfavorable debt. While municipal bonds appeal to many risk adverse investors due to their tax-exempt nature, especially those in states with high personal income tax rates and large concentrations of wealth, many muni fund managers are facing pressure to juggle their holdings to pacify moody retail investors. What is unique about Puerto Rico debt is its tax-exempt status nationwide, compared to state municipal bonds that are only tax-exempt in the issuing state. Thus, Puerto Ricos high yielding bonds were once very attractive to investors as they promised high returns, provided portfolio diversification, and had high liquidity. As a result, over 75% of US mutual funds with municipals held Puerto Rican bonds. Distressed Puerto Rico muni bonds have lured worried debt investors, who typically do not buy munis, with above 15% yields on a taxable basis. The heightened demand from investors has somewhat helped stabilize the 70B market for Puerto Rico debt as the commonwealth seeks to borrow to plug deficits and roll over bank loans. Heightened demand may work in PRs favor if extra demand drives down yields allowing the island to sell debt on better terms. Regardless, many mutual funds are facing pressure to sell from institutional investors who have been spooked by climbing interest rates and Detroits bankruptcy filing less than a year ago. Differences between Puerto Rico and Detroit Unlike Detroit, which filed for bankruptcy court protection last summer, Puerto Rico is not covered by Chapter 8 bankruptcy law. This means the debtors and creditors must negotiate the situation out of court. Mary Miller, the US Treasury undersecretary for domestic affairs, confirmed this point at the Bloomberg Link State & Municipal Finance conference by announcing that the US was not planning deep federal assistance for Puerto Rico. The recent focus on the precarious situation has raised questions regarding Puerto Ricos status as a commonwealth territory on Puerto Ricos recourse to US bankruptcy law. Compared to investor response to Detroits prior bankruptcy, investor sentiment seems to suggest a more optimistic outlook for Puerto Rico. Regardless, the two municipalities are expected to arrive at recovery through different means, with Detroit going through a lengthy legal process and Puerto Rico through budget tightening and revenue generation. Looking Forward Currently, Puertos distressed credit remains actively traded and prices are appreciating in the secondary market, even after the commonwealth was forced to cut back its bond program for the rest of the year after yields on its debt soared. Among economic recovery efforts, the Garcia Padilla administration has since pushed through an overhaul of the Employee Retirement system, and also strengthened the operations of local companies that are major contributors to the economy. However, a cautious tone still lingers as the commonwealth addresses the larger problems of over leveraging, sustaining economic recovery, and facing pension problems.
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APRIL 2014

WHARTON UNDERGRADUATE FINANCE CLUB

STATE OF THE MORTGAGE SERVICING INDUSTRY


By Graham Jordan
Almost two months ago, in early February, Benjamin Lawsky, New Yorks Superintendent of Financial Services, blocked a transfer of 39 billion dollars worth of mortgage servicing rights to Ocwen from Wells Fargo. Concerns over capacity and treatment of homeowners has led to newly increased scrutiny over the mortgage servicing industry of which Ocwen is a part of. Mortgage servicers purchase from banks the right to perform the back end of loan processing for mortgage bondholders. Companies such as Ocwen will collect money from borrowers, monitor late payments, foreclose if necessary, and then distribute this money to the lenders. In most cases the lender is the owner of a mortgage-backed security the loan is a part of. In exchange for this, bond owners agree to pay Ocwen a fee based on the size of the pool of mortgage for performing these services. Traditionally, large banks that originated loans also took on the role of servicing mortgages as well. However, recent lawsuits in which banks were forced to pay billions in fines due to malpractice involved with servicing loans and unfavorable capital treatment of mortgage servicing rights under Basel III capital regulations have pushed banks to offload the role of servicing mortgages to non-bank entities such as Ocwen. Jamie Dimon, the CEO of JP Morgan emphasized this attitude recently with his comment which described the back end process of home lending as the most painful business ever. However, this recent transition in the servicing industry has left many homeowners disgruntled and has started regulatory scrutiny of players in the industry. In December 2013, Ocwen was accused of violating consumer financial laws at every stage of the mortgage servicing process. The allegation is that Ocwen defrauded multiple homeowners in order to create fees for themselves for managing difficult accounts. On top of that there is the allegation that Ocwen unnecessarily chooses to foreclose on homeowners instead of working out problems with them as is often legally required, since it is more profitable for the business. Allegations such as these are why Lawsky blocked the sale of an additional pool of mortgage servicing rights to Ocwen. The main concern was that if Ocwen is already having so many difficulties servicing the current portfolio that they may not be able to take on an additional pool of mortgages. This blockage is incredibly harmful for Ocwen because it needs to continue to purchase new mortgage servicing rights to survive. As mortgages either are paid off or refinanced, the pool that
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Ocwen services naturally shrinks, and if Ocwen is unable to purchase more servicing rights, the company will start to shrink until it eventually goes out of business. Furthermore, some of the allegations of violating consumer protection laws have already been found to be true. In California, homeowners who were victims of Ocwens practices will receive $268 million in relief from Ocwen as a result of a lawsuit contending that Ocwen violated California state laws. Mark Buchignani of California is one resident who describes an incredibly frustrating experience where, due to a technical error when the servicer of his mortgage changed, his mortgage payments were never received. As a result Ocwen tried to foreclose on his home and when Mark tried to reach out to Ocwen to right the situation the company never responded to him and continued to pile on fees and interest and penalties and credit damage. The responses to these allegations have varied across the industry. Ocwen has recently begun to invest in quality control measures across the company. On top of that the company has emphasized a statement from the head of the Neighborhood Assistance Corporation of America, a nonprofit group focused on housing, that there are more principal reductions out of Ocwen than out of anyone else. Other players in the mortgage servicing industry such as Nationstar emphasize that their incentives align with homeowners incentives. Given that servicers continue to receive a fee payment contingent on the mortgage still being paid, Nationstar argues that it is in its best interests to work with homeowners when they run into financial trouble as opposed to quickly foreclosing on a property, which can be a lengthy and expensive process. On the other hand, a servicer is paid additional fees for the services performed during the foreclosure process so there is no clear cut line showing where the incentives for servicers really are. The mortgage servicing industry is clearly in a state of flux right now. Concerns over the sustainability of mortgage servicers due to regulatory scrutiny has recently sent stocks tumbling. Over the next few months, the issues that have been brought up should begin to be resolved, and Ocwen will learn if it is able to keep purchasing mortgage servicing rights and if it will be required to make changes to their business model.

WHARTON UNDERGRADUATE FINANCE CLUB

APRIL 2014

in the public sector or conducting research. The Federal GovOCR Advice, story continued from p. 2 tated behavioral questions too, especially those regarding great- ernment posts intern positions for the Treasury, Federal Deposit est strength/weakness, past failures, and teamwork. Also, re- Insurance Corporation, Consumer Financial Protection Bureau, member that not every candidate advances during the Securities and Exchange Commission, Commodity Futures interviewing process, so always keep applying until you actually Trading Commission and other departments on USAJOBS.gov. have signed an offer. Candidates can do everything right and Similarly, programs through the University, such as the Penn still get dinged for factors beyond their control. As an under- Wharton Public Policy Initiative (PPI) can help place businessclassman applicant this is especially common when interview- minded underclassmen in summer positions. Finally, do not foring for junior roles because even though your interviewer may get that there are many companies that do not participate in recommend you to advance, human resources often decides not OCR, but instead recruit interns simply though their websites. to advance younger candidates if there are enough qualified jun- For students interested in finance, Fortune 500 companies can provide a terrific educational experience in corporate finance iors. that will greatly help the student during OCR in the following Outside of OCR year. While OCR is useful, it does not represent the entire Closing Remarks As an underclassman, finding a summer position Do not discount the possibility of creatthrough OCR is not impossible, but it will require a massive ing an opportunity. Successful networkamount of applications. Once you have your interviews, be sure ing with past contacts, alumni, and to prepare yourself well. Remember that as an underclassman local firms is one of the best avenues for applicant, you are likely to be asked many more fit questions than technical questions since firms expect that you will be insecuring employment outside of the experienced. The most important factor in being successful will OCR process. be your passion. If OCR does not work out for you, do not forget to search outside of Penn Link. Networking, Fortune 500 comuniverse of summer internship opportunities. Do not discount panies, and the Public Sector are all great places to find relevant the possibility of creating an opportunity. Successful networking summer opportunities. Finally, if you are unable to secure a with past contacts, alumni, and local firms is one of the best av- summer internship, seriously considering enjoying your time enues for securing employment outside of the OCR process. off you will have plenty of time to forge a career next year Additionally, consider gaining finance experience by working and after your graduation.

[CREDITS]

Jasmine Azizi, Abigail Richardson, & Ese Uwhuba


Copy Editors

Karan Parekh
Editor-in-Chief Vice President of Financial Analysis

Jenny Qian
Managing Editor

Charles Bagley, Kartik Bhamidipati, Ryan Chen, Vincent Criscuolo, William Helmold, Graham Jordan, Jens Keicher, Kevin Lai, Roni Luo, Austin Tedesco, & Brendan Tsai
Financial Analysts Questions or comments? Please send your suggestions to WUFCFA@gmail.com

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