The MaGazine foR The PRivaTe invesToR
Modern in a global company is a highly challenging business. Running a complex organization means putting the latest management wisdom into practice, continually reviewing performance and meeting the demands of modern corporate governance. Then and only then will managers achieve their ultimate objective: added value for all stakeholders
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Issued by UBS AG. Regulated in the UK by the Financial Services Authority. UBS Warburg LLC and UBS PaineWebber Inc are subsidiaries of UBS AG, US registered broker/dealers and members SIPC. Photo: Philippe Schiller.
Dear reader, Management is the principal theme for this edition of optimus – a highly relevant topic, particularly for a global organization such as UBS. Our vision is to be recognized as one of the best financial service providers in the world. This has a lot to do with management, but possibly even more to do with trust. Trust in the financial and capital markets has been seriously damaged by various events, some of them headline making. How successfully have management theories been implemented in recent years? Can managers’ performance be measured and, if so, how should it be rewarded? How important is diversity to the success of a business? What are the problems that we face with corporate governance, in other words the working relationship between management and the board of directors? These are just some of the questions that we will examine in the pages which follow. The answers, though important, can provide only a partial response to the challenge of restoring confidence in the global financial markets. For me, the key to resolving the current crisis lies in personal and corporate integrity at every level. I firmly believe that this is an issue which also concerns a great many of our clients. Investor confidence in the integrity of the financial and business community is essential if the financial markets are to function and the global economy is to turn in a healthy performance. Indeed, this was reflected in the motto of this year’s World Economic Forum in Davos: ‘Building Trust’. I hope you will find optimus an enjoyable read.
Georges Gagnebin Chairman UBS Wealth Management & Business Banking
Corporate News 6 America’s Cup 2003 The race continues to promote technological innovation. 8 UBS Optimus Foundation Investing for the common good. 9 Wealth Management UBS expands in Europe.
is the key to success in the America‘s Cup. Winning the most coveted trophy in world sailing depends on mastering the interplay between man and technology.
10 Art Banking Authenticating modern art. Management 12 The manager’s thirst for knowledge Executives have always tried to apply management theory to corporate practice. The goal is to harness strategic know-how to ensure a company’s profitability. By Michael Kutschker 18 Taking public companies private In a time of volatile equity markets, going private can sometimes make strategic sense. By Christian Hess and Marcel W. Schmid 22 Measuring a manager’s performance It makes intuitive sense to pay managers according to the economic value they add to a company. It also means delivering shareholder value. By S. David Young 26 Fredmund Malik meets Mark Hoenig A professor of economics and an executive search consultant debate global management, shareholder value and management ethics.
Finance 30 An economy picking up speed Although the financial markets will remain volatile, Oliver Adler suggests that the second half of 2003 will bring some positive surprises. 34 Viewpoint: Ram Charan A corporate governance guru argues that new legislation in the US and changes in the EU will make boards more pro-active. 36 New, transparent performance standards The introduction of an international code lets private investors make a systematic comparison of investment managers. By Arthur Liao and Matt Forstenhausler Private Agenda 38 Pearls: an investment in beauty Knowing the hallmarks of pearl quality prepares buyers to choose wisely. By Fred Ward 42 The yacht man Gérard Rodriguez is the world’s foremost purveyor and builder of luxury open-deck yachts. And his company, the Rodriguez Group, is a highflyer on the stock market. 46 Implementing a global diversity policy A diverse workforce reflects the global marketplace and allows businesses to retain talented individuals. By Mona Siu-Kan Lau 49 The wine column The role of the winemaker: unlocking potential from grape to bottle. By Michel Rolland
4 | Contents · optimus 1/2003
optimus optimus is the quarterly magazine of UBS Private Banking. It forms a package with ‘optimus-online’, a complementary internet site which also includes an archive of previous editions. This website (www.ubs.com/optimus) has been specifically created for optimus readers and can only be accessed with the password given on page 8.
Modern involves mastering the complexity of corporate leadership in a global competitive environment. There are three key factors: people, markets and products.
need to be able to measure the return on an investment using objective criteria. There are now internationally recognized standards to help them achieve this.
Gérard Rodriguez has created an impressive business building luxury ocean-going yachts with his listed company, the Rodriguez Group.
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America’s Cup 2003: Technology and teamwork in pursuit of success
The Alinghi Team in action
6 | Corporate News · optimus 1/2003
to achieve superiority by improving technology. Today’s competition yachts are extremely narrow, just under four meters on average, and very minimalist in structural terms. Aside from the foredeck, there is little other than
UBS and sailing UBS is a committed supporter of sailing and has built a comprehensive world-wide sponsorship platform. As part of its commitment to one of the oldest sporting trophies in the world, the America’s Cup, UBS is Main Partner of Team Alinghi, Swiss Challenge for the America’s Cup 2003, and is an official partner of the Louis Vuitton Cup 2002-3. For the final race results, visit www.ubs.com/sailing
Photos: Thierry Martinez
The America’s Cup competition is driven by innovation and technology and has been ever since 1851, when Commodore John Cox Stevens of the New York Yacht Club despatched a schooner to England to take on the best of the Royal Yacht Squadron. His aim was to prove that the emergent nation across the Atlantic could produce faster sailing craft thanks to its superior design skills and better materials. From that foray, the America’s Cup was born. The schooner America started out in 1851 with a dual technological advantage. A new shape to the hull provided speed and its sails were made of American cotton duck – a fabric that held its shape far better than flax, the material that the English thought best for sail making. Subsequent challenges have all sought
the hull shell and the cockpit floor behind the mast. Design optimization involves the study of aerodynamics for the rig and sail wardrobe, as well as fluid dynamics for the hull, appendages (including bulb and winglets) and rig. The complete design package has to provide the advancement to win. And a competition yacht design team includes engineers and structural specialists whose task is to provide the lightest and strongest possible boat using the latest in aerospace materials. Ironically, every gram they save goes into lead for the keel bulb to provide sail-carrying power through stability. Those who sail the boats are a team in themselves, but they are also part of a much larger team – the one responsible for the design and building of these elegant craft. Few understand this relationship between team and technology better than Russell Coutts, skipper of Ernesto Bertarelli’s Alinghi Challenge. Coutts skippered Team New Zealand to victory in San Diego in 1995 – one of only two occasions when the Cup has been won away from the US – and again when the ’All Blacks’ of sailing retained the Cup in its only successful defense outside the US, in 2000. An engineer by training, Coutts recognizes the crucially important role played by technology in any winning team. ’We’ve concentrated our efforts on the towing tank,’ he said after Alinghi had produced seven wins and suffered only a single loss in the first round of the Louis Vuitton Cup, the stepping-stone to the America’s Cup for the nine challengers, six from Europe and three from the United States. ’We have tested a significant number of models,’ Coutts continued, ’and made a fairly big push in terms of the computational fluid dynamics (CFD).’ This is the tool that yacht designers use to keep track of the efficiency of their
Corporate News designs and it is at the theoretical cutting edge. CFD examines the fluid flow across the hull and the appendages – the keel with its winglets and the rudder – using complex, state-of-the-art ’Splash’ software. Every sailing syndicate uses CFD for basic design analysis, but they all test extensively first. Alinghi, for example, tested 17 models, each one-third scale, in a testing tank at St. John’s, Newfoundland, before designing and building two boats for the Louis
Vuitton Cup. ’It is fascinating the accuracy that CFD codes come up with these days,’ observed Coutts. Technology is equally important in the production of the sails, which are also subject to CFD analysis. Monitoring cameras, mounted on the mast and focused on the broad stripes that run across the sail, ’see’ the sail shapes in real time as the boat is raced. The images are then analyzed by the sail designers against the boat’s real-time performance.
Bank opening in Bahrain
In a survey by the American magazine Global Finance, UBS was named as the best financial institution in the world in 2002 for private banking. UBS also was awarded the rank of best Swiss bank. According to this annual survey, large institutions – especially UBS in its capacity as market leader – are better positioned than smaller banks to take advantage of asset growth among high net worth individuals. For the fourth time since 1996, FinanceAsia magazine has named UBS as ’Best Private Bank in Asia’. This award was made on the basis of a practical test carried out at the main private banks in the region. According to FinanceAsia, UBS came out on top because of the excellent quality of its advisory services. www.gfmag.com
Bob Fisher is a freelance writer and correspondent for the Guardian.
New e-banking service
In September 2002, Bahrain-licensed Noriba Bank BSC opened its doors for business in the Gulf kingdom. A wholly owned subsidiary of UBS, Noriba provides private and institutional Muslim clients around the world with products that comply with the religious and ethical requirements of Sharia law. The broad range of investment instruments on offer includes investment funds, asset management mandates, private equity, Islamic bonds and real estate, as well as currency and Murabaha transactions. Prior to the opening, the King and the Prime Minister of Bahrain expressed their great pleasure that UBS has had a presence in the kingdom for thirty years and they underlined Bahrain’s support for Noriba.
UBS top in Private Banking
The team with the best design is the one most likely to triumph. Yet, without the stimulus of teamwork, technology would amount to little. As UBS chairman Marcel Ospel observes, these forces ’are what carry a racing yacht to success. In global finance, they also decide who can sail harder to the wind.’
Professorship at IMD UBS has endowed a Chair in Banking and Financial Services at the International Institute for Management Development (IMD) in Lausanne. Didier Cossin Didier Cossin has been appointed as Chair Holder. Cossin, an economist, studied at the Sorbonne, gained a doctorate in business studies from Harvard Business School, and has earned an international reputation in his field. UBS is committed to increasing the quality of management training, especially in the banking sector. This commitment is reflected in its long-standing membership of the IMD Learning Network. www.imd.ch
UBS has come up with a new banking facility especially for use with hand-held computers and mobile telephones. It enables clients to access e-banking services at any time – even when they are away from the office and their computers. Account statements, electronic stock exchange orders, share prices and up-to-the-minute financial data can all be accessed worldwide via Palm, Pocket PC or WAP. UBS clients with Swiss accounts and an e-banking agreement can also use their mobile devices to access personal data and to take care of account and stock exchange transactions. The system guarantees the same level of security for these transactions as for PC banking. Mobile UBS services for Pocket PC or Palm: mobile.ubs.com. For WAP-enabled mobile telephones: wap.ubs.com. For more information about UBS’s mobile services: www. ubs.com/mobile
New: e-banking via hand-held device
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UBS Optimus Foundation: working for children The UBS Optimus Foundation, a charitable organization backed by UBS, is committed to high quality projects that put people first. Ever since it was established by UBS at the end of 1999, the Foundation’s goal has been to improve living conditions for people throughout the world. Working with dedicated partner organizations, the Foundation seeks to implement projects that meet the criteria of sustainability, innovation and quality. Support focuses on two areas: ’Children & Talents’ and ’Medical and Biological Research’. The Foundation aims at providing young people with a basis for a dignified life by protecting them from violence, abuse and illness, as well as offering them a chance to receive a solid education. The Optimus Foundation’s latest project centers on a school in Tibet. The country is rife with poverty and illiteracy. Most children have never attended school. To help support their families, they often are forced to build roads or to become prostitutes. In summer 2001 the UBS Optimus Foundation decided to help the poorest, most
vulnerable people in Tibet. Working with the Swiss aid organization ROKPA INTERNATIONAL, the Foundation launched a school project in Kenlo, in the northeast of the country. The school, which opened its doors to fifty orphans and needy young girls last September, provides children with accommodation, food and education. There are plans already for a second phase to double its capacity. The school in Kenlo places special emphasis on fostering Tibetan language and culture; but the children also study English, traditional school subjects and computer skills, and learn a craft-based trade. The most talented among them go on to attend a course in traditional Tibetan medicine at the local university. It is hoped that this will improve medical provision in rural areas over the long term and help to preserve one of Tibet’s most important cultural assets. The project’s long-term focus is a reflection of the UBS Optimus Foundation’s motto: ’If you give me a fish, I eat for a day. If you teach me how to fish, I eat for a lifetime.’
A school education for children
The organization helps to fulfill many of the hopes and dreams that children cherish: to make the world a better place, to save lives and to explore. Thanks to the UBS Optimus Foundation, UBS can offer its clients ways of investing their money that make financial sense and also help to support extremely worthwhile projects. The annual amounts paid out by UBS (Lux) Strategy Fund – Balanced C, for example, go directly to the Foundation – no deductions are made. Legacies and work with existing foundations can be structured on an individual basis. Direct donations are generally used to support all of the Foundation’s projects in the year after they are made. As a result, the Foundation’s projects enjoy the full benefit of our clients’ generosity. www.ubs.com/ubs-optimus-foundation
Access to optimus-online www.ubs.com/optimus
A new look for optimus-online
Our website was created exclusively for optimus readers. User name and password are provided below. Both are continuously updated and optimus readers are informed of changes. After entering the URL address (http://www.ubs.com/ optimus), visitors must give their user name and password. It should be noted that local restrictions may limit clients’ access to certain information.
optimus-online has been revamped, bringing the magazine and home page closer together. At www.ubs.com/ optimus, readers will find a comprehensive overview of the publication as well as access to all the articles from the current printed edition in three languages. The internet links featured in the magazine can be clicked on directly, along with various other links. In optimus art, readers will find the full versions of the short articles published in optimus magazine, together with detailed listings of major international cultural events and links to further information. Other highlights include current articles on art and culture. As a useful supplement to the investment strategy set out in the magazine, optimus-online provides asset allocation information, updated on a monthly basis. A user-friendly archive facility also gives access to all articles featured in previous editions of optimus.
User Name: private Password: forum ’optimus-online’ uses encryption technology. If you use Netscape Communicator 4.x (or later version) or MS Internet Explorer 4.x (or later), data transferred between your PC and our server will be heavily encrypted (128bit code); with Netscape Communicator 3.x or MS Internet Explorer the encryption will be less strong (40-bit code). The same applies to information sent using the contact form on this site. The visitor’s browser will display a symbol to show whether data has been encrypted. We recommend that you read the relevant manuals. Please note that although information sent via the contact form is encrypted, the sender and recipient’s addresses (i.e. the IP addresses of the visitor’s and UBS’s computers) are not, so these can be read by a third party.
8 | Corporate News · optimus 1/2003
Corporate News Expansion in Europe
Creating philanthropic foundations
Brussels Hamburg Bielefeld Berlin Düsseldorf Frankfurt Offenbach Stuttgart Munich
London Lille Paris Nantes Strasbourg Bordeaux Lyon Marseilles Barcelona Madrid Seville Valencia
Vienna Brescia Milan Bologna Florence Rome Naples
UBS aims to become the leading provider of wealth management services in Europe. As part of this strategy, new offices have been opened in Brescia (Italy), Brussels, Valencia, Lille and Strasbourg. In the five key European markets of Germany, France, the UK, Italy and Spain alone, UBS now boasts a network of more than 28 Private Banking branch offices. Further
locations in the pipeline for the coming year include Padua and Turin. Thanks to its local presence, UBS also is ideally placed when facing the challenge of a changing legal and regulatory framework within Europe. Clients have the opportunity to access the Bank’s range of services both in their home country and in Switzerland.
The UBS Family Business Group recently established a Philanthropic Initiative to assist clients in setting up and managing tailormade philanthropic and charitable foundations. Using a disciplined approach to family philanthropy, the group’s initiative combines the expertise of in-house professionals and external specialists to provide ’best in class’ skills and solutions in advising, establishing and managing a family foundation. First, it is important to work closely with families to identify causes that reflect their values and passions. Next, a suitable structure for the philanthropic or charitable foundation is determined and assets allocated to ensure the cash flow needed to support the sponsored project. The UBS team then provides an open platform where families meet social entrepreneurs. It is crucial that clients select a philanthropic cause that best matches their values and personal vision of the family legacy. Family philanthropy takes time, conviction and expertise if a unique vision of good will is to be created and maintained over generations. For more information on Family Philanthropy, please contact Jacob Bjorheim and Gabriele Roselius, UBS Family Business Group at firstname.lastname@example.org
Country-specific fund information on the internet ’Fund Gate’, the internet-based fund information platform of UBS, has been given a new look. At the same time, the site map has been revamped thoroughly and a number of new functions added. ’Fund Gate’ offered up till now access to the latest product information on all UBS investment funds on sale in Switzerland. In addition to this service, the new, improved site provides specific fund information for the following countries: Austria, Finland, France, Germany, Iceland, Luxembourg, Portugal, Spain and Sweden. The user can set the fund category, place of domicile and currency to obtain a detailed overview of UBS investment funds for sale in the country in question. www.ubs.com/funds
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UBS Art Banking: Combining art expertise with adding value
Marc Chagall: Femme coq au corsage rouge, sketch for L’apparition de la famille, ca. 1946, private collection, Germany
Last year, a successful businessman who traveled to Art Cologne – Germany’s most famous art fair – was intent on purchasing a major work. He thought of the surrealist Max Ernst, the grand master of abstraction Vasily Kandinsky, the poetic landscapes of Paul Klee, Alexei Jawlensky’s synthesis of Post-Impressionism and Russian folklore, the expressionist George Grosz or the mystic Marc Chagall – exponents of classical modern art who fascinated him.
In Cologne, he was met by Karl Schweizer, head of UBS Art Banking, and his colleague, art historian Silvia González. They had arrived in advance of their client so that they could research possible acquisitions on his behalf. After identifying eight works that might fit the bill, two were chosen for a specialist’s appraisal: a picture by Max Ernst and a miniature oil painting by Marc Chagall. On close inspection, the expert enlisted by UBS to examine the shortlisted works –
Rainer Budde of Cologne’s Wallraf-Richartz Museum – concluded that the Ernst picture was in poor condition. As a result, UBS’s client settled on a work entitled Femme coq au corsage rouge, thought to have been painted by Marc Chagall between 1948 and 1950. The original asking price for the piece was EUR 250,000; but on negotiation a final figure of EUR 205,000 was agreed. Although the gallery selling the work was able to provide expert authentication by the Paris-based Comité Marc Chagall, the supreme authority in these matters, and an unbroken provenance, the acquisition was made subject to certain conditions. As Silvia González explains, ’We advise our clients to verify all the details and check a work’s credentials with the specialist database known as the Art Loss Register to ensure that it has not been stolen or changed hands illegally.’ A new expertise by the Comité Marc Chagall, commissioned on the recommendation of UBS Art Banking, concluded on the basis of previously undiscovered sources that the picture in question must have been produced as early as 1946. In that year, the artist was working on the monumental canvas entitled L’apparition de la famille, which is now in the collection of the Centre Pompidou. The painting purchased by UBS’s client turned out to be a preliminary study for this major work. The re-evaluation may not have come cheap – the picture had to be transported to Paris and the expert report paid for – but it certainly proved worthwhile from the client’s point of view. Based on the new information which was unearthed and the significance of this knowledge in terms of art history, Femme coq au corsage rouge turned out to be more valuable than was first thought.
UBS Art Banking offers UBS private banking clients an exclusive range of services related to investing in art, including research and authentication (with the assistance of acknowledged experts), acting on behalf of clients in the acquisition and sale of works of art, assisting with the development and management of collections and offering advice on insurance matters. Art Banking also works together with the Financial Planning department to offer assistance on inheritance matters and issues relating to foundations. www.ubs.com/artbanking
10 | Corporate News · optimus 1/2003
Christoph Doswald is a freelance curator and art critic as well as a feature writer for the SonntagsZeitung, Zurich. He also acts as a consultant on corporate art projects.
Photo: Christoph Münstermann
UBS Art Banking services
Read more about the international art scene in optimus-online: www.ubs.com/optimus/art Visit the optimus art online section to access the following articles and for a comprehensive updated international art calendar with direct museum and gallery links The Aztecs: Art Basel Miami Beach – A ground-breaking exhibition ’A splendidly organized debut’ Aztec votive vessel with an image of Xilonen, c.1500. Fired clay and paint. Museo Nacional de Antropología, Mexico City.
The Aztecs at London’s Royal Academy explores the key themes of Aztec culture including the importance of the cosmos, the role of the gods, the issue of kingship, the culture of war and human sacrifice as part of the cycle of life and death, and the natural world. Dr Adrian Locke, a curator of the exhibition, fills in the historical background of this extraordinary pre-Columbian culture and describes some of the over 380 magnificent objects on display.
December 2002 saw the inauguration of this four-day art world marathon – sister of the prestigious Art Basel, also sponsored by UBS. The fair was an unqualified success and, in optimus art online, New York art journalist Judd Tully reports on some of the highlights.
Managing the environment The antiquities and art conservator Anna Bennett advises private collectors on the practicalities of looking after their works of art – from lighting and temperature control to the correct methods of dusting.
James Turrell: Artist of light and space James Turrell has been producing highly intellectual and technically sophisticated works of art since the 1960s. He deals predominantly with light and space and their interaction with one another. The London art critic Richard Cork discusses Turrell’s monumental workin-progress, the Roden Crater project, due to open in 2004, his current show at The Mattress Factory, Pittsburgh, Pennsylvannia, and his Thames Light Project for the South Bank in London. James Turrell, Hover, 1983. Fluorescent light and natural light mix, as installed at the Musée National d’Art Moderne, Paris. Collection of the artist.
International art calendar
The Aztecs, photo Michel Zabe; James Turrell, courtesy Michael Hue-Williams Fine Art Ltd. and the artist
Check our recommended exhibitions around the world – arranged under cities and subject matter and with links to the galleries and museums. Below are some examples of exhibitions to visit this spring: to 10.8.2003
Ingo Maurer Vitra Design Museum, Basel Light – Reaching for the Moon
26.3.–23.6.2003 Michelangelo The Louvre Drawings
Louvre Museum, Paris
27.3.–20.7.2003 Art Deco Victoria and Albert Museum, 1910–1939 London
James Turrell, Roden Crater
4.3.–8.6.2003 Manet/Velázquez Metropolitan Museum of Art, The French Taste for Spanish Painting New York 16.3.–29.6.2003 Egon Schiele
Museo d’Arte Moderna, Lugano
7.3.–10.3.2003 The Armory Show 2003 New York to 31.8.2003 Indian Times Museum der Weltkulturen, News from red North America Frankfurt to 31.5.2003
Chao Shao-an Gallery Hong Kong Heritage Museum, Thematic Exhibition – Landscape Painting Hong Kong
to 14.4.2003 José Jorge Oramas
Museo Nacional Centro de Arte Reina Sofia, Madrid
All articles and art listings include links to relevant websites. For this issue we suggest you look at the following: • James Turrell, Roden Crater www.rodencrater.org • James Turrell, current exhibition www.mattress.org • Aztecs exhibition www.aztecs.org.uk
Tate Modern, London
• Art Basel Miami Beach www.artbasel.com/miami_beach
20.3–20.7.2003 Mannerism in the art of Italian armour
Musée Rath, Geneva
• The Armory Show, New York www.thearmoryshow.com
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12 | Management 路 optimus 1/2003
Boom years for strategists
Photo left: Marcel Grubenmann, Photo right: DigitalVision
Over the last forty years, management theory has assumed an increasingly central role in real business activity, but with rather mixed results. Itâ€™s a situation that will have to change, because management knowledge is becoming a vital competitive factor
Successful management of global companies is a complicated process â€“ similar in complexity to building a satellite, with specialists working as a team to construct a hightech product. In satellite manufacture, highly developed management expertise is as crucial as technical knowledge; the organizational structures of the companies involved have to work smoothly together. Only when everything is running perfectly in sync can the satellite finally be launched into space. Photographer Marcel Grubenmann has captured the process on film. Based in Zurich, he works for international publications including Geo, Stern and The Sunday Times Magazine.
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In the 1960s and 1970s a philosophy of planning that had started off as a purely theoretical development found its way into company boardrooms. It was based on the assumption that businesses could be attuned to a predictable future and thus be certain of achieving
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their corporate objectives and, in particular, their earnings goals. This ‘goal model’ – which can be viewed as the first stage in the development of a strategic approach to management – aims to ensure that a company’s future performance meets expectations. It was the golden age of quantitative and qualitative forecasting techniques developed by market research institutions and internal corporate planning departments: the era of the Club of Rome, the Shell Studies, Scenario Writing and Trend Analysis; theories that required companies to identify the opportunities and threats they faced and then formulate objectives and visions. If there was a gap between the way things were and the way they ought to be, new projects and products – developed using modern creativity techniques – would be launched. The prevailing firm but naïve view was that goals could be defined and strategies deduced to attain the performance and target numbers that had been calculated. Yet despite intensive strategic planning aimed at gaining market share from competitors, instances of these techniques being applied successfully
were few and far between. Especially in industries where competition was particularly tough, rivals would engage in costly battles for market share, only for most to find themselves back more or less where they started. When competitors act in broadly the same way, sometimes even operating according to very similar theoretical constructions, ultimately the state of the market is unlikely to change very much. Remember the advertising wars that raged in the oil industry at the end of the 1960s, for example. Apart from giving us immortal phrases such as ‘put a tiger in your tank’, they had almost no lasting effect; and made little or no noticeable differ-
Photo left: GettyImages, Photo right: Marcel Grubenmann
usiness historians will look back on the 1990s as the decade of the internet bubble. But more than that, the period will be remembered as the era of virtually uncontrolled corporate stock option schemes that pushed management pay to dizzy heights – entirely, at least on the face of it, in the interests of shareholders. In the past, compensation based on shares or options has been justified by the ‘principal-agent theory’. This states that even as they press for ever greater power and expansion, top managers can still be controlled by shareholders if the interests of both parties are aligned. Owners/principals and managers/agents can co-exist harmoniously if managers become shareholders, standing to benefit from option programs if they achieve substantial increases in the value of their company. The theory long held sway in practice, but in recent times it has been sidelined increasingly by more sophisticated compensation models for senior executives (see also page 22). Companies have always striven to keep undesirable consequences under control, and are constantly endeavoring to use theoretical knowledge to get a grip on the imponderables of business life. One obvious reflection of this is the wealth of management theories that have found their way into corporate practice in the last few decades. Over the last forty years research into strategic management has become a major concern of company executives.
Technology management: in the Zurich research laboratories of Contraves Space, a laser system is used to test communication in space. When technology and communication work in perfect harmony, vast quantities of data can be transmitted back to Earth at the speed of light
ence to relative market shares within the sector. So it came as no surprise when this ‘goals model’ gave way at the end of the 1970s to the next generation of strategic thinking and the so-called ‘competition model’ of strategic management. The central premise now was that a company had to position itself in relation to its direct competitors. As competition theory took hold, managers became increasingly aware that market forces were at work in each individual industry, directly influencing the profits that each player could achieve. Only companies that managed to maneuver themselves into a perfect strategic po-
sition could hope to generate earnings that outstripped the industry average. What made things even more difficult was that many firms were involved in multiple areas of business and would sometimes operate in different sectors of the economy. In order to assess the future potential of this portfolio of business activities, theoretical tools were developed that could show at a glance how a company’s different operations were positioned and what their earnings opportunities were in different sectors. This development ushered in the age of the management consultant. Led by the Boston Consulting Group, a whole
raft of consultants, including M cKinsey, ADL and ATKearney, developed their own, mostly two-dimensional portfolio instruments. These were designed to evaluate a company’s business activities, assessing their attractiveness within the sector concerned and measuring the competitive strength of the business area in question. The goal was to produce a balanced portfolio composed on the one hand of high-growth, investment-intensive business areas for the future, and on the other of current ‘cash-cows’. If these newly developed competition models showed that a company had an unbalanced portfolio of businesses it was recommended that this imbalance be corrected by means of standard strategies; the consequence tended to be divestments and over-investment in future business activities. For example, shortly after taking the helm at General Electric, long-serving CEO Jack Welch ordered that GE must only pursue activities which gave it a chance of becoming or remaining number one or two in the industry concerned. In the wake of this strategic shift, hundreds of subsidiaries were closed or sold off. This approach brought success not only for GE but also for the German company Siemens AG, which applied both of these competition-oriented portfolio techniques – though not with the same
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However, the 1990s also brought a paradigm shift in strategic management. A new management philosophy took hold that could be described as the ‘development model’. The focus increasingly turned to the evolution of the company within an environment that is itself evolving. Strategy was seen in a more holistic light. Firstly, the company’s environment came to be perceived as extending beyond its own sector to embrace issues such as corporate governance and corporate responsibility, causing managers to consider their company’s place in society, and its ability to shape its global surroundings. Secondly, strategic management demanded that managers take simultaneous account of management philosophies, strategies, management structures and developments in the corporate environment. The goal now was to achieve a
16 | Management · optimus 1/2003
The 1970s were the golden age of ‘qualitative forecasting techniques harmonious fit between environment, structure and strategic action. Thirdly, reacting against a perceived failure of strategy in the past, the process of strategic development and implementation itself became a subject of study, and the political character of strategic management was pushed to the fore. Fourthly, more attention was paid to the ‘development dynamic’, i.e. the structuring of the process by which companies and their environments evolved in tandem with each other. In addition, corporate decision-makers increasingly focused on the particular requirements of global management. Indeed, it was thinking about international management that gave rise to holistic concepts of what the ideal ‘modern company’ should look like. The integrated network that the Harvard Business School postulates for transnational organizations competes
with European models of heterarchy – a strongly decentralized corporate form that emphasizes self-organization, internal market mechanisms and a vibrant corporate culture to bind the whole thing together. Since then, both the theoretical background and the tools used in the ‘development model’ have become more complex. The ‘Balanced Scorecard’ – an instrument widely used in the US for some time to plan, implement, communicate and control visions and strategies – is now also finding its way into Europe. The Balanced Scorecard combines qualitative learning activities with quantitative financial targets, hard facts with soft expectations, and shareholder with stakeholder value in a holistic, company-wide communications process. It also incorporates some of the familiar, tried-and-tested tools from the eras of the goal and competition models.
Photo left: DigitalVision, Photo right: Marcel Grubenmann
rigor. By contrast, many diversification strategies that took companies into ‘future’ business areas, in the hope that this would make them more resistant to crisis, proved less successful. Such problems fueled the criticism that this type of strategic management was focused almost exclusively on external parameters while internal capabilities and resources, i.e. a company’s acquired core competencies, were neglected. As the competition authorities adopted an increasingly liberal stance, the competition model led many companies to sell off divisions or take over other companies in a veritable orgy of mergers and acquisitions that reached its global apogee in the 1990s.
Team management: final assembly of a Metop satellite in Friedrichshafen, Germany; repairs in space (far left)
In a globalized economy with heterogeneous, rapidly changing operating conditions, hyper-competition and greater internal complexity within companies, knowledge – including management knowledge – is a competitive factor with an increasingly short shelf-life. This short review of the development of management studies shows that our knowledge of management techniques and strategic management has progressed by leaps and bounds over the last forty years. At the same time, the subject has become more complex, which means that communicating management knowledge has become more challenging. In the future, the efficient use of knowledge as a competitive factor will depend on a closer marriage of research and practice. There is a will on both sides to forge such a bond. Universities increasingly provide for practical projects, case studies, internships,
lectures by practitioners, and further education programs for managers. Industry is investing more resources in its own ‘corporate universities’, but also in centralized institutions like the Center for University Development funded by the Bertelsmann Foundation, or the European School of Management and Technology currently being created in Berlin. This closer interaction could produce a fourth generation of strategic thought that distinguishes between individual company types, allocating the appropriate planning philosophy to each one. As a result, companies could benefit from strategic concepts tailored to their specific needs rather than having to make do with off-thepeg solutions.
Michael Kutschker studied business administration and was a manager in the private sector for ten years. In 1989 he accepted the Chair in General Business Administration and International Management at the University of StuttgartHohenheim. Since 1993 he has taught the subject at the Catholic University in Eichstätt-Ingolstadt. He has written numerous books on international management. In 2002, he and Stefan Schmid published the standard German-language text on the subject, Internationales Management. Links on this topic: www.aom.pace.edu Website of the Academy of Management. Members can access key management journals online. Not just for academics. www.competence-site.de Competence Center on ’strategic management’ with literature on management problems and links to experts.
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Why going private can be an attractive option De-listings are not appropriate for all public companies, but may make strategic sense, particularly for those in some industrial sectors
ntil recently, the benefits of listing on a public stock exchange seemed clear and compelling. Public companies have access to a much wider and deeper pool of funding than their private counterparts. By going public, a company gains a degree of recognition that can have a positive, spill-over effect on its operating performance. Public status helps attract a broader pool of management talent. And although the obligation to produce regular reports and accounts may seem onerous, transparency and adherence to international reporting standards increases confidence in the company. Listed shares, moreover, are an acquisition currency – a passport to growth and expansion. But volatile equity markets have taken the shine off ‘going public’. Indeed, as equity valuations worldwide continue to disappoint, a growing number of managers and shareholders of publicly listed companies are beginning to examine other strategic options – among them, public-to-private (PTP) transactions, or de-listings, with or without the direct participation of a financial sponsor in the form of a private equity or leveraged buy-out (LBO) fund. Such a move is fraught with challenges. It typically means assuming a substantial burden of debt. It raises complex questions of communication management. In addition, it does not automatically guarantee higher returns for shareholders. Even so, a PTP transaction can be a valuable strategic option for companies in many industrial sectors. It can also lead to substantial returns for investors, whose exit routes, typically three to five years later, include trade sales to strategic investors operating in the same industry (the most popular option), secondary buyouts to other financial sponsors, and sometimes a return of the company to the public market via an initial public offering (IPO).
18 | Management · optimus 1/2003
Most recent European PTP activity – 52% of the total PTP market in 2001 – has been concentrated in manufacturing, real estate and building materials. It has been especially attractive to smaller companies with illiquid shares confronting low investor appetite and (in most cases) low market valuations. Moreover, although PTP transactions, with a value of $108 billion, accounted for just 0.8% of all global, public company transactions (valued at $13 trillion) between 1998 and 2002, their value has been slowly increasing, especially in Europe. The key question for a company considering a PTP transaction is whether the clear benefits of a public listing remain valid. Being publicly quoted allows greater scope to market the company, tap into liquid funding, and stimulate investor demand
Knowledge management: intricate production of an alignment mechanism at Contraves Space (left), designed for telecommunications satellites
through broker research, market analysts and credit ratings. On the other hand, the resources needed for investor relations (IR), reporting and other administrative and communication tasks may consume a substantial amount of management capacity – too substantial in some cases. A good PTP candidate typically boasts a strong management team that has historically delivered a solid financial performance, including healthy and steady cash flows. The capital market, however, may not have fully appreciated management’s achievements – especially if unattractive sector trends, limited coverage by equity research analysts (and hence limited news flow and share-trading activity) have hampered share price appreciation.
Private and institutional shareholders, in quest of liquid shares, tend to lose interest in such ‘orphan shares’, and this is reflected in below average trading multiples. A buy-out group may believe that the shares are currently undervalued. There may also be a small so-called free float (as a few shareholders control a large stake in the company.) There are, of course, many variations on these basic criteria. In February 2000, KKR, the US buyout specialists, made a £401 million ($648 million) PTP offer for Wassall, a UK-listed conglomerate. The company’s stock was suffering from a conglomerate discount, but its principal asset was Thorn Lighting Group (TLG), the second largest player in the European light-fittings market. The logic behind the deal was to create the leading player in that market by combining with the third-
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The financing structure of the deal, which will depend on the nature and assessment of the business, the availability of debt finance and the outcome of due diligence, which is usually conducted by the financial sponsors, is negotiated with the potential buy-out group. And once financing is secured, the buy-out group typically launches a tender offer to all public shareholders in order to gain majority control of the company. A PTP can also be conducted by way of a share buyback of the outstanding free float. In most jurisdictions there will be a certain level of control, which allows the ‘squeeze-out’ process
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The global PTP picture PTP transactions occur in a wide range of countries and industrial sectors. Of global transactions with an equity value of at least $100 million over the past four years, 62% of the transaction volume has been completed in the US. Nevertheless, the average transaction value is bigger in Europe. The UK, moreover, accounts for 60% of the European total. European PTP candidates are usually market leaders with established brand names – Friedrich Grohe, Sanitec and United Biscuits are prominent examples – hence the larger transaction volumes. The US market, however, is far more homogeneous, and the total number of listed companies in the US exceeds Europe by some 40%, leaving far greater scope for PTP opportunities. Because of the relatively limited funds available to financial sponsors, the AsiaPacific region is relatively underdeveloped for PTP transactions. Historically, Australia has been the only active country, and it is expected to retain its position.
and the subsequent formal delisting of the shares to be completed. In Europe, typically, it is 75% plus one share and reaches up to 98%. There are, to be sure, plenty of risks associated with this process – not least in the financing. The financing structure of the transaction will aim to maximize returns for all equity investors, a requirement that typically leaves the company with substantial
amounts of debt and a heavy interest burden. The burden of debt results in additional covenant requirements and strict control over cash flows to meet obligatory interest payments. Financial sponsors generally require a return on their investment of 20% to 35% per annum. Communication is another hazard. Communication will have to be carefully managed throughout the process,
Pages 18–19 Photo top: Marcel Grubenmann, Photo bottom: GettyImages
largest player, family-owned Zumtobel of Austria. At the same time as the PTP offer for Wassall, an unconditional agreement was also signed for Zumtobel to merge with TLG, post-bid. KKR and Zumtobel retained management control of TLG, and the Wassall board stepped down upon completion of the deal. Both lighting businesses have since operated as one entity, synergies have been reaped, and both companies’ respective market positions have been strengthened, with the potential for an IPO in several years’ time. If a company’s management team, having analyzed all strategic alternatives, concludes that a PTP transaction would be in the best interest of all stakeholders, it must then get to grips with the complex PTP process. A team consisting of various advisors – legal, tax, financial and IR among them – must be assembled. As management might also be involved in the financing, a special independent committee probably will also have to be set up in order to identify and avoid the natural conflicts of interest between management and shareholders.
Organizational management: interior view of a Metop satellite (left)
Photo left: GettyImages, photo right: Marcel Grubenmann
Christian Hess is a UBS Warburg executive director and the firm’s relationship director for a number of leading LBO firms. He successfully completed more than 20 private equity transactions throughout Europe, including PTPs.
in order to ensure and sustain shareholder support. Any rumors leaked to the market will jeopardize the deal. Legal issues may also arise from the dual role of management, acting as both buyers and sellers, and in negotiating a feasible financing structure. Managing conflict of interest is key if future liability claims from shareholders are to be avoided. Yet another critical factor is the premium offered over the share price in order to stimulate public shareholders to tender their shares. Plainly, a PTP transaction should never be undertaken lightly. A thorough case-by-case analysis is always absolutely necessary and other strate-
gic options may, in the end, turn out to be more advisable. Even so, for many companies, the advantages of such a move will outweigh the disadvantages – especially if it makes strategic sense for management to concentrate on the operating business, and if management also aims to implement a significant change in the strategic direction of the business. Indeed, if a company’s managers want the freedom to undertake a fundamental restructuring of business operations, and if access to or availability of the capital market is not yet really necessary, being privately owned may well be by far the most efficient option.
Marcel W Schmid is a managing director of UBS Warburg’s investment banking division and head of the equity advisory team in Zurich. He has been actively engaged in a number of equity offerings and M&A transactions. For further information about PTP transactions, visit www.cmbor.org, the website of the Centre for Management Buyout Research, or www.ventureeconomics.com, for global private equity news.
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Motivating managers by measuring performance
Paying managers on the basis of how much economic worth they have added to the company delivers superior value to shareholders
usinesses are supposed to be run to create value for their shareholders. But accepting value creation as the paramount corporate goal is only a starting point. Managers must also be able to measure their progress in creating value. And this requires mastery of basic valuation principles, as well as the performance measurement and incentive systems linked to these principles.
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The worth of any business is equal to the value of its shares plus the value of the debt held by its bankers and bondholders – the market value of all financial claims against it. But we cannot simply rely on stock options and other equity incentives to motivate managers to create value. In a rising market, stock options will reward all executives, regardless of whether or not they actually deserve it. Neither is the ultimate measure – share price – a substitute for proper performance measurement systems. Neither share price nor stock options provide adequate ‘line-of-sight’ – the term management consultants use to describe the extent to which managers can actually understand the performance measure they are subject to, and how they might be able to influence that measure by improving their individual performance.
We cannot simply rely on stock options ‘and other equity incentives to motivate managers to create value ’
Most managers below the level of CEO have little or no direct influence on share price. The managing director of a division comprising 10% of total revenue for a giant multinational traded on several stock exchanges might be responsible for hundreds of millions of dollars in turnover, and thousands of employees, but however well (or badly) he or she performs, their influence on share price remains minimal. Companies need better measures as indicators of performance. Specifically, they need measures that are linked to shareholder value, but which can be employed at business unit level and thus can provide line-of-sight to unit managers. Economic value added (EVA) and return on capital employed (ROCE) are the key elements in a modern system of performance measurement that does just that. The system originated in the United States, where some 90% of Fortune 1000 companies now make use of either EVA or ROCE, and often both. But EVA has also become increasingly popular among European companies, and in a wide range of industries. More and more companies in Europe and elsewhere have discovered that when managers are evaluated and paid on the basis of EVA (and to some extent ROCE), they are more likely to make the sort of operating and investing decisions that will deliver superior value to shareholders – essentially because such a system provides them with superior line-of-sight. According to Karl-Hermann Baumann, chairman
Production management: fairings, manufactured at Contraves Space (left); successful use on the Ariane 5 launcher to protect the satellites as they are transported into space (far left)
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of the supervisory board at Siemens, which adopted an EVA-based compensation system in 2001, ‘EVA creates a common language for everyone – the simple employee as well as the top manager.’
24 | Management · optimus 1/2003
it recognizes exactly how the capital markets value companies. All investors in the capital markets – bankers, bondholders and shareholders – commit cash to the companies they invest in, with the hope of getting cash back in the future. Thus, the value of any business is a function of capital market expectations regarding the firm’s ability to return cash to the capital markets in the future, discounted at the cost of capital. The more cash the company can generate in the future, based on investor beliefs, the more valuable the company is now. This simple idea suggests that firms should be managed with the aim of maximizing these cash flows. The
Management as a control function: the control room at the European Space Agency (ESA) in Darmstadt, Germany (right); satellite dish (above)
The mathematics of EVA EVA equals after-tax operating profit minus capital costs, with capital costs equal to capital employed multiplied by the weighted average cost of capital (WACC). When operating profit is divided by capital employed, the result is return on capital employed (ROCE). The difference between ROCE and WACC, multiplied by capital employed, equals EVA. EVA = (ROCE – WACC) x Capital Employed Assuming other variables remain constant, EVA increases when ROCE increases. Boosting asset efficiency, cost-cutting initiatives and structuring investments so that they require less capital can all increase ROCE – and thus EVA. Disposing of unprofitable businesses also increases EVA, provided that improvements in the spread between ROCE and WACC more than offset the reduction in capital employed. As long as the ROCE for the investment exceeds the WACC, investing is profitable and EVA increases.
Page 22–23 Photo left: ESA, photo right: Marcel Grubenmann
EVA is a measure of profit. Not the accounting profit we are accustomed to seeing in a corporate profit and loss statement, but profit as economists define it. Both are measured net of operating expenses; they differ only in the treatment of capital costs. While accountants (and, hence, income statements) recognize only explicit, out-ofpocket costs (such as the interest paid to bankers) EVA recognizes all capital costs, including the opportunity cost of shareholder funds. It is based on a century-old idea generated by the English economist Alfred Marshall: for investors to earn true economic profits, sales must be sufficient to cover all costs, including operating expenses (such as labor and materials) and capital charges. Such economic profits are the basis of value creation. It is easy to prove mathematically that the worth of any business must equal its capital employed (the sum of fixed assets, cash and working capital) plus the present (or discounted) value of future EVA. In other words, value determined in this way is mathematically equivalent to the idea that the worth of the firm equals the discounted value of future cash flows. The upshot: as capital market expectations of corporate EVA increase, so do share prices. Companies can thus use EVA targets to motivate managers to deliver the financial results that capital markets want. EVA is defined in terms of a mathematical formula (see sidebar). The secret of its success, however, is quite straightforward. EVA works because
Photo left: Prisma, photo right: Marcel Grubenmann
by equity participation, usually in the form of stock options. Although stock options provide poor line-of-sight for all but the very top managers, if structured properly – broad-based, and as part of a good system of corporate governance – they can still be the single most effective means of providing longterm wealth-creating incentives. Compensation may be a sensitive subject, but corporate boards must come to terms with it if they are to promote a strong, value-oriented culture in their companies. Declaring value creation to be the company’s top priority is never enough. Experience has shown that there is no substitute for managerial incentives – and no incentive is more powerful than pay.
arket, however, doesn’t just care m about cash flows in the short term; it also values streams of future cash flows. So the aim of the value-driven firm is not just to maximize cash flows in the short term. It is to maximize the present value of all future cash flows, not only in the coming year, but for all time. EVA bonus plans shouldn’t just motivate managers to think about current EVA. Managers need a direct economic stake in future EVA as well. In fact, in order for value creation to occur, managers need short-, medium- and longterm incentives. EVA stands at the center of a comprehensive, value-driven compensation system.
Short-term incentives are established through the use of annual EVA targets. Managers who meet or exceed these targets get higher bonuses than managers who don’t. Medium-term incentives can be formed from deferred compensation programs in which the portfolio of an EVA-linked bonus from the current year is kept in a ‘bonus bank,’ to be paid out in future years only if the manager achieves acceptable performance in those years. Such programs can force managers to think about what they can be doing now to increase their EVA in the medium run (say, three to five years). Long-term incentives, meanwhile, can be provided
S David Young is professor of accounting and control at INSEAD. He is the author of EVA and Value Based Management: A Practical Guide to Implementation and has advised several European and Asian companies on managing for value. For further information on value based management, visit www.fei.org, the website for the institute of financial executives, or www.cfo.com, the website of CFO Magazine and its sister publications, CFO Europe and CFO Asia, which run regular articles on the subject, as does the McKinsey quarterly publication, which can be accessed at www.mckinsey quarterly.com
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Fredmund Malik meets Mark R Hoenig:
Satisfied clients make sound business According to management specialist and bestselling author Fredmund Malik, managers must take their share of responsibility for the current economic crisis. For executive search consultant Mark R Hoenig, the bursting of the stock market bubble is to blame
optimus: Professor Malik, for you the current economic crisis is largely a management crisis. Why is that? Fredmund Malik: This conclusion is based on my day-to-day dealings with managers from a wide range of companies and sectors. In recent years, economic policies have been exceptionally auspicious as far as the business community is concerned, with low interest rates and an aggressive liberalization of key markets. And, in Europe, the common European currency, the euro, has been at an exchange rate that is favorable to exports. For this reason, I say that it is not economic policies that have failed but a large number of managers. optimus: Mr Hoenig, as an executive search consultant you recruit these managers. Do you agree with that assessment? Mark R Hoenig: The reason for the economic crisis is that the stock mar-
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ket bubble burst. There is no crisis of management, just a difficult economic climate in which fair-weather captains are getting into a spin. optimus: In your view, Mr Malik, has the quality of top managers declined? Malik: The main problem is that in Europe – and in Switzerland in particular – US management philosophies have been adopted unquestioningly. By that, I mean that corporate management has been reduced to little more than the grooming of key financial data, from which the formula for successful management – market capitalization – is then derived. However, shareholder and market value are purely money aggregates and it is a huge mistake to assume that there is a causal link between a company’s share price and its true potential.
Fredmund Malik Management specialist and bestselling author
Mark R Hoenig Executive search consultant
Fredmund Malik is a businessman, management consultant and academic. For more than 30 years he has devoted himself to the development of a practically based, scientific corporate management doctrine. He is Director of the St. Gallen Institute of Management which, with a staff of 150, enjoys an international reputation for management consultancy and training. Born in Austria, Malik was a visiting professor at the Vienna University of Economics and Business Administration until 1998 and is currently a titular professor at the University of St. Gallen. He is the author of numerous management bestsellers, including Führen – Leisten – Leben: Wirksames Management für eine neue Zeit (Leading – Achieving – Living: Effective Management for a New Era) and Die neue Corporate Governance (The New Corporate Governance).
Mark R Hoenig is a partner and Member of the Executive Committee of Egon Zehnder International. A PhD in Economics, Business and Public Administration, Hoenig worked for the Basel-based Sandoz Chemical Corporation in the US, Asia and Europe for several years before moving into consultancy. Egon Zehnder International is one of the world’s most prestigious executive search agencies. In 2001, Egon Zehnder International posted earnings of $296.4 million, placing it among the top three in its sector for the first time in its 38-year history. In 2002 the company generated income of $264.9 million – a result of the global economic downturn.
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Executive search consultant Mark R Hoenig recruits managers of the highest caliber …
Hoenig: The new aspect is that in Europe companies have focused more closely on the needs of the capital market. It’s not a US management system that’s been adopted, but a US approach to corporate financing which defines the value of a company as its central objective. The goal of every manager should be to maintain and indeed increase this value, not in the short term but in the long run. optimus: Often, however, the reverse has been true. Does this suggest that executive search consultants have gone for the wrong kind of manager? Hoenig: I don’t think you can say that. As in every profession, there are the good and the not-so-good examples. In a boom phase there may be those who climb the ladder too quickly, without acquiring the necessary depth of experience. When the economy is flourishing, demand for managers is particularly strong. optimus: Which gives the executive search business a boost … Hoenig: That’s only partly true. Executive search at the very highest level actually tends to fare better in a recession because the upper echelons of management are reshuffled more often. Malik: Personally, I think that a particular type of manager has come to the fore during the recent boom years whose main concern is the prestige and social status that comes with such a position. A good manager is not interested in personal glory, but the welfare of the company entrusted to him.
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optimus: Does this mean that things have gone awry in the selection of top managers? Malik: Some things have gone wrong, yes. For instance, the practice of bringing in large numbers of managers from outside a company. With very few exceptions, managers should be groomed from within a company. In this respect, the food and beverage conglomerate Nestlé and its former CEO Helmut Maucher – who himself had no time for personality cults – serve as a role model. Indeed, this remains the prevailing culture at the company even now. Hoenig: I agree with you in essence. There is much to be said for continuity of management in determining the success of a company. But there are always legitimate exceptions. Turnaround managers, for instance, should be brought in from outside when it is necessary to act quickly and without regard for existing structures, when losses need to be plugged or perhaps a company has to be saved from bankruptcy. Malik: That’s true. In general, however, bringing newcomers in to fill senior positions is a high-risk strategy. Where fresh blood is needed, it should be at middle management level. optimus: Whether they come from within the company or from the outside, managers of publicly listed com-
profit warning ‘inA timely itself is not a bad thing. It allows managers to correct any misplaced expectations on the
part of investors Mark R Hoenig
panies find themselves compelled to release quarterly and half-yearly reports and profit forecasts. Is this a sensible development? Hoenig: It really only means that top managers have to respond more effectively to investors’ demands for greater transparency. If their management approach is geared strictly to quarterly reports and thus short-term considerations, then of course that poses a problem. But a timely profit warning in itself is not a bad thing. It allows managers to correct any misplaced expectations on the part of investors. And managing expectations is one of the central functions of senior management. If
… who must have the courage of their convictions, according to management consultant Fredmund Malik
sarily produce shareholder value or be valuable in itself, but it must generate customer value and to do that it must be competitive. That is the benchmark by which management should be measured.
‘needs to make a
Obviously a company
profit, but not above all else
Photos: Hans Schürmann
management’s approach is not geared to remuneration based on short-term stock market value, but to the long term – which in the majority of cases it still is – then a requirement for quarterly reports can do no harm. Malik: A trend towards thinking in the short term originated in the US. The result was Wall Street’s sales machinery and droves of analysts who hold tremendous sway over the head offices of listed companies. This is an ominous development that will not cease until the stock market shrinks into insignificance. I would even go so far as to outlaw the publication of profit forecasts. They are completely unnecessary and
at best encourage false forecasts. Anyone thinking of investing in a company would be well advised to study the annual accounts rather than any forecasts. optimus: In your view, what makes for successful management? Malik: It’s very simple. There are six key indicators that tell you if a company is well run: market position, innovation, productivity, appeal to high-caliber staff, then – and only then – comes cash flow and liquidity, and last of all profit. Obviously a company needs to make a profit, but not above all else. Hoenig: Another factor to take into account is that in the past companies were run primarily by the CEO and the Executive Board. Today, not only investors but in particular supervisory bodies and the Board of Directors have far more influence. optimus: Suddenly everyone is talking about corporate governance. What does it really mean? Malik: I wouldn’t claim to be able to give you a definitive answer, but let me put it to you like this. The first question is: what makes a sound business? One that serves its shareholders? No. Of course shareholders are important and they must have certain rights, but the purpose of a company is to satisfy its clients. A company need not neces-
optimus: ‘Reputation management’ is the latest buzzword. What are your thoughts on that? Hoenig: Whatever it may mean, the main thing now is to restore public and stakeholder confidence in companies. If that’s what’s meant, then it might mark the first step towards renewed credibility. But without genuine performance based on integrity it’s futile. Malik: The idea of attempting to manage a reputation seems absurd to me. One can have a reputation, build it up over a long period of time and even lose it, in which case the only thing that a manager can do is stand down and hope that his successors will do better. What’s called for is not personal reputation management but an awareness of general human attributes such as integrity of character, a fundamental sense of decency and the self-confidence not to leap blindly on the bandwagon of every new trend that comes along.
René Lüchinger is an editor of optimus.
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Looking beyond the winter storms In early 2003, political risks loomed large, the global economy was worryingly weak and the world’s premier currency was under strong pressure. All this suggests that financial markets will remain volatile. Yet, beyond the winter storms there may be positive surprises: the economy will pick up speed in the second half of 2003 and corporate health will continue to improve
Active strategy for the euro ‘balanced’ portfolio: bonds
30 | Finance · optimus 1/2003
0% Overall $ £ SFR ¥ Em‘ging A$ mkts
Active strategy for the euro ‘balanced’ portfolio: equities
nternational flash points are a key concern for investors at the start of 2003. A US-led military campaign to bring about a regime change in Iraq is highly likely. While the military balance is clearly tilted in favor of the US, a swift resolution of the conflict cannot be taken for granted. A prolonged battle for Baghdad and regional turmoil beyond Iraq are the risk cases. Even if military action were to end soon, it remains to be seen whether a stable postSaddam regime could be established. In addition to the Middle East situation, tensions have been mounting on the Korean peninsula. Finally, the risk of terrorism has not been vanquished even
50% 40% 30% 20% 10% 0%
Overall $ £ SFR ¥ Em‘ging A$ mkts
January 2003: a neutral euro balanced portfolio is weighted 45% in bonds, 50% in equities and 5% in cash. In January, our equity allocation was the 50% benchmark
if an increasing number of arrests are being made. Despite all these risks, the geopolitical situation is in fact more stable than might appear. For all the current divergences of opinion over Iraq, the major countries should cooperate again on key security issues in the future. Barring the very unlikely use of weapons of mass destruction in either the Middle East or Korea, any conflicts will remain limited. Moreover, we may see some positive political impulses emerging in the next months, not least in Europe where efforts to reform the European Union by means of a constitution are gathering pace. The expansion of the EU to the east and the increasing mobility of capital in the west due to a common currency, are adding to the pressure to further liberalize the internal market. In Japan, pressure for reform is also continuing to build. We may even see positive political developments emerge in the Middle East itself if and when the Iraq conflict is resolved. Any positive political development will of course be supportive of business and consumer confidence. However, this in itself will not suffice to boost the economy and get it back onto a healthier growth path. The main drag continues to come from the after-effects of the collapsed investment boom of the late 1990s. Overcapacity in many areas of industry remains considerable and businesses are reluctant to boost spending while households in the major economies are struggling with high debt burdens and a weak labor market. Yet even in the economic sphere all is not bleak. US economic policy has reacted swiftly to the economic downturn. Interest rates have dropped to historic lows and a further fiscal stimulus package is in the pipeline. In Europe and Japan, central banks have been slower in reacting to the downturn. But the European Central Bank did finally lower interest rates at the end of 2002 and will likely do so again. The change in leadership at the Bank of Japan may also herald a
Growth and inflation forecasts (%) as at January 2003 Growth of GDP OECD1 US Canada Japan Euroland UK Switzerland Asia2 Latam Eastern Europe3
2001 0.7 0.3 1.5 -0.2 1.5 2.2 0.9 1.9 0.2 4.0
2002 1.6 2.3 2.8 -0.6 0.9 1.5 -0.3 4.5 -1.3 3.2
Inflation 2003 2.2 2.5 3.0 0.7 1.4 2.3 0.8 4.5 2.3 3.4
2001 3.5 2.8 2.5 -0.7 2.5 2.1 1.0 4.3 5.4 13.5
2002 2.1 1.5 2.2 -0.8 1.9 2.2 0.7 3.3 13.9 10.0
2003 1.9 1.9 2.5 -0.8 1.7 2.4 0.9 3.3 11.8 8.7
For inflation, excluding Turkey and Mexico 2Excluding Japan 3Including Russia
Interest rate and exchange rate forecasts (%) as at January 2003
US Canada Japan Euroland UK1 Switzerland 1
Short rates (3m) mid 2003 end 2003 1.3 2.0 2.7 3.5 0.1 0.1 2.6 3.0 4.0 4.0 0.8 1.3
Bond yields (10y) mid 2003 end 2003 4.3 4.8 5.2 5.4 1.2 1.3 4.5 4.5 4.6 4.6 2.7 2.9
$ exchange rate 12-month forecast – 1.52 110.00 1.08 1.59 1.34
more aggressive response to the ongoing deflation. Moreover, companies around the world have improved their financial health. Businesses are being restructured, debt is being reduced and costs are coming down. The foundations of recovery in the global investment cycle are thereby being laid. In the US, indicators of business spending have been stabilizing for some time, and investment, especially in the information technology area, will gradually increase. Europe is likely to follow suit. The principal challenge facing the global economy remains the imbalance in international capital flows and currency relationships. The US continues to drain capital from the rest of the world at a massive rate. The current account deficit is running at about 5% of GDP. To correct this, the dollar must decline. US consumption must abate, and exports must rise. But a weaker
dollar threatens the exports of other nations and thereby world trade. Domestic demand in Europe and elsewhere outside the US must increase if adjustment is to be successful. How fast this transition can occur remains in doubt. Some growth leadership can be expected from Asia ex-Japan, and from China in particular, as well as from eastern Europe. But both regions together still represent less than 15% of world GDP, so their role will be limited. Conclusion: The global economy will remain sluggish well into 2003, though economic policy actions and improving business spending suggest that further decline is unlikely.
Despite lingering political and economic storm clouds, we think that the most severe and protracted bear market in equities in the post-WWII era has
optimus 1/2003 · Finance | 31
Global return patterns in local currency
In the equity bear market, the flight from stocks benefited the highestquality bonds. These have now become too expensive, suggesting that return patterns will change markedly
30% 20% 10% 0 -10% -20% -30%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Return on global government bonds (JPM index)
Very shaky recovery in manufacturing
Return on global equities (MSCI World index)
The major economies are finding it hard to shake off the slump in their industries. After recovering somewhat, US industrial production has once again declined
130 125 120 115 110 105 100 95
1995 1996 1997 1998 1999 2000 2001 2002 Industrial production â€“ seasonally adjusted USA Index 1995 = 100 EMU
come to an end. Investors in equities and other risk assets will be better rewarded going forward, although large swings in asset prices may still occur and the size of returns is difficult to predict. Equally important, we believe that the relative returns amongst the major asset classes will differ substantially from past years (see upper chart), with high-quality bonds providing considerably lower returns than stocks. Equity valuations in the major markets are now at fair levels. Price-earnings ratios based on our 2003 earnings expectations range from 15 to 20. These levels should be sustainable in an environment of gradual economic recovery and low inflation, especially if political risks subside. Moreover, corporate earnings are clearly on a recovery path as low interest rates and other cost savings boost margins. Our return assumptions for equities average about 10% for 2003, although
32 | Finance Âˇ optimus 1/2003
given the volatility of returns, it may be better to assume a return range of 0% to 20%. US stocks will tend to perform better in the early stages of 2003 because the economic and earnings recovery there is more advanced. A weaker dollar will also benefit US stocks while tending to harm European and Asian stocks. Japanese stocks are no longer out of line in terms of valuation. But the weakening economy and policy confusion suggest the market will struggle. As the year proceeds, however, other markets should catch up and possibly surpass the US. Conclusion: Appropriate valuations coupled with an economic and earnings recovery suggest that the bear market in equities has ended.
In contrast to stocks, high-quality bonds are now overvalued. Last year saw huge gains in the highest-quality
segments of international bond markets. In real terms (i.e. minus expected inflation) bond yields are now unsustainably low, especially in the US. In contrast, corporate bonds generated a mediocre performance in 2002, and the high-yield segment suffered substantial setbacks until fall, above all in Europe. As corporate earnings recover and defaults subside, corporate bonds will gain ground. Higher yielding bonds in rating segments below A could have a very good year. With long-term interest rates in the US very unlikely to drop further, and possibly set to rise, returns amongst high-quality borrowers will now dwindle. Prospects for the lowerrated borrowers are better. The key to overall performance in the emerging market segment lies in Brazil. If policy reforms can be implemented and default is avoided, there is considerable upside. Conclusion: High-quality bonds will struggle in 2003, while corporate bonds and some emerging market bonds should post good returns.
Oliver Adler heads the Investment Strategy unit of Investment Research at UBS Wealth Management & Business Banking.
January 2003: Detailed asset allocation in UBS’s global balanced strategies (by base currency): a summary
2% Emerging Markets 3% Japan 5%
8% Rest of Europe
2% Emerging Markets 3% Japan
2% Emerging Markets 4%
8% Rest of Europe
4% $ 8% Rest of Europe
10.5% Euroland 39% $
10.5% US 44%
36% ¥ 26.5% US
26.5% Euroland 19% Japan
10.5% Euroland 40% £
Indicates a significant increase or decrease in weighting over the last quarter
2% Emerging Markets 3% Japan
2% Emerging Markets 3% Japan
2% Emerging Markets 3% Japan 9%
The charts show the asset allocation applied to a balanced investor (median risk) as at January 2003 in six main reference currencies. In late 2002 and early 2003, the following adjustments were made: the equity allocation was rebalanced to neutral as markets recovered from their October lows, while given the improving dynamics of US corporate earnings, US equity allocations were raised at the expense of European equities. However, given the continued outlook for a weak dollar,
7% Rest of Europe 7.5% Euroland
US assets, especially bonds, continue to be held underweight. The monthly update of the Asset Allocation is available on ‘optimusonline’, the internet service for readers of optimus. The address is www.ubs.com/optimus, which readers can access by using the password on page 8.
optimus 1/2003 · Finance | 33
A bolder, brighter board New legislation in the US and Europe should make failures of corporate oversight a thing of the past, writes Ram Charan
here is a clear correlation between corporate governance – how well a company is overseen – and the financial performance and health of the company. Whether or not it can be proved statistically, it is perfectly plain that the board greatly influences the creation (or destruction) of shareholder value – most importantly by selecting, guiding, and when necessary removing the CEO. A board can’t guarantee a company’s success, but by asking the right questions, probing the CEO’s underlying assumptions and providing him or her with a different perspective, a board can ensure clarity of thinking at the top. Boards that are well-informed, follow their natural curiosity, and debate the issues with management, actually help the CEO and thus the company to perform better. The evident failure of so many boards to provide corporate oversight has drawn plenty of scrutiny of late. There is no one explanation for this failure. Each case is, of course, different. But the most recent instances of the breakdown of corporate oversight reveal two specific weaknesses at board level: insufficient skill to detect a looming liquidity crisis and insufficient will to challenge and rein in a charismatic CEO. Corporate boards can be judged in terms of two time frames: short-term and long-term. In the short-term – two
34 | Finance · optimus 1/2003
to three years – a company’s financial health can deteriorate dramatically if the board fails to detect the early warning signs of a liquidity crisis (as happened at Enron and WorldCom). In the longer run, the board’s judgment in selecting and deselecting the CEO becomes critical. Plainly, a long history of successes and stubborn adherence to established methods can lull both management and board into complacency and blind them to reality. In the US, a decade ago, the very public failure of the boards of several big companies – GM, Xerox and Westinghouse among them – to prevent billions of dollars in market value disappearing down the drain prompted shareholder activists to demand better governance. As the Enron case has shown, directors turned a blind eye. Finally, however, attitudes seem to be changing. New US legislation in the form of the Sarbanes-Oxley Act, named for the two congressmen who sponsored it, coupled with revised guidelines from the New York Stock Exchange, will bring about more, long overdue improvements in corporate governance for all companies listed on US stock exchanges. Among them: the requirement that all members of the audit, compensation and nominating committees should be ‘independent’, and that all ‘non-management’ or outside directors
should meet periodically without the presence of the CEO. Significantly, in response to European lobbying, US regulators have agreed to exempt foreign companies listed in the US from some aspects of the Sarbanes-Oxley Act – specifically, those relating to the appointment of auditors and the composition of companies’ audit committees. German companies with US listings had lobbied particularly hard for these modifications, arguing that the audit rules were not compatible with German laws that require employee representatives to sit on company boards. US regulators have also agreed to allow the appointment of auditors by shareholders’ meetings as long as the recommendation to the shareholders comes from independent directors. This practice is common in Germany and Japan, and compulsory in Switzerland, for instance. Nor will audit committees be required to have board directors if the local law indicates otherwise, as in Japan and Italy. Since there are still plenty of ambiguities in the new US legislation, corporate lawyers will continue to debate its interpretation and a lengthy process of further clarification is likely. New guidelines from the European Union are expected to include those urging companies to disclose individual directors’ salaries and bonuses, and allowing shareholders to discuss or vote on how they are calculated. A new ‘corporate governance statement’, recommended for inclusion in all annual reports, should explain why the company believes its non-executive directors are independent from the company. These changes should help overcome the politeness problem that hampers too many boards. Directors are often reluctant to say something the CEO won’t like, or too concerned that theirs may be an isolated view. Most directors have the intuition to ask the right questions, but the protocol is to be polite – a major handicap to good governance, especially since at least one
An empowered and emboldened board ‘can help management identify problems and provide the reality check the chief executive needs
director usually suspects that trouble is brewing before it actually develops. Good governance of the sort that could make the oversight failures of the recent past a distant memory will require still more reform. Employees have the most to lose in any corporate debacle – their jobs, pensions and stock options. It is in employees’ self interest to be vigilant about top management. Employees can usually sense when something is wrong and they can provide a feedback mechanism that sends appropriate warning signals to the board. But too few companies have a mechanism that allows employees to act as watchdogs, rather than ex post facto witnesses. There should be a periodic survey, designed and administered by an outside agency, which solicits employee feedback on sensitive issues such as how much they trust management. Armed with the results, an empowered and emboldened board can help management identify problems before they happen and provide the reality check the CEO needs. The most important task for any board is selecting the right CEO, and this depends on proper due diligence in the first place. The board should not allow the outgoing CEO to become a dominant member of the selection process. He or she is bound to have
favorite candidates. The selection process, moreover, should begin at least two years in advance of the outgoing CEO’s retirement and should consume the time and attention of at least half a dozen board meetings – without the CEO being present. The selection task, furthermore, should never be delegated to headhunters; it is far too important. Directors themselves, meanwhile, can push reform by embracing the spirit of the new rules, and by changing the boardroom norms that inhibit capable directors from doing their job.
Ram Charan is a US-based management consultant, writer and educator, and an internationally renowned authority on corporate governance. His clients include Bank of America and General Electric. He is the author of Boards at Work and What the CEO Wants You to Know, is a frequent contributor to the Harvard Business Review, and a member of the National Association of Corporate Directors’ Blue Ribbon Commission on the role of the board in strategy.
optimus 1/2003 · Finance
Setting transparent performance standards Both private investors and asset managers have benefited from the introduction of this global code for marketing investment returns
nvestors today face unprecedented and often bewildering choices. Rapid industry growth and consolidation, coupled with the globalization of the investment process, have resulted in fierce competition for clients among asset management firms. Investment options and products to attract investors have proliferated. And investment managers have become increasingly aggressive in marketing their performance to better position their products. Performance standards are designed to help investors make sense of this plethora of products and sales pitches by standardizing the process of performance reporting. They are important to all investors because they aim to ensure full and fair disclosure of information and comparability between investment managers. Thanks to Global Investment Performance Standards (GIPS), the voluntary international code introduced in 1999 by the Association for Investment Management and Research (AIMR), the international body for investment professionals, and the
36 | Finance · optimus 1/2003
Investment Performance Council (IPC), private investors can now benefit from the rigorous standards more usually applied in the world of institutional fund management. GIPS allow the investing public to compare investment managers more easily. They do so by preventing managers from resorting to certain common practices designed to promote themselves. These include selecting beneficial periods of performance, including idle cash to boost returns when returns from invested assets are negative, and excluding accounts that depress overall returns. Moreover, by increasing comparability, GIPS help managers to compete more effectively in markets outside their own. Because GIPS benefit both sides, they have helped bridge the gap between the interests of investors and those of the investment management industry. GIPS arose in response to mounting market demand for more robust performance credentials. Thanks to a widely held belief that performance is a purely objective measure, the presentation of investment performance and
return history in a standard marketing presentation is frequently construed as ‘evidence’. But there are plenty of pitfalls in relying solely on investment performance to choose a manager or product. Calculating and presenting investment performance involves many subjective decisions. Moreover, its effectiveness in allowing investors to make investment choices will vary according to such factors as the degree of uniformity of investment decisions across investment managers and their impact on the performance presentation. GIPS not only allow investors to compare the results of one investment
Becoming GIPS compliant
Illustration: Mayo Bucher
UBS decided to implement GIPS for the management of its private clients portfolio on a global basis in early 2000. UBS Global Asset Management was certified fully compliant with Swiss Performance Presentation Standards (SPPS – a local version of GIPS) in the mutual fund business in early 2001, and Portfolio Management Switzerland received certification in July 2002. UBS is the first large, globally integrated financial institution in Switzerland to receive this certification in wealth management for private clients. Its performance presentation and underlying processes have been independently ranked ‘best market practice’. GIPS certification for 13 foreign portfolio management locations will follow soon. For information about GIPS compliance at UBS see www.ubs.com/optimus or contact Beat Moser, Investment Solutions, email@example.com
manager with another, or with an appropriately selected benchmark. They also serve to eliminate any confusion about methodologies and the quality of the information included in a presentation. GIPS compliance is divided among several categories. ‘Input data’ standardizes rules about supporting documentation. ‘Calculation methodology’ provides the basis for calculating both standardized account and composite returns – the primary reporting unit in GIPS. ‘Composite construction’ rules guide the manner in which accounts are grouped, and included in composites. (In order to prevent the
practice of ‘cherry picking’ the best performance results, managers must also composite all their discretionary, fee-paying accounts.) Rules on ‘disclosures and presentation and reporting’ provide the proper context in which to evaluate performance numbers, ensuring a full presentation of relevant information that is consistent amongst all managers. To become GIPS compliant, an investment management firm must meet all of the standards’ requirements. Uniformity would be compromised if firms were allowed partial compliance with the rules. Besides, the benefits to investment managers of full compliance are obvious. Indeed, GIPS compliance and certification have become a competitive marketing advantage. (Surveys reveal that three out of four consultants inquire about GIPS compliance and nearly half require compliance statements by an independent third party in their request for proposals.) When performance matters – and it plainly does – it is in everyone’s interests to know that managers adhere to the highest standards of transparency and quality in performance reporting.
Arthur Liao, CFA, is a senior manager in Ernst & Young’s Investment Per formance Services Group.
Matt Forstenhausler is a partner with Ernst & Young in New York and Global Director of Performance Measurement. As a member of the AIMR verification subcommittee, he helped design the GIPS verification process. For further information about SPPS and GIPS, visit www.swissbanking.org, the Swiss banking webpage, www.aimr.org, the AIMR homepage, and www.ubs.com/optimus
optimus 1/2003 · Finance
Pearls of wisdom Learning to identify the hallmarks of a pearl helps to avoid the troubled waters of a poor-quality gem
lizabeth Taylor owns one of the world’s great natural pearls, La Peregrina, which was a present from Richard Burton. I arranged to photograph her wearing it in 1987 to illustrate an article I was writing for the National Geographic and we agreed to do the shots one evening in her Bel Air, California home. As usual, Elizabeth was late, but gorgeous. After the pictures, we shared some wine surrounded by her fabulous collection of Impressionist paintings. I asked her if I could look at the necklace with the 11/4 inch (3cm) La Peregrina and was surprised to see scratches on the pearl’s rear. She explained that one evening, while still married to Burton, she missed the necklace and looked all over the house without locating it. Then she noticed her dog acting strangely and discovered he was nibbling the historic pearl. From then on she kept dog and pearl distinctly separated. Pearls, today’s best selling gems, have been popular since the dawn of human history. But never before have pearls been so affordable and available in such a wide variety. Knowing the hallmarks of pearl quality will prepare you to choose wisely and to avoid the troubled waters of short-culturing, which produces a poor-quality gem because the pearl has thin nacre, the coating an oyster pro duces to cover
38 | Private Agenda · optimus 1/2003
the bead. Size, color, shape, luster, and surface determine the quality and value of a pearl. Prices of large pearls with attractive uniform color, shape and bright lustrous unblemished surfaces reflect both rarity and beauty. It is likely that natural pearls – those formed without human assistance – were the first items we now call gems to be collected for personal decoration. In Egyptian tombs alongside gold, emeralds, and lapis, Persian Gulf pearls helped escort departed pharaohs to their next life. Employing a pair of large pearl earrings, Cleopatra conceived a costly seduction and devious plan to impress Marc Anthony sufficiently to
A buying frenzy in the early 1900s reached an unfathomable peak when a wealthy New York City matron traded her fashionable Fifth Avenue townhouse to a new French company, Cartier, for a single strand of pearls. Still the rarest and costliest pearl statement, matched naturals remain the elite purview of the most discriminating collectors, including our modern-day Cleopatra, Elizabeth Taylor, with her regal natural La Peregrina – even if it now sports a dog’s tooth mark. A hundred years ago, Koichi Mikimoto and two other Japanese ama teur scientists simultaneously discovered how to induce pearl growth. Since then,
Pearls, today’s best selling gems, have been ‘popular since the dawn of human history. But never before have pearls been so desirable
leave her country intact. Although we usually hear about the gold and silver sent from the New World, most likely Spain shipped more pearls by weight than precious metals.
the vast majority of pearls have been cultured. Depending on your taste, you can now choose from four important divisions of the cultured pearl world: Japanese akoya pearls (akoya); South Sea
All photos © Fred Ward
The allure and rarity of natural Persian Gulf pearls keeps them as the most expensive and desirable of all pearls. This fabulous selection in Qatar was collected before 1960, which marked the end of commercial diving in the Gulf
Pearls; black and gray Tahitian pearls; and freshwater pearls, mainly from China but increasingly from the USA, Japan, and a few other countries. After buying out his two competitors, Koichi Mikimoto, a former noodle salesman, promoted akoya pearls to the rich and famous. The first secret of culturing was to place a small sphere inside the oyster’s body. Mikimoto found that spheres made from American freshwater mussel shells worked best. The second step was to insert a small bit of live oyster mantle tissue beside the shell bead nucleus to prime the production of a pearl sac which then produced nacre to coat the bead. Together those two procedures cause
oysters to create cultured pearls with luscious nacre in about six years. Akoya at their best were lustrous white with subtle color overtones called ‘orient’. But because of pollution, ecological stresses, and poor farm management in Japan, akoya pearl farmers have had increasing difficulty growing good pearls larger than 8.5mm. In the last six years akoya production has plummeted from 60 tons a year to 25. The 9.5 to 10mm akoya, which once commanded top prices, are almost gone. Today you can buy quite a nice 8mm akoya strand for $2,000 to $5,000, but be aware that almost surely the pearls have been bleached and dyed and short-
cultured. Relatively thin nacre, less than the desired 0.40mm, means a pearl may quickly wear through to its shell bead nucleus. If you choose akoya, you may want to engage a quality jeweler to help you determine if the nacre is thick enough to last. As Japan continues to suffer from pollution, many other countries, most notably those in the South Seas, have made great strides in techniques, sanitation, antibiotics, and harvesting pearls. Dotting the South Pacific, farms with clean, nutrient-rich water are making more and better quality pearls. Thick nacre is standard on most black, white, yellow, and golden South Sea pearls.
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The world’s most expensive cultured pearls are from the South Sea, farmed primarily in Australia, the Philippines and Indonesia. It takes a mussel the size of a salad plate to create these 8 to 20plus mm beauties. Million-dollar South Sea Pearl strands in white, cream, yellow, gold, icy gray, or pink take years to match. But for drama and size, nothing surpasses black Tahitian pearls. These
pearls are less expensive and not as wellknown as their white South Sea counterparts; and, in reality, not all pearls from black-lipped oysters are grown in Tahiti. Their drama comes from their color, which is really not a pure black, but more of a dark base with iridescent peacock highlights of silver, green, pink, and golden brown. A huge portion of the South Pacific and North Pacific Oceans can sustain black
pearl culturing. Because initially they were cultured in the Society Islands, where Tahiti is the main island, almost everyone calls such pearls ‘Tahitians’, even when they are grown elsewhere. The highest known price paid at auction for a single black strand was more than $800,000. The recent Japanese and US recessions have depressed the market, so great strands may now cost only one or two hundred thousand dollars. The range
A cornucopia of natural pearls Ward: Of all the world’s gems, what is it about natural pearls that you find so fascinating? Alfardan: Their history and their unrivaled beauty. They are perfect – for owning, for wearing, and as an investment. I cannot imagine a more beautiful or satisfying gem. From early times the pearl has been a symbol of unblemished perfection. Ward: Do you consider yourself to be a pearl collector or a dealer? Alfardan: Both. I am a tenth-generation dealer. Pearls are in my blood. An old Arabic legend romantically explains that pearls formed when moonlight-filled dew drops descended from the sky into the oceans and were swallowed by oysters. When I need time to think or to relax, I take out some pearls. Because of my passion for pearls I established my jewelry business, and today I have 12 jewelry stores located in Qatar and Saudi Arabia. Ward: Why are natural pearls so much more valuable than cultured pearls? Alfardan: Rarity is the main reason. There has been no real Persian Gulf harvest since the 1950s. This is due primarily to the creation of the cultured pearl, which had catastrophic effects on natural pearls; the devastating consequences of World War II; and after India gained independence from Britain, the introduction of legislation imposing import restrictions on all luxury goods. This had an enormous impact on the natural pearl because India was one of its most important markets. In India natural
40 | Private Agenda · optimus 1/2003
good investment? Alfardan: Absolutely. In the past 10 to 15 years they increased in value six times. What else can you cherish that increases like that in value?
Hussain E Alfardan is a Qatar-based businessman and the most important pearl collector in the world
pearls were considered the perfect wedding gift and often formed part of the marriage ceremony. Natural pearls were further affected by the discovery of oil. Employment in the oil fields became a more attractive proposition, and pearl diving virtually ceased. However, although the majority of my pearls were harvested at least 60 years ago and many are hundreds of years old, I also have a number of new natural pearls in my collection. Ward: Do you consider natural pearls a
Ward: What should pearl investors look for? Alfardan: Only natural pearl prices are increasing at these rates. Natural pearls are limited. Cultured pearls can be made on demand and in almost any volume. So, for investment, look to natural pearls. Then look for the traditional measures of quality – size, shape, color, surface, luster. This five-strand necklace costs more than $2 million whereas this seven-strand necklace is only $181,000. Both necklaces have old Persian Gulf naturals. But the more expensive one has great matched pearls, all round, all with wonderful luster, and all with the same color. To put together such necklaces takes years. Indeed, the Latin word for pearl means ‘unique’, meaning that no two natural pearls are identical. Ward: Of all the world’s gems, you have an obvious preference. Alfardan: I do. Natural pearls are historic relics because they are so limited. One can always buy diamonds because they are plentiful. But a natural pearl is a gift from the sea, an unbelievably beautiful treasure.
Creating freshwater pearls
Chinese round freshwater pearls are still nucleated with pieces of mantle tissue placed directly into a mussel’s mantle to initiate nacre production
for good to fine quality Tahitian necklaces is more often $10,000 to $50,000. Now is a great time to buy. Currently there are more Tahitian pearls than there are buyers, creating what no market ever wants: a surplus. The Tahitian government has stepped into this financial crisis by decreeing that there will be no export licenses for low-quality pearls. They aim to reduce the current oversupply while raising the overall quality of Tahiti’s exported goods. While Tahitian pearls may strive for quality, the Chinese are going for quantity. During the same time that akoya production tumbled, Chinese freshwater pearl crops soared from 600 tons a year to 1300. After a stumbling start in the 1970s, the upstart culture king China now dominates the volume market. Chinese freshwater pearls account for more than 80% of all pearls sold worldwide. About four years ago fabulous 14mm round colorful and lustrous Chinese freshwater pearls debuted, thrilling buyers who were used to seeing an offround variety for under $500. Here were gems the size, shape, and luster of South
Sea pearls selling for $6,000 to $10,000 a strand – a fraction of the cost of a South Pacific necklace. Although the trade anticipated this spectacular innovation in ever-larger sizes, such first-rate strands have just as suddenly become inexplicably rare. Instead of shell-bead nucleating, the Chinese almost always culture freshwater pearls with pieces of mantle tissue from living mussels. Thus, most freshwater pearls are all nacre. Except for rare and expensive naturals and some ‘keshi’, an all-nacre byproduct of the culturing process, no saltwater pearls are pure nacre. Buyers should take note of durability as a great advantage of solid Chinese freshwater pearls. Whether you choose a long-lasting all-nacre freshwater pearl, a thick-nacrecoated large dark gray or black Tahitian or huge creamy white Australian South Sea pearl, or a thin-nacre-coated shellbead nucleated saltwater akoya, this is a great time for pearl lovers.
Most freshwater pearl cultivation differs substantially from pearl growth in saltwater conditions where nucleation almost always begins by inserting round shell beads inside oysters. Freshwater pearls grow in mussels, not oysters, which are usually large, dark, and oval-shaped. The mussels used for pearls have relatively small bodies but two big thin mantles that cover the entire inside length of the shells. The main mission of this covering is to secrete nacre to build the mussel’s shell. In the growth of saltwater pearls, a small piece of oyster mantle tissue initiates nacre production, which coats the shell bead to form a cultured pearl. With freshwater pearls, small pieces of live mussel tissue are placed in the mantles covering the inside of the shells, inducing the creation of nacre that will become pearls. Up to 30 or more pearls can be made per shell. The cultivation of saltwater pearls starts with a shell bead that is coated with nacre whereas that of freshwater pearls begins with live slices of mantle tissue. Starting nacre production without shell beads means that traditionally cultured freshwater pearls are all nacre. This difference has been blurred by recent Chinese innovations. To acquire larger, rounder pearls faster, some freshwater pearls are being nucleated using saltwater techniques.
Fred Ward is a noted American pearl specialist who has written for National Geographic and authored several books on the topic.
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Photo: Marcel Grubenmann