Letter number 119 of February 2019
- QUESTIONS & COMMENTS
Looking back year toward the last 12 months, we could tell you all about what’s looking good:
- corporate margins are the highest they’ve been for a long time, at around 16% for the 200 biggest listed European companies according to Exane BNP Paribas…
- …as a result of an economic situation in Europe that is much better than it’s been since 2008…
- …which itself is the result of unconventional monetary policies that have been phased out in the US and are in the process of being phased out in Europe;
- US tax reform which is freeing up considerable sums for financing innovation instead of the US government and lower corporation tax rates in Europe which should have a similar effect;
- progress made in international cooperation in the fight against fraud and tax evasion;
We could also tell you about what’s not looking so good:
- pockets of overvalued assets (the valuation of the Hermès share at 39 times its expected net earnings for 2019 raises eyebrows notwithstanding the qualities of this venerable company; real estate in Honk Kong, commercial real estate in the US, etc.;
- the fact that LBO financing has once again become asset-based as was the case in the years running up to 2007, and is no longer cash flow-based, with the disappearance of A and B tranches which have mostly become repayable on the due date;
- increase in Chinese corporate debt which rose from $69bn in 2007 to $2000bn at end-2017;
But, in the end, all of the above are the mere reflection of a position in the economic cycle at a given time. And in a few years’ time, it will all have been forgotten.
However, what will not be forgotten in our opinion, is that 2017 and 2018 saw an irreversible upswing in concern for the environment, social responsibility and sustainability in finance, and in particular in corporate finance, to such an extent that we predict, in a slightly pretentious paraphrasing of André Malraux, that corporate finance will in the future be green, responsible and sustainable, or it will not be at all!
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Here are some things that happened in 2018, among others, that illustrate this increased awareness of the environment, social responsibility and sustainability in the world of finance:
1/ Financial analysts from the largest sovereign wealth fund in the world, Norway’s oil fund, which has €870bn in assets under management, are now accompanied by environment social and governance (ESG) analysts when they hold meetings with managers of any of the 9,146 companies in which the fund is a shareholder or is considering becoming one;
2/ In March 2018, the European Commission published its “strategy to bring the financial system to support the European Union's climate and sustainable development agenda” which will involve:
“- establishing a common language for sustainable finance, i.e. a unified EU classification system – or taxonomy – to define what is sustainable and identify areas where sustainable investment can make the biggest impact;
- creating EU labels for green financial products on the basis of this EU classification system: this will allow investors to easily identify investments that comply with green or low-carbon criteria;
- clarifying the duty of asset managers and institutional investors to take sustainability into account in the investment process and enhance disclosure requirements;
- requiring insurance and investment firms to advise clients on the basis of their preferences on sustainability;
- incorporating sustainability in prudential requirements: banks and insurance companies are an important source of external finance for the European economy. The Commission will explore the feasibility of recalibrating capital requirements for banks (the so-called green supporting factor) for sustainable investments, when it is justified from a risk perspective, while ensuring that financial stability is safeguarded;
- enhancing transparency in corporate reporting: we propose to revise the guidelines on non-financial information to further align them with the recommendations of the Financial Stability Board's Task Force on Climate-related Financial Disclosures (TCFD).”
3/ The CEO of Blackrock, the largest asset manager in the world with over €5,300bn in assets under management wrote in its 2018 letter to the CEOs of major groups worldwide:
“Society is demanding that companies, both public and private, serve a social purpose. To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate.”
As early as 2016, Larry Finck wrote: “Over the long term, environmental, social and governance issues – from climate change to diversity and including board efficiency – have real and quantifiable financial impacts.”
4/Banque Postale Asset Management announced that in 2020, all of its assets under management, €220bn, would comply with SRI (socially responsible investment) practices.
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We may well wonder why this is happening now and not three or four years ago, or in four to five years’ time. It’s difficult to say. Like all groundswell movements, it started as the result of several factors, has been developing gradually and slowly over time and now that has gained momentum, it’s shaking up the whole system.
It is undeniable that the 2007-2008 financial crisis had a major impact on how we see the world, probably more so than any other financial crisis, apart from the 1929 crisis. It naturally impacted on the way Finance Directors exercise financial management (see chapter 39). It also had a major impact on the general public who discovered that a financial product, sub-primes, involved getting clients to borrow more than what was reasonable while getting others to take on the risk in order to get rich at their expense, with no regard for the consequences. This is now seen as morally unacceptable. Never again.
Environmental urgency is another factor: the depletion of the earth’s resources, which may well turn out to be a surmountable problem given human ingenuity, and global warming, which it is to be feared may well be a problem that we have underestimated.
Finally, a disenchantment with ideologies and the growing difficulties that governments are experiencing in maintaining their traditional post-WWII roles of protector and distributor of resources, mean that individuals are now seeking meaning in what they spend most of their lives doing which, after sleeping, is working. Young people in particular want a mission in life and not a job, a mentor rather than a boss and they want to make an impact and see meaning in what they do. Today, a lot more is expected from companies than in the past. This is backed up in a report by Nicole Nota and Jean-Dominique Senard entitled The Company and the General Interest, which states that the company has a purpose and that it contributes to the common interest. In this regard, France is lagging behind some of the other European countries (Italy, the United Kingdom) and the United States which has introduced the possibility for companies to become Public Benefit Corporations.
Without being cynical, we should also not overlook the phenomenon of lemming behaviour which is something we’re very familiar with in the world of finance. Companies seem to be competing against each other in the increasingly ambitious ESG statements that they put out. This is not cause for complaint, but now they’re going to have to deliver.
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The second part of this article will be published in the March issue.
The average corporation tax rate in the world in 2019, as computed by KPMG, is 24%, showing stability since 2013:
Country by country corporate income tax rates are pretty stable this year after 2017 which saw some large countries lowering their corporate income tax rates (France, Japan, USA).
These rates are useful to compute corporate income taxes to be paid on pre-tax profits, to compute free cash flows or cost of capital or produce business plans. But they cannot be compared from one country to the other one to appreciate the tax burden borne by companies. Indeed, in some countries some local taxes are not levied on the pre-tax result but on added value, turnover or the renting value of buildings. And they are in addition to those computed on the pre-tax result and shown in this table.
With Simon Gueguen, Senior Lecturer at the University of Cergy-Pontoise
An activist strategy involves an investment fund taking a minority but not negligible stake in a company’s capital (from 3% to 15%) and using its influence to bring about change. Such change may concern the company’s strategy, its investments or its financial policy. The US investor Carl Icahn is one of the most famous shareholder activists (with profitable positions in Time Warner, Netflix and Apple among others). Funds that specialise in shareholder activism have become key players in the system of capitalism and have incited lively debate in academic circles. They are usually recognised for their ability to create shareholder value, but they are sometimes suspected of short-termism. Questions are being asked about their regulation. The article we discuss this month defends the idea that activist funds encourage corporate innovation.
The study reuses (for the most part) a sample constructed for a previous paper (written in part by the same academics) and which is considered to be a seminal article on the subject .This study shows that announcing that an activist fund has taken a position in a company’s capital results in an increase in the target’s share price of around 7% (in the USA, over 2001 to 2006). We should point out that the main limitation of this study, and consequently also of the article that we’re discussing here (same selection method but from 1994 to 2007) is linked to the construction of the sample. Since “activist fund” is not a legally recognised category, any method used to select relevant events could be challenged. Notwithstanding this important caveat, the whole study was conducted in an extremely rigorous manner and the results are significant.
Firstly, Brav et al note that targets’ expenditure on R&D tends to decline following the arrival of an activist (average reduction of 20%) but that this reduction is proportionate to the overall reduction of assets (the R&D to assets ratio remains stable). In other words, the reduction in R&D expenditure seems to be solely a factor of the activist’s desire to refocus the business and not a short-term vision that sacrifices R&D. Most importantly, the results of R&D (quantity and quality of patents obtained) appear to improve. Less input, more output: these initial results back up the assumption of an improved R&D policy.
Analysis reveals that improvement in R&D results is very substantial for companies which had large patent portfolios before the activist arrived and which then took a decision to refocus on their area of expertise. The arrival of the activist leads to the sale of a large number of patents and these are usually very high quality patents, although they are unrelated to the company’s core business. Based on this result, Brav et al conclude that shareholder activism encourages a better macroeconomic allocation of the results of R&D. They come to the same conclusion with regard to human capital: “inventors” who remain after the arrival of activists become more efficient and those who leave also become more productive at their new place of work.
Several other tests are carried out to reinforce the assumption of causality between activism and innovation. For example, Brav et al show that hostile activist campaigns (those in which management put up resistance) have the same impact on innovation as amicable campaigns. They also note that an announcement that a patent has been obtained leads to a higher increase in the company’s share price following the arrival of the activist, even when the patent was developed previously. The market has greater confidence in the use that will be made of the patent obtained.
The conclusions that can be drawn from these results are unambiguous: activists create value, part of this value comes from an improvement in innovation, and the action taken by these funds leads to a better allocation of R&D resources. There are other studies that are a lot less vociferous about the benefits of shareholder activism. But in the debate on the regulation of activist funds, this study will carry a lot of weight.
 A.BRAV, W.JIANG, S.MA and X.TIAN (2018), How does hedge fund activism reshape corporate innovation?, Journal of Financial Economics, vol.130, pages 237 to 264.
 A.BRAV, W.JIANG, F.PARTNOY and R.THOMAS (2008), Hedge fund activism, corporate governance, and firm performance, Journal of Finance, vol.63, pages 1729 to 1775.
 Quality is measured by the number of citations the patent receives which an imperfect measure but standard practice in academic papers.
An LBO is a transaction through which an investor seeks to maximise the amount of debt that finances an asset, so it’s only natural that they are the sort of transactions where we see the most innovation in terms of debt structuring. In periods of very high liquidity in the market (as is currently the case), leverage is increasingly higher and structures are much less restrictive for borrowers. In this environment, and following the experience with LBOs during 2006/2007, banks are now reluctant to take on more risk and funds are becoming more aggressive in their quest to finance the full amount of the debt (i.e. what would previously have been split into Senior and Mezzanine debt). This means that midcap LBO debt is now increasingly taking the form of a unitranche debt provided by a fund that specialises in this type of transaction (ICG, Alcentra, Ares, Tikehau, etc.). Just like on the classic corporate debt market for SMEs and intermediate-sized companies, we are seeing an increase in disintermediation.
A new type of debt has been developed to complement the unitranche structure. A small amount of Senior debt known as First Loss-Second Loss is added to the unitranche debt to increase leverage again. This tranche is a bullet loan and has the same maturity as the unitranche debt, but enjoys priority on the net liquidation value of security in the event of insolvency and is thus considerably cheaper. During the life of the loan, holders theoretically have the same rights as unitranche debt holders, but in practice do not have much decision-making power as the latter have an absolute majority among the lenders. In the event of disagreement, banks are however able to sell their debt to the fund.
This new structure has, as is often the case, been imported from the US-UK (although it is also very popular in Germany) and does not only aim to increase leverage, but also to provide reassurance to the borrower given that a bank is more reassuring than a fund. Negotiations in the event of problems, restructuring or even a major transaction are easier with a bank with which there is a longstanding relationship than with a fund. In reality, this is rather illusory as if problems do arise, there is a strong likelihood that the bank, which has a minority stake in the financing, will do all in its power to sell its debt to the fund.
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.
Scrip dividends: some stop, others resume.
Last week, Total announced that its last quarterly dividend in respect of 2018 would be paid in full in cash, without the option to opt for a payment in Total shares (scrip dividend); and that future quarterly dividends paid on the 2019 results would be in cash only. At the same time, Société Générale announced that it would propose to its shareholders the option for payment of the 2018 dividend in Société Générale shares, as had been the case for the 2008, 2009 and 2012 dividends. If Total stops the dividend paid in shares, it is because the rise in oil prices allows it to pay its dividend entirely in cash, without increasing its net debt beyond its objective, nor impact its investments.
The scrip dividend was a tool for Total to maintain its dividend per share when the price of oil no longer allowed it to generate enough free cash flow to pay it in full in cash (Shell did the same). As the largest shareholders of Total are pension funds looking for dividends to face the payment of pensions, the scrip dividend was a smart answer to a conundrum: how to maintain the dividend flat when the free cash flow was no longer large enough and you do not want to go into debt above a certain level.
Société Générale is facing a different issue. With a CET1 solvency ratio of 10.9%, well above the regulatory constraints, but below the comparable ones (BNP Paribas is at 11.8%) and quite far from its 2020 target (12%), Société Générale reiterates the practice of a dividend payable in shares at the option of shareholders and indicates that its solvency ratio will increase to 11.2% if half of its shareholders make this choice.
We would have been the chief financial officer of Société Générale, we would have argued for a dividend only payable in shares to reach the target of 12% with one year in advance, and put aside these negative comments on an insufficient solvency ratio that are surely not doing any good to the share price and the mood of the employees.
L'Oréal's 2018 results illustrate the first law of the break-even point.
Which says, for those who would have forgotten, that the further the company is from its breakeven point, the closer the growth rate of operating profit and the growth rate of turnover are. Thus, L'Oréal has just announced a 2018 growth of its turnover at constant exchange rate of 8.0% and an increase in its operating profit of 9.2%.
If L'Oréal does not naturally communicate on its level of breakeven point, the level of 2018 operating margin at 18.3%, its highest historical level, shows that the group is very far from its breakeven point! Hat low.
And for those of you who would like to review their 3 laws of the break-even point, it is in chapter 10 of Vernimmen.