Letter number 73 of March 2013


News : Is the stock exchange playing its role of financing the economy?

The stock exchange has five main roles:

- Offering liquidity to investors who may, at a given moment or over time, sell all or part of their shares in a listed company.  This liquidity is fundamental because a share, unlike a debt security, does not contractually guarantee repayment. Accordingly, liquidity can only result from a sale, at a given time, to another investor. This means that the possibility of a listing on the stock exchange, even some time in the future, is one deterrent less to investment in equity.

- Regularly displaying the price of assets that are listed on it. Whether this price makes people happy or not, is another issue. It has the merit of existing, it's the market price and the price at which it is possible to sell a block of shares very quickly. There are alternatives which make it possible to obtain a higher price, but they are uncertain. They take time and may only be partial – sale of control, exit of the minority shareholder through the buyback of shares, a wait for better days.

- Giving a stamp of respectability to listed companies because not all companies are listed. Conditions must be met.   The market regulator ensures that checks have been made on the company’s situation at the time of listing, and subsequently on a regular basis thereafter, which is far from being a cost-free exercise for issuers, especially when IFRS is involved. Accordingly, only the best companies are likely to be listed.

- Offering protection to minority shareholders as stock exchange rules covering information and change of control, often offer better protection that that provided by shareholder agreements.

- Finally, facilitating financing using equity, because listing which gives a price to the share and provides liquidity, is a very good point when it comes to raising funds because a reference price exists in the eyes of all and at any time, a share that has been bought, can be sold.  The stock exchange is, in fact, a way for the company to reach a much larger number of potential investors, and thus theoretically, to raise more funds.

It is in fact on this last point, that the stock exchange is criticised. The amount of dividends paid and shares bought back is higher, by far, than that of capital increases, the number of companies that have listed has fallen dramatically, especially in Europe, the number of voluntary or involuntary delistings[1] following a change in control is higher than the number of IPOs.

All of this is statistically true, but seems to us to be financially dependent on the point of view.

Listed companies which pay large dividends or carry out share buybacks are not the same as those that carry out capital increases. It is normal that companies that have reached maturity carry out share buybacks and/or pay large dividends, in order to return to their shareholders the equity which they no longer need. Conversely, it is normal that companies in a high growth or restructuring phase seek new capital from investors. The fact that the balance of calls on shareholders, net of the cash back to shareholders, is negative changes nothing. Listed companies that needed equity capital were able to find it on the stock exchange, such as to take the French example. Arcelor Mittal ($4bn), Peugeot (€1bn) and Technicolor (€190m) for restructuring costs, Alstom (€350m), CGG Veritas (€414m) and Vranken Pommery (€42m) to finance external growth operations, and Energie Partagée (€3m) and GL Events (€70m) to finance capital expenditure. And that’s just looking back over the last year.

Moreover, in these calculations, it is easy to overlook hidden capital increases, such as dividends paid in shares (€4.6bn in 2012 for the French top 40 listed companies), conversion of bonds that are convertible into shares, exercise of stock options granted to employees.

But let’s not delude ourselves. In Europe at least, 2012 was not a very good year for share issues.  Share prices were low which tends to cause problems of dilution of control for shareholders who cannot subscribe their share [2], healthy capital structure for a large number of listed companies which didn’t need extra capital, few external growth operations to finance, high free cash flows and a general lack of industrial investments in an economic zone that is bordering on recession. 

But there is not just France and Europe in the world. The amount of capital increases in the world is estimated at $270bn for the first 9 months of 2012, compared with 280 for the whole of 2011 and 350 for 2010. 

Finally, and most importantly, it should not be forgotten that there are flows but also stocks. The flows are the capital increases and the stocks are the mass of book equity contributed since the establishment of the companies by shareholders or left at their disposal in the form of retained earnings. In Europe, where there is a market capitalisation of companies of around €11,000bn, a P/B ratio of around 1.5 (erring on the optimistic side) and a weighted average free float of 80%, we can estimate that the stock of investments financed by the stock exchange at around €6,000bn, in book value and accordingly in historical value.

Some of this equity capital was contributed to the company when it was listed and some before it was listed. But in any event, at some stage, investors active on the stock exchange took over for around €6,000bn in Europe, as they knew that they could sell on the shares that they were buying from other investors who knew that they too could, if needs be, sell on the shares to other investors, who knew that they too could, etc. Assets are financed and contributed by investors in the amount of €6,000bn. These investors may, individually, change quickly, but they will always be replaced, in such a way that collectively they and the stock exchange hold these assets. Forgetting that, and claiming that the stock exchange no longer finances companies as is said now and then, is ignoring €6,000bn in Europe.  That’s €6,000bn, which is 11 times the amount of outstanding loans to companies in the whole world, granted by the largest European bank in this area (BNP Paribas). So it’s not insignificant.

There is a strong correlation between the vigour of listed companies, i.e. public equity, and that of private equity, the world of unlisted companies. This is a virtuous mechanism which is self-maintaining. In some countries, creators of new companies dream that one day they will be able to IPO them. They have no trouble finding venture capitalists if they have viable projects, as venture capitalists know that if the venture is successful, their investment can be turned into cash on the stock exchange.

In other countries it’s a lot more difficult as culturally and from a tax point of view, the environment does not really encourage the taking of risk on equity capital. The stock exchange is less developed, less dynamic and entrepreneurs have more trouble finding venture capital. Fewer companies are set up and they find it more difficult to get to the IPO stage.

We cannot over-emphasise the positive indirect effects of a dynamic stock exchange on the equity financing of the economy. It is the final phase of equity and it benefits the unlisted world of companies which at some stage will use it, and in the meantime, can be more active as it will be more confident of its liquidity in time, thanks to the stock exchange.

We’ll end with a telling observation. Groups whose legal structure prevents them from listing their shares on the stock exchange (mutual companies) generally have one or several listed subsidiaries which they use as equity financing pumps, such as Natixis for BPCE, CASA for Crédit Agricole and Vilmorin for Limagrain. As for companies which do not wish to list their shares on the stock exchange, they often organise their own internal exchanges, as the Mulliez group (Auchan) has done.

[1] For more, see chapter 43 of the Vernimmen

[2] For more, see chapter 39 of the Vernimmen


Statistics : Worldwide merger activity

Mergers and acquisitions have always been a cyclical business that is highly sensitive to the economic situation. 2012 provides further proof of this phenomenon: better than 2011 but still a long way off the last high point in the cycle.[3]

The low proportion of share-payment in 2012, only 4%, is a clear indication that corporations see their stock price as undervalued and consequently are not keen to use it as a means of payment, not wanting to dilute their shareholders on bad financial terms.[4]

[3] For more on this, see chapter 43 of the Vernimmen

[4] For more on this, see chapter 39 of the Vernimmen


Research : Choice of financing: a question of character?

With Simon Gueguen – Lecturer-researcher at the University of Paris Dauphine


The psychological make-up of CEOs goes some way to explaining their financing choices. This is demonstrated by the very in-depth empirical work that we present this month[5].

It has long been established that the capital structure of certain firms is insufficiently explained by traditional theoretical factors such as information asymmetry, the size of the firm, risks, growth opportunities and taxation. Some firms systematically carry too much debt, and others too little.  Research in the field of finance is often focused on factors that are specific to each firm and that are poorly identified, which would explain the persistence of this phenomenon.  The article we present suggests another explanation – what if this phenomenon resulted from the personality traits of the managers themselves?  Certain personality traits (over-confidence, risk aversion, aggressiveness) seem to help to explain the choices of managers in terms of financing.

Malmandier et al identified over-confidence on the part of managers on the basis of two factors:  their behaviour in terms of stock options[6] and the way they are described in the press (confident, optimistic, etc.).  This personality trait leads to an avoidance of financing using equity.  The reason for this is that managers tend to overestimate future cash flows generated by the company, and consequently, they consider that the shares are undervalued (the return required on capital is excessive).  In the event of recourse to external financing, they prefer debt to equity.  For example, according to the stock options criteria, the issue of shares is 37 to 49% less frequent when managers are over-confident.  The effect has been verified by a number of complementary tests and the results are convincing.  The effect on capital structure is an increase in leverage financing of around 15%.

With regard to risk aversion, Malmandier et al study the behaviour of managers born between 1920 and 1929, who were thus children during the Great Depression. These managers tend to avoid debt.  Malmandier et al use a fiscal criterion to show that these managers are carrying too little debt and so they don’t take sufficient advantage of the tax deductibility of interest on debt.   On the other hand, there is no identified impact on capital structure. Overall, results are less convincing than with over-confidence.

With regard to aggressiveness, Malmandier et al delved into the military past of managers.  Those who served in the armed forces, tend to think that aggressiveness and taking risks are success factors.  All other things being equal, when the manager has this personality trait, leverage financing is higher by 13% (the impact is slightly lower than for over-confidence).  But it increases by 25% if managers are World War II veterans! We should specify that Malmandier et al studied the causality – it may well be that firms with high financial leverage attract and hire this sort of manager.  They checked whether the leverage financing of the same company tended to increase with an aggressive manager.

All in all, this very detailed study shows that managers' personalities play a role in corporate finance, including in areas such as apparently technical decisions, such as the choice of financing.   There could be many consequences, for example in terms of incentive.  This should be taken into account in the contracts and compensation packages for CEOs.

[5] U.MALMANDIER, G. TATE and J.YAN (2011), Overconfidence and early-life experiences: the effect of managerial traits on corporate financial policies, Journal of Finance, vol.66, n°5, pages 1687-1733.

[6] In the case of over-confidence, stock options are exercised as late as possible even when the manager is overexposed to the specific risk of the company.


Q&A : What are free riders in the financial field?

The term “free rider” is used to describe the behaviour of an investor who benefits from transactions carried out by other investors in the same category without participating in these transactions himself.

This means, first, that there must be several – usually a large number – of investors in the same type of security and, second, that a specific operation is undertaken implying some sort of sacrifice, at least in terms of opportunity cost, on the part of the investors in these securities.

As a result, when considering a financial decision, one must examine whether free riders exist and what their interests might be. Below are two examples:

  1. Responding to a takeover bid: if the offer is motivated by synergies between the bidding company and its target, the business combination will create value. This means that it is in the general interest of all parties for the bid to succeed and for the shareholders to tender their shares. However, it would be in the individual interest of these same shareholders to hold on to their shares in order to benefit fully from the future synergies.
  2. Bank A holds a small claim on a cash-strapped company that owes money to many other banks. It may be in the interests of the banks as a whole to grant additional loans to tide the company over until it can pay them back, but the interest of our individual bank would be to let the other banks, which have much larger exposure, advance the funds themselves. Bank A would thus hold a better-valued existing claim without incurring a discount on the new credits granted.