Urbana Corporation Exchange Update
After many years of work, the Chicago Board Options Exchange (“CBOE”) became a public company on June 15th at $29 a share. This initial public offering (“IPO”) price is approximately the equivalent of $2,420,000 per seat.
The CBOE share price has risen since the IPO and closed at the end of June at $32.55, the equivalent of $2.7 million per seat. While this is not the highest price at which the CBOE has been valued, it is a considerable step up from where its seats were trading just a few weeks ago in what has otherwise been a very weak overall market.
In our funds, we hold the CBOE shares that were received from the IPO at a discount to the market price, because half of the shares are restricted from sale for 6 months and the other half are restricted for one year. The discount we apply is the prime bank lending rate plus 1%. At present, this equates to about $1 per share. This discount will narrow as the time until the shares are freely tradable diminishes.
The CBOE’s IPO was an essential step in a process which we believe will culminate in its being acquired by a larger exchange or financial company. Prior to the IPO, the CBOE’s ownership structure was confusing as a result of a settlement which allocated an 18% ownership interest in the CBOE to the former members of the Chicago Board of Trade (“CBOT”), the organization which founded the CBOE.
Through the demutualization process, the CBOE’s management received shares and now has a substantial financial stake in the success of the exchange’s share price.
Goldman Sachs clearly played a significant role in advising the CBOE’s management in the IPO process. It does not seem reasonable to us that Goldman would invest as much effort and so many years in the CBOE as it did solely for the purpose of dividing the underwriting fee on a $300 million IPO with 17 other brokerage firms. Rather, it appears likely that Goldman’s true aim is to broker a multi-billion dollar deal to sell the CBOE.
The next step is for the CBOE to follow through with its plan to buy back a portion of the otherwise restricted shares from its former members using the cash it raised in the IPO. Scheduled to occur between one and four months after the IPO, this buyback will reduce the number of shares outstanding, making a subsequent takeover less expensive for a prospective bidder. While there is cash available to take-up less than 10% of the outstanding restricted shares, Goldman and the CBOE’s management can use the price and volume of members’ shares tendered to estimate the premium required to make a takeover successful.
In our opinion, a prospective buyer would have the most leverage if an offer were made while the remainder of the members’ CBOE shares are still restricted. This first lock-up ends December 15th, 2010. In brief, the CBOE’s shares have been trading higher in an otherwise down market since its IPO. It is North America’s only independent options exchange. The CBOE is also the world’s largest, most profitable and highest margin options exchange and owns its most lucrative products directly or through exclusive licenses. Goldman should be able to find a larger financial entity that is interested in improving its numbers in any or all of the above categories.
Bombay Stock Exchange
We believe that he most exciting investment opportunity in the exchange sector over the next 18 months will be the Bombay Stock Exchange (“BSE”). Our essential thesis is that an exchange is the best way to participate in the growth of a nation’s economy. Relatively unaffected by the turmoil in western economies, India’s marketplace is largely self-sustaining and growing rapidly. The world’s largest democracy, India, possess a free press and a rule of law absent from the other major economic power in the region. An investment in the oldest stock exchange in all of Asia, the BSE, makes great sense.
Our investment philosophy with regard to private securities exchanges is one of constructive engagement. Our firm’s exchange team works with management to help each exchange achieve its goals within its respective national context. In 2007, our fund’s made their first investment in the BSE, but up until last year we found its management slow to take hold of the growth in India. Throughout this period, we continued to talk with the BSE, but also with other interested parties, regarding how the exchange could better capitalize on the market and economic developments going on around it. In 2009, a dramatic changing of the guard at the very top of the BSE’s leadership began with the appointment of Mr. Madhu Kannan, formerly of the New York Stock Exchange (“NYSE”), as the new CEO. The BSE then added a team of senior managers with both western exchange experience and a deep knowledge of the Indian market. This team includes Mr. Jim Shapiro, another NYSE alumnus, who is now the BSE’s Head of Market Development. A transformation at the Board level was equally critical. When Mr. Subramanian Ramadorai was named to be the new BSE Chairman, this paved the way for Mr. Andreas Preuss, Vice-Chairman of Deutsche Borse, one of the largest securities exchange in the world, to also join the Board.
The new management and board are agreed on transforming the BSE’s business model and to get it ready for an IPO in 2011. Late last year, the Indian government created the Jalan Committee with a mandate to examine ownership limits, structure and under what terms Indian stock exchanges can transition from private to public companies. The Committee’s report is expected this autumn.
So far, we have been very pleased with the ways in which the BSE’s management has executed on its plans. With the new team in place for only 6 months of the previous fiscal year (March 31st year-end), trading volumes were up 25% and revenue grew by 15% over the previous year. The new management has enabled the BSE to take control of its own clearing and settlement operations (which is more profitable than trading). They have made the exchange more accessible to a broader range of trading firms and received hundreds of new membership applications. The BSE also bought Marketplace Technologies in order to improve the experience of brokers using the exchange’s front-end trading system. Even at the level of investor relations, which is critical for an aspiring public company, the information flow and accessibility of management is dramatically better.
None of these improvements are currently being reflected in the BSE’s share price. At 375 rupees per share, the BSE has a price-to-earnings (“P/E”) ratio of just 18. A number of public exchanges with less growth potential currently have P/E ratios that are much higher. Moreover, the total market cap of the exchange is only USD$827 million, with over $220 million in cash on the balance sheet. Should the BSE’s management be reasonably successful in its efforts, then we believe that the valuation of this exchange as a public company should be substantially higher than it is today.
At present, our funds own just over 4% of the BSE in aggregate. The maximum ownership limit is 5% and it is our intention to bring our funds’ participation up to that level. Should rules change as a result of the Jalan Committee report and higher ownership limits are allowed, then we will explore this opportunity as well.
During 2010 and 2011, we believe that the CBOE and the BSE will combine to generate significant gains for our investors. Over four years have elapsed since our funds bought their first CBOE seats, but now that its IPO is a reality, it appears that subsequent events should unfold fairly rapidly. Over the next 18 months, a relatively strong Indian economy combined with the new BSE management, its competitive focus and IPO plans should be a very profitable combination for our investors.
We hope this update is helpful. Please feel free to contact Thomas S. Caldwell with questions.