J. Christopher Flowers: Corzine's Kingmaker
Midway through 2008, when J. Christopher Flowers agreed to invest up to $300 million in MF Global (OTC: MFGLQ), the private equity magnate looked like the company's savior. But even though the money was desperately needed at the time, it would bring with it a new, and ultimately disastrous, chapter in MF Global's history.
In early 2008, MF Global broker Evan Dooley found his way around the company's trading limit controls and managed to lose $141.5 million trading the wheat market. The episode was a blow to the market's confidence in MF Global just as the company was scrambling to refinance a $1.4 billion bridge loan that it took out in conjunction with its initial public offering.
To deal with the bridge loan, MF Global needed capital, but it also needed to regain the market's confidence. At the time that Flowers invested, MF Global was leveraged at 39-to-1 -- as compared to 24-to-1 at Lehman Brothers prior to its bankruptcy -- with nearly $19 billion of its financing coming through repurchase agreements, a type of short-term borrowing that financial companies use. More than $8 billion of those repos could be pulled in 24 hours or less. For most publicly traded companies, market confidence is a nice luxury; for MF Global, it was a must for survival.
Luckily for MF Global, Chris Flowers brought both money and market confidence. Flowers, through the J.C. Flowers II investment fund, agreed to invest a minimum of $150 million -- and up to $300 million -- in MF Global via convertible preferred shares that paid an annual 6% dividend.
And though he may not have quite the brand equity of Warren Buffett or George Soros, to many on Wall Street an investment from Flowers is a very big deal. In fact, Flowers is so respected in the financial world that in 2008 he was called on to be a key player in sorting out the industry in the very depths of the meltdown, including acting as banker during Bank of America's (NYS: BAC) ill-fated acquisition of Merrill Lynch. Even here at The Motley Fool, insurer Enstar Group (NAS: ESGR) remains a recommendation of the Global Gains newsletter, largely due to the presence of J.C. Flowers' ownership stake and the deal-making prowess of Chris Flowers.
The confidence boost from the Flowers investment appeared to pay off quickly for MF Global, as the company was able to secure further funding a month later, including a $450 million financing commitment from a bank syndicate.
As good as the Flowers investment was for MF Global, though, the timing and nature of the investment was also great for Flowers. Rather than waging a rancorous proxy campaign to gain a board presence -- a tactic of many hedge fund managers that often puts them at odds with the board -- Flowers was a welcomed outside investor and a well-respected name in the world of finance. That made it far more likely that strategy and hiring recommendations from Chris Flowers and the J.C. Flowers-appointed board member, David Schamis, would find very receptive ears on the MF Global board.
Crisis brings change
Changes happened quickly following the J.C. Flowers investment. In early June, the former CEO of the Chicago Board of Trade, Bernard Dan, was brought in as the chief operating officer of North America to help whip the company back into shape.
Dan was quickly promoted to global COO and then, just four months after joining the company, he was named CEO. It was a relief for many investors, as they'd been clamoring for CEO Kevin Davis to leave. In the short time that the company had been trading on public markets, investors had seen the stock clobbered in large part due to sloppy internal controls under Davis' watch. One particularly blunt shareholder said, "I think Davis should be taken out and shot." The market provided its stamp of approval by sending MF Global's stock skyrocketing 45% following the announcement.
The environment wasn't kind to MF Global, but Dan appeared to be taking reasonable steps to expand the company's business, while simultaneously cutting back unprofitable areas and continuing to tighten controls. Early efforts had the company shutting down its Western Canada operations, applying for primary dealer status, and expanding its operations in Japan in an effort to gain a stronger foothold in Asia. During the summer and fall of 2009, the company went on a hiring spree, bringing in a small army of new executives including the positions of general counsel, head of European government bond trading, head of repo sales, chief economist, global head of fixed income, and COO of North America.
Meanwhile... a golden boy is tarnished
If you were looking for the quintessential Wall Street banker, you couldn't do much better than J. Christopher Flowers. A Harvard graduate and chess whiz, Flowers, with his eggish head, thinning hair, and glasses, fit the finance-wonk caricature to a T.
But it was Flowers' razor-sharp intellect and comfort with the complex numbers involved in financial-institution deal making that made him a standout banker at Goldman Sachs. His rise through the ranks of the then-private partnership was nothing less than meteoric; he was named a partner at 31 -- the youngest ever at the time.
Internal politics helped cut Flowers' career short at Goldman, but there were plenty of opportunities available to a former Goldman Sachs superstar. His first major splash out of Goldman would prove to be a career-making deal as he elbowed his way through the inhospitable Japanese bureaucracy to secure a role in the rescue of Long-Term Credit Bank (now Shinsei). Flowers finagled a sweetheart arrangement that relied heavily on Japanese government guarantees and allowed the company to reintroduce itself to the public markets. Private-equity leading light David Rubenstein of Carlyle hailed the transaction as "the most profitable private-equity deal of all time." Flowers reportedly walked away with $1 billion.
From there, he bucked the tough times of 2002 and raised $900 million for the first fund under the J.C. Flowers & Co. shingle. With Flowers still very much riding on his reputation at Goldman and the grand-slam Shinsei deal, the second J.C. Flowers fund closed in 2006 after raising an impressive $7 billion. In 2006, the 48-year-old nabbed a spot on the Forbes 400 list with an estimated net worth of $1.2 billion.
Flowers was off to the races investing the $7 billion in capital from J.C. Flowers II. The fund made major commitments to Dutch bank NIBC Holdings, Germany's HSH Nordbank and Hypo Real Estate, and the now-public equity of Shinsei Bank. Even though Flowers was making many of these investments in the face of a fearsome global financial meltdown, his confidence in himself and his ability to deliver for his investors was unwavering. In June of 2008 -- following the JPMorgan Chase (NYS: JPM) rescue of Bear Stearns, the Bank of America bailout of Countrywide Financial, and Britain's nationalization of Northern Rock -- Flowers told investors in the J.C. Flowers II fund that they were looking at "the Super Bowl of investment" and that it was "no time to be sitting in the bleachers." He maintained that "every single investment will make money," proclaiming the eventual internal rate of return, or IRR -- a measure of annualized returns -- of the fund would be 23%.
But the wheels were already starting to come off.
While investors waited for Flowers to produce some more of his Shinsei magic, many of J.C. Flowers II's major investments were floundering. HSH Nordbank sustained massive losses and eventually had to take a government bailout. The trusts that held J.C. Flowers' stake in HSH declared bankruptcy in early 2010. The German government was likewise forced to rescue Hypo Real Estate as it turned into an even bigger disaster. Germany's Special Financial Market Stabilization Funds (Sonderfonds Finanzmarktstabilisierung, or SoFFin) stepped in with a hefty bailout that paved the way for a full nationalization of Hypo, forcing Flowers to sell the fund's stake at a fire-sale price.
Flowers narrowly missed scoring a big win with NIBC when Iceland's Kaupthing Bank pulled out of a proposed deal to buy the bank for $4.4 billion in early 2008. The bank eked out a profit in 2010, but its pre-tax income was less than a third of what it was in 2005. Meanwhile, Shinsei, which in many ways made Flowers' career, only exacerbated the fund's problems as its share price cratered.
As if that wasn't enough, Flowers' reputation as a banker was called into question as well. Bank of America absorbed gargantuan losses thanks to its acquisition of Merrill Lynch. When the deal was struck, B of A's CEO at the time, Ken Lewis, praised Flowers' work on the deal, emphasizing that Flowers' team did "very, very extensive" due diligence.
In its 2009 letter to shareholders, Enstar Group, a J.C. Flowers portfolio company and an investor in the J.C. Flowers funds, disclosed that it had written off $61.6 million of the $96.9 million that it had committed to J.C. Flowers II due to the fund's poor performance. According to the most recent data from Preqin, a leading source of data on alternative-asset managers, the IRR for J.C. Flowers II has been -29% versus 6% for other funds in its benchmark group.
Those disastrous returns put Flowers' first big fund in the fourth quartile of its benchmark group, a place where asset manager careers go to die.
MF Global continues to limp
By early 2010, it was clear that more change was needed at MF Global. To be sure, in some ways, the company was moving in the right direction. The new people and tighter compliance that Bernie Dan brought in kept the company out of the news without any repeats of the Dooley fiasco. However, the bottom line showed that the broker was still far from healthy. In March 2010 the company reported an $89 million net loss -- its fifth straight quarterly loss.
It appeared that expansion was no longer enough for the broker to prosper. Commissions had been under pressure for years. The Federal Reserve's efforts to pull the economy out of its tailspin meant unheard-of lows in interest rates, which helped crunch what the company could earn on brokerage deposits. And at CME (NYS: CME) , where MF Global did much of its trading, average daily volume slipped 20% between 2008 and 2009 while the total notional value traded on its exchanges plunged by a third.
Meanwhile, it was increasingly looking like Flowers would have to pull a rabbit out of his hat to salvage J.C. Flowers II and his reputation. And it was all unraveling as Flowers was attempting to raise another $7 billion for J.C. Flowers III.
Aside from solidifying the suspicion that Chris Flowers was a one-hit wonder who got lucky with Shinsei, a fizzling-out brokerage firm certainly wasn't going to be of any help. On the other hand, the turnaround of a revered name in the brokerage business might help Flowers reclaim his mojo. Or, perhaps even better, he could find a way to set a turnaround in motion that would transform the broker into something much larger -- and much more profitable.
Flowers reaches out to a friend
Except to the extent that a floundering economy soured New Jersey voters, the fact that Jon Corzine lost his first gubernatorial reelection bid right at the same time that MF Global was desperately in need of a new direction was largely coincidence. The fact that Flowers reached out to Corzine to provide that new direction is, however, no coincidence.
The two finance titans had a relationship stretching back to Goldman Sachs, when Flowers was the star financial institution's banker and Corzine was the firm's chairman. Flowers played Corzine's right-hand man in the chairman's crusade to take the company public -- a push that was eventually successful, but cost both men their jobs. After Goldman, they remained friends: Corzine tapped Flowers to manage some of his fortune while he was in politics, and the duo rubbed elbows as fellow board members for the New York Philharmonic.
According to reports at the time, it took just seven days from the time that Flowers first reached out to Corzine about the job for his pal to sign on the dotted line, agreeing to step into the CEO and chairman roles at the broker. MF Global gave Corzine $1.5 million in salary, a $1.5 million signing bonus, and a $3 million target bonus for his first year. Showing just how much faith Flowers had in his former boss, he also made Corzine an operating partner at J.C. Flowers and gave him a 3.5% carried interest in J.C. Flowers III -- a significant share of the investment profits that the private equity fund was entitled to. The latter arrangement had the potential to be far more lucrative for Corzine than his pay from MF Global.
And, with that, Bernie Dan became part of MF Global's history with little more than a mention that he was resigning from MF Global "for personal reasons."
But there was no time for a teary farewell for Dan -- this was an exciting time for MF Global. It now not only had a Wall Street superstar standing behind the company, it had a Wall Street superstar -- perhaps of even greater proportions -- calling the shots internally. And soon after Corzine's joining, MF Global also got a shiny new turbocharged strategy to target big profits.
Though Corzine was unable to win the votes of the citizens of New Jersey, the stock market voters came out in his favor, boosting MF Global's stock 10% the day after the hiring announcement. The stock continued to rise soon after, tacking on 27% over the next month. It was a show of blind faith in a leader who had been out of finance for more than a decade and had no track record of success in a turnaround effort. It was a show of faith that would ultimately prove dead wrong.
In the next chapter, we explain why Jon Corzine was the wrong man for the MF Global job. Click here to read all about it.
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