Letter number 146 of December 2022

  • NEW

News : Liquidity and solvency in the energy sector

For those who may have forgotten that energy prices can be volatile, as is typical of industries with high fixed costs, the current situation is a painful reminder!


It is because of this volatility that most energy producers forward sell a portion of their production on organised markets such as the Nasdaq in Sweden, ICE London or EEX, which guarantees them a price known in advance and fixes their margin, as long as they control their production costs. This reduces the volatility of their results, which is not bad financial management!


As they forward sell part of their production on organised markets, they are not normally exposed to the risk of having to pay a stratospheric price at a given time to deliver the energy sold through these forward contracts at the end of the contract, if prices have soared. They produce this energy that they have partly forward sold which means that they will be able to deliver it at the end of the contracts. They are not like speculators who short sell.

Although they are not normally at risk on the futures markets, energy companies are not exempt from the rules that apply to all futures market participants: when entering into a futures contract, they must deposit a security deposit on the exchange's clearing house accounts, generally covering a maximum of two days' losses, and face daily margin calls to cover their theoretical losses as energy prices rise. And when these rise in a few weeks from 100 to 500, 400 must be deposited. This 400 only represents an opportunity loss for the energy company: if it had not sold part of its production in advance at 100, it could have sold it at 500 today. It’s not a real loss that would reduce its solvency.

On the other hand, its liquidity is seriously impaired, as the increase in the value of the energy price has to be deposited in a clearing house, even if at the end of the contract it will recover the 400 in question, but as the forward sales may have been made with a maturity of several quarters or even years, illiquidity or cash flow tension may be experienced over a long period!

And this is exactly what we have been seeing for several weeks, where governments have had to help energy companies face margin calls of several billion euros or several tens of billions of euros in most European countries. This explains the paradox of high energy prices and energy companies' liquidity problems, whereas one might have thought that the first fact made the second impossible. This is true, but only for those energy providers who have not hedged, i.e. for those who have taken the price risk, i.e. a solvency risk... Because if prices may well soar, they may also collapse as we saw during the 2022 pandemic.


The situation of some energy companies that have unexpected production or supply problems, which threaten their liquidity AND solvency, is quite different. Uniper, for example, did not expect Russia to fail to honour its contractual gas delivery commitments. Uniper is now having to buy gas on the market, at the market price (e.g. 500), to deliver it to customers to whom Uniper is bound by commercial contracts (e.g. 100). Or EDF, deprived by the French government of 20 TWh of its nuclear production, which it must sell at a price 5 to 10 times lower than the market price in order to deliver it to its competitors, and which it must buy on the market, at the market price, in order to deliver it to its customers with whom it is contractually bound. Or when EDF is forced to shut down nuclear power units due to unexpected corrosion problems.

These losses then eat away at both the liquidity and solvency of these players, and the amounts are by no means small: €29bn for EDF, which made €18bn in EBITDA last year. ... and whose net debt will in all likelihood exceed €100bn.


All this explains why the tax envisaged by Brussels on the excess profits made by energy companies as a result of the unprecedented surge in energy prices has yielded so little at European level, €140 billion. This is simply because part of these profits has already been redistributed to consumers via supply contracts at prices fixed over the medium term, and another part has been reduced by losses that are paradoxical in these times of high energy prices, but due to government actions or to unforeseen events.


Statistics : The number of companies listed worldwide

If the number of listed companies in the world had stagnated between 2014 and 2020. 2021 has experienced a strong increase (+6.7%) compared to the previous year. SPACs account for approximately 20% (c. 640) of the newly listed companies. But stock market clearly showed some appetite for IPOs. Part of the growth is certainly due to a catch up from 2020 postponements due to covid crisis.

No need to be psychic to foresee that 2022 will not show the same sharp increase, the number of IPO having dropped by 44% yoy as of Q3 2022. Closure of SPACs not having found a target will also mechanically reduce the number of listed firms. Finally, with the drop in valuations some controlling shareholders recently chose to go for delisting…

Research : Geographic concentration of institutional investors and its impact on company valuations

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

Many studies in finance have shown the importance of access to equity financing for the growth of companies[1] . However, investors tend to give priority to financing companies located in their geographical area, particularly for reasons of access to information.

A team of researchers had the idea of looking at this phenomenon based on the difference in the geographical concentration of investors and companies[2] . In the United States in 2013, five states alone account for 71% of institutional investors (measured by shareholdings): New York, Massachusetts, California, Pennsylvania and Illinois. At the same time, the geographical concentration of companies is slightly lower. The top five states in this respect, New York, California, Texas, Illinois and New Jersey, account for 54% of US market capitalisation. More importantly, there is a mismatch between these two concentrations.

Typically, Texas is a state where corporate market capitalisation significantly exceeds institutional ownership ($84bn versus just over $1bn). Massachusetts is in the opposite situation. The paper shows that companies located in a state with a high concentration of institutional investors compared to market capitalisation have better access to finance and, more importantly, higher valuations.

To measure the gap between these two concentrations, Kim et al propose a new ratio in finance, the AM ratio, which increases with institutional concentration and decreases with market capitalisation[3] .

The main result of the paper is the impact of this ratio on the valuation of firms. Firms located in states with a high AM ratio are significantly better valued than others, given equivalent characteristics. For example, firms located in Massachusetts are significantly better valued than those located in Texas. The effect is statistically significant: each percentage gain in the AM ratio increases the valuation of companies by about 0.14%. The effect is even more pronounced in states where institutional investors have a strong preference for local companies, confirming that geographic proximity is the cause of the phenomenon.

In the rest of the paper, the Kim et al study the transmission channels between investor proximity and valuation. They show that this proximity reduces the cost of capital of firms. Financial theory teaches us that in a world without frictional forces, investment policy should not depend on financing[4] . In practice, access to finance can be constrained, even in a financially highly developed country like the US. Thus, companies with higher cash flow are more likely to undertake value-creating projects given that they are not dependent on external financing.

The study shows that this effect is less present in states with a high AM ratio: investments depend very little on flows released, so that the investment policy of companies is closer to the theoretically optimal policy.

Overall, these results show that the proximity of institutional investors allows for a better valuation of companies due to easier access to finance.

Another argument mentioned in the article is the possibility of greater institutional involvement in corporate governance in cases of geographical proximity.

In addition to confirming the geographical bias of investors and measuring its effects in concrete terms, this article adds an argument to the discussion on links between the real and financial spheres. It seems that the physical presence of institutional investors in a given geographical area favours the development and valuation of non-financial companies in their environment.



[1] See on this subject "Access to equity markets: a tool for growth and innovation", Vernimmen.net Newsletter #84, October 2014.

[2] D. Kim, Q. Wang and X. Wang, "Geographic clustering of institutional investors", Journal of Financial Economics, 2022, vol.144-2, pages 547-570.

[3] For technical reasons, the ratio is constructed as follows (for each state):


Q&A : What are swap and mid-swap rates?

The bond market has the particularity of being rather illiquid. Most investors buy securities when they are issued and hold them until they mature. Accordingly, prices in the secondary bond market only approximately reflects the level of interest rates required by investors.


The market for interest rate swaps (which allow a switch from a fixed rate to a variable rate or vice versa) is much more liquid, particularly as many companies that borrow from banks at variable rates use this instrument to switch all or part of their debt to a fixed rate. This means that at a given time, the fixed rate of the interest rate swaps accurately reflects the level of interest rates at that time. These swap rates[1] are therefore generally used as a market reference for long rates.  Most bond prospectuses compare the interest rates of the issue to the swap rate to calculate the spread of the issue.

The term mid-swap is sometimes used more precisely to clarify that the swap rate used is the mid-point between the fixed rate of a swap where the investor receives the fixed rate and that of a swap where the investor pays the fixed rate (thus excluding the margin retained by the bank).

[1]  Swaps are quoted by announcing the fixed rate against which the bank is willing to exchange the floating rate (usually 3-month Euribor for the eurozone).


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, publish a question and its answer or quote of financial interest.

Here are some of our recent comments.


Could you be the CFO of Softbank?


The interview with Softbank's CFO, Yoshimitsu Goto, made a few days ago by the Financial Times, is a good illustration, we think, of the qualities of a CFO of a large group. It is true that managing the finances of the financial conglomerate founded by the charismatic, dynamic but chaotic Masayoshi Son since 2000 is not for the faint of heart. For alongside brilliant insights such as the investments in Alibaba and Yahoo! before we had even heard of these firms, there are far less brilliant investments such as in WeWork and Greensill Capital. 

In any case, here are some highlights:

Creative, he doesn't say no to a deal he doesn't spontaneously like, but first thinks about what conditions the deal could still be made by Softbank.

That said, he sometimes says No, knowing full well that in a group like his, his No is equivalent to the end of a project for the operational staff.

He has the absolute confidence of his boss; without it, the previous point would not hold for long.

He also and above all has the confidence of the group's main banker, Mizuho, from which he came more than 20 years ago, which helps, but which he cultivates assiduously because he knows that the day the confidence of his first banker is in doubt, the situation of Softbank, whose financial structure is not the clearest despite its efforts to simplify, changes completely.

Finally, he always tells his boss that if he finds someone better than him, then he must replace him. Which may offer you some prospects!


Taking losses to bounce back


In M&A transactions, the banks that arrange the financing commit themselves very early in the process. They can only syndicate to institutional investors or refinance on the bond markets once the deal is certain, on average 6 months for the largest deals, a little less for the smallest, but sometimes more than a year after the deal is announced. This is because the green light must be obtained from the anti-trust authorities, and there may be counter-bids or challenges. 

During this period, the financial markets may deteriorate. This has been the case since the beginning of 2022. The conditions (and in particular the price) of the financing no longer correspond to those of the market; syndicating the financing then proves complicated. 

Major deals were announced at the beginning of 2022 (Citrix: $8.5bn in financing, Brightspeed: $3.9bn, Nielsen: $8.3bn, etc.). The syndication of these financings can only be contemplated with a discount to the nominal amount of the loan to reflect the new market conditions, since the rate of the loan corresponds to that of the bank's initial commitment, even if a small part of it can be borne by the purchaser when the debt contract provided for it (flex clause). The discounts on the sale price of the loan, i.e. the potential losses for the banks, can be up to 10% of the nominal value of the loan (OID - original issue discount). What should arranging banks do? Wait for better days and "keep the paper", or syndicate at a discount? 

In 2022, in the United States, almost all banks chose to syndicate even if it was at a deep discount; they therefore accepted to make a loss on these operations. There are several reasons for this choice:

- The crisis of 2008-2009 demonstrated that keeping non-performing operations on the balance sheet made the exit from the crisis longer and more painful;

- Banks need to make room for new, more profitable transactions;

- The arranging banks benefited from significant fees for setting up the financing. The arranging banks have benefited from large fees for arranging the financing. These fees reduce their losses significantly;

- Difficult for second-tier arranging banks to make a different choice. Who would take the responsibility of holding on to the risk of mounting losses, when making losses at the same time as the arranging banks is easily justifiable?

In the US market, the arranging banks are not unhappy that the second-tier banks are incurring significant losses (the fees earned by the second-tier banks being lower because they are not structuring the financing and are not advising on the acquisition). This strengthens their position and discourages potentially threatening players.


[1]  Like it here