Behavioural Finance and Bounded Rationality

Whether fortunately or unfortunately, human beings do not behave in perfectly economically rational ways which makes them very difficult to predict. Even with our most complex models accounting for a variety of different factors, there is a high degree of volatility not explained by our multifactor regressions and the models they produce.

Behavioural finance (along with it's fraternal twin, behavioural economics) aims to better understand how humans make decisions that are non-optimal in the strict finance / economics definition and don't comply with what academics would have us anticipate as expected behaviour.

While this course is particularly interesting, what did strike me as noteworthy was that a lot of the foundation material for this course is based on the same principals as integrative thinking taught in our FIT class. In fact, it seems as if we've been doing a review of FIT, focusing on how humans make errors in judgment and build sub-optimal mental models based on well documented shortcomings in how we think.

In fact, some of the examples used in the class are lifted from the exact same material presented to us in Q1 of our first year highlighting anchoring effects, neglecting regression to the mean, availability heuristic, rational probabilty assessments, hot hand and gamblers fallacy etc.

A Framework for Measuring PE Deal Success

The Analyst Exchange and Marquee group showed us how to build LBO models and the basic framework for showing how LBOs generate returns to private equity holders through 3 mechanisms:

1. Leverage arbitrage – Increasing leverage and paying down through cash sweeps
2. Operational arbitrage – Improving operations to generate higher earnings / EBITDA
3. Multiple arbitrage – Selling the company for a higher exit multiple

Of the three, the most meaningful method of generating returns is the second, operational arbitrage. Leverage arbitrage can generate returns, but is not a strategic differentiator when it comes to a bidding process (unless you have some unusual advantage in raising capital) and multiple arbitrage is simply based on market conditions. However, operational arbitrage is directly related to value creation and is the reason why a strategic buyer can afford to pay more than a financial one.

While this is useful notionally, how can we use this to build a framework to understand how each dimension performs in a deal? In my Private Equity and Venture Capital class, they proposed the following framework and example:

So the total gain in equity value is 78.9 (112.9 – 34.0)

1. Return from leverage arbitrage is actually negative because debt increased rather than decreased at -9.2 or (4 - 13.2) and contributes to the equity gain by -12% (-9.2 / 78.9).
2. Return from multiple expansion is 27.3 or (13 x (9.7 - 7.6)) and contributes 35% (28.6 / 78.9)
3. Return from operational improvement is 60.8 or (7.6 x (13 – 5)) and contributes 77%

Using this information, you can benchmark the deal against different performance metrics and determine if the deal generates equity gain simply because of leverage or multiple expansion versus creating value by improving operations.

[Rotman] 5 Great Speakers at Rotman

[Rotman Series: 1, 2, 3, 4, 5]

Jaime is a part-time student in the MBA program at Rotman. He has worked in the sports media industry since 2002 and is currently Manager, Digital Media for the Canadian Football League. He and I went to the Latin America study tour in May last year. He was gracious enough to do a write up for me on his favourite guest speakers which follows:

By Jaime Stein

One of the first things you notice when you obtain an e-mail account at the Rotman School of Management is the sheer volume of e-mails from a guy named Steve. At first it can be overwhelming, but if utilized wisely, it can be your ticket to an exclusive roster of speakers. Steve and his team are the masterminds behind the A-list speakers that regularly visit the Rotman School.

The hardest choice I have to make each week is which speakers I will NOT listen to. This is a good problem to have because choice is always welcome when working full time and attending school part time. I simply don’t have the time to listen to every speaker that passes through Rotman. However, in almost three years, I have been privileged to listen to close to 100 guest speakers.

Most of the speakers that I have seen have delivered outstanding talks, but for the purpose of this blog I present five of the best speakers I have listened to during my time at the Rotman School:

1. Paul Martin – Former Prime Minister of Canada

Imagine you are in your second semester of a three-year MBA degree and you are studying Macroeconomics. A large focus of the course stems around Canada’s macroeconomic policies during the 1980s and 1990s; specifically the country’s battle with debt and inflation. One day you find out that the man behind the plan to battle inflation will be speaking at your school. That would be like a young basketball player having the opportunity to shoot hoops with Michael Jordan and ask him for tips.

Fortunately for our macro class, Mr. Martin came to speak at the Rotman School one morning and for about an hour took us through his plan that brought Canada back from the brink in the mid-‘90s. Following his talk he took time to speak to each of us and share some more personal insights and war stories from his time as both Finance Minister and Prime Minister. This was one of the great days at school that left me wanting to explore a subject further.

2. Isadore Sharp – Founder, Chairman and CEO of Four Seasons Hotels and Resorts

One of the main selling points of the Rotman School is its focus on Integrative Thinking – the theory coined by the current Dean, Roger Martin. In one of his books on Integrative Thinking (The Opposable Mind), Martin focuses on the story of Isadore Sharp and his path to building the greatest luxury brand of hotels in the world. In many of our classes we study the Four Seasons Model for customer service and other best-in-class management techniques. We were fortunate to have Mr. Sharp visit the Rotman School and explain firsthand how he went from one Four Seasons hotel in 1961 in Toronto to operating a chain of approximately 100 properties worldwide.

For anyone with an ounce of entrepreneurial spirit this was a motivating discussion. You could see the passion, courage and drive that Mr. Sharp possessed to launch his vision and stay true to it along the way. Any successful company will create a competitive advantage – however, these are eventually replicated by the competition over time. When people are your competitive advantage, it becomes truly sustainable as Mr. Sharp has proven. While other hotels provide outstanding service, none of been able to match the formula created by the Four Seasons.

3. Rahaf Harfoush – Digital Strategist and Author

It was November 27, 2008 when Ms. Harfoush spoke (for the first time, I believe) at the Rotman School. There was lots of hype surrounding her talk that day because Barak Obama had recently been elected President of the United States and Ms. Harfoush was a part of his wildly successful digital media campaign. I also remember this talk vividly, because it was one day later on November 28, 2008 that I joined Twitter. A lot in my personal and professional life has changed since that defining moment – all for the better.

The topic of conversation at Rotman that day was, “Applying Barack Obama’s Social Media Strategy to Your Brand’s Communications Needs” and it was Ms. Harfoush’s talk that became the inspiration for a lot of what we have done at the Canadian Football League over the past two seasons in the social media realm. To me, this is what an MBA program is about – an exchange of ideas to help stoke peoples’ imagination and potential. I’m glad I made time to attend her talk that day.

4. Michael Lee-Chin – Founder and Chairman of Portland Holdings Inc.

In October, 2009 I attended the Rotman School MBA Leadership Conference in downtown Toronto. It was a star-studded event with speakers like George Butterfield, Co-President of Butterfield & Robinson, Beth Comstock the CMO for GE, Don Morrison, COO of Research in Motion, Robert Deluce the CEO of Porter Airlines and Michael Lee-Chin, the Founder and Chairman of Portland Holdings.

Mr. Lee-Chin is one of the most engaging speakers I have had the pleasure to listen to in person. Mr. Lee-Chin spoke for about an hour on a variety of subjects including how to create wealth. He focused on a small number of blue chip businesses with long-term growth potential. But he was adamant that you know and understand where you are investing your money. One quote from Mr. Lee-Chin that sticks with me is, “If you don’t understand what you own, are you investing or speculating?” This is important advice that too many people continue to ignore this day and age.

5. Jay Hennick – Founder and CEO of FirstService

Mr. Hennick spoke to our class recently at the Rotman School. He runs FirstService, a company that provides services in commercial real estate, residential property management and property services and generates about US $2 billion in annualized revenue. Mr. Hennick told us his amazing story of how he achieved his current standing atop a multi-national company. He got his start with a company he ran as a tenth grader that brought in an income of $200,000. Yes, you read that correctly – he was in grade 10.

His key message was focused on people management; what he believed was the differentiating factor for the success of his current company. His “Partnership Philosophy” states that impact players must have more than a salary and bonus invested in the business; they must have an equity stake. His company focuses on aligning employees’ interest with shareholders in building long-term value. This was both fascinating and eye opening for most students who believe this is hard to do in a company of 18,000+. Yet FirstService continues to succeed. Listening to Mr. Hennick and his passion for success was rewarding.

As you can see, there are some overarching themes from these speakers such as focusing on people and establishing long-term strategies. But ultimately, each of these speakers is among the leaders in their field and that is why I feel fortunate to have spent the past three years at the Rotman School. The access to these great minds alone was worth the price of admission – well almost!

Arrived in Britannia!

I've arrived and moved in to my flat which is right across the street from London Business School which is convenient. Apparently, we happen to be very close to some famous addresses on "Baker street":

We've met our exchange classmates from around the world and are slowly going around meeting the 400 students in each of the 2011 and 2012 classes. There are some impressive resumes and experiences of the small sample of people we've met so far.

[Rotman] Ghana, another perspective

[Rotman Series: 1, 2, 3, 4, 5]

Darshan is an another good friend of mine from Rotman. He holds Bachelor of Technology, Applied Electronics and Instru, University of Kerala and also spent this last summer in Ghana.

Darshan has graciously written me a summary of his experiences which were from a different perspective than Harman’s (Darshan's had a bit more of a engineering / technology flavour). It follows:

Snapshots from Ghana – An Emerging Nation in West-Africa
Looking back, my 3-month Ghanaian summer experience provided a fairly deep understanding of the opportunities and challenges present in this sub-Saharan African country – one that is at the cusp of a developmental inflection point. Along with a fellow Rotman MBA student and four other Canadians, I was working for a non-profit organization located in Kumasi. The organization (SMIDO) dealt with supporting close to 80,000 people - a community of artisans, auto mechanics and metal workers in Suame Magazine (sector of densely populated metal workshops) – to gain market access and facilitate an ecosystem required for businesses to compete with the formal sector.

I arrived in Kumasi with a hazy idea in my mind about the place – drawing pictures and parallels with my home state Kerala, located in southern India. Those ideas were redrawn in the first few hours after I reached there. More than anything else, my first impression of Kumasi was that of a highly dense, busy, loud urban community trying to make ends meet. Beyond that first impression, however, the environment has a noisy vibrancy colored with great optimism about a better future.

Here are a few highlights from my visit there:

Industry and Client Site Visits: My tryst with Ghanaian business began with an introduction to Ghana's gold mining sector. After meetings with gold miner Central African Gold, who was once our client, I got a chance to tour their gold mine pits and extraction plants to see their operations first hand – this was quite an interesting piece of the visit. In another meeting with Red Back Mining, a Canadian gold miner, what was memorable was hearing the head of the firm’s social responsibility group talk at length about Red Back Mining's efforts to establish lasting relationships with the mine’s displaced community. Red Back has invested considerable resources in helping the local community in which it operates and asked our expertise in partnering with them to design skill development and training programs for apprentices from those displaced communities.

Economic Growth Prospects: Apart from mining, another key growth prospect in Ghana is information communication technology (ICT). Most high school children in urban centers have a Facebook account and there is an increasing trend toward being connected to the world - through mobile phones or the internet. Along with the addition of the focus on energy resulting from the recent discovery of sizeable oil reserves off the coast of Ghana, the country also has a Green Revolution going on where local farmers are getting more yields and income from their crops.

Talks with Ministers and Entrepreneurs: Some of the chats with Ghana’s politicians such as the Minister of State for Environment revealed a message of prudence concerning the potential perils of newfound natural resources and a desire to expand unions with other West African countries. A chance conversation with social entrepreneurs like Ashley Murray (Waste Enterprises) gave me a sense of profound optimism of the future of the private sector. The fact that Ghana enjoys a reverse brain-drain, wherein internationally educated Ghanaians and foreign nationals are increasingly returning home from North America and Europe to begin careers that will design enterprise development seems to support this growing optimism.

Despite the different rendezvous with entrepreneurs, business people and ministers, the time spent with the people within the non-profit was perhaps the best part of my summer. The long bus rides and trips were memorable as they included time to talk about our cultural experiences. Created by the common bond of intense cultural experiences – with visits to the beaches of Cape Coast, Elmina Castle slave trading post, Kakum and Mole National Parks and the countless soccer games we watched together - the personal connections forged during the trip will no doubt be more valuable to me and a true measure of my impact.

I departed Ghana very impressed by the hospitality of the Ghanaian people, the immense potential of the country and the depth of the challenges that will present themselves along this nation's path to growth.

[Rotman Series: 1, 2, 3, 4, 5]

Flying out for Exchange, London Business School

I think it's finally hit me. I'm flying to London. I'm sitting in Pearson airport taking advantage of the free wifi, wrapping up a few things and my excitement level is steadily increasing. Geoff Wylde, the other Rotman student going on exchange to LBS has been busy, having left last week. I've been getting emails from the international exchange students who are already there and their social plans for their time in the UK.

I'm really looking forward to being at a new school and meeting new people. As with Rotman, it will be another opportunity to meet likeminded individuals and participate in various events (I would be severely disappointed if my participation in events like case competitions dips even a little bit).

MBA Games was fun, with Rotman winning the Spirit Q&A awards. The Rotman organizing team did a phenomenal job planning our participation this year, only our second year participating. It occurs to me that this is the largest student event I’ve ever been to; even CFES Congress and CEC were only about 220 students, whereas the MBA games were 662 from 20 MBA schools across Canada. I also met some old friends from the FEI case comp, RIM and even junior high! Small world.

The winning team was University of Alberta, so it seems that next year’s team will have an interesting trek to the next games assuming they can get funding support. The host of the games is the previous year’s winner, unlike the CEC which uses a bidding system.

[Rotman] India, US, Canada, and Africa

[Rotman Series: 1, 2, 3, 4, 5]

Harmanpreet is an international student from India and holds a Bachelor of Computer Science and Engineering degree from the National Institute of Technology in Jalandhar, India and will be joining Deloitte’s technology consulting practice once he is finished his MBA at Rotman.

Harman had the interesting experience this past summer of working in Ghana, Africa and I’ve asked him to provide a short reflection of the experience which follows:

Before joining Rotman School of Management I was working as a technology consultant in one of the leading investment banks in New York.

To fast pace my career I decided to pursue MBA and because of some personal reasons chose Canada as place for that. I chose Rotman because of its excellent faculty and its location proximity to finance and consulting industry. I must say it has been an eye opening experience. The people I met, their vast experience, the work they have been doing in past amazes me.

I decided to take a bit different route to enrich my MBA experience. While working full-time in professional world it is very difficult to get an option of doing something completely different.

During summer break, I went to Ghana to work for Suame Magazine Industrial Development Organization (SMIDO). It is an industrial development organization of the biggest industrial cluster in sub Saharan Africa. SMIDO is an umbrella organization of various businesses in Suame Magazine area and is committed to ensuring the development of Suame Magazine into a technologically advanced industrial estate and representing the various economic groups that operate within the area.

Working in a under developed economy is a real challenge. But the satisfaction that I got from work that changes someone’s life is incomparable and this feeling kept pushing me to put more and more efforts into whatever I was trying to achieve.

My most important contribution while there was to approach a gold mining company with a proposal to sponsor apprenticeships for people displaced by their mining operations. It was ecstatic when the mining company accepted the proposal.

After summer experience my whole approach to business has changed. I used to think that business means making more money for you and for your shareholders. Now I believe that purpose of business should be to benefit human society rather than to accumulate wealth to satisfy egos.

It was an experience that I will cherish for rest of my life.
-Harman Singh

[Rotman Series: 1, 2, 3, 4, 5]