The CME's bold move

The Chicago Mercantile Exchange and the Chicago Board of Trade have been rivals since 1874, when the CBOT spun off an egg-and-butter market that later became the CME. But when the Merc, as it’s known in the City of Broad Shoulders, announced last month that it would acquire its elder for $8 billion in cash and stock, its motivation was not so much taking out a competitor as bulking up for a bigger fight against fast-growing over-the-counter and foreign markets.

The combined company, to be called CME Group, will operate the world’s biggest futures exchange in terms of both market capitalization and trading activity, handling more than 87 percent of U.S. exchange–listed futures volume. But the unregulated OTC derivatives market — which is five times the size of its exchange-listed counterpart — and aggressive overseas bourses remain big threats. Germany’s Deutsche Börse and Amsterdam-based Euronext are trying to build pan-European exchanges that trade stocks and derivatives. Both want to attract business from U.S. customers; Euronext has agreed to be taken over by the company that owns the New York Stock Exchange, although Deutsche Börse is trying to break up the deal.

CME chief executive Craig Donohue, who will continue as CEO after the merger, is already thinking about how to wage war on both fronts. He’s plotting, for instance, to capture a slice of the white-hot OTC derivatives market. Before announcing the CBOT deal, the CME asked regulators for permission to list credit default swaps, wildly popular instruments that offer buyers protection against corporate debt defaults. It also bought Swapstream, an electronic exchange for European interest rate swaps, and began to offer clearing services for short-term rate swaps in the U.S.

Donohue expects that once the CME’s short-term interest rate futures and the CBOT’s contracts on longer-term debt are available on one exchange, customers will be able to more efficiently pursue complex strategies involving the entire yield curve. That, in turn, will give CME Group an opening through which to market default swaps and other new products.

“There’s a lot of convergence that’s happening between the over-the-counter market and the exchange-listed market,” says Donohue, an attorney by training who joined the CME as a staff lawyer in 1989 and rose to CEO in 2004.

To win more business overseas, the CME plans to add the CBOT’s offerings to its Globex electronic trading system, which reaches customers in 70 countries. The exchange also will peddle new products to customers in India, China and other emerging powers and add to the rebates and discounts it provides to traders. In August, for example, the CME rolled out futures on China’s yuan.

“To be competitive now, you really do need scale on a global basis,” says CBOT chairman Charlie Carey, the third-generation grain futures trader who will be vice chairman of CME Group. Reaching a deal wasn’t that difficult, he adds, because both parties took note of global consolidation and accepted that the terms of competition were changing.

Now it’s the CME-CBOT deal that’s altering the worldviews of the Chicago markets’ rivals. That’s sure to inspire even more deal making in a sector that has seen a host of private exchanges go public and seek merger partners in the past few years.

“A deal of this magnitude will certainly push competitors to rethink their positions,” says Sang Lee, a co-founder of Boston research firm Aite Group, who has studied trading markets extensively. “This could spur more consolidation.” — L.F.

Merrill’s pipeline runneth over

Following the hot IPOs this year of such firms as Evercore Partners and Thomas Weisel Partners, Tom Petrie figured he would be the next boutique banker to strike it rich. The ex-First Boston analyst and founder of Denver-based energy boutique Petrie Parkman filed with regulators in September for a $115 million IPO.

But then Petrie got a call from Christopher Mize, head of energy investment banking at Merrill Lynch, asking if he wouldn’t rather sell all of his 17-year-old firm. Within weeks the two sides ironed out a deal; Merrill will buy Petrie Parkman for an undisclosed sum. Petrie, a 61-year-old West Point graduate who owns 38 percent of his boutique, becomes a vice chairman at Merrill, which aims to expand in energy trading and investment banking. The New York firm bet big on the sector in 2004 when it bought the trading unit of Entergy-Koch, a joint venture of Entergy Corp. and Koch Industries.

Victor Nesi, Merrill’s investment banking head for the Americas, says of Petrie Parkman: “Their strengths, specifically in the exploration and production sector, are attractive to us. This helps quickly expand our coverage in the space.”

Petrie, who often entertains clients on his Colorado cattle ranch, gets to expand his business and monetize partners’ stakes without going public. “The IPO had a lot of appeal,” he says. “But being the CEO of a publicly traded company carries responsibilities — and frankly, distractions — from the main thing I enjoy, which is helping clients.” — Pierre Paulden

Hedge fund hires for all seasons

With an array of lawmakers seeking to more closely regulate hedge funds, what better time for fund firms to bring on politically connected talent? That was the reaction of many in the industry last month when two former Treasury secretaries joined hedge funds. On October 19, D.E. Shaw & Co. announced that it had hired ex–Clinton Treasury chief (and former Harvard president) Larry Summers as a part-time managing director; that same day Cerberus Capital Management said it had tapped John Snow, who served President George W. Bush until July, as its chairman.

Some hedge fund industry executives groused that the hires were little more than marketing and public relations moves — ways for the firms to raise their profiles with potential investors and gain some connections in Washington as hedge funds come under more scrutiny there.

Snow’s business experience, however, is likely to be a plus for Cerberus, which also makes private equity investments in big corporations. Before joining the Bush administration, he was CEO of railroad giant CSX. A spokesman for the firm says Snow will be involved in strategy and investment decisions.

As for Summers, a D.E. Shaw executive who worked on the hire acknowledges that some of his time will be spent “working on policy issues” but stresses that the firm values him more for his ability to analyze markets and contribute trade ideas. (He will remain an economics professor at Harvard.) “We were very attracted to his intellect and his aptitude as an economist,” the Shaw executive says. “We didn’t hire him to be a figurehead.” — Imogen Rose-Smith

Futures

As electronic trading gains a tighter hold on Chicago’s futures markets, there are fewer elbows and fists flying on the exchange floor. How to keep the rough-and-tumble spirit alive? Try boxing! On October 21 a group of traders and exchange officials fought it out in a boxing ring set up in a ballroom at the Chicago Marriott Downtown hotel, all to benefit the local Mercy Home for Boys & Girls, a Catholic-run residence for troubled youths. The fight card featured six bouts between representatives of various exchanges, including the Chicago Mercantile Exchange and the Chicago Board of Trade, longtime rivals that just two days earlier had agreed to a historic merger (see page 7). In one bout the CME’s representative, 26-year-old Joe (Hardwood) Newren, weighing in at 195 pounds, felled CBOT’s 39-year-old, 250-pound Royce (the Wrecking Crew) Williams in three rounds.

CME chairman Terry Duffy and CBOT chairman Charlie Carey were joined ringside by two pugilistic predecessors: Pat Arbor — who as a young man lived and boxed at the Mercy Home before rising from the CBOT’s soybean pit to become the exchange’s chairman — and former CME supremo Jack Sandner, who overcame a tough childhood and trained at Mercy before becoming a Golden Gloves champion. After the home ran into financial trouble in the late 1980s, Arbor, one of its directors, suggested a black-tie fundraiser featuring boxers from the exchanges. Sandner helped drum up support at the CME.

“We had to beg people to buy tickets,” says Arbor of the first benefit in 1991. No longer. Nearly 1,200 people showed up for last month’s event, raising an estimated $1 million for Mercy.

Has the boxing become less intense in this age of electronic trading? No way, says Arbor: “Electronic traders are just as competitive as the floor traders.” — P.P.

Making private equity public

Big private equity firms have tried without much success to tap the public markets. Now one money manager is going through the back door to create a publicly held buyout fund.

In the 20 years since Malon Wilkus founded American Capital Strategies as a one-man shop run out of his Bethesda, Maryland, living room, the firm has invested $12 billion in the debt and equity of middle-market companies like Aamco Transmissions and Gibson Guitar. Wilkus took the investment firm public in 1997 as a business development company, a legal status that makes ACS tax-exempt as long as it distributes 90 percent of its earnings as dividends.

Last month ACS, which currently boasts a $6 billion market capitalization, raised a $1 billion private equity fund from three big funds of funds: HarbourVest Partners, Lexington Partners and Switzerland’s Partners Group. ACS will collect a 2 percent management fee and an incentive fee of 10 to 30 percent of the fund’s profits (the percentage will vary based on how well the fund performs). In keeping with its status as a business development corporation, ACS will pay out 90 percent of its earnings from the buyout fund to its public shareholders.

Kohlberg Kravis Roberts and Apollo Management floated public funds on Amsterdam-based Euronext earlier this year, but shares of both funds are trading below their offering prices, and no other firms have followed suit.

In contrast, Wilkus, 54, plans to continue raising private funds under the ACS corporate umbrella. He would like to launch sector-specific vehicles that focus on energy, financial services and technology, among others. In so doing, he hopes to raise ACS’s stock market valuation from about nine times forward earnings to the 20-plus multiples of big asset management firms.

“We think we will experience that result as more and more of our income comes from asset management fees,” he says.

So far, so good: ACS’s shares are up more than 5 percent, to $42 apiece, since it announced the new fund. — Loren Fox

A marathon challenge for AIG’s

Martin Sullivan has been run off his feet since taking over as CEO of insurance giant AIG last year. In addition to negotiating a $1.6 billion settlement with New York State Attorney General Eliot Spitzer of accusations that AIG had manipulated earnings before Sullivan came on board, the 52-year-old London native has traveled the globe nurturing client relationships. Now the CEO may be adding another feat to his list: training for the New York City Marathon.

The Achilles Track Club, a charitable group that helps disabled people participate in athletics, honored Sullivan for AIG’s contributions at its annual benefit dinner on November 1. Before the dinner the organization’s founder and chairman, Dick Traum, approached Sullivan and asked him to join the club, promising to help him get in shape to compete in the November 2007 marathon, a 26.2-mile race through the city’s five boroughs. The stockily built CEO, who played soccer as a young man but has never run a marathon, smiled but didn’t commit one way or the other, reports Traum.

“We’d love to get him running,” says Traum, the first above-the-knee amputee to complete the New York course, in 1976, and a veteran of more than 30 marathons. “If I have my way, he will be doing the marathon next year.”

At the dinner, held at the Metropolitan Pavilion in lower Manhattan, the club presented Sullivan with its Albert H. Gordon Award, given annually to high achievers who are committed to helping others. Gordon, a 105-year-old retired banker who took over Kidder Peabody in 1931, ran marathons well into his 80s and was a founding member of the Achilles board. AIG provides the group with financial support and employee volunteers.

Sullivan won’t comment on whether he’ll take up Traum’s challenge, but the Achilles chairman can be very persuasive. Since the Iraq war began in 2003, he has made regular visits to the Walter Reed Army Medical Center in Washington to encourage wounded soldiers — many of them amputees — to take up running. About 50 of these veterans were among the 400 Achilles athletes from six continents who tackled the 2006 New York marathon, held earlier this month. — P.P.

Then again, we’ll always have Paris...

New York, New York, so good they named it twice, or so the song says. Recent signs, however, suggest that the world’s unofficial capital is losing ground to London. What began with celebrities like Madonna and Gwyneth Paltrow has spread to finance. New York Mayor Michael Bloomberg is so concerned, he’s paying consulting firm McKinsey $600,000 to investigate why companies would rather raise money in London than in New York.

But does the mayor need to worry? Doesn’t Rip-Off London, as it’s known in the U.K., have terrible food and low wages, even in high-flying finance jobs? Not anymore. Last year New York–based Gourmet magazine named London the world’s best city for dining. And in many trading jobs, Londoners are outearning their trans-Atlantic brethren.

London’s finance types may also be ahead in the “living it up” category, at least according to our very casual survey. A typical business lunch in New York might include a pricey Sancerre, says Regina McMenamin, promotions manager for the Four Seasons restaurant — “but never more than one glass.” In London a banker would expect to finish the bottle.

Institutional Investor Staff Writer Pierre Paulden has looked at some points of comparison that McKinsey might miss:

Mutch ado about governance

John Mutch has seen firsthand that good corporate governance policies can boost a company’s value. Now he’s putting his money on the line to prove it.

From 2003 to 2005, Mutch served as CEO of software maker Peregrine Systems, helping to turn the company around after it had consented in 2003 — without admitting or denying wrongdoing — to financial fraud charges. Mutch improved Peregrine’s governance, organizing a new slate of board directors and hiring a compliance officer who reports to the board. These reforms, he says, provided confidence in the accuracy of Peregrine’s financial reporting while improving morale, customer relationships and, ultimately, profits. (Hewlett-Packard bought Peregine last year for $425 million.)

Mutch is so convinced of the correlation between governance and performance that he’s starting a hedge fund to invest in poorly governed, underperforming companies, with the goal of influencing them to make improvements that will boost their market values. He’s also donating $1 million for governance research at the University of Chicago Graduate School of Business, from which he earned an MBA in 1997. The business school fund will support research to determine whether there is a correlation between strong governance standards and company performance. In May the university will hold a symposium on governance featuring investors, regulators, auditors, attorneys and other experts.

The 50-year-old Californian has spent the bulk of his career as a technology company executive, including seven years in sales and marketing at Microsoft. His hedge fund, MV Advisors, will take 5 to 30 percent stakes in small and midsize tech companies and work with management to improve performance. The fund, based in Solana Beach, California, and targeted for $500 million, won’t officially close until January, but Mutch has been hard at work for several months, using financial and governance screens to winnow a list of 800 possible investments to about 20. One company that Mutch believes will benefit from governance improvements is Phoenix Technologies; his fund has already invested about $5 million, working alongside hedge fund Ramius Capital, to buy 13.8 percent of the software company. Mutch says he’s working with Phoenix executives to better allocate the company’s free cash flow, among other things.

“He is a smart guy and passionate about corporate governance,” says Ramius managing member Jeffrey Solomon.

Mutch sums up his investment style simply: “I want to find lousy companies and make them good, and through the process make a good investment return.”

— Stephen Taub

Richard and Christopher Chandler are going their separate ways.

The New Zealand–born brothers — who revealed to Institutional Investor this spring how they turned a $10 million family fortune into $5 billion investment fund Sovereign Global — have announced that their shared assets in the fund will be divided equally between two new proprietary vehicles: Orient Global, which will be wholly owned and run by Richard, 47, and Legatum Capital, to be owned and run by Christopher, 46. Both funds will have offices in Dubai and London; Orient will also operate out of Singapore, where Richard recently began spending three months a year.

“In responding to the challenges of scale as a result of our success, a division of the business at this time is a natural evolution,” Richard said last month in a press release announcing the split. In the same release Christopher said the new funds would be “nimbler” and added, “Our family bonds remain as warm as ever.”

The Chandlers built Sovereign’s billions by making huge bets on Hong Kong real estate and by investing in telecom and energy stocks in Brazil, Russia and South Korea. Richard’s exclusive interview with II earlier this year was the only one he ever gave to the press. Both brothers refuse to be photographed by the media. — David Lanchner