Letter number 16 of June 2006


News : 10 mistakes to avoid in corporate finance (part one)

In both our professional and academic experience we have come across certain mistakes rather frequently.  We list some of them below in the hope that we’ll get rid of them once and for all!
1. Believing that growth in earnings per share (EPS) is the same as creating value
As it is difficult to measure the value created by an acquisition, share buyback, merger, capital increase, etc., the EPS impact is often used as a measure of value creation.  However, there is a link between EPS accretion and value creation, or between EPS dilution and value destruction, only under three conditions.
Before discussing these three conditions, let’s take a fictional example.  Let’s imagine that the software company SAP (2006e P/E ratio of 27) has decided to merge with Barclays bank (P/E of 10) on the basis of current share prices.  As SAP’s P/E is higher than Barclays, its EPS will increase automatically after this transaction, by 88%. Does this mean that the merger has created value, based on this yardstick? Of course not! If there is value creation, it will be due to synergies, and in this case, we don’t see much in the way of synergies … Incidentally, looking at things from the other side, i.e. Barclays’ EPS, the impact would be completely different: -28%.
So when is an improvement in EPS an indicator of value creation? (1) 
a) when earnings growth of the merged entity is more or less the same as previously.  Clearly, in our hypothetical SAP-Barclays merger, this is not the case: SAP projects 19% earnings growth as a stand-alone entity, vs. 10% for Barclays. The new group’s growth rate would be between the two (given the absence of synergies) and, in this case, 12%.  This is not the same as 19%! Please note that the higher SAP expected growth rate in EPS explains its higher P/E ratio.
b) when the risk of operating assets after the merger is more or less the same as before the merger.  In our example, this is doubtful.  Generally speaking, however, this can be true when two companies in the same sector and with the same positioning merge, Autostrade and Abertis, for example.  This is much less true for Mittal (basic steel) and Arcelor (high value steel);
c) and when the new group’s financial structure is more or less the same after the transaction as before, as this helps ensure that financial risk is the same after the transaction as before.  Moreover, it is well known that debt leverage raises EPS but does not create value; otherwise, all companies would have leveraged up long ago and we’d all be rich!
2. Believing that merger synergies can be valued on the basis of the average of the two companies’ P/E.
There are two reasons why investors do not value announced synergies using the average P/E of the new group:
• Synergies announced at the moment of the merger are only an estimate, and the people who have announced them have every interest in giving rather high figures to get shareholders to approve the deal.  Moreover, the technical execution of a merger or any other link-up carries its own complications, such as making employees of formerly competing firms work together, creating a new culture, trying to keep from losing clients who wish to maintain diversity in suppliers, etc.  Experience shows that more than one merger out of two fails from this point of view and that synergies actually generated are weaker than announced, and take longer to show up.
• Sooner or later, the merged group will have to pass on some of the synergies to its customers, staff and suppliers.  For the company will not be the only one undertaking a merger.  M&A tends to come in waves, and competitors will be encouraged to follow suit, in order to generate synergies that allow them to remain competitive.  Ultimately, all companies will be able to lower their prices, or refrain from raising them, and it is the end customer who will benefit (2).
3. Believing that the debt/equity ratio is the best measure of debt-repayment capacity.
Financial leverage (i.e. the ratio of net debt to book value of shareholders’ equity) is often used to assess a company’s debt level and its ability to meet its debt obligations.  However, this approach has become completely archaic!  A company does not pay off its debts with its  equity but with its cash flow.  Even in the event of liquidation, equity provides a cushion of security only if the company is able to sell its assets at their book value, which, in practice, is almost never the case.
Ask a banker today the highest debt possible for a target company and he is sure to answer in terms of net debt/EBITDA (earnings before interest, tax, depreciation and amortisation) or net debt/cash flow, as these ratios are good indicators of a company’s ability to generate enough cash flow to pay off its debt.
Unilever, for example, has leverage of more than 130%, which may look huge, but when looking a little closer, we see that its net debt is equivalent to just 1.5 year of EBITDA!
At the other extreme, Rémy Cointreau has leverage of 0.6, but its debt is equivalent to 3.6 times its EBITDA (3) .
4. Confusing apparent and real cost of a source of financing and comparing the costs of financing while forgetting differences in risk.
Investment bankers are geniuses at selling their services to companies. When they “sell” a convertible bond issue, for example, they play up the “insignificant” (or even “non-existent”!) cost of this source of financing.  And it is true that companies pay a very low rate of interest on a convertible bond (4) , and its (apparent!) cost of financing is below the risk-free rate.
Obviously, this is an illusion, as the apparently low cost is cancelled out by the ultimate risk of dilution.  And CFOs are not usually duped, but it is hard sometimes to resist the temptation of low annual cash costs, especially when the materialisation of the risk (i.e. the issue of shares at a price below the current share price, thus leading to shareholder dilution) does not occur until years later.
So a distinction should be made between the apparent cost of a source of financing, i.e. the annual cash cost, and its real cost, which includes the entire ultimate cost, including deferred coupons, redemption premium, expected increase in share price, etc.
Moreover, cost of the product must reflect the risk incurred.  Obviously, issuing shares has a higher real cost than issuing convertible bonds (the difference can range from 4% to 10%). In buying new shares, the investor hopes for a good return, but the company is under no obligation to pay a dividend or to reimburse him.  Such flexibility comes at a cost – in issuing bonds, the company must pay out a coupon and guarantee repayment of the debt.
However, we are not suggesting here that all sources of financing are equivalent and that it doesn’t really matter which type of is chosen.  A convertible bond, for example, can be the best choice for a company whose cash flow is currently small but which is expected to grow strongly in the future (5).
5. Forgetting the risk to profitability (6) 
This will be obvious to our readers (at least, we hope), but in light of recent events, it is always point out.  After all, finance is nothing more than risk, return and value.  The value of a product can only be determined when risk and required return are known.
When financial markets are doing well, as in 1999 and 2000, investors have an unfortunate tendency to overlook risk.  The big losses suffered by equity investors in 2001 and 2002 were merely the materialisation of risk. The more a portfolio was invested in TMT stocks, the greater the risk was.  The losses suffered were not an injustice, but simply a reminder of common sense.
What is true for investors is also true for companies.  Some company treasurers thought they were doing well by investing some of their company’s cash in Parmalat commercial paper, which offered much more attractive returns than other Italian industrial companies… and for good reason!
(1) For more, see chapiter 32 of the Vernimmen.
(2) For more, see chapter 42 of the Vernimmen.
(3) For more, see chapter 12 of the Vernimmen.
(3) For more, see chapter 12 of the Vernimmen.
(4) For example, GBL’s seven-year convertible bonds, issued 3 months ago, pay out a coupon of just 1.7%.
(5) For more, see chapter 30 of the Vernimmen.
(6) Readers who’ve seen the film Time out may remember that the hero, as part of the scam, played up the extraordinary performances of the Russian market until a potential investor pointed out that this was also the market that suffered the steepest declines!

Statistics : Working capital around the world

Globalisation is also at work with working capitals around the world.

Since the beginning of the nineties there has been a clear convergence towards a gap between receivables and payables of around 4% of total assets for industrial companies as shown by the latest available statistics:

Their similar weight of working capital is achieved with very dissimilar commercial terms policies:

Delays of payment are large in France, Italy and Spain and shorter in Germany, the USA and Japan (1).

Research : Local versus global or the home biais

Financial globalisation and progress made in terms of information technologies have reduced the cost of international portfolio diversification.  It is a lot easier today, using E-Trade, Cortal-Consors, and other on-line trading companies, to diversify your portfolio than it was 10 years ago, especially since information on a company located in the most far flung corner of the world is just one or two mouse clicks away.  Nevertheless, this diversification remains surprisingly limited.  Institutional and retail investors tend to favour local companies (or national or regional ones) at the expense of those that are geographically more remote.  This still happens even though research carried out over decades has shown how geographic diversification can help to reduce risk for the same returns (6).
This persistence is known as home biais.
The phenomenon is not just the result of habit or ignorance of the possibilities offered by diversification.  Recently published empirical evidence shows that, on a given market, the performance of domestic investors is generally much better than that of international investors.  The main reason for this is better information available to domestic investors.  Tomas Dvorak (2) thus demonstrates (on the Indonesian market) that domestic individual investors seize more short-term opportunities than international investors.  At the same time, clients of international brokers get the benefit of their expertise and achieve better long-term performances -  the optimal combination is a mix of domestic clients (for information) and global brokers (for expertise).
Zoran Ivkovic and Scott Weisbenner (3) carried out a similar study on the US market. They show that the home bias does not only apply with regard to investments in foreign countries.   US retail investors tend to invest more in companies whose headquarters are close to their place of residence (within a radius of 400km).  These investments account for on average 30% of their portfolios, compared with 10% in cases of full geographic diversification.  Here again, this behaviour is justified by the outperformance of domestic markets (3.2% per year).  Given that this superperformance is strongest among companies not included on the S&P 500 index (ie, smaller companies), the assumption that domestic investors have an information advantage would appear to be confirmed.
Kalok Chan, Vincentiu Covrig and Lilian Ng (4) show that the home bias also applies to institutional investors.  Their study, which covers 26 countries, shows that investors everywhere are susceptible to this bias, but that there are certain market features that will encourage it.   Institutional investors will think twice before investing in geographically remote countries where a different language is spoken.  So, Canadian institutional investors’ portfolios are disproportionately weighted in favour of the USA (61% vs 47% of international market) and against Italy (0.4% vs 2%).   Home bias is thus higher for countries that are further away from the major stock markets, and for those whose national language is less widely spoken. 
There are other factors that will reinforce this bias, such as a lower capitalisation or less economic development.  The domestic bias of institutional investors is most pronounced in Greece – portfolios of Greek institutional investors contain 93% of domestic stocks, in a country which accounts for less than 0.5% of worldwide capitalisation.
Although the home bias label is mainly applied to activity on the capital markets, a similar phenomenon occurs on the loans markets.  Hans Degryse and Steven Ongena (5) show that interest rates on loans decrease as the distance between the lending bank and the borrowing company increases, and that they increase as the distance between the borrowing company and the competing banks increases.  In other words, the bank is in a position of power over companies located within a radius of its influence.  Here, it is the borrower that shows a preference for lenders that are close by.  The authors of this study see the explanation for this in the cost of transport rather than information asymmetry, but given the small size of the market studied (Belgium) their conclusions can not be generalised.
(1) See chapiter 21 of the Vernimmen.
(2) Dvorak T., 2005, Do domestic investors have an information advantage? Evidence from Indonesia, Journal of Finance, April 2005.
(3) Ivkovic Z. and Weisbenner S., 2005, Local Does as Local Is: Information Content of the Geography of Individual Investors’ Common Stock Investments, Journal of Finance, February 2005.
(4) Chan K., Covrig V. and Ng L., 2005, What Determines the Domestic Bias and Foreign Bias? Evidence from Mutual Fund Equity Allocations Worldwide, Journal of Finance, June 2005.
(5) Degryse H. and Ongena S., 2005, Distance, Lending Relationships, and Competition, Journal of Finance, February 2005.
(6) For an explanation of this disparity, see chapter 11 of the Vernimmen

Q&A : What are earn out clauses?

There are two possible ways of implementing earnout clauses.
The seller holds onto a portion of its shares and sells the balance to the buyer, who takes control of the company.  These shares are acquired by the buyer of the company at a later stage, and generally at a higher price than the transaction price.
Another possibility is for  the seller to sell all of its shares, and then receive an additional payment at a later date.
In the first option, it easier to implement the general warranties clause than in the second option. The downside is that it restricts the buyer somewhat in terms of its organisation, because for a certain period, it will have to keep a minority shareholder on board.
There are other factors that will reinforce this bias, such as a lower capitalisation or less economic development.  The domestic bias of institutional investors is most pronounced in Greece – portfolios of Greek institutional investors contain 93% of domestic stocks, in a country which accounts for less than 0.5% of worldwide capitalisation.
Advantages of earnout clauses
When a transaction includes an earnout provision, the parties are brought closer together.  A seller that is confident of the short-term prospects of the company can expect to receive an extra payment which will increase the transaction price, while the buyer will appreciate the fact that the full price will only have to be paid if the results are achieved.  Earnout clauses can thus help smooth negotiations during the final phase by resolving issues of information asymmetry. 
This technique also helps to ensure that the manager-sellers will stay on in order to facilitate the transition and encourage him to perform, because he or her has a stake in the outcome.  To some degree, an earnout clause is a non-compete agreement in disguise.
This helps explain why earnout clauses are often included in M&A deals involving companies where the personal skills and experience of the managers are key for the success of the company, such as in advertising agencies, IT consulting firms, etc.
Drawbacks of earnout clauses
Earnout clauses do not, however, come without their own drawbacks.
There is the possibility that the shareholder-seller, who stays on at the helm during the earnout period, will seek to maximise short-term results – on which the additional earnout payment is based – at the expense of the medium- and long-term future of the company.  
Calculating the amount of the earnout payment is a complex process and disputes often arise once the perimeter of the acquired company has been modified. This is often the case when the buyer seeks to implement potential synergies between the acquiring group and the company acquired by merging them.
Finally, it imposes a situation in which the buyer and the seller are forced to cohabit which, although facilitating the transaction, can become a bit crowded.  The buyer may feel hemmed in and unable to make decisions freely, while the seller may suspect that the policies that the new majority shareholder wishes to introduce will reduce earnings, and thus reduce the size of the earnout payment. 
Consequently, the period over which the size of the earnout payment is calculated should be kept short – three years at the very most.  Additionally, the method used for calculating the earnout payment should be as simple and as clear as possible, with fixed floor and ceiling payment amounts, in order to avoid disputes and excessively large or small payments (1).
(1) For more see chapter 42 of the Vernimmen.