ICOs have precedence — they were called “High Yield Project Finance Bonds”by@jdorman81
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ICOs have precedence — they were called “High Yield Project Finance Bonds”

by Jeff DormanJune 17th, 2018
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As I wrote <a href="" target="_blank">last month</a>, almost everyone I know who entered the Crypto-world from more traditional Wall Street backgrounds begins their Blockchain &amp; Crypto journey with harsh skepticism. But gradually, each person starts to come around after a ton of reading, talking and engaging with others.

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As I wrote last month, almost everyone I know who entered the Crypto-world from more traditional Wall Street backgrounds begins their Blockchain & Crypto journey with harsh skepticism. But gradually, each person starts to come around after a ton of reading, talking and engaging with others.

First, Bitcoin starts to make sense as a store of value and a hedge to perpetually declining fiat currencies. Then Ethereum starts to make sense as a “pay to play” app store, and finally, “Tokenizing the World” becomes a concept that seems more reality than fiction. Eventually, everyone comes to terms that this new asset class is real, unless of course they are paid to create controversy with no consequences.

ICOs on the other hand remain a polarizing topic.

For good reason: Anytime a company can raise hundreds of millions, if not billions of dollars, in a matter of days without a working product, an experienced team, or a well-mapped out plan, it naturally raises eyebrows.

A history of innovative but untested financing vehicles

But let me remind you that risky, unproven companies have been raising money for decades. As a former investment banker and bond trader, I’ve seen my share of financial shenanigans/innovations before.

  • I was at Lehman Brothers when the now infamous (but brilliant) Erin Callan basically invented Trust Preferred Securities for banks in order to qualify as Tier 1 Capital — a financing boom for banks followed. Like ICOs, this was a completely new way for companies to raise money.
  • I was at Friedman, Billings, Ramsey during the PIPE boom, when public companies raised insane amounts of capital at large discounts through private security offerings.
  • And I was at Merrill Lynch when every CDO, CDO-squared, and other credit derivative instrument was created out of thin air simply to satisfy demands from investors for higher yields, regardless of perceived risk (that didn’t end well).
  • Anyone invest in a SPAC recently? That’s the equivalent of giving an entrepreneur a blank check, and many have been disasters for investors.

Some of these innovative techniques worked (and still work today); others did not. But at the time of their creation, the general consensus was to praise the investment banks’ ingenuity. However, the narrative surrounding ICOs is completely different — with some event claiming that they are mostly fraudulent. Many pioneers and leaders have since dispelled this myth, and even the SEC has outspokenly refuted this claim, but ICOs still carry a negative connotation in the Finance world. ICOs are unique only in the sense that you are receiving tokens for your investment rather than certificates of stock or coupon-paying bonds, and that you are funding the buildout of new Technologies instead of funding acquisition vehicles or infrastructure projects.

Which Brings us to Project Finance Bonds

Project financing has been around for 50+ years, as Governments and corporations alike have issued project finance bonds to fund anything from infrastructure projects to new Casinos. Just like with today’s ICOs, if there are investors out there that believe in the project’s ability to grow, or repay their debts, the project will get funded at some price.

Back in 2007 and 2008, I was on the High Yield trading desk at Merrill Lynch. Merrill Lynch had a niche in the Casino market, underwriting tens of billions of dollars of “Greenfield Casino Bonds” during a construction boom (pre-crisis). These bonds carried high coupons (usually 8–15% yields), with 1–2 years of coupon payments in escrow (to guarantee payment pre-revenue), and the proceeds of these bonds were then used to build new casinos (often in markets that had just become available due to new State Government regulation). Some of these project financings worked out very well for both the issuer and the investor, as the casino would open 18–24 months after raising the money, and would use cash flow from gambling customers to pay back bondholders.

Others were unmitigated disasters.

Many projects ran way over budget, and other casinos never even got completed. In some cases, the casino did in fact open, but failed to generate enough revenues to pay back obligations, causing bond prices to plummet. There were even claims of fraud (sound familiar?).

  • Fontainebleu Las Vegas raised over $2 billion from banks and asset managers… the casino still hasn’t opened 10 years later and the project was sold to Carl Icahn out of bankruptcy for $150 million, nearly wiping out investors with a 99% loss.
  • Revel Atlantic City raised over $3 billion from banks and asset managers to fund its ground-breaking luxury casino & hotel…Morgan Stanley alone lost $1 billion, and the casino sold in bankruptcy for under $100 million, once again, wiping out investors (not once but twice).

You might argue that these investments make more sense than ICOs because you at least had a claim on the asset itself and the securities were registered. Sure. But there were also famous Native American Casino financings that lead to bond defaults (like Buffalo Thunder in New Mexico, and Foxwoods and Mohegan Sun in Connecticut). In these cases, because the casinos were built on Native American land, bondholders were forced to go through lengthy bankruptcy proceedings in “Tribal court”, completely outside of US jurisdiction and bankruptcy law. In fact, the credit rating agencies (Moody’s, S&P and Fitch) even acknowledged that they didn’t know how to properly assess the risks because there was no precedence (sound familiar?).

Conclusion — ICOs are innovative, give them time to mature

When an ICO fails, many outspoken critics rush to assume it was fraudulent, or that retail investors were “bamboozled”. But I rarely see or hear any uproar when a casino fails and investors get wiped out, and it certainly hasn’t resulted in a slow-down of this type of financing.

Is it because investors in these other projects were more knowledgeable and knew what they were getting into? Very successful, established mutual funds and hedge funds purchased these bonds and lost a lot of money.

Is it because the underwriter (Merrill Lynch, Bank of America, Goldman Sachs, etc) “blessed” the project with a completely biased, positive research report about the company’s future? This is a CYA policy, but most professional money managers know what the goal of sell-side research is.

Or is it simply because a casino is more easy to understand than a blockchain _protocol?_There are plenty of people who understand software and protocol more than they understand the cash flows of a casino.

Perhaps the investing vehicle itself (Debt & equity) just makes more intuitive sense to people. Regardless, it’s important to recognize that new and innovative financial products will always be invented if there is demand for it. Some will work; others will fail. But ultimately, if the regulatory rules are followed, and investors are aware of the risks, then companies should continue to explore these financing options.

One day soon, ICOs may be the most common form of financing. Indepent of your views on any specific ICO available today, the opportunity to invest via this structure will expand the investable universe and offer new opportunities to increase your wealth.

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