Letter number 110 of February 2018
- QUESTIONS & COMMENTS
Holding stakes in listed companies has the advantage of having an investment in an asset with real liquidity, immediate performance monitoring, and the possibility of an influence in governance, depending on the size of the stake and the shareholding structure. This type of investment naturally has its drawbacks and its advantages, in particular the share price changes that could impose the recording of capital losses, if any, (but that are not realised).
But such stakes in listed companies also facilitate easier financing and dynamic management of the economic exposure.
Like for any asset with an objective value on a liquid market, banks are more readily disposed to lending if they get the shares in a listed company as collateral. It’s a simple and flexible product, a sort of transposition of a mortgage loan to listed shares, referred to as a margin loan. The bank lends an amount that is less than the value of the listed shares and requires that the value of the shares should at all times represent, for example, 150% of the amount of the loan (this is called over-collateralisation). If the share price falls and the value of the shares pledged falls to below 150% of the amount of the loan, the company will have to (i) pledge more shares (if it still has shares that have not been pledged), (ii) provide collateral in cash, (iii) reimburse the whole or part of the loan, or allow the bank to sell the shares to reimburse the loan (or at least raise the level of collateral).
Let’s take the example of an Orange shareholder that has a 1% stake in the capital (or 26.2 million shares). The Orange share is trading at €14 and the telecom group’s market capitalisation is €37bn. This shareholder could negotiate a bank loan of €200m backed by its Orange shares. Let’s say that the bank requires over-collateralisation in the amount of 150%. The shareholder will pledge 21.4 million shares (21.4 x 14 = 300 or 200 x 150%). If the share price falls to €12, the shareholder will have to pledge another 3.6 million shares so that the value of the collateral on the loan retains a value of €300m. If the share price falls to €10, the shareholder will not have enough shares to make up the guarantee (it would need 30 million shares and it only has 26.2 million). So it will have to choose between providing collateral in cash, repaying the loan (if it has other resources) or selling the shares.
For the bank, these loans have the advantage (as for all asset-backed loans) of limiting risk, because of the capacity to liquidate the liquid collateral and they can thus offer more attractive terms. This type of product enables some companies that would be unable to borrow on the strength of their own signature (as their cash flows are too low or too unpredictable) to gain access to the banking market. Finally, we note that a margin loan can be put in place when the stake is constituted or at a later stage (thus enabling the company to finance the acquisition of another stake or another project).
Conceptually, equity swaps are another way of financing an exposure to a stake in a listed company. With equity swaps, the bank acquires the shares, but enters into a contract with the investor to exchange the performance of the share (rise/fall and any dividends) for interest. Accordingly, the investor is exposed economically like a shareholder, but does not get involved in governance (it does not exercise voting rights as it is not the owner of the shares). Like for margin loans, equity swaps require a mechanism for regular margin calls to be put in place so that the bank does not become at risk on its counterparty without collaterals. The contract can make provision for the equity swap to be unwound on maturity in shares (i.e. the bank will effectively deliver the shares to the company in exchange for payment of their initial value) or in cash (the unwinding of the contract will only be an exchange of performance).
To conclude, it should be clear that neither margin loans nor equity swaps modify the economic exposure of the investor.
The dynamic management of performance
The holder of a stake in a listed company generally has risk/return goals in line with the fundamental value of the shares. It may have set a target share price or annual performance given the fundamentals of the company in which it has invested. Options can be used to modify the profile of economic exposure of a stake in order to comply with any anticipations or objectives of (partial) securitisation of the rate of return on the investment. These instruments can be used to:
- Securitise all or part of a capital gain with the purchase of put options. If the share price falls, the company will be compensated by the increase in the value of its options. When the options mature, the company could then decide to sell its stake at the securitised price or simply to receive the drop in the share price observed in cash and hold onto the shares.
- Put in place a leverage effect with call options or a combination of options. In this way, a 1% rise in the share price will be increased.
We note that by nature, the simple fact of setting up a loan to finance the acquisition of a stake is, in itself, a form of dynamic management of performance because it makes it possible to use the leverage effect, but to a lesser degree than the purchase of a call option and with a downside risk that is often greater than the premium on a call option alone.
- Create a performance profile. In a more sophisticated way, a shareholder could combine options (call or put) with the different strike prices in order to determine the risk/return profile that it requires. The simplest strategy is a collar which makes it possible to define a share price bracket within which it agrees to be at risk. This strategy will be achieved through the combination of the purchase of a put option (to securitise the fall partially or fully) financed by the sale of a call option at a higher strike price. The investor will then be exposed to the change in the share price only between the strike price of the put option and that of the call option. Below the strike price of the put option, it will be protected against a fall; above the strike price of the call it will not benefit from the rise (opportunity cost).
- Improve its performance by selling put options. In this case, the company takes the risk of having to buy back the shares at a lower price if the buyer of the put options exercises them. Nevertheless, we note that the company will be forced to buy, but at a price that it has deemed, ex-ante, to be acceptable to strengthen its positions, the alternative being to pay for the fall in the share price. The counterpart is the immediate receipt of a premium. If the option is not exercised, the amount of the premium will improve the performance linked to holding the stake in the company.
- In a similar line of reasoning, the sale of a call option will improve the performance by taking the risk of having to sell its stake if the options are exercised (but at a price that it will have found to be attractive).
Managing influence in governance
As we have seen above, certain instruments (equity swaps, call options) can make it possible to assume an economic exposure without actually having any voting rights. But reciprocally, an investor can conserve the voting rights of its shares on which its economic exposure is reduced and/or managed. So for example, the holder of a stake in a company that has securitised it by purchasing put options will have its economic exposure protected, but can still exercise its voting rights at general meetings of shareholders.
To take this reasoning further, the investor may decide to fully cover the economic risk through the forward sale of its stake: it will then keep the shares for as long as the forward sale is not unwound, but it will have frozen its economic risk. Here again, it can continue to exercise its voting rights. The bank with which it has contracted can also offer to lend it the funds that it is guaranteed of receiving on maturity. In this case we talk about a prepaid forward. The same result can be achieved by using an equity swap, but this time, the investor abandons the performance of the share in favour of the bank. This type of operation was put in place by Sofina for securitising the capital gains on a stake with a value of €1bn of its Richemont shares, or more recently by BPI in its exit from Valeo. This sort of structure is also that implemented in employee shareholding plans with a guaranteed capital and a leverage effect implemented by issuers in order to enable their employees to be exposed to the performance of the company’s share, but with a guaranteed capital and non-transferability for 5 years, for example.
Although it is not used in the context of the economic management of an economic risk, the stock lending market could, at the other end of the spectrum, theoretically be used by an entity (person) seeking to increase its weight in the company’s governance. So it could borrow shares from a specific shareholder or on the repo market in order to increase the number of its voting rights at the general meeting then return the shares afterwards, without any economic risk. This is what the government did with Alstom for example, when it exercised the voting rights of 20% of the capital, lent by Bouygues between February 2016 and October 2017.
We note that such operations can be challenged as they break the link between the voting right and the share. This is why shareholders that have borrowed shares have to declare this publically, via the issuer and prior to the general meeting in certain countries. But although aligning economic interests with governance appears to be healthy, it does not detract from the legitimacy for an investor to manage its economic exposure and its risk/investment profile.
The role of the bank
For all of these derivatives – equity swaps, call and put options, prepaid forwards – the bank that puts the operation in place hedges its equity risk on the markets throughout the whole duration of the process. This dynamic management of its hedging in delta neutral protects it from changes in the share price. So its risk will mainly be on the long-term management of the position (mainly volatility and liquidity). The bank’s know-how in managing an optional position that has been made to measure and based on relatively large notional values compared with existing products on the market, will enable it to offer its clients structures that are suited to their goals at attractive prices.
It’s a bit different for margin loans: in this case, the shares are used as collateral and thus as a risk buffer, as the bank takes a risk on the borrower guaranteed by shares. It could then potentially sell a block (potentially at a discount, set off by the over-collateralisation ratio) if the borrower defaults.
Thanks to the Natixis Strategic Equity Transactions team for proofreading this article
 The term refers to margin calls that will be necessary during the life of the loan and in the event of a major drop in the share price.
 And often to require equity to be raised to meet regulatory solvency constraints, even if this depends on the eligibility of the shares (liquidity, risk diversification vis-à-vis the borrower, etc.).
 If it has not loaned the shares to the bank that is managing the put option.
 In case of unwinding in shares and not by paying the price difference.
Regularly released by Thomson Reuters in its annual review of M&A statistics, the EBITDA multiples paid for changes of control in 2017 show worlds apart and net segmentation based on growth rates, as if the risk played only a minor role in determining a valuation multiple:
Thus Japan's average EBITDA multiple of 10.5 (30% lower than the world average of 14.8) is a reflection of sluggish economic growth in part due to declining demographics since 2005 and a restrictive immigration policy. In addition, the rest of Asia is at 17.6, the highest level observed in 2017.
With Simon Gueguen, Senior Lecturer at the University of Cergy-Pontoise
We recently presented an article extoling the virtues of greenshoe options, a technique that helps with price stabilisation in the period that follows an IPO. This month, we take a look at the allocation mechanism. Since the late 1990s, the bookbuilding mechanism has become largely dominant in Europe and in the USA. This mechanism has the reputation of facilitating an allocation of shares to long-term investors, and thus avoiding immediate resales after the allocation, a practice known as flipping. The article that we look at this month provides empirical confirmation of these predictions.
Neupane et al used a very particular field for this study – IPOs on the Indian market between 2004 and 2010. There are two advantages to this market. The first is that a regulatory change was introduced on the market in November 2005 under which the bookbuilding method was abandoned in favour of allocation by auction (between 2006 and 2010). This was of great methodological interest. Comparing the different mechanisms on a market that left the choice to the issuer (or the bank) would have been more difficult, as this choice clearly depends on the characteristics of the company (problem of selection bias). Moreover, Neupane et al note that the average characteristics of companies in their sample that were IPOed using each method are very close. We note however that the fact that the operations compared did not take place during the same period may present a few problems.
The second advantage is that the authors have, for the Indian market, a data base that can be used for monitoring share purchases and sales made by foreign institutional investors (FIIs), from allocation until final resale.
The main takeaway from the article is that flipping is less frequent when the bookbuilding method is used. When the two samples were compared directly, the resale of shares during the first three days of listing amounted to 37% in the case of bookbuilding, compared to 63% for auctions (median value). The econometric study, which takes the characteristics of operations into account, confirms this result.
Another interesting result concerns the influence of the reputation of the (subscriber) bank. When the bank has a strong reputation,, flipping is generally less frequent and this effect is more substantial in the case of bookbuilding. This could probably be attributed to the bank’s discretionary allocation capacity when this mechanism is used. The difference between the amounts resold according to the two mechanisms almost evens out (but not quite) over a period of six months. What bookbuilding does is help to prevent flipping. Institutional investors who take part in a number of IPOs do, nonetheless, most often resell their shares in the following months, regardless of the allocation mechanism.
Finally, Neupane et al confirm that for their sample, flipping results in an increase in the volatility of the IPOed shares. Limiting this volatility is a key objective of allocation mechanisms. Bookbuilding seems to be able to achieve this objective, in the same way as the greenshoe option is an efficient post-IPO price stabilising technique.
 S. Neupane, A. Marshall, K. Paudyal and C. Thapa (2017), Do investors flip less in bookbuilding than in auction IPOs?, Journal of Corporate Finance, vol. 47, pages 2653 à 2687.
 FII allocation on this market represents around 25% of the total IPO, i.e. 53% of the institutional investor allocation (with the remainder allocated to retail and non-institutional investors).
 By banks with a “strong reputation”, Neupane et al mean banks that carried out the most transactions in their sample.
When valuing a bond, implicitly it is assumed that the coupons received before maturity are reinvested until the maturity of the bond at the rate of return of the bond.
Take the example of a bond with a coupon yield of 8% over another two years. The market rate is 8%. The bond is then worth 100, ie 8 / (1 + 8%) + 108 / (1 + 8%)^2, which also corresponds, by multiplying the first term in the numerator and the denominator by (1 + 8%), to : 100 = 8 x (1 + 8%) / (1 + 8%)^2 + 108 / (1 + 8%)^2, which is also equivalent to: 100 = (8 x (1 + 8%) + 108) / (1 + 8%)^2 and we can see that we need to capitalize the first flow of 8 at 8% over the second year to find a value of the bond of 100.
That said, rates can change over the period. If they go up, you will be able to reinvest your coupon at more than 8% and if you can wait for the repayment of the bond without having to sell it before, you will have obtained a return of more than 8% on your investment. But if the rates go down, you will reinvest your coupon at less than 8% and if you wait for the bond to be repaid but can not sell it before, you will get a return of less than 8% on your investment. This is known as reinvestment risk on a fixed rate bond.
For more details, see Chapter 20 of Vernimmen.
Regularly on the Vernimmen.com Facebook page we publish comments on financial news that we deem to be of interest. Here are some of the comments published over the last month.
Why are US banks now announcing losses related to the lowering of the corporate tax rate from 35 % down to 21 % when this is a favorable measure for them?
In fact, those which have tax losses carried forward and which activated them on the assets side of their balance sheet are in this situation. Indeed, when they recorded a pre-tax loss in the past, of 100 for example, they were able to reduce it to 65 by accounting for a future tax credit of 100 x 35% = 35 (taking into account the corporate tax rate of 35%). This was of course conditional on the expectation that, in the future, their earnings would be large enough to be offset against this loss of 100, thus saving them future taxes for 35. They then recorded among their assets in their balance sheet a deferred tax asset of 35.
With a corporate tax rate that drops to 21%, the amount of deferred tax assets becomes false, since carried forward losses will no longer generate a tax saving of 35% of their amount, but simply 21%. Therefore, these deferred tax assets must be depreciated by 40% of their amounts ((1- 21/35). Therefore the losses currently published which concern only past estimates of future tax savings.
For more details on deferred taxes, see Chapter 7 of the Vernimmen.
Understand who can!
A broker, certainly not one of the most important one, but the only one to follow this mid cap listed in Paris, has revised down its annual sales forecast now counting on €618m in 2017/2018 against €634 m. In addition, this broker targets an EBITDA of €38.2m, or 6.2% of sales, against a target of 6.5% set by the company. This broker maintained its Neutral recommendation while lowering its target price from 6 to 5.80€. So far, so good. The current share price is €3.50, offering, if you believe in the work of this broker, a potential price increase of 66% (sic). In these circumstances, why not a Purchase recommendation? Are there so many undervalued companies in its universe of analysis that a mere 66% increase to a target price deserves only a Neutral recommendation? Or does it want to please at the same time the savvy investor who understands that a recommendation Neutral means in plain English Sell, and the mid cap management who would not appreciate a Sell recommendation and could cut all investment banking business with this broker? As for the target price of €5.80, is it there to amuse the gallery and flatter the midcap, while deceiving the confident but inexperienced investor?
In other words, does the investment banking business that this broker provides to the midcap, in addition to its financial analysis work, disturb its view? But has it forgotten the deontology and the rules of management of conflicts of interest between its interests (as an investment banker of this midcap) and as a professional financial analyst to its clients, the investors who read its works?
An unexpected and positive side effect of a financial krach.
Until 1882, Paul Gauguin worked as a broker on the Paris Stock Exchange and was an artist in his spare time. The crash of the financial group Union Générale in January 1882, and the fall of the Stock Exchange that followed after a few years of irrational exuberance, made him lose his job and he decided to devote himself entirely to his artistic career.
The Paul Gauguin exhibition at the Grand Palais in Paris, which inspired this note, has closed its doors on January 22nd.
Return on tangible equity
Most banks, in the publication of their 2017 results, put forward the criterion of the return on tangible equity. This ratio is computed on the shareholders' equity of the group from which the intangible assets are deducted. In prudential matters, the solvency ratios of banks are computed after deduction of intangible items, which is quite logical, because if a bank has solvency problems, it is doubtful whether its intangible assets (mainly goodwill and brands) still have significant value. To calculate the return on equity in the same way seems to us unfair. Indeed, this portion of equity that disappears in the calculation of the return on tangible equity, under the pretext that it is used to finance intangibles, was contributed one way or another by shareholders, is still on the balance sheet of the bank and shareholders continue to expect on this equity they own a certain return. If this calculation is done and put forward, it is of course that it allows to display profitability figures more flattering than those resulting from a classic calculation of the return on equity, classic but especially more rigorous and often relegated to second place. Without heartache, we can note that banks that have lost billions or tens of billions of euros of capital (Citi, UBS, Deutsche Bank, RBS, Bank of America Merrill Lynch, Unicredit, etc.) already benefit from a powerful effect of boosting their returns on equity, since these losses have eaten parts of the equity that have disappeared from their balance sheet without the shareholders having to settle for a zero return on these funds.