Letter number 32 of May 2008
- QUESTIONS & COMMENTS
By Yann Ait-Mokhtar, head of quantitative research at Exane BNP Paribas
1. Part I – The 2001-2002 credit crunch and its consequences Credit stress situation
During the credit crunch that followed the bursting of the Internet bubble, a lot of companies, such as France Télécom, Suez and PPR suffered negative impacts resulting from the implementation of protection mechanisms that triggered massive buying and selling of shares, in reaction to the way the market was moving. At the time, these mechanisms had been put in place to hedge against credit risk.
To simplify, when there is a deterioration in the firm’s situation, the value of its debts, like that of its shares, falls. To hedge against its credit risk, the lender can thus sell short the shares, which are a lot more liquid than debts. Losses on the credit are set off by gains made by short selling the shares.
This mechanism does not have any negative secondary effects on the share price, as long as flows generated by this credit rest hedging remain marginal. As soon as flows increase, sales of shares on the stock market reduce the market value of the firm, which in turn depreciates its credit because a larger percentage of the firm’s capital employed is then financed by debt (1). Arbitrageurs and those seeking to hedge against risk, will then sell their shares again, so the mechanism becomes self generating. This movement does not, however, go on ad infinitum, and stops when the fall in the share price justifies buyers’ trades, on the basis of sufficiently fundamental arguments.
Intrinsically, mechanisms for hedging against credit risk generate the sale of shares when the share price falls, and the purchase of shares when the share price rises. In doing so, they transfer the credit risk to the equity markets. The shares then become excessively volatile and depreciated. The depreciation results from an additional risk premium to cover the credit and the liquidity risk transferred by the credit arbitrageurs.
The credit bull market
Between 2003 and mid-2007, the scarcity of credit (caused by the deleveraging of listed groups) gradually led to a reversal in the way the mechanisms operated. The equity risk was bought by the bond market in synthetic form, which played a major role in reducing the volatility of the equity market. The mechanism was reversed compared to the situation during the credit crunch – when share prices rose, arbitrageurs sold and when it fell they bought. This acted as a sort of shock-absorber for market movements.
The exponential development of credit derivatives over recent years has given these arbitrage mechanisms a macro-economic dimension. In normal market conditions, they regulate the markets by consuming a small amount of liquidity when there is a surplus on the credit market and by providing liquidity when there is a shortage on the credit market. During periods of crisis on the credit market, arbitrage mechanisms are amplified.
The following graph illustrates these arbitrages. The equity risk indicator (volatility) is fully correlated to the bond risk indicator (the spread).
2. Part II – The current situation
A number of groups and funds have acquired stakes in the capital of firms using debt financing without going through banks. The table below provides a few examples in Europe:
A bank that lends without any hold over the investor other than the value of the shares acquired, does so on the basis of a percentage of the value of the shares financed, a process known as Loan to Value (LTV). If the value of the shares falls, the bank will ask the investor to set off the fall in value of its guarantee using margin calls in the form of cash or securities. If necessary, it will automatically sell all or some of the shares to cover its risk, which could accelerate the fall in the share price.
The investor, or the bank, could also have partially protected its portfolio by buying put options, which would mean selling short a number of shares equal to the number of protected shares multiplied by the option’s delta. When the share price falls, the put option’s delta rises (2), making it necessary to sell more shares short in order to maintain an efficient hedging mechanism. If on the other hand, the share price rises, shares should be bought in order to adjust the hedging position. In all cases, these operations amplify market fluctuations and therefore increase the volatility of the share, in the same way as mechanisms during the credit stress situation in the first part of the decade did.
3 – From an increase in volatility to an increase in the cost of capital
The increase in volatility generated by mechanisms recently put in place to cover minoritory positions increases the beta of the share compared with its benchmark index as assumed in the CAPM, and thus increases the company’s cost of capital (3). The increase in the cost of capital will then penalise the value of the share and the shareholders.
This increase in volatility also leads to an increase in credit risk, as valued by the optional models (increase in likelihood of default). Financially, the company will thus also be penalised as soon as it needs to take out debt, by paying an excessive risk premium.
Schematically, this sort of mechanism transfers the risk from the “protected shareholder” to the ordinary shareholders of the company. The share is discounted by the increase in the cost of capital. This increase in the cost of capital corresponds to the theoretical additional return that ordinary shareholders get in exchange for the risk that is transferred to them, without their knowledge, by the “protected shareholder”. But before this larger future return (which compensates ordinary shareholders for the higher risk) is earned, there has to be a fall in the share price, which could well invoke the ire of ordinary shareholders.
(1) For those of you who are keen on options, a company’s debt can be analysed as a risk-free bond and a put option sold by the lender to the shareholder at a strike price that is equal to the amount to be repaid. The value of this option increases when the value of the capital employed decreases as the likelihood of it being exercised increases. If the value of the put option that has been sold increases, the value of the debt decreases. For more information, see chapter 35 of the Vernimmen.
(2) For more information, see chapter 29 of the Vernimmen.
(3) For more information, see chapter 23 of the Vernimmen.
Two main formats of income statement are frequently used, which differ in the way they present revenues and expenses related to the operating and investment cycles. They may be presented either:
• by function (1), i.e. according to the way revenues and charges are used in the operating and investing cycle. This shows the cost of goods sold, selling and marketing costs, research and development costs and general and administrative costs; either
• by nature (2), i.e. by type of expenditure or revenue which shows the change in inventories of finished goods and in work in progress (closing less opening inventory), purchases of and changes in inventories (closing less opening inventory) of goods for resale and raw materials, other external charges, personnel expenses, taxes and other duties, depreciation and amortisation.
Moreover, a new presentation is making some headway, it is mainly a by-function format but depreciation and amortisation is not included in the cost of goods sold or in selling and marketing costs, or research development costs but isolated on a separate line.
Whereas in the past France, Germany, Switzerland and the UK tended to use systematically the by-nature or by-function, the current situation is less clear-cut.
(1) Also called by-destination income statement.
(2) Also called by-category income statement.
Whether or not multinationals require their subsidiaries to remit incoming dividends is one of their key management decisions. This month we take a look at the reasons why multinationals may require their subsidiaries to pay them dividends. Three US professors(1) studied this phenomenon at multinationals operating in the USA over a period of 20 years (between 1982 and 2002). Their article goes over the theoretical explanations for the payment of incoming dividends by subsidiaries and verifies their relevance using econometric tests. This study adds to the large body of existing literature on the subject, and for the most part confirms the results that have already been established (2).
Criteria on which incoming dividend remittance decisions are based can be divided into three categories.
1. Tax considerations
Multinational firms will have to pay additional tax on incoming dividends. Under US regulation, the parent company must pay the IRS the difference between the US tax and the tax due by the subsidiary in the country in which it is established. Econometric tests confirm that subsidiaries located in countries in which tax rates are low pay fewer dividends to the parent company, in order to avoid heavy taxation. However, the authors underline the fact that it is not unusual to see parent companies requiring incoming dividends and at the same time injecting capital into their subsidiaries, even though they are penalised by the IRS for this type of behaviour. Accordingly, one of the main outcomes of this study is to show that the tax issue is not the determining factor in the functioning of internal capital markets within multinationals.
2. The multinational’s financing needs
The parent company may wish its subsidiaries to remit more dividends when it has investment opportunities but is unable to obtain external financing very easily (for example it may already be carrying a lot of debt). Here again, the econometric study confirms that indebted companies with investment opportunities are more likely to get their subsidiaries to remit incoming dividends. Additionally, tax issues take second place in the case of heavily indebted companies.
3. Control over subsidiary managers (agency issues)
According to the authors, this is the main decision-making criterion behind the remittance of incoming dividends. Tax considerations and financing requirements differ from one year to the next, depending on the revenue and prospects of the parent company. However, we observe that the incoming dividend rate remains very stable (on average and over 20 years, subsidiaries pay the parent company 40 cents out of every extra dollar they earn).
By requiring subsidiaries to make regular payments in this way, the parent company is able to limit the ability of its subsidiaries’ management teams to behave in an opportunistic manner. This argument is essential, even for understanding the other two types of criteria. It provides justification for behaviour that results in the company being penalised by the Tax Man and explains why multinationals require their subsidiaries to pay them dividends when they themselves are up against an agency problem and are forced to pay dividends to their shareholders.
(1) Desay M.A., Foley C.F. and Hines J.R., 2007, Dividend Policy Inside the Multinational Firm, Financial Management, n°36-1
(2) For more dividends policy, see chapter 38 of the Vernimmen.
A SPAC is a Special Purpose Acquisition Company.
It is in fact a shell company that obtains a listing on the stock exchange by raising capital on the market with the aim of taking control over a company, that is yet unidentified, whether listed or not, within a period that does not exceed 24 months. If it fails to do so, the SPAC is automatically liquidated and the investors recover at least 98% of the funds raised when the company was listed. But does this make it a blank cheque that the shareholders give to the SPAC's management? No, it doesn’t. Once the target has been identified and its acquisition negotiated, the SPAC must obtain approval for the operation from shareholders (majority of 60 to 80%) and if it fails to obtain shareholder approval, the SPAC is automatically liquidated and the shareholders recover the cash they put into the company.
Since they first emerged in the USA in 2003, 156 SPACs have been listed after raising $21.5bn, an average of around $138m per SPAC.
The continued increase in the size of SPACs is an indicator of their success, as is their arrival in the UK (on the AIM), the Euronext Amsterdam (Pan-European Hotel Acquisition Company NV raised around €100m last year) and India and China, not to mention the high profile names on Wall Street who have launched or who are about to launch SPACs – Ronald Perelman, Bruce Wassertein, Nelson Peltz, Joseph Perella and others.
Materially, and in order to protect investors, US stock exchanges have made it mandatory for SPACs to have a minimum market capitalisation on the date on which they are listed of $250m with a free float of $200m, for 90% of the funds raised to be invested in a trust fund that will only release the cash to finance the acquisition approved by shareholders or to liquidate the SPAC, and finally, for the investment to be made within three years of the IPO. In practice, 98 to 100% of funds raised are placed in a trust fund.
SPACs are IPOed by a management team which generally invests 3 to 5% of the amount of the capital raised, which is placed in a trust fund. Management must then identify a target, negotiate its acquisition and convince the shareholders in the SPAC to approve the operation. Throughout this period, management receives no remuneration, but if all goes well, they will be able to use their share subscription warrants at the time of the IPO and pocket 20% of the capital of the SPAC, having only invested between 2 and 5%. Managers of private equity funds, who have to “make do” with 20% of the fund’s capital gains, are by comparison, rather small fry! However, if things don’t work out and the SPAC has to be liquidated, its managers get nothing and they lose their initial investment and leave with their reputations slightly tarnished. This is what is known on Wall Street as checks and balances.
As a shareholder of a SPAC, what are the sort of companies you could you have bought in recent years? American Apparel, CMA – CGM container shipping business, a hedge funds management firm (GLG Partners), Jamba Juice, sports stadiums for anyone with an odd ideas about financing sport(1)
After completing the acquisition, the SPAC generally adopts the name of the target it has acquired. The SPAC’s management team is required to hold onto its shares for at least six months following the acquisition. In general, management will sit on the target’s board of directors alongside its existing directors, playing an advisory role.
SPACs make it possible for investors who do not have access to private equity or hedge funds to access investments on better liquidity terms (SPACs are listed) and with greater transparency (SPACs are subject to standard stock market regulations). However, the price paid is high – 15 to 17% of the value.
Thus far, annual profits made by SPACs have not, on average, been spectacular:
SPACs contribute equity capital to companies that may be having trouble in raising funds on the market (a merger with a SPAC is equivalent to a capital increase), enabling unlisted companies to access a listing (even when the IPO market is closed) not to mention the liquidity at a fair price that unlisted companies acquired by SPACs get. It is one of the few segments on the financial market which recorded as much business in the first quarter of 2008 as in the first quarter of 2007. Another indication of the vitality of SPACs is the 60 or so SPACs ready to enter the New York market, and the reduction in the percentage given to the management team from 20% to around 15% for the last SPACs.
And to end, just to illustrate that innovation begets innovation, a new rather dubious practice has sprung up on Wall Street - SPACmailing. You buy a block of shares in a SPAC which has announced its intention to acquire a company, and you then threaten to derail the process by voting against the acquisition (which would result in the immediate liquidation of the SPAC and the evaporation of the 20% that management hopes it has coming to it), unless of course management might just see its way clear to granting you a few minor trifles just before the vote. After all, everybody needs to eat!
For those of you who may be thinking that all of this is just a huge joke, take a look at www.spacinfo.com and www.spacanalytics.com, or better still, go to the New York Hilton on June 5, 2008 and attend the SPAC Conference!
(1) For more details see the Vernimmen.com Newsletter n° 18, September 2006.