Letter number 131 of July 2020


News : Stock market or investment fund shareholding?

The disenchantment with stock markets and the rise of unlisted investments is a fundamental trend that is not about to stop. While the number of listed companies worldwide has stagnated since 2015 at just over 50,000, in the United States it has been declining since 1997, now less than half the number of the companies listed on the stock exchange as in 1997.

As nature abhors a vacuum and with companies less attracted by the stock market, investment in unlisted, or private equity is growing apace. Its precise definition is unclear and differs from one source to another. Let's say that it covers all investments made through investment funds in unlisted companies or companies that become unlisted on that occasion, or in unlisted assets (such as real estate or natural resources).

Preqin estimates that private equity funds raised in 2019 will total $894 billion, significantly higher than pre-2008 records:

This is well above the amounts raised in IPOs on listed markets ($247 billion in 2019). In the United States, there are twice as many companies financed by private equity (8,000) as there are listed companies.

1/ The origin of investment funds

The origins of unlisted investment in its modern form can be traced back to the United States when, after the Second World War, a Harvard management professor, Georges Doriot, set up the world's first venture capital company, AR&D, in the Boston area. With funds provided in particular by the John Hancock insurance company and MIT, AR&D financed DEC from its beginnings in 1957, which was a huge success and became the second largest computer manufacturer in the world before its takeover in 1999 by Compaq, which itself merged with HP in 2002.

In the United Kingdom, private equity initially took the form of minority investments to help SMEs or second tier companies to grow and turn into groups. The unlisted, fund-managed sector developed later in continental Europe, where development capital had been pre-empted at the beginning of the 20th century by listed financial companies, the best known of which were Mediobanca, Paribas, Suez, Générale de Belgique, Deutsche Bank, Commerzbank, etc.

Then in the 1980s, a genetic mutation took place in the world of unlisted investing with the appearance and then the development of LBO funds[1] taking full control of a target, a new occurrence as unlisted investing had previously limited itself to minority stakes. The refocusing of listed groups, spurred on by the development of the concept of value creation, the end of the large conglomerates (General Electric plc, Saint-Gobain, ITT, etc.), and the succession of family businesses created in the immediate post-war period, provided a breeding ground for the development of this new form of private equity.

The long phase of falling interest rates and the correlative rise in valuation multiples (which favours financial performance), the renewed motivation of the managers of acquired divisions (often managed very loosely) through management packages, and the focus on cash and profitability, combined with the leverage effect of debt, explain the very high returns on investment that attract and retain investors. Over the years, the success of LBOs has been considerable, so much so that for many, private equity has become synonymous with LBO funds. From being a temporary lock between a family shareholder or a division of a group and the stock market or another group, LBOs have become a means of long-term ownership of companies with the development of secondary and tertiary LBOs, etc., such as Optven for example.

Buoyed by their success, some of the historical LBO funds (KKR, Blackstone, Apollo, Ardian, etc.) are expanding their activities to include investments in private debt, infrastructure, development capital, venture capital, real estate, distressed companies, natural resources, minority stakes in listed companies, etc. As a result, McKinsey estimates that in 2019   private equity, in its broadest sense, will manage $6,500 billion, up 12% over 2018.

Although it has been growing since 2002 at twice the rate of world market capitalisation, and has multiplied its outstandings by more than seven since then, the unlisted market still represents only around 7% of world market capitalisation ($92,500 billion at the end of 2019), compared with half as much in 2000.

Although this share may seem small, we no longer meet investors today who say they are not interested in private equity. On the contrary, most want to increase the proportion of their assets allocated to this type of investment, which has now become mainstream.

So much so that a number of major investors, sovereign wealth funds, family offices and pension funds have developed their own tools and structures for investing in the unlisted market in a traditional manner.

2/ The growing complexity of life on the stock market

A few years ago, market windows were used to refer to periods when the stock market felt able to subscribe to capital increases or to welcome new recruits into its ranks. Outside those ranks, there was no salvation and the only thing to do was wait. Today, it would be more appropriate to call them windowlets given how widely spaced and narrow they have become, sometimes leading, after a few months of preparing a financial transaction, to cancellation on the eve of the launch! All this because a competitor's quarterly results are 2% below expectations and its share price has fallen 10-15%, or because a central bank has not announced the expected quarter-point drop in its refinancing rate, not to mention the unpredictable effects of a Washington tweet. You have to have nerves of steel and have your plan B ready. Gefco, Virgin Train USA, Bitmain, Traton, etc. all cancelled their IPOs in early 2019.

Most listed companies with a market capitalisation below €1bn are not covered by analysts or are only included in studies that paraphrase their publications. The rise of passive management, which now accounts for around 20% of assets under management in Europe (and 45% in the United States), and which simply duplicates an index without basing its investment choices on fundamental research based on financial analysis, is the primary reason. The Mifid II Directive, which came into force in Europe in 2018, by seriously reducing the quantity, or even quality, of research published on listed companies, has reinforced this trend. The share of transactions taken by high-frequency trading (HFT), which can exceed 50% of volumes, increases the suspicion that prices are disconnected from companies' actual performance.

While it seems to us to be completely unjustified to claim that stock markets are affected by short-termism, or that listed companies are affected by propagation of this defect5, the fact remains that:

  • Business life is often a succession of setbacks, of changes in strategy necessary for survival or of seizing opportunities. When you're listed, it's hard to escape a 10-20% drop in price in one day, which is not always justified. It's hard not to think that some people sell first and think later. While this decline will be corrected over time, managing the effect on employee morale is an extra task.
  • Governance of listed companies has improved significantly over the years[2] and is often of better quality than governance of family businesses, cooperatives or subsidiaries of groups. However, it is still often marked by complacency with independent directors chosen de facto and de jure by the majority shareholder or manager. There is not always sufficient debate and challenging of ideas. And poor governance sooner or later has consequences for the company's operations.
  • There are fewer and fewer shareholders with whom the managers of listed companies can discuss strategy and figures, since some shareholders simply duplicate a stock market index and others often delegate to agencies the task of studying meeting resolutions.
  • The stock market allows you to vote with your feet (by selling your securities) when you disagree with a strategy or with the execution thereof. But sometimes a manager or a team just has to be replaced and this often happens too late in the day when there aren't any strong voices on the board of directors or among the shareholders of a listed company.
  • A listed company may find it difficult to take on debt beyond the levels accepted on the stock exchange (say more than 3 times EBITDA), and it may not always be the right time for the desired capital increase (see windowlet above). In short, the "easy" financing that comes with being listed may be somewhat theoretical.
  • To be listed is to be on a market and to be subject to its fluctuations (market risk), sometimes independently of a company's actual health. Cogelec went public in June 2018 raising €40m, half by investment funds wanting to sell, half to finance its conquest of four European countries and launch a new product. The IPO was a success with an oversubscription of 1.8 and full exercise of the extension clause7. Its price then fell very gradually by 50% until April 2019, before rebounding by 45% and then falling again by 20% before Covid-19 hit. Fundamentally, there was nothing new under the sun at Cogelec, which was rolling out its business plan as planned, on time and on schedule, with no changes to what had been announced at the time of the IPO. On the other hand, the mid-cap segment fell by 25% overall, before recovering by 25%; hence its own stock price gyrations.
  • Activist funds are increasingly present, including on small-cap stocks. These funds play an undeniably useful role, but they can also try to impose decisions that are not consistent with the company's long-term strategy. They act according to certain canons of financial orthodoxy from which you sometimes have to deviate when you are an entrepreneur.



[1] For more on LBO funds, see Chapter 46 of the Vernimmen.

[2] For more on governance issues, see Chapter 43 of the Vernimmen.



Statistics : The ICO market

We have already expressed our doubts about the Initial Coin Offerings process. The economic reality seems to prove us right: after two successful years in 2017 and 2018, the ICO trend seems to be waning and the volumes and number of transactions as reported by Strategy& and PwC are in sharp decline.

These results are hardly surprising in light of the performance of past ICOs analyzed by two researchers[1]. They show that, out of 674 ICOs whose tokens are effectively listed (i.e. 24% of ICOs), only 7.5% of them have, 6 months after their issue, a price higher than that paid by investors, and in more than 70% of cases the tokens have almost lost all value! In the field of start-ups, it is only after 10 years that such a result is achieved with a survival rate of 3 out of 10 companies created.


[1] Mathias Fromberger and Lars Haffke in: ICO Market Report 2018/2019: Performance Analysis of 2018’s Initial Coin Offerings.


Research : Wrong about dividends: just like financial professionals!

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


Teachers of finance are well placed to know that dividends are poorly understood by the general public. The idea that dividends are a form of shareholder compensation in the same way that salaries are a form of employee compensation is widely held. This error in reasoning, described in the academic world as the 'dividend fallacy', can lead the individual investor to irrational behaviour.

Finance professionals (or at least readers of the Vernimmen Newsletter! [1]) know that receiving a dividend is more comparable to withdrawing cash from an ATM than to receiving a salary, and that any reasoning based on dividends must take into account the mechanical effect of their payment on the stock market price. However, two US researchers recently published an article[2] which shows that many investment funds, institutional investors and financial analysts seem to be making the same mistake in their investment behaviour: capital gains and dividends are treated as if they were independent.

Hartzmark and Solomon use behavioural biases already widely documented in the literature. For example, the disposal effect is behaviour of excessively selling stocks that have recently risen in value, and refusing to sell stocks that have fallen in value. The article shows that this bias relates in fact to the price of the share and not to its performance, ignoring the dividends. To be clear: if two shares A and B see their price go from €5 to €6 over the same period, but share A has paid a €1 dividend (and B has paid nothing), then the disposal effect will be observed in the same proportions on share A and on share B, as if the two shares had recorded the same performance. In other words, to the disposal effect (already known) is added a bias linked to an artificial separation between capital gain and dividend in the measurement of performance.

Another spectacular result concerns the behaviour of dividend reinvestment. Individual shareholders tend to use dividends received for their consumption (instead of reinvesting them). Surprisingly, the reinvestment of dividends is also very rare on the part of funds and institutions. Over a long period (between 1980 and 2015), the adjustment of the number of shares per line is virtually independent from whether dividends are paid or not. It is as if the funds (and the institutional investors) wanted to reduce their participation in these shares exactly by the amount corresponding to the dividend received. For Hartzmark and Solomon, this is in fact additional proof of a differential treatment between dividends and capital gains on the part of professionals.

This error has negative consequences for investors. The search for dividend yield creates upward pressure on the prices of high dividend stocks, especially in times of low interest rates (dividends being assimilated to stable income). Hartzmark and Solomon measure an average annual performance loss of 2.4% for investors who buy these stocks when they are most in demand. They pay too much for dividends, at the expense of performance.

Hartzmark and Solomon note with a certain humour that US Airways did not call its loyalty program Dividend Miles to indicate that these miles would be irrelevant or fiscally disadvantageous, but because dividends are largely perceived by the public as remuneration. A great deal has been written by academics since the founding articles by Modigliani and Miller, but there is still quite a bit of work to be done in terms of education!


[2] S.M. Hartzmark and D.H. Solomon (2019), The dividend disconnect, Journal of Finance, vol.74-5, pages 2153 to 2199.


Q&A : Brain teasers for the holidays

1 - You are evaluating a motorway concession that expires in 15 years, which has no longer any debt and has no cash today. It plans to pay a constant dividend over the next 15 years and to pay the balance of its cash flow in the sixteenth year, as it will have to hand over the motorway free of charge to the community at the end of its concession.

How can you explain the fact that you cannot find the same share value when you use the discounted free cash flow method and the discounted dividend method, when you start from the same operating flows and the discount rates are consistent with each other?

2 - What is this large oil company (no need to look for market capitalisations below €70bn), with no significant diversification outside energy, whose share price since 1st of January 2020 has fallen by only 15%, compared with 30 to 40% for all of its peers? And for what reasons, in all likelihood?

3 - Why has the price of Occidental Petroleum fallen by two-thirds since the beginning of the year? What effect does this illustrate?

4 - Vallourec, a group active in the production of seamless tubes for the energy, construction and automotive sectors, announced on 20 February 2020 a €800 million capital increase in order to reduce its debt, which is very heavy, something it cannot do with its free cash flow after years of losses. Vallourec employs 18,000 people. Via Bpifrance, the French State owns 15% of Vallourec and in this context, has announced a €120m participation in this capital increase.

Do you interpret this latest decision as a signal to financial investors? If so, is it positive or negative? If so, is it positive or negative?

5 - How to calculate the cost of capital in Haiti for a project to install a cable network delivering TV, internet and telephone, knowing that the rate of Treasury bills is 7%, the cost of bank loans is 16% and that there is no stock market?



1 - It is logical that you will not find the same figure between these two methods, because in this example, the annual dividend is lower than the free cash flow, since the company pays out its cash at the end of the concession, which can only be made up of the gradual accumulation, over the remaining term of the concession, of the difference between the free cash flow and the dividend paid out. In the current interest rate environment, this gradually accumulating cash flow does not yield any return. Therefore, over 15 years, sums that yield nothing are capitalized, before being discounted at a positive interest rate, to find a present value that is naturally lower than their initial amount. Hence the difference in estimate between discounting free cash flows that are assumed to be immediately paid out and discounting dividends, which defers in time the portion of annual free cash flows not immediately paid out as dividends.

2 - Well, it's Aramco, probably because its small free float (2%) allows the Saudi authorities to do what it takes to ensure that it doesn't stray too far from the IPO price last December.

3 - Because Oxy took on a lot of debt to buy Anadarko a year ago, and with the fall in oil prices, the resulting fall in the value of its economic assets precipitated a much greater fall in its market capitalisation, which now represents only a third of the nominal amount of its debts, whereas all the other oil groups, which are much more cautious than Oxy in terms of financial structure, have logically seen their share price fall much less. This is another manifestation of the leverage effect, not in terms of profitability, but in terms of the value of the company's shares.

4 - The French State's stake in Vallourec is, in all likelihood, not of a financial nature but meets the objectives of preserving employment or the French character of this company.

As the French State's decisions are not taken according to financial criteria, it is difficult to see in its subscription to the capital increase a signal that investors could exploit.

5 - The cost of capital is surely higher than the cost of bank borrowing of 16% because banks run less risk than shareholders. This 16% corresponds to the 7% of Treasury bills plus a risk premium to cover the company's risk which is probably greater than the government's risk.

Given our experience, we would say a rate of return required by the shareholders of an unindebted company of 16 to 25% seems correct. Then you modulate according to the beta value of the activity. It does not seem that cable and Internet access activities deserve a beta greater than one, as it is a commodity, at least for those who can afford to subscribe to it.

So a rate of around 20% seems correct.

Our colleague Damodaran, from the Stern School of Business at New York University, a specialist in valuation calculations, gives for Haiti an equity market risk premium of 14% which, added to the Treasury bill rate of 7%, gives the equity market an average rate of return demanded by shareholders of 21%.