Letter number 83 of September 2014
- QUESTIONS & COMMENTS
Few of our readers have been confronted, during their professional lives, with a situation of having to manage a firm's finances during a period in which prices are falling steadily. The last time that this situation was observed in Europe was in the 1930s.
With a current average annual inflation rate in Europe of 0.3%, it cannot be said that the economy in the region has entered a deflationary period. But behind an average, there is very often dispersion and some segments of the economy have without doubt entered a deflationary period. For example, the fees charged by audit firms fell by 4% in 2013 compared with 2012 for the top 40 French listed companies - €731m vs €756m. Over the past 12 months, food prices have fallen by 1.5% in France and manufactured product prices by 1.3%. Some sectors are being confronted structurally by falling prices of their products, such as the computer hardware sector.
A deflationary situation that is more or less widespread which lasts several years is characterised by a continual drop in sales prices, by falling sales volumes (why buy now if I think that I can get the same item cheaper at a later date), falling production volumes (why produce so much if sales volumes are declining), falling margins (producing at yesterday’s costs and selling at tomorrow's lower prices), high real interest rates (as it is difficult to imagine that the nominal interest rate could become negative). All of the above lead to high numbers of bankruptcies and a drop in the value of equity capital.
Our aim here is not to predict whether all of the sectors of the economy will follow this deflationary path, nor how long this situation will last, but to look at the measures that a financial director, who is worried about protecting his/her firm against the risk of deflation, could suggest to the firm’s manager.
We have come up with seven measures, of a financial and non-operational nature, that we think should be on our financial director's list:
1. Deleverage as much as possible as there is a risk that debt, during deflationary periods, will be taken out at a high real interest rate, even if the nominal rates are low, i.e. a highly negative scissors effect for an activity with falling volumes. It is, in effect, paradoxical to have a high real interest rate (e.g. 5%) during a period of very low nominal interest rates (e.g. 2%). Inflation just has to be running at -3%.
In this regard the firm could carry out share issues while there’s still time (i.e. before a depression takes hold of the equity market), dispose of production capacities that run the risk of becoming surplus to needs over a certain period, and sell off non-operating assets (non-operational real estate, minority stakes, diversifications).
We cannot help noticing the repeated announcements, since the beginning of the year, by large groups indicating their desire to sell off assets that have become peripheral in order to focus on a few flagship products in their portfolios – BHP Billiton in the mining sector, GlaxoSmithKline and Sanofi in the pharmaceutical sector, Procter& Gamble in the consumer goods sector, etc.
2. Sell off all or part of the operating real estate that can be sold in order to deleverage and rent back the property at a rent that is indexed to inflation, a rent which is very likely to drop in the future.
3. For the remainder of bank and financial debt, switch to a floating interest rate in order to benefit from nominal interest rates which are likely to drop in the future.
4. For residual debt, extend the repayment period in order to limit annual outflows of cash.
5. In as far as possible, reduce working capital, both in terms of inventories in order to limit sources of potential capital losses (finished products) or extra costs (raw materials) as well as in terms of receivables, which are a source of potential losses (bankruptcies).
6. Invest cash in assets of which the financial director has checked the solvency him/herself in the light of this new economic era. It should be remembered that during the 1930s recession, rating agencies did not show that they were better able to anticipate insolvencies. Recent examples such as Enron and the subprime lending fiasco unfortunately show that there has been little improvement in this regard.
This cash will be used, when the time comes, to buy up industrial facilities and equipment at knock-down prices from firms which have been crippled by debt.
7. When giving back cash to shareholders, favour share buybacks over dividends, which are more difficult to reduce.
At an operational level, the financial director will have to plead for strategies of cost “variabilisation” and for maintaining R&D expenditure as innovation is probably one of the drivers that will help to protect against deflation.
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All in all, and unsurprisingly, since deflation is the opposite of inflation, financial management during a deflationary period means doing the opposite of what one would do during an inflationary period, for example taking out debt at a fixed rate in order to take advantage of negative real interest rates, over producing and keeping excess inventories in order to make profits out of inflation.
Although these measures make sense at the level of the firm, it is clear that on a macro-economic level, they contribute to increasing deflationary pressure and accordingly ushering in what we fear most. Once again, psychology is very important in finance.
The average corporation tax rate in OECD countries in 2014 is 24.11%, continuing the downward trend it has been on since 1993 (38%)! But the average has been brought down by countries from the former Soviet Block as the scope of the KPMG study has been extended to a number of small countries with rather low corporation tax rates, intended to attract investors.
Corporate income tax rates rate are going down in Japan and the UK.
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 – Lecturer-researcher at the University of Paris Dauphine
A scientific study of loan agreements must take account of factors other than the interest rate alone. The article presented in the last issue showed the positive impact of a CDS market on the non-price factors of agreements (clauses and guarantees). In the same way, the article that we present this month looks at the determinants of these non-price factors. A Yale researcher shows that banks increase the severity of covenants in loans that they grant when they are experiencing defaults on other loans.
Most studies looking at loan agreements focus on the characteristics of the borrower. When the probability of a borrower defaulting is high, the loans that it obtains are not only more expensive but they also contain harsher covenants. Our article shows that the determinants of these covenants are also to be found on the supply side. For equivalent borrower characteristics, loans granted by bank that have recently suffered a default, are more severe.
In order to measure this, Murfin first constructed a measurement of the severity of covenants in loan agreements. These covenants give the lender the possibility of demanding the immediate repayment or renegotiation of the loan as soon as certain thresholds (cash flow levels, debt ratios, etc.) are breached. Without going into details of the formula, the article considers agreements as more severe when the probability of triggering any one of these covenants increases.
Using this measurement, Murfin shows that banks draft stricter loan agreements after they have suffered a default in their portfolio of loans. This loan remains true when the default has happened in another sector and another geographical region than the loan being considered. Murfin concludes that this default does not constitute a signal on the quality of the borrower, but information for the lender on its own ability to assess risks. A bank which experiences a default becomes aware of its limitations in the selection of the companies that it finances. This heightened uncertainty leads to more stringent requirements in terms of contractual clauses. Of course, the occurrence of a default also leads to a reduction in the equity capital of the bank, which is then forced to tighten up its terms and conditions. But Murfin shows that factoring in this effect does not cancel the information effect.
Economically, the effect is highly significant. The econometric study covers 2,642 loan agreements (both syndicated and bilateral) granted to non-financial US companies by banks between 1984 and 2008. An increase in the number of defaults in a bank's loan portfolio of 2.7 (or one standard deviation) has the same impact on the severity of covenants as the downgrading by one notch of the borrower’s rating by Standard & Poor’s. This result is interesting as it goes against the intuition that the characteristics of loan agreements depend only on the qualities of the borrower.
Finally, Murfin asks what pushes borrowers to accept these more stringent contracts. Previous studies have shown that companies were often better served, in terms of loans, by a small group of banks with which they had long-term relationships, than on the open lending market. Companies tend to stay with their historical lenders, even when these lenders introduce more severe covenants.
The study shows, however, that companies dependent on a small number of lenders are more sensitive to a deterioration in the loan portfolios of their partner banks than others. Accordingly, companies have to find a compromise between close lender-borrower relationships (in order to reduce information asymmetries) and more independent relationships (in order to avoid being a victim in the deterioration of the situation of partner banks). Just another illustration of how you can’t have your cake and eat it…
 J. MURFIN (2012), “The supply-side determinants of loan contract strictness”, Journal of Finance, vol. 67, no 5, pages 1565 to 1601
 See chapter 35 of the Vernimmen.
 See for example C. DEMIROGLU and C.M. JAMES (2010), “The information content of bank loan covenants”, Review of Financial Studies, vol. 23, pages 3700 à 3737.
Over the past few quarters, we’ve seen an increase in M&A deals involving a US buyer which has itself “bought” by its foreign target, in particular, but not exclusively, by UK firms in the pharmaceuticals sector. Specialists refer to such deals as tax inversion and put a figure of $200bn on deals underway or completed since early 2013 (Chiquita Brands-Fyffes, AbbVie-Shire, Medtronic-Covidien, Liberty Global-Virgin Media, Burger King-Tim Hortons, etc.).
We remember that the parent-subsidiary regime, which exempts from corporation income tax dividends received from subsidiaries paid out of profits that have already been taxed in a country or abroad, does not exist in the USA. When a US firm repatriates dividends from its international subsidiaries to the USA, it is taxed normally on these profits, at the normal rate of tax on profits in the USA (35% at a federal level) although there is a tax credit capped at the amount of tax paid on these profits in the country in which they were made. Accordingly in the UK, income of 126, before corporation tax at rate of 21%, results in net income of 100. If 50 is paid in dividends to the US parent company, the latter will pay tax of 35% x 63-21% x 63 = 9 in the USA. The 63 corresponds to half of the pre-tax income of the UK subsidiaries which is paid as a dividend. As soon as they are repatriated to the USA, the profits of the international subsidiaries of US groups are ultimately taxed at the US tax rate of 35%, except profits made in countries which have a higher tax rate, such as France for firms with sales of more than €250m.
This tax structure explains why a large number of US groups only repatriate sufficient dividends necessary to cover their debts and the dividends they pay to their shareholders, except when dividends originate in countries that have higher tax rates on profits. The remainder stays with the international subsidiaries, pending a hypothetical temporary tax amnesty, as has happened in the past. Often tax optimisation, or even tax fraud, comes into play. Through internal sales prices, fees, etc. pre-tax profits are kept in European countries where tax rates are the lowest (Ireland at 12.5%, Switzerland at an average of 18%).
If, as part of an M&A deal, a US firm is acquired by a foreign firm, if the foreign shareholders hold onto at least 20% of this foreign firm for at least 12 months and if at least 25% of the assets, or the workforce, or the wage bill or the earnings are located or made in the country of the foreign subsidiary, then the tax domicile of the US group can migrate from the USA to this country. As the reader will have understood, the rule of 20% minimum capital held by non-US shareholders enables the US group, even if it has become British or Irish, to continue to be controlled by the same shareholders, most often, American.
Once it has become “British”, our US group will continue to pay federal taxes at a rate of 35% on its US profits, but will not have to pay a tax surcharge to send profits from subsidiaries up to its “British” parent company, because there is a parent-subsidiary type tax regime in the UK. Savings can thus be substantial (Walgreens share price fell by 14% when the company announced in early August that it was not going to seize the occasion of the acquisition of the balance of the capital of Alliance Boots to carry out a change of tax domicile).
Alongside the winners, there are the losers, the biggest of which is, of course, the IRS. The IRS is thinking about raising the 20% threshold to 50%, which would mean a loss of control of the US firm by its existing shareholders, which would make them think twice before carrying out a tax inversion. Other losers are the rivals of US groups in an acquisition, who do not benefit from this tax advantage and so are less likely to take it. And finally, there are the managers of firms located in countries with low tax rates, which are natural targets for tax inversion (see AstraZeneca).