Letter number 18 of September 2006


News : Football clubs and the stock exchange 

The football pitch is probably not where most readers of the Vernimmen.com Newsletter would expect to find us! And they’d be quite right, notwithstanding the fact the writers of the Vernimmen are coming from the 2 countries which were opposed on the final of the last World Cup. We thought that we ought to make an effort and at least take a look at the game, although admittedly it will be from a financial point of view.
The first football club to be listed on the stock market was Tottenham Hotspur in 1983.vToday, there are 37 listed football clubs in Europe. The main ones are:

Some clubs that were listed have subsequently delisted when at the top of the market (Manchester United was bought in 2005 by US billionaire Malcom Glazer, and Chelsea in 2003 by Russian billionaire Roman Abramovitch) and others when at the bottom (Leicester City which went bankrupt, Notthingham Forest because of financial difficulties).
From a stock market point of view, the sector cannot really be called a sector, given its microscopic share of European market capitalisation - €1,700m, which is equal to the market cap of Tod’s or Iberia or 0.02% of European market capitalisation.  
There are at least two specific sector indices (calculated by Bloomberg and Down Jones), although their performance is not very impressive – 1.3% average earnings per year since 1992 compared with 6% for the market, with a much higher risk level: 
Performance of European football index:

It is true that at an individual level, shareholders of football clubs have not really received much in the way of dividends, although most have benefited from tax credits on their capital losses. Clubs like Manchester United or Galatasaray are the exception rather than the rule:
Performance of European index of football club share prices compared to their IPO prices (base 100)

Does this make the football club market inefficient? (1)
No, say José Allouche and Sébastien Soulez very firmly in a recent study (2) on the behaviour of English football club share prices.  They also so how share prices react to: 
 The announcement of sporting results:  when a club wins a match, its share price outperforms the index by 0.5% the next day, and when it loses, it underperforms the index by 0.7%.  The impact of a defeat is even greater for clubs playing in higher divisions, as it reduces the club’s chances of qualifying for the European cup, which would generate extra revenues.   Similarly, qualification for or elimination from the national championships or the European cup will impact on the share price
 The announcement of financial results:  here the share price reacts in the same way as share prices of other companies – positive results trigger a rise and negative results a drop.  The announcement of new investments (mainly the renovation or construction of a new stadium) or the signing of new sponsorship deals will have a positive impact on the share price
 The announcement that the club is buying or selling a player:  since financial analysts never allow their emotions to interfere with the figures, they predict a rise in the share price when a club sells a player and a fall when it buys one. What they like to see most of all though is an underperforming trainer being fired – outperform by 4 %.  The study does not say by how much the share price was underperforming before the sacking was announced!
Although the share prices of football clubs appear to react to information on them, we have to confess to being at a loss when it comes to valuations – a P/E ratio of 100 for Juventus of Turin, the last year in which it achieved positive earnings (2003), 2006 EBIT multiple of 123 times (calculated before the recent legal proceedings and the resignation of its board).
It is true that financial analysts don’t really cover the sector, which is the obvious reason for the low market caps of all football clubs.  Nevertheless, even though very little information is available, it is likely that most of the free float is made up of retail rather than institutional investors.  Low liquidity is not the sort of thing that’s going to attract institutional investors.  Allouche and Soulez calculated, that before its acquisition, daily trading in the shares of Manchester United was on around 1.62% of its free float, compared with 0.49% for Leeds United and only 0.26% for the 12 other listed English football clubs. 


All in all, if you’re a football fan, it’s probably better to spend you money on tickets for matches than to become a shareholder of your favourite club, unless you’re convinced that it’s going to become the next Manchester United.  Manchester United has a clear, long-term group strategy which it has implemented with determination. This has enabled it to perform far better than its competitors, many of whom have very short-term goals or strategies based on prestige, with very little financial rigour. The shareholder rate of return from 1992 to the takeover in 2005 was 26% per year, although admittedly the share price was extremely volatile over the period.  Enough to make 99.9% of listed companies green with envy though.
As for those who don’t like football, well, there are loads of other investment opportunities just waiting to be seized!
(1) For more on efficient markets, see chapter 15 of the Vernimmen.
(2) Listing of English football clubs. A differentiated analysis of factors explaining share price fluctuations. GREGOR University of Paris I. 2005.

Statistics : Delisting from the Stock Exchange

The French Stock Exchange watchdog authority (AMF) has recently published an analysis of voluntary delistings(1). It shows that they represent, year after year, a fairly stable rate from 2% in Japan, 7% in France and in the USA to 12% in the UK:

As the authors of this study wrote “The regular exit of firms from the list squares with Schumpeter’s principle of creative destruction, which is inherent to the capitalist system”.
(1) For more on delistings, see chapter 42 of the Vernimmen.

Research : Debt maturity and marketability

Although a lot of research has been done into how corporations finance their activities, very few empirical studies on bank debt have been carried out.  One of the reasons for this is that there is a lot less exploitable data on this subject that is more difficult to collect than there is on the debt securities markets.
Two recent articles take a look at commercial loans granted by banks to firm. 
The first, written by A.B. Güner (1) looks at the role of the secondary market for loan sales in the determination of the cost thereof to companies.  We have seen (2) that in Europe, 40% of bank loans are sold on to financial investors after they’ve been granted.  Last year, this percentage exceeded 50% in the USA.  The second article is an IMF paper (3) on the role or risk and information asymmetry in the choice of debt maturity.  
The article by A.B. Güner attempts to assess the impact of the possibility of loan sales on the cost of corporate borrowing.  Intuitively, one would imagine that firms that authorise banks to split up loans granted to them at the time they are put in place, and then to sell on all or part of these loans on the secondary market, should be given a lower interest rate.  There are two reasons for this:
• From the bank’s point of view, the possibility of selling on the loan could entail a number of advantages – diversification of risk, management of solvency ratios, possible tax advantages.
• From the firm’s point of view, however, the splitting up and sharing out of the loan has a number of drawbacks, the chief of which is that it would make it more difficult for the corporate borrower to renegotiate a loan which may in the future be held by several parties with diverging interests, instead of a single lender.  Eurotunnel is well placed to testify to the major drawbacks of this situation!
As the author did not have access to data on whether or not resale agreements were signed for each loan, he assessed the cost of loans in banks that are very active on the secondary market compared with all banks as a whole.  For the most active banks, the test confirms that the spread applied to the loans that they grant is lower, by 20 to 30 base points, depending on the specifications.
The IMF article is based on two theoretical models linking debt maturity to company ratings -  the Flannery model and the Diamond model.
Flannery explained that debt maturity should be an upward-sloping function of the company’s risk rating.  It is better for a high-risk business to borrow over a period that is in line with its project (ie, generally long term).  In the case of short-term borrowing, the bank could make a quick assessment of the level of risk of a project, and require the corporate borrower to pay a very high interest rate to renew the loan (over and above the loan fees).  Additionally, the company will not want to add the financial risk involved in periodically renewing its loans to the risk of its project. By taking out a long-term loan, the company reveals the high-risk nature of its business, but avoids the costs of renewing the loan.  A company involved in a low-risk business will however be prepared to bear these costs by taking out a short-term loan, which sends out a signal that it is a high quality enterprise.
According to Diamond, this relationship would not be valid for very high-risk businesses.  Banks could refuse to grant them long-term loans but agree to short-term loans in order to obtain information on their projects.  For both models, the relationship between risk and maturity is explained by information asymmetry.
The test carried out by the authors tends to confirm the Flannery model.  When there is information asymmetry, corporate debt maturity increases with risk.  The relationship will continue to slope upwards for very high-risk companies, contrary to predictions by Diamond.  This happens when loans are for both small and large amounts.  This study also shows that this relationship is indeed explained by information asymmetry.  The impact of risk on maturity disappears when research is restricted to banks using techniques to reduce information asymmetry (especially small business credit scoring) (4).
(1) A.B. Güner, 2006, Loan Sales and the Cost of Corporate Borrowing, Review of Financial Studies, Vol. 19, n° 2.
(2) For more details see the Vernimmen.comt Newsletter, October 2005.
(3) A.N. Berger, M.A., Espinosa-Vega, W.S. Frame et N.H. Miller, 2005, Debt Maturity, Risk and Asymmetric Information, IMF Working Paper WP/05/201.
(4) For more on credit scoring, see chapter 8 of the Vernimmen.

Q&A : What are Vendor due diligences?

Vendor Due Diligence (VDD) is an audit carried out with a view to the disposal of a company, performed by independent third parties (specialised departments in audit firms, lawyers) at the request of the shareholders of the company for sale, the results of which are made available to potential buyers. VDD first emerged on continental Europe four to five years ago in transactions involving equity investment funds.  It has now become standard practice for most M&A operations.
What does VDD cover?
In general, VDD covers the following areas:
 Operational: detailed description of business and risks involved
 Accounting: principles, organisation and internal control
 Financial: analysis of previous accounts, the current budget and whether it is being met, the business plan
 HR: organisation, compensation policy, trade unions, liabilities (pension fund commitments)
 Tax, legal, environmental, IT: identification of risks
What are the goals that VDD seeks to achieve?
From the seller’s point of view, VDD enables it to take a step back from the company up for sale, to gain a better understanding of how it works and to take any necessary corrective measure rapidly before launching the sale process.   Such measures could include the formalisation of oral agreements, the acquisition of minority stakes, the implementation of appropriate procedures, etc.  This general tying up of longstanding loose ends coupled with the in-depth understanding of the target company during VDD, helps to pave the way for handing over control of the company.  It also means that the seller will not end up in a position of weakness if, during the negotiating phase, the buyer unearths a problem of which the seller was unaware.
From the buyer’s point of view, and also that of its advisors and providers of funds, VDD facilitates the analysis of the information provided on the company, especially if the buyer is an investment fund with no experience in the activity of the company being sold.  The document presenting the company (known as the Info Memo in investment banker’s jargon) will be far more accurate and relevant if VDD is carried out.
Finally, it lends greater credibility to the sale process, especially if the seller is approaching equity investment funds that have introduced acquisition procedures similar to those of trade players. VDD is now a mandatory one of these procedures.  VDD can, depending on the circumstances, reduce or even remove the need for additional accounting and legal due diligence on the part of the buyer, before the acquisition is finalised.
At the cost of upstream work that is both heavy and fastidious (taking from two to five months), and requiring close collaboration between the company's management,  staff, auditors and lawyers, VDD helps speed up the process in which the buyer learns about the company as well as that of the negotiating phase. 
Who is VDD aimed at?
The results of VDD are disclosed to potential buyers who have got through the first round of the sale procedure, in the form of a preliminary report. They are required to acknowledge that the party responsible for the VDD has no liability towards them if they do not acquire the company for sale.  When the final buyer is selected, the final version of the VDD report is handed over, following signature by the buyer of a reliance letter, in which the buyer agrees to the terms and conditions of the request for VDD made by the buyer.  The buyer then obtains the same rights as the seller vis-à-vis the party responsible for drafting the VDD report.
VDD costs between €200,000 and €2m.  It is difficult to put an exact figure on how much value-added it generates, but in most cases, it is generally a good investment.