Letter number 137 of March 2021

  • NEW

News : Some thoughts on recent episodes involving governance issues

Stock exchanges have long ceased to be public services, and those who work there are no longer ministerial officers, as in some countries the stockbrokers in the old days were. Listing of stock exchanges has turned them into companies like any other that compete with each other to attract companies that wish to be listed on the stock market, and investors. Stock exchanges have in fact become IT service firms whose data diversification is often their main and most lucrative activity.

In the face of corporate disaffection with listing in London due to the rise of private equity[1] and the growing importance of the tech sector which favours listing in the United States, a recent report proposed that the London Stock Exchange reduce its governance requirements for companies it lists. Two main proposals are emblematic and specifically target tech entrepreneurs: accepting the listing of companies with plural voting rights and a listing of only 15% of the capital, against the 25% currently required in London. Other more technical measures are planned and could be applied by the end of 2021, in particular by reversing the suspension of SPAC[2]  prices when the latter announces that it has found its target.

This would mean that controlling shareholders could sell fewer shares during their IPO, which in a bull market is the guarantee of being able to sell the 10% not sold at a higher price; and keep control of their company thanks to A shares (one voting right) or C (no voting right) for new shareholders, and B (10 voting rights), or D (20 voting rights) for controlling shareholders. However, this last option would only be valid for five years before reverting to common law: one share equals one voting right.

However, the London Stock Exchange should not fool itself into thinking that just because it lowers its admission standards it will regain ground over the New York Stock Exchange or avoid losing ground to the Amsterdam Stock Exchange. Unfortunately, we are in a field where bad money drives out good money, as the Hong Kong Stock Exchange illustrates. By denying Alibaba waivers to its governance rules in 2014, Hong Kong lost the e-commerce giant's listing to the NYSE. Subsequently, when it lowered them, this did not enable it to become the centre of attraction for Chinese listing applicants and New York retained its status given its higher valuation levels.

Although we can understand that founders of a start-ups need to feel "at home", even after several rounds of dilution, in order to give the best of themselves, and that to achieve this, disconnecting financial rights and voting rights is an option, this is a little more difficult to understand for listed companies which, most of the time, have found their business model. It should also be noted that even for an unlisted start-up, we do not usually find a system as advantageous as shares with ten or twenty voting rights.

This system is not merely theoretical. Although at the 2019 Google AGM, 92% of holders of A shares demanded a return to the one share = one voting right rule, the two Google founders who each hold between 5 and 6% of the shares voted against, and guess what? With 51.3% of the votes between them, the resolution was voted down. Likewise, in 2020, when a majority of investors were of the view that compensation of $281m for CEO Sundar Pichai, although essentially linked to Google's stock market performance, but representing 1,085 times the median compensation at Google of $259,000 was too much. This compensation was nevertheless approved thanks to the votes of the two founders who hold 11% of the shares. Sundar Pichai is without a doubt a seriously good manager. But what makes him any different from other seriously good managers, other than his decision to go and work for Google in 2004, a firm which has developed and consolidated monopoly or quasi-monopoly positions over years, enabling it to generate the kind of profits ... of a monopoly.

And one cannot help but think that this amount of compensation, which does not reflect a sense of satiety and responsibility, can only stir up frustration, resentment and undermine the social consensus that any society needs.

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Serial announcements by companies of a change in their governance in 2021, with a CEO becoming a simple Chairman of the Board of Directors, and the appointment of a CEO (L'Oréal, Saint Gobain, Bouygues, Valeo, Scor) are not, in our opinion, a new trend, as sometimes presented, but the result of coincidence of timing.

The transformation of the CEO into a simple Chairman of the Board for a few years is inconceivable in the UK, requires a two-year vacancy in Germany, but is a well-established French practice. It has shown in the past that it can be effective in reassuring investors about the succession of an emblematic boss (Thierry Desmarest at Total, Lindsay Owen-Jones at L'Oréal, Jean-Louis Beffa at Saint Gobain, etc.) who promotes to CEO a person whom he has trained, and often chosen (Patrick Pouyannet, Jean-Paul Agon, Pierre-André de Chalendar), and who will, after a few years, combine both roles again, with the Chairman then leaving the group for good.

It probably presents less risk of blocking governance than a scheme where a CEO and a Chairman who have not chosen each other must work together, especially if in reality, the Chairman does not intend to restrict his actions to chairing the Board of Directors (Engie).

In this area, as in many others, much depends on the temperament of the men and women involved and the strength and determination of directors. All the more reason to be pragmatic and maximise the chances of a positive outcome when facing a change that the passage of time makes inevitable, by being able to choose between several options, without one option necessarily being a hard and fast rule for all situations.

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A naive reader might be surprised that two investment funds, one holding 3% and the other less than 5% of Danone's capital, were able to obtain a change in governance as major as that of entrusting the operational management of the group to a manager to be recruited from outside, for the first time since the creation of the group in 1919, and the departure of the CEO who had been in the job since 2017.

In fact, these two funds said loud and clear what many other investors have been thinking for some time without daring to publicly criticise the "Chartres Cathedral"[3]. This is not a formal attack by Anglo-American investors against the first CAC company to have adopted the status of a public-benefit organisation. Adoption of this status obtained the approval of 99% of shareholders last year, probably including these investors who are not shy about speaking out, as is their right, without seeking to destabilise the company by unfair manoeuvres like other activist funds.

This is criticism of operating performance (less growth, lower margins, overpaid acquisition) which, over time, has fallen below than that of Nestlé and Unilever, and which naturally poses problems of governance and choice of who should be in the driver's seat. When the criticism comes from an investment fund founded by the former CEO of Bulgari which, from its IPO to sale to LVMH, increased sales by 28% per year for sixteen years and delivered a TSR of 17% per year, it has a better chance of carrying weight than if it had come from just another finance firm. Since the appointment of Emmanuel Faber as Danone CEO in October 2014, Nestlé's stock has risen by 42%, that of Unilever by 37% and that of Danone by 0%, all three with a dividend yield of approximately 3% per year. Without giving an opinion on management performance, we consider it healthy for shareholders to be able to express themselves on it and exercise their right to guide governance.

To come back to the previous subject, proposing the separation of the functions of CEO and Chairman of the Board and entrusting the latter to the former CEO only makes sense, it seems to us, when the latter can boast a career path and performance without reproach and has reached an age that leaves no doubt as to his/her ability to take the necessary distance and not be tempted to interfere in the running of the business. The alternative spells problems ahead, a situation that the Danone Board of Directors took two weeks to understand before it made this difficult decision, fortunately before any problems actually materialised. Sometimes making complicated changes requires making the change (whether intentionally or not) twice.

We'd like to end by commending the integrity of Emmanuel Faber who did not seek to obfuscate his departure with the affectations we read far too often in press releases ("leaving for personal reasons") and who had long since waived any compensation payments and golden parachutes that we hope are of a bygone era.


[3]  “Danone is Chartres Cathedral, and you don't buy Chartres Cathedral,” said its founder, Antoine Riboud.


Statistics : Corporate income tax rates in the world

Corporate income tax in the world have stabilised at c. 24%. They keep reducing in Europe (for example in France or Switzerland) where they are now close to 21% in average due to lower corporate income tax rates in Eastern Europe. Nevertheless, UK has announced increasing its rates from 19 % last year to 25 % in 2025, and the Biden administration plan to move the federal rate from 21 % to 28 %.

KPMG is our source.

Research : The role of creditors in internal resource allocation

With the collaboration of Simon Gueguen, lecturer-researcher at CY Cergy Paris University


Financial theory has long been concerned with the relations between shareholders and lenders. These are most often seen as essentially conflicting: shareholders seek the creation of value by optimising the risk/return ratio, while lenders are keen to limit risks, even if it means giving up projects that create value. The problem becomes salient when the company is in difficulty, because then the nature of the decisions taken can lead to transfers of wealth between shareholders and creditors[1].

However, more recently, some publications have shown that the increased role of creditors in times of crisis could paradoxically have virtuous effects favourable to shareholders[2]. The article we present this month[3] follows in that vein. It shows that the power obtained by creditors, when loan contract clauses are not respected (covenant breaches), favours an allocation of resources in the company that also benefits shareholders.

The general idea is as follows. When a loan agreement clause is breached (typically, because the business is in trouble), the lender gets the right to be reimbursed. If it requests reimbursement, it obviously increases the business' difficulties. Usually, instead of activating the clause, it uses this threat to influence company decisions and force a reallocation of internal resources. The danger for shareholders is then that lenders may force the discontinuation of risky activities, even when they create value. However, there is another source of conflict in decision-making: the conflict between shareholders and managers. Ersahin et al explain that some creditors, through their influence, are able to impose on executives decisions favourable to all investors, but shareholders alone were not able to push through. These include, in particular, the closure of businesses that are both risky and underperforming, and the layoffs that accompany such closures.

The authors use a sample of US firms at which loan agreements were breached between 1996 and 2009[4]. They find that these firms tend to refocus on their core business and to give up non-core activities. This effect can be beneficial: financial research has shown that managers who are poorly controlled by shareholders tend to overdevelop peripheral activities, either because they are pursuing personal ambition (empire building) or, for younger managers, because they lack experience in the core business. The assumption of Ersahin et al is that this refocusing is the (favourable) consequence of pressure from creditors.

With regard to employment, breaches of covenants led to a 2.6% drop in the number of employees in the main activity and an 8.9 % drop in secondary activities. Redundancies are observed exclusively in risky secondary activities[5]: a 15.4% drop in the number of employees, while no significant change is observed for the least risky activities. This result seems to confirm that resources reallocation is aimed at reducing the risk. However, the variations are particularly significant for activities that are both risky and unproductive, so this reallocation is likely to benefit shareholders as well.

Finally, at the end of the article, Ersahin et al present a result that seems to us crucial in interpreting the results. They observe that the effects identified are significant only when creditors have particular experience in the sectors concerned. Accordingly, more than an alignment of interests between shareholders and creditors, it is a question of benefiting from additional expertise (that of creditors) to react in the event of financial difficulties.

This article has the merit of showing that creditors, when they have expertise, can help shareholders to control management. As the Ersahin et al rightly point out, the firms concerned (those that do not comply with the provisions of loan agreements) are very different from the potential targets of activist funds. Activists most often target cash-flow generating companies, usually successful ones, and force them to return excess cash to shareholders. Conversely, creditors use their influence in distressed companies to improve their creditworthiness.


[2] Notamment G. Nini, D.C. Smith and A. Sufi, "Creditor control rights, corporate governance, and firm value", Review of Financial Studies, 2012, vol. 25-6, p. 1713 to 1761.

[3] N. Ersahin, R.M. Irani and H. Le, "Creditor control rights and resource allocation within firms", Journal of Financial Economics, 2021, vol. 139-1, p. 186 to 208.

[4] Part of their database is from the article by G. Nini et al., above.

[5] Ersahin et al use operational risk here, measured by the variability of operating margins. This may represent a limitation of the findings, as this is not a market risk against which the creation of shareholder value can be assessed.


Q&A : A few questions and short answers

Don't sustainable bonds, whose cost varies in part inversely with the achievement of ESG objectives, misalign creditors and shareholders? In fact, if the penalty is anything other than a mere token, lenders, once the contract has been concluded, only want one thing: for the company not to achieve its objectives in order to receive a higher interest rate. Perhaps to the detriment of the shareholders, but also to the detriment of the planet somewhere.

Perhaps this is the real revolution in this product, which shows that even for a financial investor, one can prefer a less profitable product if it is good for the planet. We don't think that those who subscribe to it want the company not to achieve its sustainable development objectives, any more than the lender who includes in his/her credit contract a variable margin according to the rating wants the company to experience a deterioration in its solvency in order to obtain a better interest rate. 

This is both a penalty for the company to encourage it to be virtuous and thus avoid paying it, and a compensation for the investor in the event that, contrary to its expectations, the company does not achieve its sustainable development objectives. And the lender may pay the extra margin to environmental NGOs as provided for in some sustainable loan contracts.

In calculating the weighted average cost of capital, should a liquidity premium, also known as an illiquidity premium, be added to the rate of return requested by shareholders or to the cost of capital itself?

The liquidity premium is added to the cost of equity and not to the weighted average cost of capital calculated in the indirect approach. Indeed, bank lenders have no reason to ask for a liquidity premium since they know from the outset that their debt is not listed and that it will find its liquidity through repayments.   On the other hand, the reasoning holds for shareholders since the cost of equity is determined on the basis of the expected of return of the stockmarket calculated on a perimeter of large or very large companies whose application to small and medium-sized companies is, to say the least, questionable without taking into account a liquidity premium. Indeed, the liquidity of the latter share markets has nothing to do with the liquidity of these large companies, which is used to calculate the expected return, and therefore the risk premium of the equity market once the risk-free rate is deducted.

Why do you write in the Vernimmen that the asset value of a company in a declining sector is particularly speculative?

Because usually a phase of decline begins with a slow decline, then at some point the decline accelerates and can quickly become abrupt.  A very good example is currently the oil sector. Since 2015, the decline is real but relatively slow, and at the moment there is an acceleration of this decline with a conviction increasingly shared by investors that part of the oil resources of the earth, mapped and well known, will never be pumped out, they will remain, contrary to the assumptions of 3-4 years ago, forever in the bowels of the earth.

From then on, the value of these oil fields becomes highly speculative, i.e. uncertain, volatile and likely to fall very quickly, as illustrated by the tens of billions of dollars in provisions that have just passed Shell and Exxon.


New : Comments posted on Facebook

Regularly on the Vernimmen.com Facebook page[1] we publish comments on financial news that we deem to be of interest, publish a question and its answer or quote of financial interest.

Here are some of our recent comments:

Shell submits its Zero Carbon in 2050 Plan to the vote of its shareholders

While more and more groups are announcing plans to reduce their net carbon emissions to zero by 2050, including in the use of their products by their customers, few like Shell include in this scope the carbon emissions of products traded by its trading arm, and less put it to the vote of their shareholders. While the outcome of the vote is not in doubt, the vote makes it possible to involve shareholders in the strategy followed, to anchor it solemnly in the long term and to widen the gap in investors' perceptions with competitors which will have difficulties in making such a commitment quickly (American oil companies, Aramco, etc.). As in Europe, half of the investors say they follow ESG criteria in their investment choices, it is important not to be in the bottom 15 or 20% of a sector that will be eliminated from the field of investable companies by more than 50 % of investors.


Reading Warren Buffett’s 2021 letter

We found 4 interesting reflections from a financial point of view in this year’s edition:

Still as impressive as ever, the comparison since 1965 of the average annual performance of an investment in the stock market index (10% per year) and in its investment holding company (20%), which leads in the first case to a 235-fold increase in the invested assets and an increase in the portfolio of.... 28,106 for investors who put their trust in Warren Buffett in 1965. There is no typo, you have read 28,106 correctly, i.e. 120 times more for a "simple" doubling of the annual performance. That's the power of compound interest over time, here 55 years.

It is true that treating shareholders as partners and associates, and not as customers who are charged management and possibly performance fees, changes a lot in terms of governance and incentives.

A detailed analysis of the mechanism and consequences on shareholder wealth of the share buybacks carried out by Berkshire Hathaway in 2020. We are not fans of share buybacks per se. We think it is a stupid tool for companies that are able to regularly find investments that yield more than their cost of capital, and a relevant tool for those that can no longer do so. As it so happens that cash is accumulating in Berkshire, in the order of $140 billion invested in U.S. Treasury bonds, i.e. 24% of its market capitalization, without its managers finding relevant investments, $25 billion has been returned to shareholders in 2020, and it is up to those shareholders who have sold their shares to do better than Warren Buffett's team.

Finally, an analysis of the financial performance of conglomerates, which is both a defense and an illustration of Warren Buffett's investment approach. Just as companies that excel in their sector, such as L'Oréal, Apple or BMW, for example, have no desire to lose their independence, a conglomerate is condemned to acquire second-rate companies, and therefore is not the best investment vehicle that you can imagine. Whereas Berkshire Hathaway can take long-term financial minority stakes in these massive creators of value. Thus the 5% stake in Apple acquired since 2016 for $31 billion and which is now worth $120 billion.


When greed meets incompetence

You have the situation of a number of German public entities that had deposited €500m of their cash with Greensill Bank, because unlike other German banks, Greensill Bank did not charge 0.5% for deposits. But as this bank is now bankrupt and deposits of public sector entities deposited with private sector banks are no longer covered by the public deposit guarantee scheme since 2017, this is probably as much money gone forever. In short, in order to save 0.5% per year, some people have taken the risk of losing 100% of their capital.

It cannot be repeated often enough that when a bank pays above-market interest on deposits, it is not to please you, but because it cannot get into debt at market rates, and therefore presents a higher risk. No need to do a financial analysis, no need to check its rating, just GET OUT! When the risk-free rate is - 0.5%, anything above that, even at - 0.2%, contains a greater or lesser degree of risk. This has been in the Vernimmen for several decades. 

A special prize to the city of Monheim, North Rhine-Westphalia, 42,000 inhabitants, and 38 M€ deposited with Greensill Bank ... . 


The Global Money Week

The Global Money Week is intended to make children and teenagers aware of money issues and how to manage it, and could be extended to adults. One of our children, who has been working for some time, discovered on receiving an annual statement that his employer paid him into a Pension Savings Plan (PSP) every quarter. This is good news, but employers don't often make the most of it with their employees.

But someone with the basic financial skills of an average Mr.Smith, i.e. not much, misses the point. The money was automatically invested in a bond fund at 1.5% and will be capitalised until our child retires in 45 years time. Whereas the best thing would have been to invest in an equity fund because over such a long period the probability of the equity fund outperforming should be close to 100%. So over 25 years, capitalisation at 1.5% per year multiplies the initial sum by 1.5, and by 6.8 for an equity investment that would yield as much as the CAC 40 over the last 25 years (8% per year). Then, at age 50, our child could reduce the equity portion to increase the bond portion in order to reduce his risk as retirement approaches. But here, despite his father's help, this is not possible: the riskiest fund proposed by the specialist pension manager is 2/3 bonds and 1/3 equities... ... 

Moral: Check your Pension Savings Plan and make your HR aware of basic financial reasoning, especially if you are under 40.