Investment Banks Hedge Funds Private Equity

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Investment Banks, HedgeFunds, and Private EquitySecond Edition

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Investment Banks, HedgeFunds, and Private EquitySecond EditionDavid P. StowellAMSTERDAM BOSTON HEIDELBERG LONDONNEW YORK OXFORD PARIS SAN DIEGOSAN FRANCISCO SINGAPORE SYDNEY TOKYOAcademic Press is an imprint of Elsevier

Academic Press is an imprint of Elsevier225 Wyman Street, Waltham, MA 02451, USAThe Boulevard, Langford Lane, Kidlington, Oxford, OX5 1 GB, UK# 2013 Elsevier Inc. All rights reserved.All case studies are copyright # Kellogg School of Management. To request permission for these, pleasecontact part of this publication may be reproduced or transmitted in any form or by any means, electronic ormechanical, including photocopying, recording, or any information storage and retrieval system, withoutpermission in writing from the publisher. Details on how to seek permission, further information about thePublisher’s permissions policies and our arrangements with organizations such as the Copyright ClearanceCenter and the Copyright Licensing Agency, can be found at our website: book and the individual contributions contained in it are protected under copyright by the Publisher(other than as may be noted herein).NoticesKnowledge and best practice in this field are constantly changing. As new research and experience broaden ourunderstanding, changes in research methods, professional practices, or medical treatment maybecome necessary.Practitioners and researchers must always rely on their own experience and knowledge in evaluating and usingany information, methods, compounds, or experiments described herein. In using such information or methodsthey should be mindful of their own safety and the safety of others, including parties for whom they have aprofessional responsibility.To the fullest extent of the law, neither the Publisher nor the authors, contributors, or editors assume anyliability for any injury and/or damage to persons or property as a matter of products liability, negligence,or otherwise, or from any use or operation of any methods, products, instructions, or ideas containedin the material herein.Library of Congress Cataloging-in-Publication DataStowell, David (David P.)Investment banks, hedge funds, and private equity / David Stowell. — 2nd ed.p. cm.Rev. ed. of: Investment banks, hedge funds, and private equity. c2010.ISBN 978-0-12-415820-71. Investment banking. 2. Hedge funds. 3. Private equity. 4. Finance—History21st century. I. Stowell, David (David P.) Investment banks, hedge funds,and private equity. II. Title.HG4534.S76 2012332.66–dc232012022210NOTE: The companion site for this book can be found at itish Library Cataloguing-in-Publication DataA catalogue record for this book is available from the British Library.For information on all Academic Press publicationsvisit our website at in the United States of America12 13 14 15 1610 9 8 7 6 54 32 1

DedicationFor Janet, Paul, Lauren, Audrey, Julia and Peter

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ContentsPrefacexviiAcknowledgmentsxxiiiPart I.1.2.3.Investment Banking1Overview of Investment Banking3Postcrisis Global Investment Banking Firms4Other Investment Banking Firms4Investment Banking Businesses6Investment Banking Division7Trading Division16Nonclient-Related Trading and Investing17Asset Management Division19Regulation of the Securities Industry21Introduction21Section One: U.S. Regulations21Section Two: Recent Developments in SecuritiesRegulations32Section Three: Securities Regulations in OtherCountries39Financings45Capital Markets Financings45Financing Alternatives51Fees to Bankers64Distribution Alternatives65Shelf Registration Statements66vii

viiiCONTENTS4.5.“Green Shoe” Overallotment Option66International Financings68Mergers and Acquisitions69The Core of M&A69Creating Value71Strategic Rationale71Synergies and Control Premium72Credit Ratings and Acquisition Currency72Regulatory Considerations74Social and Constituent Considerations74Role of Investment Bankers75Other M&A Participants75Fairness Opinion76Acquisitions77Breakup Fee79Alternative Sale Processes79Cross-Border Transactions80Tax-Free Reorganizations83Corporate Restructurings83Takeover Defenses85Risk Arbitrage86Valuation87Trading109Client-Related Trading109Equity Trading112Fixed Income, Currencies, and Commodities Trading116Market Making123Proprietary Trading126

Contents6.7.8.9.ixInternational Trading127Risk Monitoring and Control128Value at Risk128Asset Management, Wealth Management,and Research131Asset Management131Wealth Management134Research136Credit Rating Agencies, Exchanges, and Clearingand Settlement143Credit Rating Agencies143Exchanges148Dark Pools151Over-the-Counter Market151Clearing and Settlement153International Banking157Euromarkets157Japan’s Financial Market158China’s Financial Market160Emerging Financial Markets164Global IPO Market167American Depositary Receipt174Standardized International Financial Reporting174International Investors175Convertible Securities and Wall Street Innovation177Convertible Securities177Wall Street Innovation185

xCONTENTS10. Investment Banking Careers, Opportunities,and IssuesPart II.197Investment Banking197Trading and Sales200Private Wealth Management203Asset Management204Research205Principal Investments205Other Investment Banking Functions206Investment Banking Opportunities and Issues207Hedge Funds and Private Equity11. Overview of Hedge Funds217219Leverage220Growth222Composition of Investors226Industry Concentration226Performance227Slowdown during 2008231Market Liquidity and Efficiency234Financial Innovation235Illiquid Investments235Lock-Ups, Gates, and Side Pockets236Comparison with Private Equity Funds and MutualFunds237High-Water Marks and Hurdle Rates238Public Offerings238Fund of Funds24012. Hedge Fund Investment StrategiesEquity-Based Strategies243243

ContentsxiMacro Strategies247Arbitrage Strategies247Event-Driven Strategies254Summary26213. Shareholder Activism and Impact on Corporations269Shareholder-Centric versus Director-Centric CorporateGovernance270Activist Hedge Fund Performance273Activist Hedge Fund Accumulation Strategies274CSX versus TCI276Changing Rules That Favor Activists278Daniel Loeb and 13D Letters279Carl Icahn versus Yahoo!281Bill Ackman versus McDonald’s, Wendy’s, Ceridian,Target, and MBIA282Summary28514. Risk, Regulation, and Organizational Structure287Investor Risks287Systemic Risk290Regulation294Organizational Structure29715. Hedge Fund Performance and Issues301Hedge Fund Performance301Funds of Funds305Absolute Return306Benefits Revisited307Transparency308Fees308

xiiCONTENTSHigh-Water Mark309Searching for Returns310Future Developments310Merging of Functions311International Hedge Fund Initiatives31316. Overview of Private Equity315Characteristics of a Private Equity Transaction316Target Companies for Private Equity Transactions317Private Equity Transaction Participants318Structure of a Private Equity Fund319Capitalization of a Private Equity Transaction321Assets under Management323History323Financing Bridges325Covenant-Lite Loans and PIK Toggles326Club Transactions and Stub Equity327Teaming up with Management328Private Investment in Public Equities331Leveraged Recapitalizations331Secondary Markets for Private Equity333Funds of Funds333Private Equity Goes Public334Impact of Financial Services Meltdown on PrivateEquity33417. LBO Financial Model343Determining Cash Flow Available for Debt Serviceand Debt Sources344Determining Financial Sponsor IRR346

ContentsxiiiDetermining Purchase Price and Sale Price347LBO Analysis Example348LBO Analysis Post–Credit Crisis36718. Private Equity Impact on Corporations369Private Equity–Owned Companies: ManagementPractices and Productivity369Private Equity–Owned Company Failures370Scorecard during 2008371Private Equity Purchase Commitment Failures372Private Equity Portfolio Companies Purchased during2006 and 2007373Private Equity Value Proposition for Corporations385Corporate Rationale for Completing Private EquityTransactions387Private Equity as an Alternative Model of CorporateGovernance389Private Equity Influence on Companies39119. Organization, Compensation, Regulation,and Limited Partners393Organizational Structure393Compensation396Regulation401Limited Partners40320. Private Equity Issues and Opportunities409PIPEs409Equity Buyouts410Distressed Assets412

xivCONTENTSPart III.1.M&A Advisory412Capital Markets Activity412Hedge Fund and Real Estate Investments4132008 Losses and Future Expectations413Boom and Bust Cycles414Annex Funds414Limited Partner Pullbacks415Risk Factors415Asian Private Equity Activities415European Private Equity417Strategic Alliances417Private Equity IPOs418Focus on Portfolio Management418Comparison of Private Equity Firms423Profile of The Carlyle Group428Future Issues and Opportunities428The New Landscape430Case Studies433Investment Banking in 2008 (A): Rise and Fallof the Bear4352.Investment Banking in 2008 (B): A Brave New World4593.Freeport-McMoRan: Financing an Acquisition4774.The Best Deal Gillette Could Get?: Proctor & Gamble’sAcquisition of Gillette4955.A Tale of Two Hedge Funds: Magnetar and Peloton5136.Kmart, Sears, and ESL: How a Hedge Fund BecameOne of the World’s Largest Retailers531

Contents7.8.9.10.IndexxvMcDonald’s, Wendy’s, and Hedge Funds: HamburgerHedging?: Hedge Fund Activism and Its Impact onCorporate Governance553Porsche, Volkswagen, and CSX: Cars, Trains,and Derivatives577The Toys “R” Us LBO587Cerberus and the U.S. Auto Industry609625

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PrefaceThe world of finance has dramatically changed following the global financial meltdownof 2007–2009 and ongoing financial challenges during 2010–2012. Market participantshave been significantly impacted and attitudes toward risk, transparency, regulation,and compensation have changed. Investment banks, hedge funds, and private equityfirms are at the epicenter of a transformed financial landscape, forging new roles andseeking new ways to create value within a paradigm of lower risk and greater regulation.This book provides an overview of investment banks, hedge funds, and private equityfirms and describes the relationships between these organizations: how they both compete with and provide important services to each other and the significant impact theyhave on corporations, governments, institutional investors, and individuals. Together,they have reshaped global financing and investing patterns, attracting envy and awebut also criticism and concern. They dominate the headlines of the financial pressand create wealth for many of their managers and investing clients. This book enablesreaders to better understand these heavily interconnected organizations and theirimpact on the global financial market by detailing their historical development andprincipal activities, the regulatory environment, and the risks and opportunities thatexist in the postcrisis world.Ultimately, the objective of this book is to demystify investment banks, hedge funds,and private equity firms, revealing their key functions, compensation systems, andunique role in wealth creation and risk management, as well as their epic battle forinvestor funds and corporate influence. After reading this book, the reader should betterunderstand financial press headlines that herald massive corporate takeovers, corporateshareholder activism, and large capital market financings, and be able to discern themyriad strategies, risks, and conflicts in the financial market landscape. The inclusionof case studies and spreadsheet models provides an analytical framework that allowsthe reader to apply the book’s lessons to real-world financing, investing, and advisoryactivities.Target AudienceThe target audience for this book includes MBA, MSF, and Executive MBA students, andupper-level undergraduates who are focused on finance and investments. Investmentbanking classes can use this book as a primary text, and corporate finance and investments classes can use it either as a secondary text or as a principal text whenfocused on hedge funds and private equity. In addition, professionals working atxvii

xviiiPREFACEinvestment banks, hedge funds, and private equity firms can use the book to broadentheir understanding of their industry and competitors. Finally, professionals at lawfirms, accounting firms, and other firms that advise investment banks, hedge funds,and private equity firms should find this book useful as a resource to better understandand assist their clients.Distinguishing FeaturesThis book is unique for two reasons. First, it is a product of a long career working for andwith investment banks, hedge funds, and private equity firms, in addition to seven yearsof teaching students about these institutions. Second, by addressing all three of theseinstitutions in the same book, and focusing on their simultaneous competition andcooperation with each other, the book provides a more holistic view of the changingboundaries and real-world impact of these institutions than has previously beenavailable.I wrote this book following a twenty-year career as an investment banker at GoldmanSachs, J.P. Morgan, and UBS, and an additional four years at O’Connor & Associates, alarge hedge fund that is now part of UBS. As an investment banker, in addition to completing numerous M&A, debt and equity financing, equity derivative, and convertibletransactions with corporate clients, I worked with private equity firms (financial sponsors) as they acquired companies and pursued exit strategies through recapitalizations,M&A sales, and IPOs. Since 2005, I have been a professor of finance at NorthwesternUniversity’s Kellogg School of Management, where I have had the privilege of teachingwhat I learned during my pre-academic career while completing ongoing research intothe ever-changing landscape of investment banks, hedge funds, and private equity.Teaching these subjects in classrooms has provided greater objectivity and the opportunity to refine concepts and make them more relevant to students. This book is thereforea blend of practitioner experience and academic experience, creating a new educationaloffering that more fully opens the door to understanding the key participants in theglobal financial and advisory markets.Case StudiesThe inclusion of ten cases facilitates greater understanding of the concepts described inthe chapters. These cases focus on recent actual financial and advisory transactions andinclude a summary of risks, rewards, political considerations, impact on corporationsand investors, competition, regulatory hurdles, and other subjects that are linked tochapter topics. The cases include questions for students and case notes and teachingsuggestions for instructors. In addition, several case studies include spreadsheet modelsthat allow readers to create an analytical framework for considering choices, opportunities,and risks that are described in the cases. The cases are assembled together at the end ofthe book, but are all linked to preceding chapters. As a result, cases are designed to be usedin conjunction with chapter reading to reinforce concepts and enhance learning.

PrefacexixThe World Has ChangedDuring 2008, Bear Stearns collapsed into a fire sale to JPMorgan Chase; LehmanBrothers declared bankruptcy; Fannie Mae and Freddie Mac were placed into U.S. government conservatorship; the U.S. government assumed majority control over AIG andinjected more than 100 billion to keep it afloat; Countrywide and Merrill Lynch both soldthemselves to Bank of America under duress; Wells Fargo bought Wachovia at the brink ofbankruptcy; Washington Mutual went into receivership with its branches absorbed byJPMorgan Chase; Goldman Sachs and Morgan Stanley became bank holding companies;and banks all over the world had to be rescued by their respective governments. In theUnited States, this included the rapid provision to banks of over 200 billion of equity capital by the U.S. Treasury as part of a larger 700 billion rescue program, guarantees of debtand asset pools by the FDIC totaling many hundreds of billions of dollars, and an unprecedented expansion of the Federal Reserve’s balance sheet by trillions of dollars as itprovided credit based on almost any type of collateral. All of this occurred as the worldexperienced the most significant globalized downturn since the Great Depression in the1930s. The global markets rebounded somewhat during 2010–2012, but financial anxietycontinued as regulators sought to shore up financial institutions by requiring an increasein capital and a reduction in risk.The investment banking business, in many ways, will never be the same. Leveragehas been reduced, some structured financial products have ceased to exist, and regulation has increased. However, the fundamental business remains the same: advisingcorporations and investors, raising and investing capital, executing trades as an intermediary and principal, providing research, making markets, and providing ideas and capitaldirectly to clients. As investment banks reinvent some aspects of their business andlearn to live in a world of decreased leverage and increased regulation, new opportunities loom large while issues such as public perception, compensation, and risk management must be carefully worked through.Hedge funds and private equity funds suffered significant reversals during 2008, withhedge funds recording investment losses of over 19% on average and private equityfirms acknowledging similar potential losses to their investors. Although these resultswere undesirable and caused some investors to abandon funds, the global equity markets fared even worse, with the major U.S. stock market indices dropping by more than38% and other equity and nongovernment debt indices throughout the world postingsimilar, or greater, losses. Hedge funds and private equity have had to adjust to a changing landscape and re-explain their value proposition while contending with downsizingin the number of funds, assets under management, and return expectations. Reinvention and patience were the watchwords during the global financial crisis as these fundsfought to hold on to as many limited partners as they could while considering newinvestment strategies for a credit-deficient world. During 2009–2012, many hedge fundsand private equity firms bounced back, with positive returns for most hedge funds and arefocus on smaller and less leveraged investments the hallmark of private equity investment activity.

xxPREFACEInvestment banks, hedge funds, and private equity firms have redefined their rolesand developed new processes and business plans designed to maintain historical positions of power and influence. The world has changed, but these institutions will continue to have a significant impact on global capital markets and M&A transactions.This book projects how they will achieve this and the resultant impact on corporations,governments, institutional investors, and individuals.Structure of the BookThe book is divided into three parts. The first part comprises ten chapters that focus oninvestment banks. The second part includes five chapters that discuss hedge funds andfive chapters that review the activities of private equity firms. The third part of the bookincludes ten cases that focus on recent transactions and developments in the financialmarkets. These cases are cross-referenced in the preceding chapters and are used toillustrate concepts that benefit from more rigorous analysis.Part One: Investment BankingThis part includes ten chapters that provide an overview of the industry and the threeprincipal divisions of most large investment banks, including descriptions of the M&Aand financing activities of the Banking Division; the intermediation and market making,as well as principal activities, of the Trading Division; and the investment gathering andmoney management activities of the Asset Management Division. In addition, the otherbusinesses of large investment banks and the activities of boutique investment banksare reviewed. Other chapters focus in more detail on financings, including the activitiesof capital markets groups and the underwriting function, and discussion of IPOs, followon equity offerings, convertibles, and debt transactions. The role of credit rating agencies, prime brokerage groups, research, derivatives, and exchanges is also explored.Finally, regulations, leverage, risk management, clearing and settlement, internationalinvestment banking, career opportunities, and the interrelationship between investmentbanks, hedge funds, and private equity are discussed. The capstone chapters in thispart of the book drill deeply into M&A, convertible securities, and investment bankinnovation.Part One is designed to be used as the text for a full course on investment banking.It should be used in conjunction with cases in Part Three that are specifically referencedin Part One chapters. Part Two’s hedge fund and private equity chapters may be used assupplemental material.Part Two: Hedge Funds and Private EquityThe first five chapters of Part Two focus on hedge funds, including an overview ofthe industry; a focus on selected hedge fund investment strategies; shareholder activism and the impact of hedge fund activists on corporations; risk, regulation, andorganizational structure of hedge funds; and a review of performance, risks, threats,

Prefacexxiand opportunities, as well as the changing value proposition offered by hedge funds totheir limited investor partners. Finally, hedge fund competition with investment banksand private equity is reviewed, as well as the symbiotic relationship between all threeparties.The last five chapters of Part Two examine private equity from the perspective ofthose firms that principally focus on leveraged buyouts (LBOs) and other equity investments in mature companies. These chapters provide an overview of private equity; anexplanation of an LBO model and how it drives decision making; the impact of privateequity on corporations, including case histories of more than a dozen LBO transactions;a description of organizational structures, compensation, regulation, and limited partner relationships; and a discussion of private equity issues and opportunities, diversification efforts, IPOs, historical performance, and relationships with hedge funds andinvestment banks.Part Two is designed to be used as the text for a full course that focuses on hedgefunds and private equity. It should be used in conjunction with cases in Part Three thatare specifically referenced in Part Two chapters. Part One’s investment banking chaptersmay also be used as supplemental material.Part Three: Case StudiesThis part contains ten cases that are referenced in different chapters in Parts One andTwo. The cases enable students to drill deeper into the subject matter of the chaptersand apply concepts in the framework of real transactions and market developments.Case questions (and teaching notes for instructors) are provided, as well as severalspreadsheet models that enable students to manipulate data. The cases focus on the following: the dramatic change in the global investment banking landscape that occurredduring the 2008 financial crisis; Freeport McMoRan’s acquisition of Phelps Dodge, whichfocuses on M&A, risk taking, and financing activities; Proctor & Gamble’s acquisition ofGillette, including the advisory role of investment bankers and discussion of corporategovernance and regulatory issues; the divergent CDO investment strategies of two hedgefunds, which in the first case resulted in excellent returns and in the second case causedbankruptcy; the acquisition through a bankruptcy court process and management ofKmart and Sears by ESL, one of the world’s largest hedge funds; activist hedge fundinvestor Pershing Square’s impact on the capital and organizational structure of McDonald’s Corporation; the LBO of Toys “R” Us, focusing on the role of private equity fundsand investment banks; and Cerberus’s investments in Chrysler and GMAC (GM’s captivefinance subsidiary).New Content in the Second EditionThe second edition reflects the most significant developments for investment banks,hedge funds, and private equity funds during 2009–2012 in relation to regulatory andtax considerations as part of ongoing global financial reform. In addition, developments

xxiiPREFACEin the global competitive landscape are addressed and significant new content thatfocuses on international markets is included in many chapters. All time-sensitive exhibits have been updated, reflecting current information and considerations. Basically, thisedition brings the reader up to date through 2012 on all of the key issues and considerations that impact investment banks, hedge funds, and private equity funds as key participants in the global financial markets.

AcknowledgmentsI am very grateful to many who have contributed to Investment Banks, Hedge Funds, andPrivate Equity. My wife Janet and my children (Paul, Lauren, Audrey, Julia, and Peter)have been very patient and supportive during the more than two-year process ofresearching and writing this book. When I decided to become an academic, theyassumed that my investment banker workweek would drop from 70 þ hours to less thanhalf that amount. This has not been the case, as I learned that academics work longhours too, and the book added many hours to my schedule. My oldest son, Paul, is abanker, derivatives structurer, and former convertibles trader, and I relied on and appreciated his wisdom in thinking through the organization of the book and benefited fromhis many technical suggestions. I wish to thank Xiaowei Zhang, who worked on my teamat J.P. Morgan, for her very diligent and efficient contributions as my principal assistantduring the editing and model-producing stage of this project. I was very fortunate to beable to rely on her many talents during an interlude in her investment banking career.I am also grateful to many finance department colleagues and administrators atNorthwestern University’s Kellogg School of Management for their support for this project and for me over the past five years as I transitioned from practitioner to academic.They have been very patient and encouraging during this process. Special thanksto Kathleen Haggerty for her assistance from the Office of the Dean and to seniorfinance department faculty members Robert Korajczyk, Robert McDonald, and MitchellPetersen for providing valuable suggestions regarding the content of the book.I am indebted to the following colleagues and friends from investment banks thatprovided excellent input to selected chapters: John Gilbertson, Managing Director, Goldman SachsMark Goldstein, Managing Director, Deutsche BankDavid Topper, Managing Director, J.P. MorganJeffrey Vergamini, Executive Director, Morgan StanleyJeffrey Zajkowski, Managing Director, J.P. MorganXiaoyin Zhang, Managing Director, Goldman SachsThe following professionals provided greatly appreciated input regarding hedgefunds and private equity firms, as well as suggestions regarding legal, regulatory, andtax topics in the book: Bryan Bloom, Principal, W.R. Huff Asset Management Co.Deirdre Connell, Partner, Jenner & Blockxxiii

xxiv ACKNOWLEDGMENTSTom Formolo, Partner, Code Hennessy & SimmonsMargaret Gibson, Partner, Kirkland & EllisJason Krejci, Vice President, Standard & Poor’sAnna Pinedo, Partner, Morrison & FoersterJim Neary, Managing Director, Warburg PincusJoel Press, Managing Director, Morgan StanleyJames Rickards, Senior Managing Director, OmnisChirag Saraiya, Principal, Training the StreetPhillip Torres, Portfolio Manager, ForeSix Asset ManagementCatherine Vaughn, Managing Director, Highbridge Capital ManagementJulie Winkler, Managing Director, CME GroupElaine Wolff, Partner, Jenner & BlockI express appreciation to Kellogg Ph.D. candidates Fritz Burkhardt and JonathanBrogaard and Northwestern undergraduate research assistants Esther Lee, Tom Hughes,Anya Hayden, and Ashley Heyer for their earlier work on the book. For the second edition of the book, I received excellent assistance from Kellogg Ph.D. candidate AndreasNeuhierl and Northwestern undergraduate research assistants Stephanie Weinsteinand Radu Cret. Finally, I appreciate the patience and guidance extended to me by mycontacts at Elsevier, especially Scott Bentley, Executive Editor, and Kathleen Paoni,Editorial Project Manager.

PartIInvestment Banking

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1Overview of Investment BankingThe material in this chapter should be cross-referenced with the following cases: Investment Banking in 2008 (A) and Investment Banking in 2008 (B).Investment banking changed dramatically during the 20-year period preceding the globalfinancial crisis that started during mid-2007, as market forces pushed banks from their traditional low-risk role of advising and intermediating to a position of taking considerable riskfor their own account and on behalf of clients. This high level of risk-taking, combined withhigh leverage, transformed the industry during 2008, when several major firms failed, hugetrading losses were recorded, and all large firms were forced to reorganize their business.Risk-taking activities of investment banks were reduced following large losses thatstemmed primarily from mortgage-related assets, bad loans, and an overall reduction in revenues due to the financial crisis. This led to an industry-wide effort to reduce leverage ratiosand a string of new equity capital issuances. By the end of 2008, five U.S.-headquartered“pure-play” investment banks (which did not operate deposit-taking businesses, unlikelarge “universal” banks such as JPMorgan Chase, which operated a l

investment banks, hedge funds, and private equity firms can use the book to broaden their understanding of their industry and competitors. Finally, professionals at law firms, accounting firms, and other firms that advise investment banks, hedge funds, and private equity firms should

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