Letter number 132 of October 2020

  • NEW

News : Stock market or investment fund shareholding? (2/2)

The first part of this article was published in the previous issue of the Vernimmen.com newsletter that you can read here.



3/ Investment funds have taken care of their weak points and kept their strong points

In recent years, private equity funds have been working on their weak point: the illiquidity of their securities, which corresponds most closely to the maturity of their funds. This is a bit like squaring the circle, because how do you allow investors to exit a fund before it matures, while at the same time allowing the fund to have the time it needs to create value in its holdings by improving margins, digital transformation, acquisition and integration of competitors?

Faced with this need, unlisted funds have specialised in or have created funds specialising in secondary transactions (such as Ardian in Europe) to buy all or part of their shares from private equity investors before the normal maturity of the funds. This provides liquidity to those who need it in amounts that are constantly increasing and that reached $85 billion in 2019.

 Before the eruption of  covid-19, an investor in an unlisted fund could sell its shares in an LBO fund at a discount of less than 5% of the estimated value, about 10% for a fund invested in real estate and 15-20% for a venture capital fund with much more volatile assets. These levels are well below the discounts we see for listed conglomerates or investment companies.

At the same time, private equity funds have not let their guard down on their strong points:

  • They continue to have their own mode of governance[1] which constitutes a real competitive advantage. Unlike investors in listed companies, that hold very small minority stakes in scores (or even hundreds) of listed companies, whose managers they see only occasionally, private equity fund managers monitor only a few investments, which gives them a degree of understanding of these companies that facilitates intense and regular dialogue with their managers, fruitful discussions between informed people. The strategy is then better defined and controlled. In addition, management packages offered to the managers of the companies in which they invest, combine the carrot and the stick to align their interests with the progression of the company's value that they and their teams will create;
  • They continue to offer risk-adjusted rates of return, after manager compensation, that are on average at least equal to those of listed investments, with the best of them well above. For example, the French private equity industry reports an all-in average rate of return of 11.2% per annum over the last 15 years, and 9.9% over 30 years (i.e. a 18.7-fold increase in value);
  • They continue to be part of an average investment period of 5 years, which gives management time to implement a strategy, and if the horizon of the managers' business plans does not correspond to that of a private equity shareholder fund, it is not uncommon for the latter to sell its stake to another fund whose liquidation deadline is falls after the end of the business plan.

4/ How does the company position itself in this match between listed and unlisted companies?

Today, above a valuation range of around €10-15bn, only the stock market is likely to offer liquidity to investors who want to sell their shares. Admittedly, before 2008, LBOs were valued at around €30bn[2]. But that was before 2008, although they will most certainly be back. That's why Uber went public in the end. With a valuation of over $80bn, as an unlisted company, the private equity industry ran the risk of running out of steam fairly quickly, especially if Uber continued to push back its equilibrium over time. And since there was market appetite...

It will take some time before private equity funds have the financial means to buy control of one of the giants of the stock market, worth more than €50 or €100bn and which represent the bulk of market capitalisation in value terms. And even if they had these means, current conditions do not suggest significant value creation, with a few exceptions. Most of these groups are currently well managed and difficult to consolidate among themselves, given the antitrust problems involved.

 With a valuation below €10 to 15 bn, everything becomes possible again. As an illustration, in 2019, KKR bought the free float of the German media group Axel Springer to take it off the stock market in a transaction that values it at €6.8 bn, i.e. 40% above the stock market price. The same controlling shareholder and the same managers are thus moving from listed to unlisted. This example is far from an isolated one as we also have Ahlsell, Wessanen, Merlin, Latécoère, etc.

It seems clear to us that, again with some exceptions, the future of small and medium-sized listed companies will increasingly be in an unlisted environment, given the advantages and drawbacks of these two types of ownership. This would only be the continuation of a trend that has seen the average size of listed companies increase: doubling since 2010 in France (from €1.3bn to €2.7bn, $8bn in the United States), while the stock market index has risen by only half as much.


5/ Under what conditions could such a small company stay and prosper on the stock market? We see several:

•         Run a simple, easily understandable business, with rated peers to facilitate comparisons and avoid discounts;

•         Avoid carrying too much specific risk;

•         Have a free float of at least 30 to 40%, because free float counts more on the stock market than market capitalisation;

•         Have a story to tell investors (equity story), and tell it, whether it is one of growth like Tesla, consolidation of a sector like Euronext, or dividend yield like Pearson;

•         Seek out several funds and favour a fragmented shareholding structure (the Stock Exchange) in order to remain in charge of your own house, rather than one fund investment, even a minority one, which leads to a certain amount of shared control.

Otherwise, we believe there is a high risk of a discounted valuation, which is not a short or medium-term problem if control is retained and if there is no need for financing. Given the growing size of asset managers on the stock exchange, the largest of them (Blackrock) manages $7,400bn and the largest European (Amundi) €1,650bn, liquidity is concentrated on large caps with small and mid-caps being neglected. For the latter, valuation multiples are often significantly lower than for large stocks and the required rates of return are higher in view of a growing liquidity premium[3].

At the same time, the regulatory constraints of listing are increasing without the cost/benefits balance tilting significantly towards the latter: IFRS standards on turnover and operating leases, the MAR Directive, internal insider listings, etc. The aim is to protect investors, specifically private individuals, who are less and less frequently direct shareholders of listed companies (one third of listed companies' shareholders in the United States, around 10% in Europe). You have to be really motivated to stay listed when you're a small or medium-sized company, and you are not likely to carry out an ICO[4], where, in order to attract buyers, the regulatory environment is very light, although not very consistent with the rest!

6/ In the end, a porous border between the listed and the unlisted

We believe that listed and unlisted companies will continue to coexist in a complementary fashion, with private equity increasing its dominance in the segment up to around €10bn in value, and listed investment prevailing beyond that.

The boundary between these two modes of shareholding and governance is porous and we see a lot of toing and froing. Private equity firms have no qualms about selling companies on the stock market for which they no longer see any significant value-creation potential, especially if the stock market then generously values the companies, or those whose size is testing their limits. But private equity, in a surprising turn of events, can also have its funds listed on the stock market, and provided they are of a certain size, and even hope one day to have them listed at a discount equal to or lower than that offered by secondary funds. A large listed investment fund controlling SMEs and second tier companies probably makes more sense to investors, and some companies, than a direct listing of the latter.

It is also to be expected that the height of the boundary between these two modes of shareholding and governance will gradually increase. It is unlikely that this will be a linear process. This has not been the case in the past. Players active in unlisted investment are not without their flaws. They have a definite tendency to mimic others (see "As long as the music is playing, you’ve got to get up and dance. We’re still dancing" said one of the main LBO players in July 2007), and some of them are driven by hubris and never satisfied, not even when sated.


Statistics : Evolution of creditworthiness of non financial companies in the USA since the 1990s

Published by The Financial Times, this graph shows that:

·       more and more US firms were given access to the bond market with ratings lower than those of firms already raising money this way, which does not come as a surprise as new markets are opened by the most creditworthy issuers before enlarging the market to lower quality issuers;

·       the number of AAA rated companies has collapse in the USA mirroring the evolution on the world stage where they were sixty-five 40 years ago, and are now only 5, of which Microsoft and Johnson & Johnson for the USA.

Having a AAA rating is not in itself an objective for a CFO or a board. It is rather a relic and a subject of pride. To get it and keep it requires a level of shareholder equity and cash on the asset side of the balance sheet that might be better used elsewhere. We have not the feeling that Nestlé’s managers, who came to that conclusion in 2007 when they announced a share back-buy program for CHF 15bn, losing their supposedly coveted AAA rating the very same day, made a stupid mistake.

Research : Access to collateral and the democratization of credit

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


In 2006, the French Government passed a decree reforming the law covering collateral that had been enshrined in the French Civil Code since 1804. Expanding the contractual possibilities in terms of pledges and liens, the objective of the reform was to facilitate access to credit and to bring French collateral law more into line with that of most other developed countries. The article we present this month[1] offers a detailed empirical analysis of the effects of this reform. According to the results presented, the reform has made it possible to democratise access to credit and has led to better macroeconomic allocation of capital.

When the French Civil Code was drafted, the French economic system was centred around activities based on land ownership. The intention behind the wording of the law covering collateral in the Code was twofold: on the one hand, to protect borrowers from lenders abusing their position, and on the other hand, to protect lenders from borrowers that might be unable to hand over goods put up as collateral in the event of default. To achieve this balance, the Code specified that pledged property had to be transferred to the lender. The borrower could therefore not continue to control and use this property. Much of the 2006 reform consisted in removing this contractual limit, in particular to allow companies to pledge physical assets without losing control over them. In terms of corporate financing, it opened up new possibilities by significantly widening the scope of assets that could potentially be put up as collateral (in particular machinery and equipment). In addition, the reform made it possible to put goods up as collateral vis-à-vis several borrowers (in the case of syndicated loans).

For researchers, this reform has another advantage. While it broadens the possibilities of collateralisation for buildings and physical assets that are difficult to move, it does not change the conditions regarding liquid assets, nor does it alter the balance of power between debtor and creditor. It is therefore easier to identify the specific economic effects of the measure introduced.

The first result concerns changes in levels of indebtedness of companies affected by the reform. After the reform, the financial leverage of companies with a high rate of fixed assets increased by 7%, and that of other companies by only 1%. This variation is entirely accounted for by long-term debt (which benefits from the new opportunities). No change in short-term debt was observed over the same period. The reform therefore seems, in accordance with its objectives, to have facilitated access to credit for the companies concerned.

However, this result alone does not suffice to demonstrate the reform's positive effects. It is possible to imagine that better access to credit could create windfall effects and encourage excessive debt. Aretz et al are therefore also interested in the effects on the real economy. They find that companies that borrowed more increased investment and even created jobs. Above all, and contrary to the idea of excessive debt, the volatility of their results decreased and so did bankruptcy rates! So, it appears that borrowers have actually benefited from these increased opportunities.

Moreover, the authors show that the companies which have benefited the most from the reform are the smallest and the youngest. For example, companies with less than 35 employees (last quartile of the sample classified by workforce) saw their financial leverage increase by twice as much as those with more than 165 employees (first quartile), all other things being equal. The same effect is visible for start-ups with a high rate of fixed assets: their debt increased and their bankruptcy rate decreased (while no change is observed for other start-ups). Added to the fact that the positive effects are particularly pronounced for companies located outside large metropolitan areas, these results lead Aretz et al to claim that the reform has ushered in the democratisation of credit. Finally, at the macroeconomic level, they measure various indicators of the quality of the allocation of capital within the country, and conclude that the reform has had a positive effect on the French economy.

The benefits of the reform presented and studied in the article have therefore been manifold, without calling into question the very principle of civil law as this concept is defined in France, criticised in some academic literature for the links between law and finance. According to Aretz et al, this is an example of a useful reform, with a high impact, and which was less problematic to implement than a comprehensive reform of the legal system.


[1] K. Aretz, M. Campello and M. T. Marchica, "Access to collateral and the democratization of credit: France’s reform of the Napoleonic security code", Journal of Finance, vol. 75-1, p. 45 à 90.

Q&A : What's meant by a covenant holiday and a covenant reset?

We're all are entitled to a break, even from covenants… In 2020, the financial results of a large number of groups will be seriously impacted. Many of those that are subject to compliance with certain financial ratios (financial covenants) under their credit contracts will be unable to meet their commitments and therefore be in breach of covenant[1]. To avoid this situation and given these exceptional and (we hope) non-recurring events, these groups have or will ask their banks for a temporary exemption from compliance with their covenants. We call this a "covenant holiday". This exemption is generally given for 12 or 18 months (that is, for one observation if the ratios are observed annually, and for 2 or 3 if the ratios are observed semi-annually).

When it is anticipated that ratios will not be complied with over a longer period (this may be the case when the borrower has just completed a significant transaction (such as an acquisition) or following a change in accounting method), the company may ask its banks to permanently review the level of covenants; new thresholds are then set. This is called a "covenant reset". Banks will only agree to review these levels if the financial health of the company remains sound. The margin level may be reviewed at the same time.

Whether in the case of a covenant reset or a covenant holiday, the company sometimes offers a waiver fee, which is a commission paid to banks to accept this change to the contract. In the current environment, this is rarely the case, as the Covid-19 crisis has had a significant one-off impact irrespective of how responsible the company has been managed.


[1] For more on covenants, see chapter 39 of the Vernimmen.

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.

The world upside down?

Read yesterday in an economic daily newspaper: Veolia has placed two new hybrid perpetual bonds on the financial markets for a total of €2 billion. The first for €850 million has a maturity of 5.5 years; the second €1.15 billion has a maturity of 8 years; and the journalist continued with a paragraph entitled: "Debt accounted for as equity".

So, the end of the world is in 8 years since these two perpetual debts will then have been repaid, and this financial product, which is indeed a debt as the journalist understood it very well, is part of the shareholders’ equity!

It is therefore high time that the IFRS reformed its standard for accounting for hybrid debts, as it has planned to do, in order to put an end to these aberrations. It is nevertheless sad to have to point out that a perpetual debt has no maturity and that a debt is accounted for as debt and not as equity! Unless you take it with a smile, which we wish you will!

PS: For those who may have forgotten, a hybrid bond[2] is a bond that is in theory perpetual but with the issuer's option to redeem "early" at a given date, here in 5.5 years and 8 years. Otherwise, the coupon paid is significantly increased, which is a particularly strong incentive for the issuer to "voluntarily" exercise its early redemption option. Under IFRS, the classification in equity can be obtained if a clause suspending interest payments is provided for.

Veolia - Suez

A few days ago, the board of directors of the energy company Engie agreed to the sale of 30% of Suez to Veolia for €18 against a price of €10.3 at the end of July, before Engie declared itself the seller of its 32% stake. The French state, a 24% shareholder in Engie, announced in a press release that its three representatives on Engie's board voted against the sale due to the lack of an amicable agreement between Veolia and Suez.

On this occasion, we would like to remind you of two points:

1/ That the rules of governance normally require directors to act within the Board of Directors, and if necessary, to vote, according to the interest of the company of which they are directors and not according to the interest of the shareholder they may represent. And it is somewhat difficult to understand why a cash offer with an 80% premium on a pre-announced share price is not in the interest of Engie, which only holds this stake without synergy with the rest of its activities for historical reasons. Especially as there were no other offers on the table. Let us salute the courage of Engie's other directors who did not let themselves be impressed by the refusal of the State representatives.

2/ That a merger operation between two companies is only qualified as hostile by the target's managers and/or directors, never by its shareholders who are offered a more or less significant premium to acquire their shares. The desire of the Minister of the Economy to reach an amicable agreement between Suez and Veolia is surely based on good sentiment. But unfortunately, this does not resist the analysis of the facts. Major merger operations between large French groups, those that succeeded, that created value and jobs were hostile operations (at least at the beginning): BNP for Paribas, Sanofi for Aventis, Total for Elf, AXA for UAP. The big friendly operations: Carrefour and Promodès, France Telecom and Orange, Capgemini and Ernst & Young Consulting, Crédit Agricole and Crédit Lyonnais, led, on the contrary, to negative synergies, loss of positions and jobs, not to mention destruction of value.

The reason is quite simple and let's call a spade a spade. When, in the long run, a company performs less well (Suez's share price at the end of July 2020 was 26% below that of July 2010, against the same for Veolia), it's because some of its main managers are less good. When their company is taken over after a friendly operation, they can often stay because the management of the new group is the result of a friendly haggling between the managers of the two groups. When the under-performing company is bought out after an unfriendly transaction, the buyer's managers have much less reason to keep the less good ones, and that makes all the difference.


Sic transit gloria mundi

Exxon Mobil, long the world's largest market capitalization and the world's largest oil company, with a market value of $500 bn in 2007, $400 bn in 2016, and $300 bn at the beginning of the year, is now worth only $140 bn, 27% less than its book equity. And it is surpassed in value by NextEra which claims to be the world's leading producer of green energy, and which gained in the first half of this year as much as Exxon lost: $1.7 billion in net income.

NextEra still produces 74% of its electricity from natural gas. But investors' enthusiasm for one is the inverse reflection of the disenchantment for the other, which has just been ejected from the Dow Jones.

In Europe, the changes are less brutal, because oil companies have turned to renewable energies, unlike Exxon: Total at €75 billion, capitalizes nearly two-thirds of Exxon, and is the 5th French market capitalization behind Hermès at €79 billion and ahead of Kering at €73 billion, while Exxon is now only 45th American capitalization. Shell value is only €80 bn and BP is only worth €57 bn, but they are still ranked in the top 10 UK groups.

What a massive destruction of value for those who have not been able to turn the corner!


Congratulations to the CFO of Tesla!

By proceeding with a capital increase placed in the market of $5 billion which increases the number of Tesla shares by around 1.3%, he increases the shareholders' equity on the balance sheet by ... 50 % (sic!). This is made possible by an PBR of 40 times (Tesla's market capitalization last Friday, $390bn, was 40 times its book equity at June 30, 2020, $9.9bn).

When there is such a craze for your share (whose value has multiplied by 9 in one year), you should not hesitate for a second to take advantage of it to issue equity capital, at a very good price, because no one knows what the future holds, especially for a company whose price is very volatile (see stock market movements of the last few days). In our opinion, not to make a capital increase in such a context is tantamount to professional misconduct. Tesla's CFO brilliantly avoided it.

This example shows the marketing dimension of a CFO who has to sell good products at a high price.


Unibail Rodamco Westfield, the anti-Tesla?

From a financial point of view, certainly! URW announced on September 16th a capital increase of €3.5bn while the shopping center group was worth €5bn on the stock market for a book equity of €21.5bn. This means that the new shareholders will contribute 14% of the book equity, but will be granted at least 41% of the shares (the operation should be carried out with a preferential subscription right and therefore a discount on the share price, unknown at this time and therefore not included in the calculation).

It is true that when your equity is worth less than a quarter its book, when 96% of the real estate assets on your balance sheet are valued at market price (and not historical cost), when you have recently purchased assets at the highest level by financing them with debt, and when the first page of your website proudly displays a dividend yield of 15%, which is unsustainable over time, it is difficult to do better.

If governments have effectively addressed liquidity risk since March, solvency risk clearly weighs on the most affected sectors. The only positive point for URW is that it is among the first one to raise equity (even if a deal in June would have been much better as its June's price was 80% higher), but those who will come last (Air France, Vallourec, Europcar, etc.) risk making their shareholders swallow a bitterer potion.


"The Social Responsibility of Business is to Increase Its Profits", by Milton Friedman

50 years ago, Milton Friedman published his article on corporate social responsibility in the New York Times. Often quoted, even if most of those who quote him stop at his title that is the title of this post, and which is perhaps a title written by the NY Times as often in this situation.

It is easy to find it on the Internet and its full reading (a few pages in A4 format) is very interesting for several reasons.

1/ Mr. Friedman writes that if "the social responsibility of companies (…) will be to make as much money as possible", he immediately specifies in the same sentence, and this is very rarely repeated "while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom".

2/ Corporate social responsibility is not a theme born with this century, as is often believed, nor was it invented by M. Friedman. It appeared in the 1930s and certain passages in M. Friedman's article resonate with a very topicality . . . today.

3/ M. Friedman's reflections are set in a context that is no longer ours and which explains them a lot on two points: the struggle of communism against capitalism, which seems very distant to many today, whereas in 1970 the final collapse of communism because of its own inefficiencies was a hope but not a shared certainty; and the world of the listed company where the CEO reigned unchallenged with a board of directors most often populated by friends and with a non-existent shareholder dialogue. Hence the proliferation of conglomerate structures, most of which were to disappear from the 1980s onwards (Gulf and Western, ITT, GEC, Compagnie Générale des Eaux, etc.).

4/ According to M. Friedman, the manager of the listed company is an employee of the shareholders and must comply with their wishes (even if in 1970, as recalled above, this was far from being the case for large companies with a fragmented shareholding). For him, social responsibility can only exist at the level of individuals, shareholders or managers as citizens and not at the level of companies. And if it is not at the level of the company, it is to prevent a single individual, its manager, from deciding to use company resources that belong to the company, and therefore to all its shareholders, at his or her sole initiative, thus reducing the profits that accrue to all shareholders to make expenditures that most likely will not benefit the company, but a small minority of the shareholders, or even the manager alone (for example, donating the company money to a museum so that the manager can then celebrate his or her birthday there with friends). M. Friedman makes an analogy which revolts him with the power of the totalitarian, undemocratic state to tax and spend, without being controlled by the National Representation, or by a rogue National Representation (the Supreme Soviet), to the benefit of a nomenklatura.

Therefore, according to M. Friedman, if the company wanted to develop social responsibility, it would have to set up political control mechanisms, which could lead progressively to collectivism and which would sooner or later undermine the foundations of the company, and more generally that of a free Society. And we find here Milton Friedman, author of the book Capitalism and Freedom, whose thesis is that economic freedom is a necessary condition for political freedom (1962).



Warren Buffett’s 90th anniversary

On this occasion (a few weeks ago, 30 August), let us recall that a person who would have invested one dollar in Berkshire


Hathaway, its listed investment company launched in 1964, would today have $27,373! That is an IRR of 20% per year.

The same dollar invested in the S&P 500 index would have given you $198, or 138 times less, but with a very correct IRR of 9.9%, half as much as Warren Buffett, which you wouldn't have said spontaneously when comparing values. Over time (here 56 years) modest differences in IRRs produce large differences in values. Another argument in favour of value at the expense of the IRR as a tool to allocate capital.