Linking up a Hedge Fund, a Revolution and the Fall of the Berlin WallPublished: November 16, 2005 in Knowledge@Wharton
The collapse of Long-Term Capital Management, The Orange Revolution in Ukraine, and the unification of East and West Germany all caught corporate executives by surprise and revealed the links between global change and business opportunity, according to members of the board of governors of the Joseph H. Lauder Institute of Management and International Studies at Wharton.
In the future, China, India and Eastern Europe are likely to play major roles in the development of international business, they said during a wide-ranging panel discussion titled, Understanding Global Linkages: Lessons from Recent Events.
Richard Herring, Wharton finance professor and director of the Lauder Institute, began the discussion by asking the panelists to describe events that took them by surprise and revealed an under-appreciated interconnectedness in the global economy. “We all have mental models of how things should work and usually they do, but every now and then something unexpected happens and causes you to step back and manage differently,” said Herring, who is also co-director of Wharton’s Financial Institutions Center.
Carl Hahn, former CEO of Volkswagen, offered an example of these linkages by noting how the fall of the Berlin Wall, while unanticipated, created an enormous opportunity for his company. Volkswagen raced into East Germany and quickly negotiated transactions with the government to acquire what turned out to be modern, efficient factories with highly productive workers. The facilities were in excellent condition, but had been mothballed because the East Germans lacked the financial strength to generate production, said Hahn. Indeed, the waiting time for a car in East Germany was then 16 years.
“But what was astonishing to me during this race is that I was unnecessarily speeding, because nobody followed. Nobody seemed to be interested in this new market,” he said. “The lesson to be learned is that when something completely new comes up, big corporations study it and that takes some time.” Volkswagen simply plunged in. “It was beneficial. We found out that the East Germans had not adopted all the bad things about East Germany.”
Hahn also negotiated the development of a Volkswagen joint venture in China just as that planned economy began to embrace free-market economic systems. He noted that Volkswagen executives were uncertain about the level of China’s commitment to capitalism, but took comfort in an unconventional indicator. “We found out these Chinese leaders were all sending their children to study in the United States. I must say this was, for us, a very clear signal that [the country] intended to go in a new direction.”
Looking ahead, he said, India is the next frontier. “From a European point of view, we hardly talk about India, which is strange,” said Hahn. “India is 20 years behind China, but it has hundreds of millions of people who speak the right language for the global market.” In addition, India has a youthful, enthusiastic and intelligent population of engineers and scientists to drive economic development.
Closer to home, he noted that rising gasoline prices, particularly after Hurricane Katrina, have made Europeans increasingly concerned about dwindling natural resources and ecological problems. And yet industries in the U.S. still don’t “consider this scenario a key element in their future product planning,” he said. “As a consequence, this could be an additional handicap” for the American automobile industry and “an additional advantage” for the European and Japanese auto industries. As for Germany, he added, economic growth is lagging. “It suffers from too much of a socialist tradition, is not yet inhaling fully free enterprise, and has rules and regulations which paralyze the country.”
Fed to the Rescue
Allen Wheat, former CEO of Credit Suisse First Boston, recalled the shock waves that went through the investment markets after the collapse of Long-Term Capital Management in 1998. Wall Street, he said, had been in awe of the hedge fund founded in 1994 by John Meriwether, of Salomon Brothers, along with Nobel-prize winning economists Myron Scholes and Robert Merton. “The trading was done by the baddest traders on the street.”
But in the summer of 1998 the Russian default on government debt set off a “perfect storm” that wounded LCTM’s positions. Wheat said he had heard rumblings that the firm was in trouble, but didn’t know the magnitude of the problem until he received a call from the president of the New York Federal Reserve, William J. McDonough. McDonough asked Wheat and several other Wall Street executives to come to the Fed that evening for a meeting, insisting on Wheat’s presence despite arrangements he had made to fly to Madrid that night.
“What we heard was shocking,” Wheat recalled, adding that he and the other Wall Street managers in the room were amazed at the magnitude of the losses and the degree to which Wall Street had extended credit to Long-Term Capital. The Fed and those at the meeting agreed to put up new capital to prevent a default. “The Long-Term Capital bailout was done on an ad hoc basis,” Wheat noted. “The Fed had no authority over it. That’s still what the situation would be today should there be another Long-Term Capital.”
While the pools of hedge fund money are much larger than they were seven years ago, “there still is nobody directly responsible,” Wheat said. He has developed models that indicate it would be highly unlikely for another problem as dramatic as Long-Term Capital to develop. “But maybe with a perfect, perfect storm there could be something like Long-Term Capital lurking out there. One thing has not changed: If [it happened again], you wouldn’t know exactly where to go. It would have to be solved on an ad hoc basis.... I hope whoever takes responsibility is as good as the guys at the Fed were seven years ago.”
Hard to Hide from the Media
Ronald Lauder, chairman of Clinique Laboratories and former U.S. Ambassador to Austria, focused his remarks on the 2004 Orange Revolution in Ukraine, which he said underscored changes in democracy and media business opportunities around the world. The election of Viktor Yushchenko as Ukraine’s president, after a run-off election and an attempt to assassinate him with dioxin poisoning, is part of that historic moment, said Lauder.
“Ukraine is one of the most corrupt countries in Europe, if not the world. There are other countries that get close, but Ukraine wins every time,” he noted. The Orange Revolution -- named after the main color used in the campaign for Yushchenko -- “changed things dramatically” because it had a contagion effect, spurring democratic movements in Kyrgyzstan, where President Askar Akayev was overthrown in April 2005, and in Lebanon. The Orange Revolution also has had an impact on Jordan and Morocco, where citizens are beginning to question their leaders, Lauder noted. “All these countries had one major problem. They couldn’t find people in government who believe in private enterprise. The fact is that Eastern Europe and the Middle East are exploding. When you have a free media you open up all sorts of possibilities for business. Free media puts the spotlight on the rule of law and on what people can and cannot do. With a free media, it’s hard for government to [take actions] that are illegal or corrupt.”
Lauder began investing in media in 1993 when former Soviet countries in Europe started to auction off broadcasting licenses. His firm, Central European Media Enterprises, and its partners operate 10 stations in six countries. As a teenager, Lauder’s fascination with Central and Eastern Europe led him to travel there regularly and eventually to build a network of contacts. During the Soviet era, he pointed out, television was largely used as propaganda, creating pent-up demand for new media with the fall of the Iron Curtain.
Asked about the market for media in China, Lauder noted that he had recently been to Shanghai to investigate television and Internet markets. “It became clear to me that the government wants to stop free media as much as it can,” said Lauder. “It’s very subtle. They have taken a page out of the Russian book.” It is always difficult to invest in media when a country’s commitment to democracy is cloudy, he added. “I believe sooner or later there will be enough push in China to open up the media business. Once you [do that], it’s difficult to close it down again. I feel it will happen in China, but not that quickly.”
Understanding Different Cultures
According to Jean-Pierre Rosso, former CEO of CNH Global N.V., the global manufacturer of agricultural and construction equipment based in Lake Forest, Ill., leadership and cultural understanding are two key dimensions of managing a global business. In a crisis, such as the September 11 terror attacks in New York and Washington, D.C., leadership should be straightforward, he said. Managers need to act with speed and the conviction to do what is right. “The second dimension is cultural understanding of what’s going on in the world and of the various issues you are going to face as you are doing business.”
In its line of business, CNH has run into conflicts over the purchase of equipment by certain foreign governments, Rosso noted. “We were shocked to find that equipment had landed in Libya in violation of the embargo,” he said, adding that when the company tracked down more information about the sale, it learned that the equipment had come to Libya through another country. “The question was, ‘Who was responsible for that?’” Rosso asked. Another problem surfaced when CNH equipment, manufactured through a joint venture in Pakistan, was purchased by the Taliban in Afghanistan. And lately, as the company expands into Central Asia, CNH has had to be wary of violating the U.S. Foreign Corrupt Practices Act, which outlaws bribery by U.S. firms operating abroad. “The point is, you cannot deal with those issues if you really don’t understand the cultural environment,” he said. “You have to obey those laws faithfully but sometimes there are holes in the system.... In a global business you will be faced with very complex issues. If you don’t have the right people, or you are not prepared, you will be in a difficult situation.”
According to Rosso -- who served on President Bush’s Advisory Committee for Trade Policy and Negotiations -- despite movement toward free trade, agriculture remains complicated by politics and subsidies. “That is a hard one to resolve,” he said, adding that the Bush administration hopes to advance trade between the United States and Latin America through treaties, such as the Central American Free Trade Agreement. “Their hope is to expand free trade with South America step-by-step. Once you develop trade with a country, you are not likely to fight with it.”
Europeans, Rosso noted, are making strong inroads into Latin America through the Mercosur trade bloc, which includes Brazil, Argentina, Uruguay and Paraguay. Meanwhile, since 1991, the U.S. has been attempting to broaden trade throughout the western hemisphere with its proposed Free Trade of the Americas Act, modeled after the North American Free Trade Act. But negotiations have been slow. “It could well be that Europe and Mercosur make strong trade ties even before we do,” he said. “The Free Trade of the Americas Act is the battle to watch.”
Paul Fribourg, chairman of the Lauder board of governors and CEO of the ContiGroup Companies -- a privately held agribusiness firm headquartered in New York -- described how his own firm had evolved in the global business environment. He joined the company in 1976 when it was mainly a commodities trading house doing a strong business selling grain to Russia, and China was just entering the world market. “It was a very sexy period,” he said, but by the time he reached senior management in the 1990s, commodities trading had become a high-risk, low-reward business. Managers at the firm asked: “How do you deal with a new world order when your core business has become a buggy whip?”
The company launched a major restructuring. It diversified its holdings in industries including beef, poultry and shipping by taking on new partners. It is also analyzing possible new ventures, including a Chinese investment company. “We are looking at the key positions in direct investment in companies where we play an important role as a board member -- like Warren Buffett [does],” he said. “You don’t have to own a controlling interest, but you can go into business with a partner you trust and roll up your sleeves and help build great companies.” That partner-based structure gives the company the flexibility to follow new opportunities. “We can be opportunistic. We can go where the world takes us. Today it’s China. Who knows where it’s going to be tomorrow?”