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The ABC of investment banking

Source: Wikipedia
An investment bank is a financial institution that assists individuals, corporations and governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities. An investment bank may also assist companies involved in mergers and acquisitions, and provides ancillary services such as market making, trading of derivatives, fixed income instruments, foreign exchange, commodities, and equity securities.
Unlike commercial banks and retail banks, investment banks do not take deposits. From 1933 (Glass-Steagall Act) until 1999 (Gramm–Leach–Bliley Act), the United States maintained a separation between investment banking and commercial banks. Other industrialized countries, including G8 countries, have historically not maintained such a separation.
There are two main lines of business in investment banking. Trading securities for cash or for other securities (i.e., facilitating transactions, market-making), or the promotion of securities (i.e., underwriting, research, etc.) is the "sell side", while dealing with pension funds, mutual funds, hedge funds, and the investing public (who consume the products and services of the sell-side in order to maximize their return on investment) constitutes the "buy side". Many firms have buy and sell side components.
An investment bank can also be split into private and public functions with a Chinese wall which separates the two to prevent information from crossing. The private areas of the bank deal with private insider information that may not be publicly disclosed, while the public areas such as stock analysis deal with public information.
An advisor who provides investment banking services in the United States must be a licensed broker-dealer and subject to Securities & Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) regulation.[1]

Organizational structure

Main activities

An investment bank is split into the so-called front office, middle office, and back office. While large service investment banks offer all of the lines of businesses, both sell side and buy side, smaller ones sell side investment firms such as boutique investment banks and small broker-dealers focus on investment banking and sales/trading/research, respectively.
Investment banks offer services to both corporations issuing securities and investors buying securities. For corporations, investment bankers offer information on when and how to place their to an investment bank's reputation, and hence loss of business. Therefore, investment bankers play a very important role in issuing new security offerings.

Core investment banking activities

Front office

  • Investment banking (corporate finance) is the traditional aspect of investment banks which also involves helping customers raise funds in capital markets and giving advice on mergers and acquisitions (M&A). This may involve subscribing investors to a security issuance, coordinating with bidders, or negotiating with a merger target. Another term for the investment banking division is corporate finance, and its advisory group is often termed mergers and acquisitions. A pitch book of financial information is generated to market the bank to a potential M&A client; if the pitch is successful, the bank arranges the deal for the client. The investment banking division (IBD) is generally divided into industry coverage and product coverage groups. Industry coverage groups focus on a specific industry, such as healthcare, industrials, or technology, and maintain relationships with corporations within the industry to bring in business for a bank. Product coverage groups focus on financial products, such as mergers and acquisitions, leveraged finance, project finance, asset finance and leasing, structured finance, restructuring, equity, and high-grade debt and generally work and collaborate with industry groups on the more intricate and specialized needs of a client.
  • Sales and trading: On behalf of the bank and its clients, a large investment bank's primary function is buying and selling products. In market making, traders will buy and sell financial products with the goal of making money on each trade. Sales is the term for the investment bank's sales force, whose primary job is to call on institutional and high-net-worth investors to suggest trading ideas (on a caveat emptor basis) and take orders. Sales desks then communicate their clients' orders to the appropriate trading desks, which can price and execute trades, or structure new products that fit a specific need. Structuring has been a relatively recent activity as derivatives have come into play, with highly technical and numerate employees working on creating complex structured products which typically offer much greater margins and returns than underlying cash securities. In 2010, investment banks came under pressure as a result of selling complex derivatives contracts to local municipalities in Europe and the US.[2] Strategists advise external as well as internal clients on the strategies that can be adopted in various markets. Ranging from derivatives to specific industries, strategists place companies and industries in a quantitative framework with full consideration of the macroeconomic scene. This strategy often affects the way the firm will operate in the market, the direction it would like to take in terms of its proprietary and flow positions, the suggestions salespersons give to clients, as well as the way structurers create new products. Banks also undertake risk through proprietary trading, performed by a special set of traders who do not interface with clients and through "principal risk"—risk undertaken by a trader after he buys or sells a product to a client and does not hedge his total exposure. Banks seek to maximize profitability for a given amount of risk on their balance sheet. The necessity for numerical ability in sales and trading has created jobs for physics, mathematics and engineering Ph.D.s who act as quantitative analysts.
  • Research is the division which reviews companies and writes reports about their prospects, often with "buy" or "sell" ratings. While the research division may or may not generate revenue (based on policies at different banks), its resources are used to assist traders in trading, the sales force in suggesting ideas to customers, and investment bankers by covering their clients. Research also serves outside clients with investment advice (such as institutional investors and high net worth individuals) in the hopes that these clients will execute suggested trade ideas through the sales and trading division of the bank, and thereby generate revenue for the firm. There is a potential conflict of interest between the investment bank and its analysis, in that published analysis can affect the bank's profits. Hence in recent years the relationship between investment banking and research has become highly regulated, requiring a Chinese wall between public and private functions.

Other businesses that an investment bank may be involved in

Middle office

  • Risk management involves analyzing the market and credit risk that traders are taking onto the balance sheet in conducting their daily trades, and setting limits on the amount of capital that they are able to trade in order to prevent "bad" trades having a detrimental effect on a desk overall. Another key Middle Office role is to ensure that the economic risks are captured accurately (as per agreement of commercial terms with the counterparty), correctly (as per standardized booking models in the most appropriate systems) and on time (typically within 30 minutes of trade execution). In recent years the risk of errors has become known as "operational risk" and the assurance Middle Offices provide now includes measures to address this risk. When this assurance is not in place, market and credit risk analysis can be unreliable and open to deliberate manipulation.
  • Financial control tracks and analyzes the capital flows of the firm, the Finance division is the principal adviser to senior management on essential areas such as controlling the firm's global risk exposure and the profitability and structure of the firm's various businesses. In the United States and United Kingdom, a Financial Controller is a senior position, often reporting to the Chief Financial Officer.
  • Corporate strategy, along with risk, treasury, and controllers, also often falls under the finance division.
  • Compliance areas are responsible for an investment bank's daily operations compliance with government regulations and internal regulations. Often also considered a back-office division.

Back office

  • Operations involves data-checking trades that have been conducted, ensuring that they are not erroneous, and transacting the required transfers. While some believe that operations provides the greatest job security and the bleakest career prospects of any division within an investment bank,[4] many banks have outsourced operations. It is, however, a critical part of the bank. Due to increased competition in finance related careers, college degrees are now mandatory at most Tier 1 investment banks. A finance degree has proved significant in understanding the depth of the deals and transactions that occur across all the divisions of the bank.

Size of industry

Global investment banking revenue increased for the fifth year running in 2007, to a record US$84.3 billion,[5] which was up 22% on the previous year and more than double the level in 2003. Subsequent to their exposure to United States sub-prime securities investments, many investment banks have experienced losses since this time.
The United States was the primary source of investment banking income in 2007, with 53% of the total, a proportion which has fallen somewhat during the past decade. Europe (with Middle East and Africa) generated 32% of the total, slightly up on its 30% share a decade ago. Asian countries generated the remaining 15%. Over the past decade, fee income from the US increased by 80%. This compares with a 217% increase in Europe and 250% increase in Asia during this period. The industry is heavily concentrated in a small number of major financial centers, including London, New York City, Hong Kong and Tokyo.
Investment banking is one of the most global industries and is hence continuously challenged to respond to new developments and innovation in the global financial markets. New products with higher margins are constantly invented and manufactured by bankers in the hope of winning over clients and developing trading know-how in new markets. However, since these can usually not be patented or copyrighted, they are very often copied quickly by competing banks, pushing down trading margins.
For example, trading bonds and equities for customers is now a commodity business, but structuring and trading derivatives retains higher margins in good times—and the risk of large losses in difficult market conditions, such as the credit crunch that began in 2007. Each over-the-counter contract has to be uniquely structured and could involve complex pay-off and risk profiles. Listed option contracts are traded through major exchanges, such as the CBOE, and are almost as commoditized as general equity securities.
In addition, while many products have been commoditized, an increasing amount of profit within investment banks has come from proprietary trading, where size creates a positive network benefit (since the more trades an investment bank does, the more it knows about the market flow, allowing it to theoretically make better trades and pass on better guidance to clients).
The fastest growing segment of the investment banking industry are private investments into public companies (PIPEs, otherwise known as Regulation D or Regulation S). Such transactions are privately negotiated between companies and accredited investors. These PIPE transactions are non-rule 144A transactions. Large bulge bracket brokerage firms and smaller boutique firms compete in this sector. Special purpose acquisition companies (SPACs) or blank check corporations have been created from this industry.

Vertical integration

In the U.S., the Glass–Steagall Act, initially created in the wake of the Stock Market Crash of 1929, prohibited banks from both accepting deposits and underwriting securities, and led to segregation of investment banks from commercial banks. Glass–Steagall was effectively repealed for many large financial institutions by the Gramm–Leach–Bliley Act in 1999.
Another development in recent years has been the vertical integration of debt securitization.Previously, investment banks had assisted lenders in raising more lending funds and having the ability to offer longer term fixed interest rates by converting lenders' outstanding loans into bonds. For example, a mortgage lender would make a house loan, and then use the investment bank to sell bonds to fund the debt, the money from the sale of the bonds can be used to make new loans, while the lender accepts loan payments and passes the payments on to the bondholders. This process is called securitization. However, lenders have begun to securitize loans themselves, especially in the areas of mortgage loans. Because of this, and because of the fear that this will continue, many investment banks have focused on becoming lenders themselves,[6] making loans with the goal of securitizing them. In fact, in the areas of commercial mortgages, many investment banks lend at loss leader interest rates in order to make money securitizing the loans, causing them to be a very popular financing option for commercial property investors and developers. Securitized house loans may have exacerbated the subprime mortgage crisis beginning in 2007, by making risky loans less apparent to investors.

2008 Financial Crisis

The financial crisis of 2008 saw the last of the largest bulge-bracket US investment banks which had not gone bankrupt or been acquired in a bankrupt-like state convert over to "bank holding companies" which are eligible for emergency government assistance.[7]

Possible conflicts of interest

Conflicts of interest may arise between different parts of a bank, creating the potential for market manipulation. Authorities that regulate investment banking (the FSA in the United Kingdom and the SEC in the United States) require that banks impose a Chinese wall to prevent communication between investment banking on one side and equity research and trading on the other.
Some of the conflicts of interest that can be found in investment banking are listed here:
  • Historically, equity research firms have been founded and owned by investment banks. One common practice is for equity analysts to initiate coverage of a company in order to develop relationships that lead to highly profitable investment banking business. In the 1990s, many equity researchers allegedly traded positive stock ratings for investment banking business. On the flip side of the coin: companies would threaten to divert investment banking business to competitors unless their stock was rated favorably. Laws were passed to criminalize such acts, and increased pressure from regulators and a series of lawsuits, settlements, and prosecutions curbed this business to a large extent following the 2001 stock market tumble.
  • Many investment banks also own retail brokerages. Also during the 1990s, some retail brokerages sold consumers securities which did not meet their stated risk profile. This behavior may have led to investment banking business or even sales of surplus shares during a public offering to keep public perception of the stock favorable.
  • Since investment banks engage heavily in trading for their own account, there is always the temptation for them to engage in some form of front running – the illegal practice whereby a broker executes orders for their own account before filling orders previously submitted by their customers, there benefiting from any changes in prices induced by those orders.

Further reading

See also

References

  1. ^ U.S. Securities and Exchange Commission
  2. ^ Rachel Sanderson (October 22 2010). "UniCredit municipal deal nullified". The Financial Times. http://www.ft.com/cms/s/0/0fb16d54-de18-11df-88cc-00144feabdc0,dwp_uuid=eddfd4e0-4bc3-11da-997b-0000779e2340.html. Retrieved October 23, 2010. 
  3. ^ Merchant Banking: Past and Present
  4. ^ http://asiapaccareers.jpmorgan.com/content/content_298.html
  5. ^ BANKING City Business Series
  6. ^ Morgan Stanley Real Estate Lending
  7. ^ Jagger, Suzy (2008-09-22). "End of the Wall Street investment bank". The Times (London). http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article4800550.ece. Retrieved 2010-05-05. 
Retrieved from "http://en.wikipedia.org/wiki/Investment_banking"

A lifestyle change to stop several types of cancers

Simple life changes could stop millions of cancers
By Kate Kelland | Reuters – Fri, 4 Feb 3:19 AM EST 
LONDON (Reuters) - About a third of all common cancers in the United States, China and Britain could be prevented each year if people ate healthier food, drank less alcohol and exercised more, health experts said on Friday.

Estimates from the American Institute for Cancer Research (AICR) and the World Cancer Research Fund (WCRF) suggest that making simple lifestyle changes could prevent some 40 percent of breast cancers alone in Britain and the United States, as well as tens of thousands of colon, stomach and prostate cancers.

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"It is distressing that even in 2011, people are dying unnecessarily from cancers that could be prevented through maintaining a healthy weight, diet, physical activity and other lifestyle factors," Martin Wiseman, a WCRF medical and scientific adviser, said in statement.

In China, 620,000 cases, or 27 percent are preventable, the WCRF said, as are about 35 percent, or 340,000, in the United States and 37 percent in Britain. Healthier lifestyles could prevent 61,000 cancers in Brazil and 79,000 in Britain.

The WCRF findings are backed by World Health Organisation (WHO) recommendations, which say regular exercise can prevent many diseases such as cancers, heart diseases and diabetes.

Cancer is a leading cause of death around the world and its incidence is rising. Each year around 12.7 million people discover they have cancer and 7.6 million people die from some form of the disease. There are about 200 known types of cancer.

According to the International Agency for Research on Cancer (IARC), cancer will kill more than 13.2 million people a year by 2030, almost double the number it killed in 2008 -- and the vast majority of deaths will be in poorer countries.

In a separate statement, the Geneva-based WHO said low levels of physical activity are the main cause of an estimated 21 to 25 percent of breast and colon cancers, 27 percent of diabetes cases and 30 percent of heart disease cases worldwide.

Rachel Thompson, the WCRF's deputy head of science, said that while the message was simple -- that not smoking, eating good food and being a healthy weight can help ward off many cancers -- it was still a difficult one to get across.

"It's all very well us saying 'this is what you need to eat and this is how much physical activity you need to do', but we need to make it easier for people to make those changes," she said. "Everybody has a role in that -- from international organizations, to governments, to people themselves."

The WHO says adults should do at least 150 minutes of moderate exercise a week. This could be done by walking for 30 minutes five times per week or by cycling to work every day.

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Peter Baldini, head of the World Lung Foundation, also called on all governments to introduce smoke-free laws and raise the price of cigarettes.

Tobacco kills millions of smokers every year, and tobacco-related lung cancers also kill hundreds of thousands of people who don't smoke but have been exposed to it second-hand.

"There isn't a magic bullet to cure all forms of cancer, but we have the opportunity and the obligation to protect people from developing cancer wherever possible," Baldini said.

Nasdaq's computers hacked

Hackers Penetrate Nasdaq Computers
Source: Wall Street Journal
By DEVLIN BARRETT
Hackers have repeatedly penetrated the computer network of the company that runs the Nasdaq Stock Market during the past year, and federal investigators are trying to identify the perpetrators and their purpose, according to people familiar with the matter.

The exchange's trading platform—the part of the system that executes trades—wasn't compromised, these people said. However, it couldn't be determined which other parts of Nasdaq's computer network were accessed.

Investigators are considering a range of possible motives, including unlawful financial gain, theft of trade secrets and a national-security threat designed to damage the exchange.

The Nasdaq situation has set off alarms within the government because of the exchange's critical role, which officials put right up with power companies and air-traffic-control operations, all part of the nation's basic infrastructure. Other infrastructure components have been compromised in the past, including a case in which hackers planted potentially disruptive software programs in the U.S. electrical grid, according to current and former national-security officials.

"So far, [the perpetrators] appear to have just been looking around," said one person involved in the Nasdaq matter. Another person familiar with the case said the incidents were, for a computer network, the equivalent of someone sneaking into a house and walking around but—apparently, so far—not taking or tampering with anything.

A spokesman for Nasdaq declined to comment.

A probe into the matter was initiated by the Secret Service and now includes the Federal Bureau of Investigation.

The mystery surrounding the hackers and their motives is worrying investigators, who remain unsure whether they have been able to plug all potential security gaps—especially since invaders typically seek new ways to breach systems.

The case involving New York-based Nasdaq OMX Group Inc. is part of what cyber-crime authorities see as a broader problem of hackers nosing around corporate computer networks, with varying degrees of success.

U.S. companies are a continual target, and sometimes their public websites are vandalized. It is rarer for perpetrators to penetrate internal systems. Such breaches rarely come to light because companies fear that acknowledging them would alarm customers or encourage copycats.

Tom Kellermann, a former computer security official at the World Bank who now works at a firm called Core Security Technologies, said the most advanced hackers in the world are increasingly targeting financial institutions, particularly those involved in trading.

"Many sophisticated hackers don't immediately try to monetize the situation; they oftentimes do what's called local information gathering, almost like collecting intelligence, to ascertain what would be the best way in the long term to monetize their presence,'' he said.

People familiar with the Nasdaq matter said the Secret Service first began investigating last year. Investigators have informed White House officials of the case, according to the people familiar with the situation, who said that such a move is typical in hacking investigations, particularly in the early stages of the probes.

Authorities haven't yet been able to follow the trail to any specific individual or country. Those familiar with the case said that some evidence points toward Russia, but the person or people responsible could be almost anywhere, perhaps using computers in Russia merely as a conduit.

The case poses two concerns for authorities: preserving the stability and reliability of computerized trading, and ensuring that investors have full faith in that system.

Stock exchanges know they are frequently targets for hackers.

"We take any potential threat seriously and we are continually working to ensure that our systems operate at the highest levels of security and integrity," said Ray Pellecchia, a spokesman for NYSE Euronext, which operates the New York Stock Exchange.

He declined to discuss any specific instances of computer-hacking attempts against that exchange.

In 1999, hackers vandalized Nasdaq's publicly accessible website. In that incident, a group of hackers quickly claimed responsibility for defacing the site, as well as major media websites. Nasdaq officials at that time said the company's internal network wasn't affected.

Computer hacking is a problem for many countries. In recent years, U.S. authorities have dealt with cyberattacks linked to computers in Russia, China and Eastern Europe.

Hackers can use geography as a foil. Prosecutors said Albert Gonzalez, perhaps the most renowned hacker, perpetrated his biggest theft with help from computers in Eastern Europe even though he lived in Miami.

According to a 2009 federal indictment, he used computers located in the U.S., Latvia and Estonia, in a conspiracy that netted more than 100 million stolen credit-card numbers.

The case is considered the largest hacking crime in U.S. history. Mr. Gonzalez eventually pleaded guilty and was sentenced to 20 years in prison.

Going back to investing in artifacts

Making Collectibles More Investable
The market for antiques and other collectibles is inefficient and daunting to nonexperts. WorthPoint, a new website, thinks technology is the answer
Source: Bloomberg Business Week
By Ben Steverman
The prices of stocks and bonds update many times a second. Will Seippel, the founder of the website WorthPoint, says it should be almost as easy to get a fair price on your antique or collectible.

He has quite a challenge ahead of him, say experts on the market for collectibles, which can include any object that has some resale value—from ancient coins to 19th century furniture to vintage Led Zeppelin T-shirts. Almost everyone owns collectibles, but very few people know how to determine their value. In a market this large, inefficient, and opaque, "it's very difficult to know when you're getting a fair price on something," says Christopher Didier, a managing director at Robert W. Baird's family wealth-management group.

Seippel tells a story of a jeweler offering his mother $25 for a gold coin that he knew contained about $250 in gold. Technology can help avoid these situations, he says. A "better armed" collector "is going to do better," he says.

For subscriptions costing $10 to $50 per month, WorthPoint allows users to gauge the value of their own collectibles—or collectibles they want to buy—by searching through sales records of similar items. For each item, ranging from baseball cards to classic cars, users can see photos, descriptions, prices paid, and where and when they were sold. So far, the WorthPoint database contains records of 73 millions items bought and sold, and it adds 3 million to 5 million each month.

Opposite of Snooty

Unlike more established sites aimed at appraisers or dealers, WorthPoint is aimed at the general public. It focuses on "stuff that the everyday person would have in [his] house," Seippel says. "There are great people in our industry, [but] you can get screwed. My goal is to make this more transparent [and] more fun."

To make the site more entertaining to browsers, WorthPoint spotlights interesting items in its database, like a 1916 quarter-dollar coin sold at auction in 2006 for $18,400, or a 1957 Mickey Mantle baseball card sold on eBay for $152.50 in 2007. The site's "worthologists"—experts on particular types of collectibles—write articles on such topics as circus memorabilia or Chinese porcelain.

WorthPoint, which was launched in 2007, is seeing a surge in traffic as it adds more data. According to comScore, the site received 2.76 million unique visitors in December 2010, more than three times its traffic a year earlier. WorthPoint says it has boosted its number of paid subscribers 40 percent since October, to 14,000.
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How Used is "Used"

Some are skeptical. Novice collectors should know there are important pieces of information that no website can provide, says Elizabeth Stewart, an appraiser in Santa Barbara, Calif., with 26 years of experience. Although Stewart is a WorthPoint subscriber who uses Web research as a starting point in appraisals, she says collectors need an eye for subtleties such as condition—which is not always apparent in an online photo—or a knowledge of the tastes of the top collectors of each kind of item. "Each category of collectibles has its own wildcard," she says. "Really great collectors live, eat, and breathe their material."

One prominent competitor in antiques and collectibles is a company called Prices4Antiques, while several other well-established sites tackle the art market. All the sites compile photos, descriptions, and other data from auctions or other sales, allowing collectors, appraisers, and dealers to check on values by looking up the transactions of similar items. The art market is on its way to being more of a "valid asset class," says George Collins, president and chief executive of the website AskART.com. "Years ago, the art market was jump ball," with the outcome of each transaction unpredictable, he says. "Now there's a lot more confidence in taking action."

Collins notes that art is widely studied in universities, and works can be categorized by artist and style, while collectibles are a market of almost infinite variety and much more difficult to organize.

WorthPoint's data come from auctions, dealers, and especially the online auction service eBay. Through a deal with eBay, WorthPoint collects the records of all the site's completed transactions, which make up about 80 percent of WorthPoint's records. Seippel plans to add better search tools, information from reference books on popular collectible categories, a mobile-phone application, and photos of "makers' marks," the small clues on pottery, silver, and other collectibles to their origin. "We have a long way to go," he says.

Higher up the Ladder

WorthPoint's "big data" approach to collectibles contrasts with Prices4Antiques, founded in 1999. In contrast to WorthPoint's 73 million records, Prices4Antiques contains less than 600,000 records, with about 6,000 added each month. Rather than collect every record it can find, Prices4Antiques founder Kent Anderson says every record is created and reviewed by one of the site's seven expert editors, making it is a more authoritative site with consistent records that are easier to search and contain less "junk." "It makes the data much, much more useful and reliable," he says. With 2,800 subscribers paying $45 to $79 per month, Prices4Antiques has a narrower audience of mostly appraisers.

Seippel defends WorthPoint's inclusion of a broad array of data. "We have low-end, and we have high-end," he says, a range that is appropriate for amateurs trying to value the items in their homes.

Better use of the Internet has the potential to attract more investors to collectibles. "The more transparency you have in this marketplace, the broader you can make the market," says Baird's Didier, who helps families manage their wealth, which often includes valuable collections. That's something many market participants say they favor. Then again, Didier says, "there is also an incentive to keep the market inefficient." Says Douglas Bilodeau, who has run Douglas Auctioneers in South Deerfield, Mass., for 45 years: "Inexperienced people get taken advantage of when they start selling stuff." The Federal Trade Commission issued a "consumer alert" in September 2010 warning consumers about getting taken advantage of in the collectible-coin market.
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Beware the Hidden Costs

A public auction can be a reliable determiner of value, Bilodeau says, but buyer preferences can change quickly. Certain kinds of collectibles "go in and out like the wind," he says.

Beyond the possibility of fraud or not getting a fair price, there are several other reasons why the general public might not want to think of collectibles as investments, Didier says. Buyers of collectibles must pay sales tax, insurance, appraisers, high commissions, and the costs to ship and store their collectibles. Transaction costs and fees are an issue for any investment, but the many hidden costs associated with collectibles can turn profitable antiques into money losers without collectors realizing it, he says.

"There's nothing wrong with buying a piece of art, a coin, or bottle of wine just because it inspires you," says Didier. "But if you're looking at something [with] a profit motive, it's imperative you get expertise." Collins, of the AskART.com site, agrees. "There is no substitute for turning to a professional," he says. "Online is still a little bit amateur hour."

Steverman is a reporter for Bloomberg News.

Why is Peter Thiel named a free radical ?

Peter Thiel: 21st Century Free Radical
Never mind enormous yachts: Peter Thiel is spending his billions on space travel, life extension, artificial intelligence, and paying top students not to go to college
Source: Bloomberg Business Week
By Romesh Ratnesar
(Corrects James B. O'Neill's name.)
On a chilly December night, a few hundred people gathered at San Francisco's Palace of Fine Arts for an event called Breakthrough Philanthropy. For an hour the guests engaged in the familiar social rituals of Silicon Valley, trading business cards and startup ideas over sushi, spring rolls, and pinot noir, before filing into an auditorium to listen to fundraising pitches from eight nonprofit organizations. The groups had disparate agendas, but all shared a fantastic vision for changing the world—defy death through regenerative medicine! Harness intelligence from machines smarter than the human brain! Build self-governing communities on the high seas! They also had a common benefactor: Peter A. Thiel, the iconoclastic, libertarian 43-year-old venture capitalist and macro-hedge-fund investor. When the speakers finished, James B. O'Neill, who runs the Thiel Foundation, introduced his boss as someone "who works every day to reshape the world and focus on solutions to problems other people overlook."

Thiel emerged from backstage, wearing a navy blue striped shirt, jeans, and a blazer. "The future is not an abstraction," he said. "It's something we are all participants in, helping to create and forge and shape." Thiel is not a natural performer. He has a flat, mechanical delivery that instantly deflates his attempts to inspire. After three and a half minutes, he wrapped up his remarks and encouraged the audience to stay, schmooze, and "start building the future for the 21st century."

Thiel followed the crowd into the main hall, where a Stanford University freshman named Max Marmer was waiting. Marmer had come to the event in part because of Thiel's latest philanthropic brainchild: a program that will award fellowships of $100,000 to 20 entrepreneurs under the age of 20, on the condition that they drop out of college for two years to pursue their ventures full-time. Marmer, who's launching a business consulting startup with two friends, decided to apply for the fellowship as soon as he heard about it on Facebook. At the Palace of Fine Arts, Marmer introduced himself to his idol. For the next five minutes "it was mostly me talking," Marmer says. Thiel steered him toward a partner in the Founders Fund, Thiel's venture capital firm, who agreed to listen to Marmer's pitch. Marmer has informed his parents that, whether he wins a Thiel Fellowship or not, he is dropping out of Stanford.

Three of America's defining tech geniuses are renowned college dropouts—Bill Gates and Mark Zuckerberg left Harvard University; Steve Jobs hung around Reed College but was enrolled for only one semester—and it has almost become expected that visionary technologists will stop everything to pursue a ripening idea. It's worth remembering, however, that Gates, Zuckerberg, and Jobs are anomalies. Thiel thinks it's the anomalies who matter and thinks he can create more of them. Whether you view his plan as cause for celebration or horror depends on your take on America's future. Are we hobbled by a deficit of risk or too much of it? Does government spending stimulate innovation or obstruct it? Are America's best universities assets or liabilities?

Despite his fund's disastrous recent performance—Clarium Capital Management fell about 23 percent in 2010, the third straight year of declines, according to investors—Thiel is financially set for life. He co-founded PayPal (EBAY) with Elon Musk and Max Levchin, was the first outside investor in Facebook, and owns a stake in a bevy of promising tech companies, from LinkedIn to Halcyon Molecular to Palantir Technologies. He made the Forbes 400 before he reached 40. After being portrayed in The Social Network, Thiel is perhaps the most famous venture capitalist in the world.

Despite all that, he remains troubled. Absent rapid, groundbreaking scientific breakthroughs, Thiel foresees an age when, he says, "people will have a lower quality of life, where people won't be able to retire, where governments are pushed toward more and more austerity. That will lead to a more constrained, pessimistic future. That's a big part of what is happening, and that trend is likely to continue."

Thiel has thus far put his money into the kind of bleeding-edge technologies he says can expand human possibility and stave off the future he fears: nanotechnology, artificial intelligence, robotics, space exploration. A science fiction junkie, he adheres to a worldview shaped as much by French social theorists as by Star Trek. "I wouldn't necessarily categorize him as a pessimist, though he can be," says David O. Sacks, a college friend who worked with Thiel at PayPal and has since founded Yammer, a social networking service. "He is very bullish about technology, but he just doesn't think it's happening fast enough."

Even as Thiel pushes for a bolder future, Clarium has conspicuously bet against present macroeconomic trends—and lost. While Thiel's views, including predictions that the U.S. would face the threat of deflation and that the dollar and oil would rise, mostly have come true, the losses reflect poor market timing and risk management, according to several current and former clients. "It doesn't matter if a manager is correct in his long-term views if they don't get the timing right or manage volatility along the way," says Donald A. Steinbrugge, managing partner of Agecroft Partners, a Richmond (Va.) consulting firm that advises investors and hedge funds. Since 2008 the fund's assets have fallen 90 percent. Thiel has closed the fund's New York office and acknowledges the need for stricter risk controls. "If he was Joe Hedge Fund Manager, he would have to live and die by his track record, but that's not the case with Peter," says Tammer Kamel, president of Toronto-based Iluka Consulting Group, which advises clients on investing in hedge funds. "He's got his fingerprints on two of the most successful Web services ever developed."

Still, Clarium's free fall has exposed Thiel to attacks from those who see his investment strategy and his philanthropic ventures as expressions of a reckless, preening vanity. No initiative has provoked more howls than the "20 Under 20" Thiel Fellowship, hatched by Thiel and his foundation staff on a flight from New York to San Francisco last October and announced by Thiel during an appearance at the TechCrunch conference the next day. Writing on Slate.com, Jacob Weisberg condemned the plan as an "appalling," "nasty" idea that will encourage college students to "halt their intellectual development around the onset of adulthood, maintaining a narrow-minded focus on getting rich as young as possible, and thereby avoid the siren lure of helping others or contributing to the advances in basic science that have made the great tech fortunes possible."

Such critiques only help to confirm Thiel's hunch that he is right, in his view. The business credo that a college education is a prerequisite for professional advancement is, he believes, precisely the reason to encourage people to try something else. "I don't think I believe in market efficiency," he says. "If I believed in an efficient market, then none of the stuff I'm doing makes any sense."

In the various accounts of Facebook's founding, Thiel is almost always cast as a remote, brooding master of the universe, the archetypal tycoon in a black wing chair, stroking a cat. In The Accidental Billionaires, the 2009 book that is the basis for The Social Network, Thiel is described as "secretive and incredibly competitive." Also "scary as hell."

The day after the Breakthrough Philanthropy event, Thiel arrives for lunch at a restaurant overlooking the San Francisco Marina in a blue Mercedes sports car. He's modestly built, with angular features, and he has an engaging, if slightly awkward, conversational manner; on several occasions Thiel starts to answer questions while his mouth is half full. Asked about Clarium's dismal 2010 performance, he replies, "We've had a rough year. We've got some things wrong. But over time, I think we've gotten more right than we've gotten wrong." He adds: "It's not the right thing to focus on a six-month horizon. The future happens over a very long period of time. My mindset is to make sense of where things are going over the next decade and to try to think about a set of problems people haven't asked questions about."
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One of Thiel's frequent themes is the folly of promoting "extensive" gains over "intensive" breakthroughs. He believes that governments and investors have an "extensive" bias when it comes to science and technology, a desire to replicate or "extend" what has already been shown to work. He perceives a dangerous shortage of the kinds of ambitious, "intensive" innovations he says are ultimately necessary for long-term growth. "My thesis is that the world is too heavily geared in the extensive direction," he says. "It's what everyone would like: a sure thing, something that gets a predictable return. I don't think that model is the right one for our world anymore. But the alternative is necessarily quite risky. And so there's no safe alternative."

Born in Frankfurt, Thiel had an itinerant childhood. His father's career as a chemical engineer took the family to South Africa, Namibia, and Ohio before the Thiels settled in the Bay Area in the late 1970s. (Thiel has a younger brother, Patrick.) At San Mateo High School, Thiel finished first in his class and was a nationally ranked chess master. He majored in philosophy at Stanford, where he studied under René Girard, a French émigré professor who coined the term "mimetic desire," the idea that people want things they perceive as objects of other people's desire, giving rise to a herd mentality. To Thiel, mimetic desire provided a way to explain everything from stock market bubbles to political correctness on campus.

In 1987, Thiel founded The Stanford Review, a conservative newspaper that became an outlet for student jeremiads against multiculturalism, speech codes, affirmative action, feminists, and ethnic and gay campus groups. Sacks, who worked with Thiel at the Review and succeeded him as its editor, says, "We thought the people on campus were way outside the mainstream, and if the people who were funding the university—the alumni, the donors, the American taxpayer—knew what was going on, they would be pretty outraged."

Thiel stayed at Stanford for law school and remained embroiled in the culture wars, co-authoring a book with Sacks in 1995, The Diversity Myth, which decried multiculturalism at the university. He clerked for federal judge James L. Edmonson, wrote speeches for former Education Secretary William J. Bennett, and worked at Sullivan & Cromwell and Credit Suisse First Boston in New York before moving back to California in 1996. In 1998, Thiel met Levchin and, over breakfast in Palo Alto, launched the company that became PayPal. Thiel and his co-founders defined their mission in historical terms. They saw PayPal as a vehicle for realizing the libertarian dream of a global financial marketplace in which transactions took place entirely outside the reach of governments. The company's T-shirts read THE NEW WORLD CURRENCY. "There was an idealistic element to it—that's what everyone within Peter's circle of friends talked about," says Ajay Royan, a PayPal veteran who is now the managing director of Clarium. "The business side was secondary to the vision."

Thiel says that "there were a lot of cool, interesting questions we wanted to engage in, but at the same time we had to develop a very detailed, specific plan" to enable people to buy and sell items seamlessly on eBay (EBAY). It worked: PayPal weathered the Internet bust and went public in February 2002. Eight months later, eBay bought the company for $1.65 billion. Thiel, who had initially invested $240,000, walked away with $60 million, which he used to launch Clarium Capital, the hedge fund, and the Founders Fund, an early-stage venture capital shop. Two years later he agreed to a meeting with Zuckerberg, then a Harvard sophomore, and Sean Parker, a co-founder of Napster who was helping Zuckerberg raise funding for his fledgling social networking site, Thefacebook. Thiel lent Zuckerberg and Parker $500,000 in exchange for a 10 percent stake in the new company. Thiel sold half his shares in 2009, mostly to Digital Sky Technologies. Based on Facebook's current valuation—a number that fluctuates depending on whom you ask and, seemingly, the minute you ask—a conservative estimate of his remaining stake is about $1.5 billion.
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There's no evidence that Thiel's good fortune has softened his edges. After he was subject to ridicule on the Internet for revealing in 2007 that he lived at the Four Seasons in San Francisco and drove a McLaren, he has guarded his privacy and lashed out at those who invade it. When the gossipy website Valleywag outed Thiel as gay in late 2007, he responded by branding it "the al-Qaeda of Silicon Valley" and calling its reporters terrorists. In a 2009 essay titled "The Education of a Libertarian" published on the Cato Institute's website, Thiel wrote, "I no longer believe democracy and freedom are compatible" and that the "broader education of the body politic has become a fool's errand." Most notoriously, the essay suggested that the advent of women's suffrage in the 1920s had "rendered the notion of 'capitalist democracy' into an oxymoron," as women, in Thiel's view, tend not to support laissez-faire policies.

Thiel is now at pains to play down his image as a radical ideologue. "I do tend to think that a libertarian society in which there is more economic and personal freedom is a better society, but there are all sorts of caveats," he says. Take Facebook. "If you believed in radical autonomy and the idea that we're all self-contained individuals—a kind of caricature version of Ayn Rand's world—then the social networking thing would be one of the most ridiculous things imaginable. Why in the world would you care about friends or sharing or being connected with other people? I'm very skeptical of centralized power, and I believe personal and economic freedom are important—but I also believe we are living together on the same planet and that human society exists and that human beings are born into this world and live and develop."

Except for a few donations in the most recent electoral cycle (to Rand Paul and in support of marijuana legalization), Thiel has given up on politics. He says he is "not dogmatic" about whether government should play a role in stimulating the kinds of intensive technological innovations he thinks the country needs, just that he believes the political class isn't smart enough to make it happen. "Only 35 out of 535 members of Congress have any background in science or technology," he says. "That's why I believe the government thing is so hard to fix—the people there don't actually believe these are important problems. Maybe the answer would be to change the other 500 people and replace them with engineers. But then you're not really talking about a practical option."

In Thiel's view, the biggest threats to innovation emanate not from Washington but from a sector Americans tend to view as one of the country's greatest strengths: higher education. His antipathy for its elite universities dates to his time attending one. In The Diversity Myth, Thiel predicted that unless they reformed themselves, institutions such as Stanford would face "massive and unprecedented displacement....New educational venues may arise and meet demands that are no longer being satisfied by the existing institutions." Where once he subscribed to the idea that the system could be fixed from within, Thiel is now certain some students are better off opting out of it altogether. "A necessary condition for a bubble is that [something] is believed to be extremely valuable, but which very few people are thinking about," he says. "And my only candidate for a bubble in the U.S. right now is education." He continues: "People can't do anything entrepreneurial or innovative or even nonprofit—anything that's not safe and well-paying—because they have this mountain of debt. And so education is something that has become a retardant to technological innovation and progress, even though the common perception is the exact opposite."

The Thiel Fellowship is probably the first scholarship aimed at college-age students that stipulates that recipients not go to college. Representatives from Thiel's five-person foundation say they have received a few hundred applications from more than 25 countries. Applicants had to submit two 1,000-word personal statements. One was in response to: "Tell us one thing about the world that you strongly believe is true, and that most people think is not true." The other answered: "How do you want to change the world?" Once selected, the 20 winners will be given $100,000 to cover living expenses in the Bay Area while they spend two years developing the Next Big Thing. Thiel insists that the goal isn't necessarily to find the next Zuckerberg, but rather to prod more young people to question what they're getting out of their college experience.

"The main thing I'd say is that people should think about it," he says. "I certainly did not. I got good grades in high school. I went to college. I got good grades in college, I went to law school. When I look back, I have no regrets. But if I could do it over, I would have reflected on it a lot more rather than it being this thing that I reflexively did."

There is something irksome about Thiel's critiques of a system from which he has benefited so handsomely. And it's easier to extol the virtues of the Silicon Valley entrepreneur's life when you are already leading the fantasy version of it. Thiel's vision of a society full of entrepreneurs and innovators developing life-extending technologies is a seductive one and may well be the only hope for avoiding chronic economic decline. But it's worth asking whether people will truly be better off if more bright young students follow the path Max Marmer has chosen.

A month after meeting Thiel at the Palace of Fine Arts, Marmer has quit school and moved out of his parents' home in San Francisco. He's living in the pool house behind a friend's place in Atherton, near Palo Alto, where he and his partners are working on a startup devoted to developing a "management science" for boosting the success rate of other startups. "Have you seen The Social Network? The house looks a little like that," Marmer says over the phone in early January. "A few people who have come by have actually said, 'Oh, it's just like Facebook.' "
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Marmer is waiting to hear whether he has won a Thiel Fellowship, though he's concerned that his age—he turned 20 in September, before applications were due—may disqualify him. Regardless, Marmer says he has found his purpose. "People talk a lot about college as one of the best times of their lives. But it was pretty clear I had to make [a] choice between enjoying campus life or continuing to pursue my passion for entrepreneurship. I tried to do both, and when that wasn't working, I decided to choose this." If all else fails, Marmer says, he can always go back to Stanford someday. "They're really flexible. I can take up to two years leave of absence, and even after that I've heard it's not that hard to get back in. If I change my mind, I know I haven't really closed any doors behind me."

He pauses, then says: "But I don't anticipate that. If this doesn't work out, I'll probably go and start another startup."

With Saijel Kishan. Romesh Ratnesar is a Schwartz Fellow at the New America Foundation.
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