Letter number 92 of January 2016


News : A conversation with a CFO

A conversation with Thomas Baumgartner, member of the Executive Board and CFO at Mersen, the worldwide expert in electric specialties and graphite materials. In 2014, Mersen recorded sales of €730m, EBIT of €60m with a headcount of 6,368 and an average market cap of €450m in 2015.

What sort of financial incentives are in place for Mersen’s key managers?

In the 2000s we mostly used EVA[1]. The variable compensation of around 100 managers depended on the company’s EVA. But we no longer do so because this indicator wasn’t transparent and motivating for staff, firstly because of the large number of adjustments to be factored in (goodwill, deferred tax losses or credits) and secondly because of the large number of variables that were beyond their control, such as the cost of capital or interest rates.

So now we use ROCE as an indicator of capital employed and as one of the elements for calculating compensation for top management. For the other managers, we have chosen to link bonus criteria to operating cash flow and EBIT, which are items that contribute to ROCE but which are more pragmatic for these managers.

More generally, we make sure that targets include both individual criteria (50%) and collective criteria. For members of the Executive Board, the share of collective targets can reach up to 70%.

Finally, we have long-term incentive programs that depend on internal performance criteria. For members of the Executive Committee, we have also added a criterion linked to the share price performance.

How do you manage your pension fund commitments in the UK and USA and any related deficits?

In the US and the UK we have defined benefit schemes that have been closed to new joiners for several years. Nevertheless, we have to manage the commitments agreed on and the financial assets that we have invested to cover these commitments.

Pension management, especially in these two countries, is complex as it involves issues that are very different – local financing standards, local accounting standards and IFRS, asset management. And this is without factoring in the importance of the human resources aspect. Every country has its own specific features.  Accordingly, it seemed important to set up a pensions committee that had both human resources and financial competencies.  This is at a group level because local subsidiaries are de facto both judge and jury.

In the UK, the precise rules are not written down and fund trustees, who are external to the group, play a very important part. They are the ones, for example, who calculate the deficit using their actuaries, on the basis of assumptions that are often more conservative than the market parameters used by IFRS accounting. Another particularity is that a lot of room is left for negotiation between the company and the trustees, such as period for covering a possible deficit. 

So it is very important to keep on good terms with them and ideally to have an employee among the pension fund trustees, for example, the Treasurer or the HR Manager.

In the US, the rules are very clearly set out and there is no room for negotiation. Any deficit has to be covered in 7 years. It is true that measures introduced by President Obama authorized the use of higher interest rates and thus reduced deficits booked in local standards compared with deficits booked using IFRS in our consolidated accounts. Which resulted in limited outflows. And trustees are not third parties like in the UK, but members of the company.

Although we have closed these regimes, we have not transferred our commitments to insurance companies like some groups in the USA or UK have done. The cash cost is too high given the current low interest rates, which are unfavorable, and the extremely cautious policy of insurance companies.  We prefer to continue to carry our pension fund commitments which remain reasonable compared with the group's balance sheet.

Mersen is one of the first French groups to make use of USPP[2] private placements (in 2003, then in 2011). What struck you about the approach of these investors?

Their long-term vision. They’re interested in the risks of a loan over the long term which corresponds to their investment period. So they ask questions about technological risks, competitive positions, diversifications in terms of customers, geographies, sectors, etc. These are questions that are not always asked by banks. So in 2003, we secured 10-year loans on excellent financial terms at a time when we were making losses.

What is your foreign exchange risk policy?

Mersen is a company which operates on a worldwide basis with around one-third of its sales in Europe, one-third in North America and the balance in Asia.

Debt is more or less shared equally among the countries as is EBITDA, because we hedge risk carried on the balance sheet by, where possible, taking out debt in local currency.  So our ROCE and net bank and financial debt / EBITDA ratio are not very sensitive to variations in foreign currency exchange rates.

For example, when there are not enough debts in US dollars, Mersen draws on its central credit lines in dollars, lends these funds to its US subsidiary so as to enable it to pay its parent company a dividend, which is converted into euros and partially reimburses a credit line in euros.

In countries with exotic currencies, local debt has an advantage other than balance sheet hedging. Because such debt is often taken out at a high interest rate, it makes us aware of the specific risk attached to these countries and means that the concept of the cost of capital is more easily accepted by local managers.

A fixed or floating interest rate, how do you choose?

These days there is a correlation between interest rates and the economic situation, even industrial GDP to which we are partially correlated. Interest rates are low when the environment is unfavorable and high when it is healthy. This encourages us to increase our share of loans at floating rates. Having said that, we currently have a balanced share of fixed and floating rates as a result of our 2011 fixed rate USPP. Conditions were very good and the carrying cost, at that time, did not encourage us to swap it for a floating rate[3].

Are you often questioned on your other comprehensive income[4] ?

No practically never. At Mersen, this mainly includes foreign exchange differences and actuarial differences linked to retirement schemes. Two items that we monitor before we record our other comprehensive income.

And to finish off with, what do you think about the covenants on your loans?

They’re a very useful internal safety railing!

Statistics : How long do LBO funds keep a company under LBO

Around 6 years now and a bit longer compared to the palmy days pre 2009 where the average was around 4 years:

Source: S&P Capital IQ

Research : A single cost of capital used by corporates?

A 1993[1] survey conducted among 100 US firms on the Fortune 500 found that 90% of them used a unique discount rate to value their investment plans, regardless of the activity involved, and that only 35% employed different division-level discount rates; and yet, we are taught at MBA school and university that discount rates should depend on risk! 

Choosing a unique rate is quick and simple and serves to avoid any discussions about the correct percentage to be applied. But what impact does this practice have on investments that are not carried out because they are (incorrectly) considered unpromising? What is the impact on investments that were thought to be profitable but ultimately destroy firm value?

Thesmar, Landier and Kruger[2] measured the impact of the discount rate choice by examining the investment decisions of US conglomerates and comparing them with those made by firms operating in a single business segment. The result is asymmetric. In conglomerates, the non-core divisions involved in safer industries suffer from under-investment linked to the high discount rate selected by the parent company, which artificially reduces the value of their projects. The opposite, however, is not true: corporations whose core activity is relatively protected from market shocks do not tend to over-invest in their riskier affiliates.

The second phase of the research was devoted to analyzing the cost of pricing acquisitions incorrectly. Targeting acquisitions has the advantage that it concerns large-scale investment projects (with comprehensive data), and therefore valuation mistakes are likely to affect the acquirer’s value. The researchers observed the stock price reaction for the purchaser after the announcement of the acquisition. The data shows once more that the markets react negatively to the news of a deal made by a bidder from a safe sector (hence with a low discount rate) in a risky sector (with a high discount rate). The markets “understand” that such acquirers tend to “overpay” for their targets. The study found that an over-valued acquisition generates an average loss of 0.7 % of the bidder’s market equity, and approximately 7% of the value of the purchased company. On the scale of the US market, this represents losses of billions of dollars due to mistakes in valuation.

The researchers discovered an interesting phenomenon: valuation mistakes have diminished over time. While there were significant errors in the 1980s, they fell to the point that they barely registered in the 2000s. This shows that the good practices taught in MBA schools are being increasingly applied!

The study undertaken by Thesmar, Landier and Kruger also shows that the higher the potential cost of a miscalculation, the more likely it will be avoided, as large acquisition projects are scrutinized by an investment bank. And when an investment project relates to a secondary business line that has an important role in a corporation’s global value, finance departments provide the means to implement an appropriate discount rate. This is also the case when conglomerate firms are highly diversified or when the head of a firm holds more than 1% of the capital. It would appear that company heads take greater care to surround themselves with competent financial managers, in such a way that any miscalculations that ultimately remain are more and more marginal, and apply to projects with the smallest impact on the firm. This kind of behavior is consistent with what economists call “bounded rationality”: individuals and organizations have a limited ability to manage cognitive errors, and it is the most costly mistakes that are prioritized.

[1] Bierman J.H. « Capital budgeting in 1992: a survey », Financial Management, vol. 2, n°15.

[2] Krüger P., Landier A., Thesmar D., « The WACC fallacy: the real effects of using a unique discount rate», Journal of Finance June 2015, vol. 70, no 3, pages 1253-1285.


Q&A : What is a green bond?

With the media storm surrounding the Cop 21, it was difficult to avoid hearing talk about green bonds. These bonds issued by companies or by local authorities are, from a financial flows point of view, standard bonds, i.e. with a fixed coupon and reimbursement at maturity[1]. Their green status comes mainly from the fact that the issuer gives an undertaking to the investor to use the funds for investing in or positive spending on the environment. Unfortunately, there is no standard for defining projects that fall under green expenditure, so it is up to the company (generally assisted by an independent firm) to define it.

Monitoring expenses and allocating a source of financing to a specific use require a specific organisation that is not standard practice for the financial director. This organisation has a cost. But because investors are not prepared to purchase green bonds at a higher price than standard bonds (the yield is the same), this cost is borne by the company. Green bonds are a communication tool, even though companies sometimes seek to deny this. The involvement of general management in communication surrounding green bonds is clear proof that this is the case.  The CEO of a large group would rarely go to the trouble of commenting on the issue of an ordinary bond.

Some funds are labelled “green” and only invest in companies whose products have an environmental connotation. Accordingly, green bonds are a way of accessing these investors. It is interesting to note, and a bit of a paradox, that many issuers of green bonds are active in industries the ecological nature of which is not, at first sight, all that obvious – energy (EDF), chemicals (Air Liquide) and automobile (Toyota). 

The volume of issues is growing very fast but remains modest (less than 10%) of the bond market.

We have also seen, in the same vein as green bonds, the appearance of the first issues of social bonds, which are intended to finance projects with a social aspect.

Only the future will tell if this is just a passing trend or a product that is here to stay.