Mr. Kinney’s Background: Senior Employee of Morgan Stanley from 1986 – 2009, including Chief Operating Officer for Morgan Stanley Capital Group. 2001-2009. Morgan Stanley Capital Group (MSCG) was the legal entity for the Commodities Trading Division which was active in the oil, power, metals, and agriculture markets globally. During Mr. Kinney’s tenure MSCG invested in various existing or new businesses related to commodities. In addition, the commodities division assisted clients in either providing financing of new ventures or to provide trading structures to allow new ventures to get bank financing. MSCG had over 400 employees globally, primarily in New York, London and Singapore.
Question
Morgan Stanley, and in particular, the Commodities Trading Division would not be viewed as traditional venture capital firm. How did a global trading business act as a funding venture for entrepreneurs?
First, one of the differentiators for MSCG’s Commodities business was having a deep understanding of the physical commodity markets in addition to being a major player in the financial commodities markets. Outside of MSCG and Goldman Sachs, most of the major financial firms lacked expertise in the physical commodity markets. This meant that we could often play a broader role than our competitors could for our customers, who were major producers or consumers of commodities. Examples could be refiners, gold mines, power companies – virtually anyone who had major exposure to commodity prices. Second, we had both a long-term macro view of the various commodity markets as well as strategic objectives to broaden our business geographically or expand the breadth of our commodities business. As a result, we often came in contact with a broad range of opportunities.
Question
Can you give an example how would this work?
As one example, in the late 90’s, crude prices had dropped dramatically, actually as low as $11-$12 a barrel. Although prices recovered in early 2000 to the mid $20’s per barrel, oil price volatility caused several major oil companies to be interested in dumping older, less productive wells. In early 2002, we began working with an entrepreneur, currently in oil services business, who was interested in expanding their operation by purchasing and managing these unwanted oil wells, but lacked funding. Since a drop in the price of oil could make some of these wells potentially unprofitable, other potential investors (for example, college endowment funds, or pension funds who wanted commodity diversification) were concerned about exposure to price risk. MSCG did two things: in addition to investing in the venture, it also helped the company execute a multiyear hedge to reduce their risk to downward oil prices. The venture, named Helios Energy Partners, became extremely successful as oil prices rose to $50-70 a barrel in the mid 2005-2007.
A slightly different example, involved the purchase of an oil refinery by an investor group, including the management team of the refinery. In order to secure a bank loan, MSCG agreed to supply and own the crude oil input, and own and distribute the refined oil products; in effect, eliminating the need to finance the venture’s physical inventory. This reduced the amount of funding required to support their balance sheet, which made the venture more acceptable to their bank.
Other examples included power plants, oil pipeline and storage facilities, gold mines, and shipping operations. Probably one of the most notable examples was MSCG, along with Goldman Sachs, involvement in the creation of Intercontinental Exchange (NYSE ticker ICE) in 2000. Seeing that electronic trading was inevitable, MSCG funded and were active participants in the introduction of the automated commodity trading platform. Founder Jeffrey Sprecher, had been involved in an earlier electricity trading platform, called Continental Power Exchange. Enron had also introduced its own electronic trading platform for commodities that collapsed with Enron’s demise, but MSCG and Goldman Sachs correctly perceived the need for an independent exchange, not tied to a particular firm. They recruited other major commodity players (BP, Total, Shell, Deutsche Bank and Societe Generale) to become investors, and the exchange became very successful.
Question
How did MSCG choose and evaluate these opportunities?
In some ways, I don’t think we approached this much differently than venture capital firms, although we were narrower in our interests. As mentioned earlier, we had a strategic vision for our business. This allowed us to focus our efforts where we thought there was the most upside, where our expertise was the most relevant, and there was synergy with the expansion of our sales and trading business. When we looked at an investment opportunity, we would evaluate the competitive advantage that both the venture and MSCG were bringing to the table. Why would this new venture succeed versus its competitors? What were the various roles that MSCG could potentially play? What is the strength and weaknesses of the business team? Then you can review the financials and the opportunity. If there is a history, you need to understand the previous success or failure.
Question
Following up to the response to the last question. How did MSCG assess the strength of the business team involved with any given venture? What elements of this assessment do you consider to be most important?
This is a good question since this is a fairly subjective area. I think in general you start with definition of their competitive advantage in the last question. Is it driven by a single person or a few key individuals? Beyond technical skills, what is the management structure and philosophy? Is there a collaborative environment that will support the potential expansion? Let me use three examples of businesses looking for potential funding or acquisition.
In the first company, there was a strong team, with both business expertise, and team strengths in accounting, operations, and marketing. It had a strong senior CEO, who was looking to retire, and several strong managers, but no clear succession plan in place. One concern was that the managers looked at the acquisition with some suspicion and regularly mentioned wanting control and independence. The second company, was a tightly run family business, had experienced some financial cash flow problems, and were looking to cash out. They had run the business as an extension of the family, and lacked true senior employees beyond the family. The last company was led by a family founder, who was also the majority owner. Like the first company, he had a solid team in place, but had begun to delegate as he thought about and led the team to an understanding of the need to change in order to get to the next level. All three companies had tremendous expertise in their particular field and fit in well with MSCG’s strategy.
In the first company, although there was very good individual talent, the removal of the CEO was going to create political turmoil since there was no logical successor. The internal controls were good, and this was, in general, a well run company. However, the old management structure relied on strong central control by the CEO, and masked a potential power struggle among the managers that could break down team cooperation. Since new investors were going to drive the eventual succession change, there was internal suspicion about change driven from outside. It was important to understand that there was a high probability for the need to parachute talent into the organization or spend a lot of time managing the culture change from the old organization.
The second company was a disaster. Since the original owners treated it like an extension of their family finances, there were no strong corporate controls. Their people were competent, but many were long time employees that had learned to survive the family management, and lacked understanding of best practices. There was also a history of cash flow problems, which were blamed on high debt levels, but could be masking other problems. Drilling into their account receivables and cash flow controls, eventually confirmed these suspicions. It was very unclear what the actual value of this company was and what investors would be getting with an investment in this company. Radical change would be required to make this company successful.
The last company ended up being an extremely successful acquisition. The team was prepared for a management change, there was a clear succession plan, and they were actively searching for synergies with MSCG to expand their business or increase their competitive advantage. Since the family founder was gradually stepping away, he had led his employees towards a workable corporate structure. They knew their roles, and were focused on how to grow the company. Unlike the first example, there was no political infighting. Although this may sound like subjective or soft evidence, as opposed to numbers driven analysis, the reality is that collaboration and openness to change are critical traits for successful companies.
Question
Innovative technology has created new patterns in commodities supply. Examples include deeper oil wells and new methods for extracting shale oil. Does MSCG track R&D efforts to prepare for potential shifts in supply patterns? Has MSCG ever invested in projects that include promising new technologies (but may not have a proven track record for success)? If so, how does MSCG measure risk?
As a business, you always need to stay on top of innovation, in particular, understanding the implications of disruptive change. In regards to fracking, there are tremendous implications for power generation, transportation, water usage, and other related technologies. So I think you need to be constantly revising and rethinking your views on markets and implications of change. An advantage of being active in the physical commodity markets was a natural tendency to come across new potential opportunities.
However, going back to my earlier point about understanding core competencies and competitive advantages, I don’t think we believed that we had any advantages in knowing which new technologies would succeed. If MSCG considered investment in unproven technologies, I think our approach was similar to any venture capital firm. You would look to have a portfolio of investments, since the eventual winner cannot be known. Just because something is hot doesn’t mean success is guaranteed. For example, when George Bush promoted cellulosic ethanol in 2006, the US government invested in 6 projects), with the most promising being Range Fuels, promoted by Vinod Khosla. It appeared that with government support, subsidies and mandates for use in gasoline, that this was a can’t-miss investment and yet it didn’t succeed. For background on Range Fuels see (http://online.wsj.com/article/SB10001424052748704364004576132453701004530.html)
Around the same time, the view was that the US was running out of natural gas and needed to import liquefied natural gas (LNG), requiring infrastructure at ports to convert and inject into US pipelines. Fracking has completely turned this around, with exports now being discussed instead of imports. So the approach to managing risk in new technologies is by having a portfolio and continually reevaluating opportunities.
From MSCG’s perspective, we didn’t have a competitive advantage in evaluating new technology. We tended to concentrate our investment in areas where there was a synergy with our sales and trading business. Our traders were experts in their specialist area and connected to their markets constantly. Our sales and marketing personnel invested time in understanding our clients’ needs (as significant users or suppliers of commodities) which would lead to opportunities.
Question
Does MSCG rely primarily on internal research to identify opportunities (or in this case, ventures)? How often was MSCG approached by businesses to arrange unique partnerships or financing arrangements (such as the project in which MSCG owned the inventory at a particular refinery)? Does either of the latter two methods for sourcing deals tend to yield greater success?
MSCG approached this in several ways. First, there was a Structured Products Group, whose role was to investigate and execute a wide range of structures such as financing deals, acquisitions, joint ventures – in general, any opportunity that was outside of the normal trading business. They would respond to Requests for Proposals as well as work on ideas generated by the trading business. Since they could come in contact with sensitive information, there were tight controls concerning access to information. Second, within each trading business (oil, metals, electricity, agriculture) there were specialist salespeople, called Originators, who worked with existing clients on devising solutions to complex business problems. They would involve the Structured Products Group as their expertise was needed. Third, our trading personnel had many contacts that could result in uncovering opportunities. There was a fairly regular flow of ideas and discussion.
Any of these approaches could identify opportunities. After a preliminary investigation, there was a formal process that involved senior commodities management and key support groups (accounting, operations, technology, risk management, as examples), to evaluate and support any potential deal.
