Who's Advising on ABN Deal? Only 19 Who Insist `I'm Spartacus'
By Ambereen Choudhury
Aug. 28 (Bloomberg) -- Like the rebellious Roman slaves who vowed to save their leader by declaring ``I'm Spartacus,'' the contested sale of ABN Amro Holding NV has 19 investment banks each insisting it is advising the would-be winner in the financial industry's largest takeover.
The Romans never found Spartacus and no one may ever know the real adviser to the victor of this six-month battle. Goldman Sachs Group Inc., UBS AG, Morgan Stanley, Lehman Brothers Holdings Inc. and N.M. Rothschild & Sons Ltd. make equal claim to coaching Amsterdam-based ABN Amro.
For its 61 billion-euro ($83.5 billion) bid for the Netherlands' biggest bank, Barclays Plc has retained Citigroup Inc., Credit Suisse Group, Deutsche Bank AG, JPMorgan Cazenove Ltd. and Lazard Ltd. as counselors. A Royal Bank of Scotland Group Plc-led group appointed Merrill Lynch & Co. the strategist for its 72 billion-euro counter offer and enlisted Greenhill & Co., Fox-Pitt, Kelton Ltd., NIBC Holding NV, Banco Santander SA, Fortis and its own executives for extra help.
``I cannot recall a deal that has so many advisers,'' said Scott Moeller, a professor of mergers and acquisitions at Cass Business School in London and a former banker at Morgan Stanley and Deutsche Bank. ``The most significant issue is bragging rights. It's more important to the bank than the client.''
No securities firm can afford to be left out if it hopes to be counted among the leaders in a record year for mergers and acquisitions. Takeovers already surpassed $3.28 trillion in 2007, just $277 billion short of last year's total, according to data compiled by Bloomberg.
Full Credit
Each banker to ABN Amro will be credited with the full value of the purchase in mergers tables. Those representing London- based Barclays and Edinburgh-based Royal Bank only get recognized if their suitor wins. Santander of Santander, Spain, and Fortis, based in Brussels and the Dutch city of Utrecht, are bidding with Royal Bank.
This year's top three advisers -- New York-based Goldman, Citigroup and Morgan Stanley -- have little more than ABN Amro's $90 billion market value separating them in the rankings.
Goldman and Morgan Stanley's spots are safe no matter who wins because they are working for ABN Amro. Citigroup will lose its No. 2 ranking if the Barclays bid fails, while Merrill would drop as low as eighth place from fifth should Royal Bank lose.
A handful of the firms will get the lion's share of what New York-based Freeman & Co. estimates to be as much as $459 million in M&A fees because most are providing limited services for their clients, said people with knowledge of the talks. Bankers may collect another $170 million for underwriting the stocks and bonds needed to finance the acquisition, according to Freeman.
`Trophy Deal'
The purchase of the biggest Dutch bank will eclipse Travelers Group Inc.'s $69.9 billion buyout of Citicorp in 1998, until now the biggest in the financial industry. It also may become the third-largest ever, behind the $186 billion acquisition of America Online Inc. by Time Warner Inc. in 2000 and Vodafone Group Plc's $185 billion hostile takeover of Mannesmann AG in 1999, according to Bloomberg data.
``Nobody wants to miss it,'' said David Dodds, an investment analyst who helps manage $1.2 billion at SVM Asset Management in Edinburgh. ``It's a trophy deal.''
ABN Amro has become more important after the rout in securities related to subprime mortgages caused investors to shun riskier assets, increasing costs for financing mergers.
Fees from advising in mergers accounted for about 5 percent, or about $6.4 billion, of the combined revenue last year at Goldman, Morgan Stanley, Merrill and Lehman. Fixed-income and equities trading generated about half of the firms' revenue and underwriting accounted for almost 9 percent.
Slowest Month
August has been the slowest month for deals since July 2005, Bloomberg data show. London-based Cadbury Schweppes Plc, the world's biggest candy maker, and Virgin Media Inc. have delayed asset sales. Atlanta-based Home Depot Inc., the biggest home- improvement retailer, had to cut the price on its contractor- supply business by 18 percent to $8.5 billion to salvage a sale.
Using a group of banks allows companies to reward financiers and eliminate support for rival bidders.
``Companies hire advisers to honor prior favors and relationships,'' said Roy Smith, professor of finance at New York University's Stern School of Business and former head of Goldman's London office. ``It probably doesn't make too much difference how many you have, except that the chairman will get fewer frantic pleading calls if he hires several.''
Six Banks
Barclays hired JPMorgan Cazenove and Lazard in February and added Citigroup, Credit Suisse and Deutsche Bank in March, the month it announced the merger talks. It also has about 15 of its own employees on the deal.
Until last year, Barclays Chairman Marcus Agius, 61, was the U.K chairman of New York-based Lazard, the firm run by Bruce Wasserstein. He helped arrange Halifax Group Plc's 9.8 billion- pound ($20 billion) purchase of Bank of Scotland in 2001 to create HBOS Plc, the biggest U.K. mortgage lender.
Lazard's team is led by Jeffrey Rosen, 59, who advised Wal- Mart Stores Inc., the world's biggest retailer, in its acquisition of U.K. supermarket chain Asda Group Plc for $10.8 billion in 1999.
JPMorgan Cazenove's corporate-broking relationship with Barclays stretches back more than two decades. Cazenove, overseen by Chairman David Mayhew, 67, formed a joint venture with New York-based JPMorgan Chase & Co.'s U.K. unit in 2004.
Corporate Brokers
Corporate brokers, unique to the U.K., act as liaisons with investors and help companies comply with London Stock Exchange rules. They accept nominal fees or work for free, expecting the relationship will lead to underwriting and M&A assignments.
Credit Suisse, the second-largest Swiss bank, has been Barclays's other broker for about 15 years. Zurich-based Credit Suisse worked on the U.K. company's largest deals, including the 5.9 billion-pound purchase of Woolwich Plc in 2000, and bought Barclays's BZW equities and investment-banking arm 10 years ago. The team is led by London-based European mergers chief David Livingstone, 44, and Ewen Stevenson.
Frankfurt-based Deutsche Bank's team is led by Tony Burgess, 48, and Tadhg Flood, 35, while Citigroup's is under Hamid Biglari, 48, and Christopher Williams. The biggest German bank and Citigroup, the largest U.S. financial-services company, were hired for their relationships with hedge funds and prime- brokerage businesses, according to two people with knowledge of the deal.
Balance Sheets
``A number of the advisers are there to prevent them representing others,'' said Philip Keevil, a senior partner in London at Compass Advisers LLP and former head of European mergers at Salomon Smith Barney Inc. ``Some of them are there because they have large balance sheets and could help push the ball over the line.''
Morgan Stanley's Donald Moore and UBS's John Cryan are the lead advisers to ABN Amro. Zurich-based UBS arranged the Dutch bank's sale of its Bouwfonds property management units for 1.69 billion euros last year. UBS, the biggest Swiss bank, and Morgan Stanley, the second-largest U.S. securities firm by market value, have been paid about 39 million euros each, according to U.S. regulatory filings.
ABN Amro's own employees are playing a part, along with bankers from Goldman, New York-based Lehman and London-based N.M. Rothschild.
The Royal Bank-led group is relying on a team of about 15 Merrill bankers led by Andrea Orcel, 44, and London-based Matthew Greenburgh, 46. Merrill has advised Royal Bank since about 1999, when the company bought National Westminster Bank Plc in a 23.6 billion-pound hostile takeover. Merrill has also advised Santander, according to Bloomberg data.
Merrill Lynch
New York-based Merrill, the third-biggest U.S. brokerage firm, may earn about 90 million euros from advising the Royal Bank group if it's successful, according to a person with direct knowledge of the talks. It may get another $120 million for helping finance the deal, Freeman's estimates show.
The members of the Royal Bank group are also using advisers from their own companies as well as New York-based Greenhill, NIBC, based in the Hague, and Fox-Pitt, Kelton, a London firm specializing in the financial industry, according to Bloomberg data.
ABN Amro spokesman Jochem van de Laarschot said the company has ``a number of advisers and they each have their role.'' Spokespeople for all the banks weren't immediately available or declined to comment.
Multiple advisers are common in larger deals. The 13 billion-euro takeover battle for Altadis SA, the Spanish maker of Gauloises cigarettes, and the 63 billion-euro contest for Endesa SA, Spain's largest power company, both attracted about a dozen investment banks, according to Bloomberg data.
``Increasing the number of advisers doesn't increase the quality of the advice,'' said Compass's Keevil. ``It's payback time for the relationship banks, particularly for ABN Amro, for which this is the last deal.''
Tuesday, August 28, 2007
Merrill enters project financing market to secure coal
Merrill breaks ground with coal mine financing
By Anette Jönsson 24 August 2007
The bank increases its involvement in the privately arranged deal for an Indonesian coal producer.
Merrill Lynch has put its own money to work alongside a couple of hedge funds in yet another highly structured equity deal, which will provide financing for an Indonesian coal mine at a time when global demand for this commodity continues to increase.
The $135 million transaction stands out not only because it was completed last week in the midst of one of the most volatile periods in Asian equity markets in recent years, but because it is a greenfield project that currently contains nothing more than the coal in the ground, a reserve report and a management team.
In an unusual move for an investment bank – especially in a deal it is structuring itself - Merrill Lynch has also entered into an exclusive multi-year offtake agreement to buy all the coal produced by the new mine in the initial years. This level of involvement is noticeable because it significantly increases Merrill’s exposure to the project, but makes sense when one takes into account that the US investment bank also owns commodity and energy trading firm Entergy-Koch, which is keen to get its hands on more physical coal.
For the other investors participating in the deal, this type of guarantee will also provide additional comfort about the credit worthiness of the company.
The open pit mine, which is owned by PT Ilthabi Bara Utama (IBU) and located in East Kalimantan, won’t be ready to begin operations for almost another year – the expected start is June or July 2008 – but a very low strip ratio (which measures how measure of how much waste material has to be mined for every volume of mined ore) should allow for a quick ramp-up in production that will make it “quite a large mine” within just four or five years, according to IBU’s two backers.
For the same reasons, the production costs will also be quite low and the mine will be profitable in its first year of production with expected earnings before interest, tax, depreciation and amortisation of $40 million to $50 million in the first 12 months, they say. “We are expecting to be running at a rate of 5 million tonnes per annum before the end of our first year in operation, which is pretty fast for a mine, and we will probably ramp it up to 10 million tonnes per annum within about two years of the start of production,” says private equity specialist Patrick Alexander, who is one of the two sponsors. “Indeed, with further investments, we will probably get to 20 million tonnes per annum within five years of the start of mining.”
That will compare with an annual production of 30 million to 40 million tonnes at the biggest Indonesian mines. Still, a production rate of 20 million tonnes could produce an Ebitda of $200 million per year, based on the company’s current forecast margins, he adds.The IBU mine’s proven probable reserves of 270 million tonnes, or just under 10% of the overall coal resources of approximately 3.3 billion tonnes, already makes it one of the top five coal mines in Indonesia. That ratio is expected to increase to about 20% by the time the company starts mining as additional drilling before then is expected to produce a mineable reserves figure of 600 million to 700 million tonnes, which according to a Alexander is “more than enough for many years of mining.”
The deal, which was put together in about four months after the completion of the reserve report and the offtake agreement in March, consists of equity-linked notes with a 4 year and nine month maturity but with a detachable convertible equity element that doesn’t expire until 2037. The equity units entitle the holders to part of a royalty stream that will be paid out of the Ebitda and can be exchanged for equity in the unlisted company once the notes expire. They will be automatically converted in case of an initial public offering.IBU, which means mother in Bahasa, won’t be coming to market for the next few years, however, and when it does it won’t be to create an exit opportunity but rather to raise new capital for continued expansion, the sponsors say.
“We probably need more money to ramp up production to get above say 10 million tonnes (per year) as we need to invest in more equipment and more sophisticated transportation such as larger conveyor belts," says Ilham Habibie, the founder of an Indonesian investment company and the second sponsor of IBU. "We think when we are moving strongly towards the 20 million tonne threshold that will probably be the right time to start thinking about going public. From today that will be perhaps in another three to four years.”
According to sources familiar with the transaction, the three note holders will own a bit less than 10% of the company if the notes are fully converted. Meanwhile, the notes will pay an annual coupon of 10% and the investors can expect an internal rate of return of 25%-30% as the notes will be redeemed at a premium.
As a security for the investors the deal is pre-funded for two years, meaning part of the $135 million will be put aside to pay the annual coupons to cover the period before the mine becomes fully operational. In addition, IBU will get its hands on the money on a staggered basis with each draw-down having to be preceded by the passing of pre-defined milestones. The first draw-down, which will account for about one third or so of the total capital, will be made next week and among other things will be used towards the construction of a road from the mine to the river, a river port, the acquisition of barges and other transport vehicles, as well as the ground work needed before the mine can bee opened. The actual mining operations will be outsourced to a separate company, according to a model that is commonly used in Indonesia. IBU has shortlisted a couple of candidates, but the final decision has yet to be made.
According to Alexander and Habibie, the key advantage of this type of privately arranged funding is that it gives them the ability to build the mine with relatively minor equity dilution, albeit at a high cost to begin with. “And because we believe this is a mine that can be ramped up quickly because of the relative simplicity of the mine and the shallowness of the coal, it will allow us build up the enterprise value by beginning production as fast as possible and then refinancing the notes. At the same time we have given an equity kicker to the investors in those notes,” Alexander says.
Project financing, which alongside equity is the other obvious solution for large-scale greenfield projects, is typically not available for start-up companies and does in any case also take much longer to put in place.
For Merrill, this deal can be expected to bring profits on several fronts, given that it is involved both as in investor and as the buyer of the coal – although it will have to share some of the profits from the eventual sale of the coal with IBU depending on the price achieved – and on top of that it will collect an undisclosed, but likely quite substantial, fee for structuring the deal in the first place.
Sources didn’t have any information on how much Merrill or the other two investors put into the deal, except that it wasn’t an even split. However, in previous deals of this type, where a portion of the investment has been syndicated out to other parties, Merrill has typically kept between 15% and 25%.
By Anette Jönsson 24 August 2007
The bank increases its involvement in the privately arranged deal for an Indonesian coal producer.
Merrill Lynch has put its own money to work alongside a couple of hedge funds in yet another highly structured equity deal, which will provide financing for an Indonesian coal mine at a time when global demand for this commodity continues to increase.
The $135 million transaction stands out not only because it was completed last week in the midst of one of the most volatile periods in Asian equity markets in recent years, but because it is a greenfield project that currently contains nothing more than the coal in the ground, a reserve report and a management team.
In an unusual move for an investment bank – especially in a deal it is structuring itself - Merrill Lynch has also entered into an exclusive multi-year offtake agreement to buy all the coal produced by the new mine in the initial years. This level of involvement is noticeable because it significantly increases Merrill’s exposure to the project, but makes sense when one takes into account that the US investment bank also owns commodity and energy trading firm Entergy-Koch, which is keen to get its hands on more physical coal.
For the other investors participating in the deal, this type of guarantee will also provide additional comfort about the credit worthiness of the company.
The open pit mine, which is owned by PT Ilthabi Bara Utama (IBU) and located in East Kalimantan, won’t be ready to begin operations for almost another year – the expected start is June or July 2008 – but a very low strip ratio (which measures how measure of how much waste material has to be mined for every volume of mined ore) should allow for a quick ramp-up in production that will make it “quite a large mine” within just four or five years, according to IBU’s two backers.
For the same reasons, the production costs will also be quite low and the mine will be profitable in its first year of production with expected earnings before interest, tax, depreciation and amortisation of $40 million to $50 million in the first 12 months, they say. “We are expecting to be running at a rate of 5 million tonnes per annum before the end of our first year in operation, which is pretty fast for a mine, and we will probably ramp it up to 10 million tonnes per annum within about two years of the start of production,” says private equity specialist Patrick Alexander, who is one of the two sponsors. “Indeed, with further investments, we will probably get to 20 million tonnes per annum within five years of the start of mining.”
That will compare with an annual production of 30 million to 40 million tonnes at the biggest Indonesian mines. Still, a production rate of 20 million tonnes could produce an Ebitda of $200 million per year, based on the company’s current forecast margins, he adds.The IBU mine’s proven probable reserves of 270 million tonnes, or just under 10% of the overall coal resources of approximately 3.3 billion tonnes, already makes it one of the top five coal mines in Indonesia. That ratio is expected to increase to about 20% by the time the company starts mining as additional drilling before then is expected to produce a mineable reserves figure of 600 million to 700 million tonnes, which according to a Alexander is “more than enough for many years of mining.”
The deal, which was put together in about four months after the completion of the reserve report and the offtake agreement in March, consists of equity-linked notes with a 4 year and nine month maturity but with a detachable convertible equity element that doesn’t expire until 2037. The equity units entitle the holders to part of a royalty stream that will be paid out of the Ebitda and can be exchanged for equity in the unlisted company once the notes expire. They will be automatically converted in case of an initial public offering.IBU, which means mother in Bahasa, won’t be coming to market for the next few years, however, and when it does it won’t be to create an exit opportunity but rather to raise new capital for continued expansion, the sponsors say.
“We probably need more money to ramp up production to get above say 10 million tonnes (per year) as we need to invest in more equipment and more sophisticated transportation such as larger conveyor belts," says Ilham Habibie, the founder of an Indonesian investment company and the second sponsor of IBU. "We think when we are moving strongly towards the 20 million tonne threshold that will probably be the right time to start thinking about going public. From today that will be perhaps in another three to four years.”
According to sources familiar with the transaction, the three note holders will own a bit less than 10% of the company if the notes are fully converted. Meanwhile, the notes will pay an annual coupon of 10% and the investors can expect an internal rate of return of 25%-30% as the notes will be redeemed at a premium.
As a security for the investors the deal is pre-funded for two years, meaning part of the $135 million will be put aside to pay the annual coupons to cover the period before the mine becomes fully operational. In addition, IBU will get its hands on the money on a staggered basis with each draw-down having to be preceded by the passing of pre-defined milestones. The first draw-down, which will account for about one third or so of the total capital, will be made next week and among other things will be used towards the construction of a road from the mine to the river, a river port, the acquisition of barges and other transport vehicles, as well as the ground work needed before the mine can bee opened. The actual mining operations will be outsourced to a separate company, according to a model that is commonly used in Indonesia. IBU has shortlisted a couple of candidates, but the final decision has yet to be made.
According to Alexander and Habibie, the key advantage of this type of privately arranged funding is that it gives them the ability to build the mine with relatively minor equity dilution, albeit at a high cost to begin with. “And because we believe this is a mine that can be ramped up quickly because of the relative simplicity of the mine and the shallowness of the coal, it will allow us build up the enterprise value by beginning production as fast as possible and then refinancing the notes. At the same time we have given an equity kicker to the investors in those notes,” Alexander says.
Project financing, which alongside equity is the other obvious solution for large-scale greenfield projects, is typically not available for start-up companies and does in any case also take much longer to put in place.
For Merrill, this deal can be expected to bring profits on several fronts, given that it is involved both as in investor and as the buyer of the coal – although it will have to share some of the profits from the eventual sale of the coal with IBU depending on the price achieved – and on top of that it will collect an undisclosed, but likely quite substantial, fee for structuring the deal in the first place.
Sources didn’t have any information on how much Merrill or the other two investors put into the deal, except that it wasn’t an even split. However, in previous deals of this type, where a portion of the investment has been syndicated out to other parties, Merrill has typically kept between 15% and 25%.
Saturday, August 25, 2007
David Rubenstein's Interview with WSJ
'How Could Buyers Resist Taking Those Terms?'
Carlyle Founder on Cheap Debt, Credit Crunch and the New Buyout Landscape
By HENNY SENDER
August 25, 2007
The buyout boom that saw a handful of investment firms snap up ever larger public companies seems to be fizzling as the debt market used to fuel these takeovers seizes up.
Carlyle Group's David Rubenstein says private equity is no longer too 'private.'
David Rubenstein, who co-founded Carlyle Group in 1987, has seen his share of deal cycles. With deals harder to finance, private-equity firms will have to live with their companies for longer now. In an interview with The Wall Street Journal, Mr. Rubenstein struck an optimistic tone despite the challenges facing the industry.
WSJ: How serious a setback for private equity is the turmoil in the debt markets?
Mr. Rubenstein: Cheap debt fooled people. Because financing was so cheap relatively in the past few years, many people think all we do is buy companies with cheap debt, wait a short while and then sell them. But most private-equity firms are about hard work, not just financial engineering.
In the near future, we won't see buyout deals of the size we saw 60 days ago due to the debt-market uncertainty. And available debt will be more expensive. The sellers will have to adjust to lower prices. This is not a calamity. What we have now is just a temporary imbalance of credit. When the debt market returns to equilibrium, a lot of companies will be available and there will be clear bargains. Private-equity firms will continue to buy companies with a bit more expensive debt but also a bit more pricing discipline.
WSJ: But isn't it true that in recent years, financial engineering was a big part of what drove deals? Your partner Bill Conway himself described cheap debt as the "rocket fuel" of this cycle.
Mr. Rubenstein: We got labeled with the financial engineering label because in the early days, the deals were done with only 5% to 7% equity and the companies were highly levered. Today, the average equity is between 32% and 35%. Deals aren't as heavily engineered or have as levered structures.
WSJ: How dramatic is the change in the debt market today?
Mr. Rubenstein: The banks found that providing financing to private-equity firms was very attractive and profitable, so the banks made it easier and easier to accept their financing. They offered us relatively low interest loans. They later said they didn't need "mac" clauses (which give the banks an out if circumstances change). Then they offered us covenant-lite loans and pik toggles (which give borrowers much more flexibility). And then they offered to bridge some of our equity. How could buyers resist taking those terms, knowing the result would be better returns for their investors.
And because of this favorable financing, we could pay a bit more for companies. For the last five years, there was almost no penalty for overpaying by 5-10%, for we were emboldened by these attractive loan features. Now these things are probably a relic of the past, or at least for the next few years. We won't see many covenant-lite or pik toggles. That will no doubt mean more discipline in assessing deals. But private equity can do quite well in this changed environment, as it has in previous times of retrenchment. Prices will return to more normal levels. And that will be quite helpful to the industry.
WSJ: Can you describe the dialogue between the banks and the private-equity firms now?
Mr. Rubenstein: Now there is a Kabuki dance going on among the buyer, the seller and the lenders. Everyone is assessing what to do. Some deals announced in the past 60 days will close as negotiated and some will be renegotiated and some will never close.
Our attitude has been we live with the banks every day. They help us get our deals done. We are not in the business of saying we win and you lose. You create more animosity and you don't live to play the next day. Our attitude is we want everyone to make a profit and we are willing to have discussions to get deals done on sensible terms. You make more friends when you help when there are problems.
WSJ: Are there other sources of capital to tap?
Mr. Rubenstein: Five years ago, a lot of buyers, including [managers of collateralized loan obligations] and hedge funds realized the debt financing buyouts is a good investment. They liked the higher fees and the higher interest rates on [leveraged-buyout] debt. As a result, a great deal of debt money came into the market so there were many sources of capital for debt deals. But at some point, you will see pension funds and sovereign wealth funds, especially those with fixed-income investment departments, come in as sources of debt. It won't happen overnight or dramatically but it will happen.
WSJ: How will private-equity firms evolve in coming years?
Mr. Rubenstein: Private equity is in the process of becoming bifurcated. There are eight to 10 brand names and thousands of other private-equity firms. Most make investments in small firms and do so profitably, but they don't get publicity and they should still be able to raise money. However, the better known private-equity firms will benefit from a flight to quality, for many investors will want to invest in brand-name firms, assuming their returns stay consistent.
You will also see more mergers and acquisitions, especially after some of the private equity go public and have currencies in the form of stock. When investment banks went public, they bought niche firms. Large private-equity firms might do the same, especially when expanding abroad.
WSJ: How is Carlyle itself changing?
Mr. Rubenstein: We are a deeper, more global organization today. We have 425 investment professionals, operating in all continents and in many different investment disciplines. We can clearly add more value than we did in our early years. We also have dozens of individuals who have been CEOs and CFOs at other companies, and they can now add real value through their experience to our portfolio companies. Twenty years ago, we couldn't say that. If the economy slows, our companies and all companies will feel the effects. It will delay returns and slow down exits. We are not magicians. But we are not as vulnerable to downturns as in earlier years.
WSJ: How do you feel about the limelight into which private-equity firms have been thrust?
Mr. Rubenstein: In the current environment, private equity is not so private. We need to deal with Congress, regulators, environmental groups, trade unions, the media and community organizations. It is a complicated shift. Now we recognize that we must explain to other constituencies -- and to the public -- how we add value and why we are productive forces in the national economy and contributors to local communities.
WSJ: Was Blackstone Group's going public a mistake in that it brought attention to the industry and its big profits? What are Carlyle's plans to go public?
Mr. Rubenstein: The private-equity industry was attracting attention for its considerable success and growth in size long before that offering. If we feel it is necessary to be public to be competitive and to maintain our track record, we would look at it. But we are comfortable now with our posture of the last 20 years -- privately owned.
WSJ: What's your prognosis on the Grassley-Baucus bid to raise taxes on private-equity firms?
Mr. Rubenstein: Treating private equity differently will likely bring back the Law of Unintended Consequences -- the same law which gave us the [alternative minimum tax], an earlier effort to produce a tax "fix" on a few. It now covers 50 million Americans.
Carlyle Founder on Cheap Debt, Credit Crunch and the New Buyout Landscape
By HENNY SENDER
August 25, 2007
The buyout boom that saw a handful of investment firms snap up ever larger public companies seems to be fizzling as the debt market used to fuel these takeovers seizes up.
Carlyle Group's David Rubenstein says private equity is no longer too 'private.'
David Rubenstein, who co-founded Carlyle Group in 1987, has seen his share of deal cycles. With deals harder to finance, private-equity firms will have to live with their companies for longer now. In an interview with The Wall Street Journal, Mr. Rubenstein struck an optimistic tone despite the challenges facing the industry.
WSJ: How serious a setback for private equity is the turmoil in the debt markets?
Mr. Rubenstein: Cheap debt fooled people. Because financing was so cheap relatively in the past few years, many people think all we do is buy companies with cheap debt, wait a short while and then sell them. But most private-equity firms are about hard work, not just financial engineering.
In the near future, we won't see buyout deals of the size we saw 60 days ago due to the debt-market uncertainty. And available debt will be more expensive. The sellers will have to adjust to lower prices. This is not a calamity. What we have now is just a temporary imbalance of credit. When the debt market returns to equilibrium, a lot of companies will be available and there will be clear bargains. Private-equity firms will continue to buy companies with a bit more expensive debt but also a bit more pricing discipline.
WSJ: But isn't it true that in recent years, financial engineering was a big part of what drove deals? Your partner Bill Conway himself described cheap debt as the "rocket fuel" of this cycle.
Mr. Rubenstein: We got labeled with the financial engineering label because in the early days, the deals were done with only 5% to 7% equity and the companies were highly levered. Today, the average equity is between 32% and 35%. Deals aren't as heavily engineered or have as levered structures.
WSJ: How dramatic is the change in the debt market today?
Mr. Rubenstein: The banks found that providing financing to private-equity firms was very attractive and profitable, so the banks made it easier and easier to accept their financing. They offered us relatively low interest loans. They later said they didn't need "mac" clauses (which give the banks an out if circumstances change). Then they offered us covenant-lite loans and pik toggles (which give borrowers much more flexibility). And then they offered to bridge some of our equity. How could buyers resist taking those terms, knowing the result would be better returns for their investors.
And because of this favorable financing, we could pay a bit more for companies. For the last five years, there was almost no penalty for overpaying by 5-10%, for we were emboldened by these attractive loan features. Now these things are probably a relic of the past, or at least for the next few years. We won't see many covenant-lite or pik toggles. That will no doubt mean more discipline in assessing deals. But private equity can do quite well in this changed environment, as it has in previous times of retrenchment. Prices will return to more normal levels. And that will be quite helpful to the industry.
WSJ: Can you describe the dialogue between the banks and the private-equity firms now?
Mr. Rubenstein: Now there is a Kabuki dance going on among the buyer, the seller and the lenders. Everyone is assessing what to do. Some deals announced in the past 60 days will close as negotiated and some will be renegotiated and some will never close.
Our attitude has been we live with the banks every day. They help us get our deals done. We are not in the business of saying we win and you lose. You create more animosity and you don't live to play the next day. Our attitude is we want everyone to make a profit and we are willing to have discussions to get deals done on sensible terms. You make more friends when you help when there are problems.
WSJ: Are there other sources of capital to tap?
Mr. Rubenstein: Five years ago, a lot of buyers, including [managers of collateralized loan obligations] and hedge funds realized the debt financing buyouts is a good investment. They liked the higher fees and the higher interest rates on [leveraged-buyout] debt. As a result, a great deal of debt money came into the market so there were many sources of capital for debt deals. But at some point, you will see pension funds and sovereign wealth funds, especially those with fixed-income investment departments, come in as sources of debt. It won't happen overnight or dramatically but it will happen.
WSJ: How will private-equity firms evolve in coming years?
Mr. Rubenstein: Private equity is in the process of becoming bifurcated. There are eight to 10 brand names and thousands of other private-equity firms. Most make investments in small firms and do so profitably, but they don't get publicity and they should still be able to raise money. However, the better known private-equity firms will benefit from a flight to quality, for many investors will want to invest in brand-name firms, assuming their returns stay consistent.
You will also see more mergers and acquisitions, especially after some of the private equity go public and have currencies in the form of stock. When investment banks went public, they bought niche firms. Large private-equity firms might do the same, especially when expanding abroad.
WSJ: How is Carlyle itself changing?
Mr. Rubenstein: We are a deeper, more global organization today. We have 425 investment professionals, operating in all continents and in many different investment disciplines. We can clearly add more value than we did in our early years. We also have dozens of individuals who have been CEOs and CFOs at other companies, and they can now add real value through their experience to our portfolio companies. Twenty years ago, we couldn't say that. If the economy slows, our companies and all companies will feel the effects. It will delay returns and slow down exits. We are not magicians. But we are not as vulnerable to downturns as in earlier years.
WSJ: How do you feel about the limelight into which private-equity firms have been thrust?
Mr. Rubenstein: In the current environment, private equity is not so private. We need to deal with Congress, regulators, environmental groups, trade unions, the media and community organizations. It is a complicated shift. Now we recognize that we must explain to other constituencies -- and to the public -- how we add value and why we are productive forces in the national economy and contributors to local communities.
WSJ: Was Blackstone Group's going public a mistake in that it brought attention to the industry and its big profits? What are Carlyle's plans to go public?
Mr. Rubenstein: The private-equity industry was attracting attention for its considerable success and growth in size long before that offering. If we feel it is necessary to be public to be competitive and to maintain our track record, we would look at it. But we are comfortable now with our posture of the last 20 years -- privately owned.
WSJ: What's your prognosis on the Grassley-Baucus bid to raise taxes on private-equity firms?
Mr. Rubenstein: Treating private equity differently will likely bring back the Law of Unintended Consequences -- the same law which gave us the [alternative minimum tax], an earlier effort to produce a tax "fix" on a few. It now covers 50 million Americans.
Lord Browne resurrected by private equity
From Here To Obscurity: BP Browne’s Newest Job
August 24, 2007, 10:06 am
Posted by Dennis K. Berman
For a person terribly protective of his privacy, former BP boss John Browne has found a perfect new gig.
That’s Riverstone Holdings, a private-equity firm devoted entirely to energy investing. While Riverstone looms large in the energy space, it has somehow eluded much wider public attention. Perhaps there — where Browne will be managing partner of its Europe office — he can also find some peace and quiet.
Without the frenzy surrounding Blackstone or KKR, Riverstone has quietly built up one of the best energy businesses around. It’s biggest deal to date has been a role in the $13.5 billion buyout of Kinder Morgan in 2006. It has also purchased oil services firm Dresser Inc. and an array of oil and gas interests around the world. Riverstone was founded by top energy bankers from Goldman Sachs and JPMorgan in 2000, and soon after developed funds in tandem with the big buyout firm Carlyle Group.
But it is obscure. How obscure ? A Factiva check of one its founders — former Goldman Sachs banker David Leuschen — found just 41 articles. By comparison, Blackstone’s Stephen Schwarzman registered 2040 mentions and Carlyle boss David Rubenstein 911.
Private-equity recruits love to talk about the freedom and the riches of their world. But we can only see an uncomfortable acculturation period for Lord Browne. Running a London outpost of a little-known U.S. firm can only be disorienting for a man who once presided over a $200 billion colossus with outlets on every other street corner.
August 24, 2007, 10:06 am
Posted by Dennis K. Berman
For a person terribly protective of his privacy, former BP boss John Browne has found a perfect new gig.
That’s Riverstone Holdings, a private-equity firm devoted entirely to energy investing. While Riverstone looms large in the energy space, it has somehow eluded much wider public attention. Perhaps there — where Browne will be managing partner of its Europe office — he can also find some peace and quiet.
Without the frenzy surrounding Blackstone or KKR, Riverstone has quietly built up one of the best energy businesses around. It’s biggest deal to date has been a role in the $13.5 billion buyout of Kinder Morgan in 2006. It has also purchased oil services firm Dresser Inc. and an array of oil and gas interests around the world. Riverstone was founded by top energy bankers from Goldman Sachs and JPMorgan in 2000, and soon after developed funds in tandem with the big buyout firm Carlyle Group.
But it is obscure. How obscure ? A Factiva check of one its founders — former Goldman Sachs banker David Leuschen — found just 41 articles. By comparison, Blackstone’s Stephen Schwarzman registered 2040 mentions and Carlyle boss David Rubenstein 911.
Private-equity recruits love to talk about the freedom and the riches of their world. But we can only see an uncomfortable acculturation period for Lord Browne. Running a London outpost of a little-known U.S. firm can only be disorienting for a man who once presided over a $200 billion colossus with outlets on every other street corner.
Friday, August 24, 2007
Restructuring distressed companies using debt-equity swaps
Germany: Corporate Acquisitions Through Debt-Equity Swaps in Germany
01 August 2006
By Dr. Volker Kammel and Dr. Markus Bauer
The German economy has experienced minimal growth for a number of years. Insolvencies have reached record levels, and the number of businesses outside of formal insolvency proceedings, but in need of restructuring, is significant. Recently, however, a number of positive factors have fueled hopes for a revival of the German economy. There has been a strong increase in German industrial production activity and a substantial increase in the generation of new orders and capital expenditures by German businesses. Agreements with employees regarding wage and salary increases have been moderate on the whole, and financing conditions for businesses have been favorable. Although German companies have undergone significant operational restructuring in the past, many continue to exhibit weak balance sheets.
Not surprisingly, economic stagnation and record insolvency levels have left many German banks with large amounts of bad debt on their books. Estimates of aggregated bad debt range from €160 to €300 billion. German banks have historically held bad debt due to strong customer ties. However, beginning in 2003 and continuing in 2004 and 2005, German banks have sold non-performing loan portfolios as well as loans to single borrowers. Banks have become motivated to sell their non-performing loans for a number of reasons. Among them are the new risk-weighting criteria introduced by the Basel II banking accord, which will significantly increase the equity costs associated with banks holding non-performing assets and therefore create a strong incentive for them to sell.
The current market conditions provide excellent investment opportunities with respect to distressed companies and have attracted international investors, particularly U.S. investors who are familiar with distressed asset transactions. Investors typically acquire high-risk loans to companies with turnaround potential at a purchase price significantly below par. They attempt to generate high returns by performing an intensive workout of the acquired loans, usually in connection with a restructuring of the target company.
Structure of the Investment
The structure of the investment depends largely on the needs of the target company. While the specific restructuring measures are normally identified on a case-by-case basis by means of a restructuring plan drafted by turnaround advisors, target companies are invariably in need of new funds and a reduction of their debt burden.
The recapitalization of a distressed company typically involves a reduction of its statutory share capital to reflect the real amount of equity remaining after netting out historical losses. The registered share capital is then increased and new equity is contributed either in the form of cash or by releasing the company from a portion of its debt (debt-equity swap). Frequently, both types of capital increase are combined. The deal structures in this context are flexible and can be adapted to the requirements of different types of investors. Traditional private equity investors typically will seek to acquire 100 percent of the corporate debt in order to take control of the target company after the debt-equity swap and realize their return through an exit after three to five years. More passive investors, on the other hand, might only seek to provide financial resources for the restructuring without taking an active role in the process. These investors are more inclined to execute a modified debt-equity swap where instead of shares, they take convertible bonds or similar mezzanine instruments that are flexible and can be tailored to the specific needs of the investor. Over and above the actual capital measures, the investor may have to provide new lending facilities to the company and/or extend the maturity of any loans remaining after the debt-equity swap.
A successful implementation of a debt-equity swap transaction requires both (i) substantial restructuring expertise and an in-depth knowledge of the target’s industry by the investor and (ii) the full support of at least a majority of the existing shareholders. If these conditions are fulfilled, the debt-equity swap can both save the target company from a possible winding-up and be a very interesting investment.
A number of issues under German law need to be addressed when implementing an investment that involves a debt-equity swap.
Restructuring Plan
Before undertaking the investment, an investor will need to convince himself of the turnaround potential of the target company. Normally, a restructuring plan drawn up by turnaround advisors on the instructions of the target company will be available. Management of a German company in financial difficulty is required to explore restructuring opportunities. Management typically will involve external turnaround specialists when approaching banks for new loans. In order to avoid lender liability exposure, banks will extend loans to companies in financial difficulty only after a restructuring plan has been drawn up that demonstrates that the company is capable of being successfully restructured. The German Institute of Chartered Accountants (Institut der Wirtschaftsprüfer) requires a restructuring plan to set forth an analysis of the situation of the company together with the causes of the crisis and to specify the concrete measures that need to be implemented in order to return the company to profitability, including any necessary contributions by the various stakeholders (e.g., investors, existing shareholders, employees, creditors, etc.).
Consent of Existing Shareholders
To restructure a company successfully through a debt-equity swap transaction, it is important to obtain the consent of at least a majority of the existing shareholders, for both legal and practical reasons. The implementation of the capital measures, in particular the capital decrease and the ensuing capital increase, requires approval by the existing shareholders. Depending on the corporate form of the target and the provisions in the articles of association, the required shareholder approval percentage is usually at least 75 percent. In order to allow the investor to subscribe to the desired number of shares, the subscription rights of the existing shareholders must be waived. In order to convince shareholders whose shareholdings are being diluted that this waiver is necessary for the implementation of the restructuring, the support of a majority of the shareholders and the management of the company is vital. The same is also true for the discussions with the tax and securities authorities regarding necessary exemptions, which are described in more detail below.
Where the investor is unable or unwilling to obtain the consent of the existing management and shareholders to the investment and wants to pursue a more hostile approach, he can theoretically purchase the loans without the consent of the target company, provided that the bank — which typically has a long-standing business relationship with the target — is willing to sell. As the new owner of the non-performing loans, the investor then has significant leverage in the negotiations with management and shareholders. While an acquisition of shares may need to be disclosed, there are no disclosure obligations regarding the holding of certain portions of outstanding corporate debt. Needless to say, the risk that the investor will not achieve his aims with respect to equity in the target company is much higher with a hostile approach than with a consensual approach.
Acquisition of the Loans
Once the investor has decided to invest, he must acquire the company’s debt from the banks. The level of complexity associated with the debt acquisition varies greatly, depending on the structure of the loans, the security (in particular if a security pool agreement is in place), and the selling bank(s) involved. Providing information regarding the loans and the debtor to the investor during a due diligence review can be an issue under German banking secrecy rules unless management has consented to the investment and agrees to the provision of due diligence information to the investor.
The acquisition of the loans can be structured as (i) a subparticipation in the loans and the underlying security, (ii) an assignment of the claims under the loans and the security, or (iii) a complete transfer of the loan agreements and the security agreements. A complete transfer of the loan agreements will usually be chosen where revolving or partially undrawn credit lines are acquired that need to remain available to the company. A transfer requires the consent of all the parties to the agreements that are being transferred and is more complicated as a result. If the loan is part of a syndicated loan or the underlying security is subject to a security pooling agreement, the bank must also transfer its contractual position under these agreements in order to allow the investor to assert his rights against the other members of the syndicate or the security pool. Under German law, the transfer of these contractual positions requires the consent of all other members of the syndicate or the security pool, which adds to the complexity and may delay the process.
Specific issues arise where the loans are secured by a government guaranty. The investor is well advised to approach the government at an early stage because its approval is generally required for a transfer of the guaranty to the investor. In any case, the investor and his advisors must ensure that the contractual positions assigned to the investor allow him to implement the workout strategy, in particular, contribution of the loans to the company in the debt-equity swap and the associated release of security.
Restructuring in Formal Insolvency Proceedings
In Germany, companies in financial difficulty are usually restructured outside of formal insolvency proceedings. The impact of a formal insolvency proceeding on business relations with suppliers and customers is usually severe, and there is a substantial risk that key employees will leave the company due to speculation that the company will be unable to continue with its business operations. However, the high volume of insolvencies in recent years has resulted in a number of successful restructurings in formal insolvency proceedings. Examples such as these are beginning to change the stakeholders’ perception that a formal insolvency process will most probably result in a winding-up of the business.
Formal insolvency proceedings offer a number of advantages for the restructuring of the company, in particular the ability to terminate (and possibly renegotiate the terms of) contracts and the easing of restrictions on the dismissal of employees. Restructuring in formal insolvency proceedings is achieved by means of an insolvency plan. It can be proposed by the insolvent company itself as a prepackaged plan in conjunction with the commencement of insolvency proceedings. The plan can be freely arranged and include all provisions that could be made in an ordinary restructuring agreement (e.g., waiver and deferral of claims, alteration of security, an undertaking of the investor to contribute the acquired loans and/or to provide new capital to the company, or an undertaking of a stakeholder to extend financing to the company to fund the reorganization).
Increasingly, an insolvency plan proposal is combined with a motion for "self-management" by the management of the insolvent company, which is similar to the concept of a chapter 11 "debtor in possession" under U.S. law. Under self-management, the management of the insolvent company remains in control of business operations but is placed under the supervision of a creditors’ trustee. To date, German insolvency courts have rarely left management in control, generally appointing an insolvency administrator who takes control of the company’s business operations. Self-management has the distinct advantage of retaining the experience and market know-how of existing management. An insolvency administrator who is unfamiliar with the company and its operations has very little time to acquaint himself with the business. The chances of prevailing on a motion for self-management can be improved if the insolvent company appoints proven restructuring experts to its board prior to filing an insolvency application. The main advantage of self-management is that the identity and expertise of the personnel who will be implementing the restructuring are known to the stakeholders at the outset of the proceedings. Investors are much more reluctant to invest if it is unclear who is managing the business, and whether such manager will implement the restructuring plan, as is frequently the case when an insolvency administrator is appointed.
Valuation of the Debt
During the course of a debt-equity swap, the non-performing loans will be contributed to the target company as a contribution in kind in exchange for the issuance of new shares that are issued in connection with the increase in the target’s capital. If the loans are contributed to a corporation (either a stock corporation ("AG") or a limited liability company ("GmbH")) or by a limited partner of a limited partnership ("KG"), the fair market value of the contribution (i.e., the claims against the target company based upon the loans) must be at least equal to the nominal value of the shares or partnership interest issued for it. Should the fair market value of the contribution in kind be below the nominal value of the shares, the investor runs the risk that (i) the commercial register will refuse to register and thus prevent the capital increase, or (ii) if the deficiency in the value is discovered after the registration, the investor will be personally liable to pay the shortfall. Because in turnaround situations the fair market value of the loan will be substantially below its nominal value, the exact value has to be determined by means of an expert opinion of an auditor. In the case of a capital increase in a stock corporation, such opinion has to be provided by a court-appointed neutral auditor. In the case of a limited liability company, an expert opinion will typically be requested by the commercial register before the capital increase is registered.
Equitable Subordination of Loans
Typically, an investor will convert only a portion of the purchased loans into equity and will retain the remainder in the form of shareholder loans. Shareholder loans to a company in financial difficulty may be subject to the rules of equitable subordination and may be treated as if they were equity. During an insolvency, equitably subordinated loans rank behind the claims of normal creditors. Outside of formal insolvency, the company may be entitled to refrain from repaying such loans until its financial difficulties have been resolved.
In order to provide an incentive for investors to provide new funds to distressed companies, the rules of equitable subordination were modified by the introduction of the so-called restructuring privilege. Under these rules, existing and new loans by an investor will not be subject to the rules of equitable subordination, provided that the investor becomes a shareholder of the company in a crisis situation with the aim of restructuring the company. Nevertheless, an investor should carefully review whether the requirements of the restructuring privilege have been met.
Tax Exemption for "Restructuring Profits"
Because the nominal amount of the shares issued as consideration for the contribution of the non-performing loans in a debt-equity swap will be significantly lower than the nominal amount of such debt on the books of the company, the target company will show a restructuring profit in the amount of the difference. If this restructuring profit were subject to regular taxation (i.e., income and trade tax), the benefits of the restructuring to the company would be largely eliminated.
In order to address this conflict between the taxation of restructuring profits and the aim of the German Insolvency Code to facilitate the restructuring of a distressed company, the German Federal Finance Ministry on March 27, 2003, issued a letter to the state tax authorities providing that income tax on restructuring profits shall be deferred and subsequently waived under the principles of equity (sachliche Billigkeitsgründe) if the following conditions are met: the company is (i) in a crisis but (ii) capable of being restructured and (iii) the tax waiver is a suitable and sufficient restructuring measure and (iv) the investor intends to restructure the company. The tax authorities will normally require the company to provide them with its restructuring plan to determine whether these conditions have been fulfilled.
Once the tax authority has qualified the profits as privileged restructuring profits and agreed to defer and waive the respective income tax, the company can apply to the municipality where the company’s operations are located for a similar decision with respect to the trade tax. Although these are two separate proceedings and the municipality is not bound by the decision of the tax authority, the municipality generally follows the lead of the tax authority, particularly if the waiver of the trade tax is necessary for a successful restructuring of the company and the decision will keep jobs and a (potential) taxpayer in the city.
Exemption From Mandatory Tender Offer
If the target company is listed on a stock exchange, the rules of the German Takeover Code (Wertpapiererwerbs- und Übernahmegesetz) apply. Pursuant to the German Takeover Code, an investor who acquires shares in a listed company as a result of a debt-equity swap or otherwise and subsequently directly or indirectly holds at least 30 percent of the voting rights in the company must make a mandatory tender offer for all of the remaining shares of the company. This obligation generally makes any debt-equity swap transaction regarding a public company unattractive for an investor who, alone or jointly with other investors, intends to take a controlling interest in the company in order to implement the restructuring plan. In order to address this concern, the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, or "BaFin") may exempt an investor from the obligation to make a tender offer if the investor gains control of the target company in connection with the restructuring of the company.
The decision to grant an exemption is in the discretion of BaFin. However, the exemption will generally be granted if the interests of the other shareholders are not negatively affected and the investor can demonstrate to BaFin that the target company is in a serious crisis and that the planned restructuring measures are suitable to restructure the company. In addition, the investor seeking the exemption must make a substantial restructuring contribution to the company, which in the case of a debt-equity swap will be the waiver of the claims under the acquired loans plus, in most cases, the provision of new money. The investor can apply for the exemption either before he assumes a controlling interest in the company or within seven days thereafter.
Conclusion
German companies in financial difficulty continue to provide interesting investment opportunities for international investors. The acquisition of controlling stakes by means of debt-equity swaps is no longer a novelty in the German market. Although it is potentially more complicated than a straightforward M&A transaction, a debt-equity swap can still offer extremely attractive returns.
01 August 2006
By Dr. Volker Kammel and Dr. Markus Bauer
The German economy has experienced minimal growth for a number of years. Insolvencies have reached record levels, and the number of businesses outside of formal insolvency proceedings, but in need of restructuring, is significant. Recently, however, a number of positive factors have fueled hopes for a revival of the German economy. There has been a strong increase in German industrial production activity and a substantial increase in the generation of new orders and capital expenditures by German businesses. Agreements with employees regarding wage and salary increases have been moderate on the whole, and financing conditions for businesses have been favorable. Although German companies have undergone significant operational restructuring in the past, many continue to exhibit weak balance sheets.
Not surprisingly, economic stagnation and record insolvency levels have left many German banks with large amounts of bad debt on their books. Estimates of aggregated bad debt range from €160 to €300 billion. German banks have historically held bad debt due to strong customer ties. However, beginning in 2003 and continuing in 2004 and 2005, German banks have sold non-performing loan portfolios as well as loans to single borrowers. Banks have become motivated to sell their non-performing loans for a number of reasons. Among them are the new risk-weighting criteria introduced by the Basel II banking accord, which will significantly increase the equity costs associated with banks holding non-performing assets and therefore create a strong incentive for them to sell.
The current market conditions provide excellent investment opportunities with respect to distressed companies and have attracted international investors, particularly U.S. investors who are familiar with distressed asset transactions. Investors typically acquire high-risk loans to companies with turnaround potential at a purchase price significantly below par. They attempt to generate high returns by performing an intensive workout of the acquired loans, usually in connection with a restructuring of the target company.
Structure of the Investment
The structure of the investment depends largely on the needs of the target company. While the specific restructuring measures are normally identified on a case-by-case basis by means of a restructuring plan drafted by turnaround advisors, target companies are invariably in need of new funds and a reduction of their debt burden.
The recapitalization of a distressed company typically involves a reduction of its statutory share capital to reflect the real amount of equity remaining after netting out historical losses. The registered share capital is then increased and new equity is contributed either in the form of cash or by releasing the company from a portion of its debt (debt-equity swap). Frequently, both types of capital increase are combined. The deal structures in this context are flexible and can be adapted to the requirements of different types of investors. Traditional private equity investors typically will seek to acquire 100 percent of the corporate debt in order to take control of the target company after the debt-equity swap and realize their return through an exit after three to five years. More passive investors, on the other hand, might only seek to provide financial resources for the restructuring without taking an active role in the process. These investors are more inclined to execute a modified debt-equity swap where instead of shares, they take convertible bonds or similar mezzanine instruments that are flexible and can be tailored to the specific needs of the investor. Over and above the actual capital measures, the investor may have to provide new lending facilities to the company and/or extend the maturity of any loans remaining after the debt-equity swap.
A successful implementation of a debt-equity swap transaction requires both (i) substantial restructuring expertise and an in-depth knowledge of the target’s industry by the investor and (ii) the full support of at least a majority of the existing shareholders. If these conditions are fulfilled, the debt-equity swap can both save the target company from a possible winding-up and be a very interesting investment.
A number of issues under German law need to be addressed when implementing an investment that involves a debt-equity swap.
Restructuring Plan
Before undertaking the investment, an investor will need to convince himself of the turnaround potential of the target company. Normally, a restructuring plan drawn up by turnaround advisors on the instructions of the target company will be available. Management of a German company in financial difficulty is required to explore restructuring opportunities. Management typically will involve external turnaround specialists when approaching banks for new loans. In order to avoid lender liability exposure, banks will extend loans to companies in financial difficulty only after a restructuring plan has been drawn up that demonstrates that the company is capable of being successfully restructured. The German Institute of Chartered Accountants (Institut der Wirtschaftsprüfer) requires a restructuring plan to set forth an analysis of the situation of the company together with the causes of the crisis and to specify the concrete measures that need to be implemented in order to return the company to profitability, including any necessary contributions by the various stakeholders (e.g., investors, existing shareholders, employees, creditors, etc.).
Consent of Existing Shareholders
To restructure a company successfully through a debt-equity swap transaction, it is important to obtain the consent of at least a majority of the existing shareholders, for both legal and practical reasons. The implementation of the capital measures, in particular the capital decrease and the ensuing capital increase, requires approval by the existing shareholders. Depending on the corporate form of the target and the provisions in the articles of association, the required shareholder approval percentage is usually at least 75 percent. In order to allow the investor to subscribe to the desired number of shares, the subscription rights of the existing shareholders must be waived. In order to convince shareholders whose shareholdings are being diluted that this waiver is necessary for the implementation of the restructuring, the support of a majority of the shareholders and the management of the company is vital. The same is also true for the discussions with the tax and securities authorities regarding necessary exemptions, which are described in more detail below.
Where the investor is unable or unwilling to obtain the consent of the existing management and shareholders to the investment and wants to pursue a more hostile approach, he can theoretically purchase the loans without the consent of the target company, provided that the bank — which typically has a long-standing business relationship with the target — is willing to sell. As the new owner of the non-performing loans, the investor then has significant leverage in the negotiations with management and shareholders. While an acquisition of shares may need to be disclosed, there are no disclosure obligations regarding the holding of certain portions of outstanding corporate debt. Needless to say, the risk that the investor will not achieve his aims with respect to equity in the target company is much higher with a hostile approach than with a consensual approach.
Acquisition of the Loans
Once the investor has decided to invest, he must acquire the company’s debt from the banks. The level of complexity associated with the debt acquisition varies greatly, depending on the structure of the loans, the security (in particular if a security pool agreement is in place), and the selling bank(s) involved. Providing information regarding the loans and the debtor to the investor during a due diligence review can be an issue under German banking secrecy rules unless management has consented to the investment and agrees to the provision of due diligence information to the investor.
The acquisition of the loans can be structured as (i) a subparticipation in the loans and the underlying security, (ii) an assignment of the claims under the loans and the security, or (iii) a complete transfer of the loan agreements and the security agreements. A complete transfer of the loan agreements will usually be chosen where revolving or partially undrawn credit lines are acquired that need to remain available to the company. A transfer requires the consent of all the parties to the agreements that are being transferred and is more complicated as a result. If the loan is part of a syndicated loan or the underlying security is subject to a security pooling agreement, the bank must also transfer its contractual position under these agreements in order to allow the investor to assert his rights against the other members of the syndicate or the security pool. Under German law, the transfer of these contractual positions requires the consent of all other members of the syndicate or the security pool, which adds to the complexity and may delay the process.
Specific issues arise where the loans are secured by a government guaranty. The investor is well advised to approach the government at an early stage because its approval is generally required for a transfer of the guaranty to the investor. In any case, the investor and his advisors must ensure that the contractual positions assigned to the investor allow him to implement the workout strategy, in particular, contribution of the loans to the company in the debt-equity swap and the associated release of security.
Restructuring in Formal Insolvency Proceedings
In Germany, companies in financial difficulty are usually restructured outside of formal insolvency proceedings. The impact of a formal insolvency proceeding on business relations with suppliers and customers is usually severe, and there is a substantial risk that key employees will leave the company due to speculation that the company will be unable to continue with its business operations. However, the high volume of insolvencies in recent years has resulted in a number of successful restructurings in formal insolvency proceedings. Examples such as these are beginning to change the stakeholders’ perception that a formal insolvency process will most probably result in a winding-up of the business.
Formal insolvency proceedings offer a number of advantages for the restructuring of the company, in particular the ability to terminate (and possibly renegotiate the terms of) contracts and the easing of restrictions on the dismissal of employees. Restructuring in formal insolvency proceedings is achieved by means of an insolvency plan. It can be proposed by the insolvent company itself as a prepackaged plan in conjunction with the commencement of insolvency proceedings. The plan can be freely arranged and include all provisions that could be made in an ordinary restructuring agreement (e.g., waiver and deferral of claims, alteration of security, an undertaking of the investor to contribute the acquired loans and/or to provide new capital to the company, or an undertaking of a stakeholder to extend financing to the company to fund the reorganization).
Increasingly, an insolvency plan proposal is combined with a motion for "self-management" by the management of the insolvent company, which is similar to the concept of a chapter 11 "debtor in possession" under U.S. law. Under self-management, the management of the insolvent company remains in control of business operations but is placed under the supervision of a creditors’ trustee. To date, German insolvency courts have rarely left management in control, generally appointing an insolvency administrator who takes control of the company’s business operations. Self-management has the distinct advantage of retaining the experience and market know-how of existing management. An insolvency administrator who is unfamiliar with the company and its operations has very little time to acquaint himself with the business. The chances of prevailing on a motion for self-management can be improved if the insolvent company appoints proven restructuring experts to its board prior to filing an insolvency application. The main advantage of self-management is that the identity and expertise of the personnel who will be implementing the restructuring are known to the stakeholders at the outset of the proceedings. Investors are much more reluctant to invest if it is unclear who is managing the business, and whether such manager will implement the restructuring plan, as is frequently the case when an insolvency administrator is appointed.
Valuation of the Debt
During the course of a debt-equity swap, the non-performing loans will be contributed to the target company as a contribution in kind in exchange for the issuance of new shares that are issued in connection with the increase in the target’s capital. If the loans are contributed to a corporation (either a stock corporation ("AG") or a limited liability company ("GmbH")) or by a limited partner of a limited partnership ("KG"), the fair market value of the contribution (i.e., the claims against the target company based upon the loans) must be at least equal to the nominal value of the shares or partnership interest issued for it. Should the fair market value of the contribution in kind be below the nominal value of the shares, the investor runs the risk that (i) the commercial register will refuse to register and thus prevent the capital increase, or (ii) if the deficiency in the value is discovered after the registration, the investor will be personally liable to pay the shortfall. Because in turnaround situations the fair market value of the loan will be substantially below its nominal value, the exact value has to be determined by means of an expert opinion of an auditor. In the case of a capital increase in a stock corporation, such opinion has to be provided by a court-appointed neutral auditor. In the case of a limited liability company, an expert opinion will typically be requested by the commercial register before the capital increase is registered.
Equitable Subordination of Loans
Typically, an investor will convert only a portion of the purchased loans into equity and will retain the remainder in the form of shareholder loans. Shareholder loans to a company in financial difficulty may be subject to the rules of equitable subordination and may be treated as if they were equity. During an insolvency, equitably subordinated loans rank behind the claims of normal creditors. Outside of formal insolvency, the company may be entitled to refrain from repaying such loans until its financial difficulties have been resolved.
In order to provide an incentive for investors to provide new funds to distressed companies, the rules of equitable subordination were modified by the introduction of the so-called restructuring privilege. Under these rules, existing and new loans by an investor will not be subject to the rules of equitable subordination, provided that the investor becomes a shareholder of the company in a crisis situation with the aim of restructuring the company. Nevertheless, an investor should carefully review whether the requirements of the restructuring privilege have been met.
Tax Exemption for "Restructuring Profits"
Because the nominal amount of the shares issued as consideration for the contribution of the non-performing loans in a debt-equity swap will be significantly lower than the nominal amount of such debt on the books of the company, the target company will show a restructuring profit in the amount of the difference. If this restructuring profit were subject to regular taxation (i.e., income and trade tax), the benefits of the restructuring to the company would be largely eliminated.
In order to address this conflict between the taxation of restructuring profits and the aim of the German Insolvency Code to facilitate the restructuring of a distressed company, the German Federal Finance Ministry on March 27, 2003, issued a letter to the state tax authorities providing that income tax on restructuring profits shall be deferred and subsequently waived under the principles of equity (sachliche Billigkeitsgründe) if the following conditions are met: the company is (i) in a crisis but (ii) capable of being restructured and (iii) the tax waiver is a suitable and sufficient restructuring measure and (iv) the investor intends to restructure the company. The tax authorities will normally require the company to provide them with its restructuring plan to determine whether these conditions have been fulfilled.
Once the tax authority has qualified the profits as privileged restructuring profits and agreed to defer and waive the respective income tax, the company can apply to the municipality where the company’s operations are located for a similar decision with respect to the trade tax. Although these are two separate proceedings and the municipality is not bound by the decision of the tax authority, the municipality generally follows the lead of the tax authority, particularly if the waiver of the trade tax is necessary for a successful restructuring of the company and the decision will keep jobs and a (potential) taxpayer in the city.
Exemption From Mandatory Tender Offer
If the target company is listed on a stock exchange, the rules of the German Takeover Code (Wertpapiererwerbs- und Übernahmegesetz) apply. Pursuant to the German Takeover Code, an investor who acquires shares in a listed company as a result of a debt-equity swap or otherwise and subsequently directly or indirectly holds at least 30 percent of the voting rights in the company must make a mandatory tender offer for all of the remaining shares of the company. This obligation generally makes any debt-equity swap transaction regarding a public company unattractive for an investor who, alone or jointly with other investors, intends to take a controlling interest in the company in order to implement the restructuring plan. In order to address this concern, the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, or "BaFin") may exempt an investor from the obligation to make a tender offer if the investor gains control of the target company in connection with the restructuring of the company.
The decision to grant an exemption is in the discretion of BaFin. However, the exemption will generally be granted if the interests of the other shareholders are not negatively affected and the investor can demonstrate to BaFin that the target company is in a serious crisis and that the planned restructuring measures are suitable to restructure the company. In addition, the investor seeking the exemption must make a substantial restructuring contribution to the company, which in the case of a debt-equity swap will be the waiver of the claims under the acquired loans plus, in most cases, the provision of new money. The investor can apply for the exemption either before he assumes a controlling interest in the company or within seven days thereafter.
Conclusion
German companies in financial difficulty continue to provide interesting investment opportunities for international investors. The acquisition of controlling stakes by means of debt-equity swaps is no longer a novelty in the German market. Although it is potentially more complicated than a straightforward M&A transaction, a debt-equity swap can still offer extremely attractive returns.
Standardizing Terms for PPP - A case in South Africa
South Africa: Public Private Partnerships
17 July 2007
Article by Clare Corke
Public Private Partnerships – Government To Relook At Standardisation
In 2000, the PPP Unit of National Treasury published the first draft of the standardised terms for public private partnership (PPP) agreements ("Standardisation"). At the time that the Standardisation was first published for comment a number of concerns were raised by various entities involved in PPPs, including law firms, banks, construction entities and service providers. Many of these issues remained unresolved by March 2001, when the practice manual in relation to PPPs together with the official Standardisation was issued by the PPP Unit.
Since then the projects that have come to the market or closed have continued in the main to be plagued by these issues. In many instances these items have caused projects to be called unbankable by lenders and unpalatable by equity holders, as the risks being placed at the doors of lenders and equity holders cannot be managed effectively by them. Often, however, the risks cannot be managed or controlled by Government either, and are often risks of very low probability, but high impact in the event that they occur. This raises the question of who should bear the risk of an uncontrollable, unforeseen event occurring? Should it be the private sector, on the basis that they are earning a return and therefore should be obliged to bear the risk irrespective of the cost? Or should it be Government, on the basis that the risk is usually of low probability (save that off-site power shortages is and will continue to be a very real risk for the foreseeable future)? These issues have not been the subject of intense debate in a number of projects and a true market position has not been determined.
Accordingly, the review and amendment of Standardisation is critical to the future of PPP. Should Government be able to meet some of the expectations of the private sector, the cost of PPPs should be reduced and the procurement process should be eased. It is therefore hoped that the process will commence during the course of 2007 and that a revised Standardisation will be available for comment later this year for publication early in 2008.
Public Private Partnerships – An Opportunity Missed?
Public private partnerships (PPPs) have been promoted by the Government since before the promulgation of the Public Finance Management Act in 1999. But despite almost 10 years of PPPs, we have still not seen the influx of projects that many people anticipated and feel are needed to help address some of the infrastructure needs and service issues of the Government.
While there are a number of projects which indicate the potential benefits of PPPs to South Africa, there do appear to be difficulties in the roll out. Questions are continually asked as to whether PPPs can be implemented successfully in South Africa.
One project that does indicate the benefits of PPPs is the Inkhosi Albert Luthuli Hospital in Kwa-Zulu Natal, in which Impilo Consortium (Pty) Ltd was appointed not only to provide facilities management services, but also information technology and "state of the art" equipment. When it was first implemented there were concerns about whether a tertiary hospital should be the focus of a PPP. This project has however indicated the ability of the private sector to facilitate the provision of services within the public sector, and is a shining example of excellence within the national healthcare system. The success is due not only to the PPP, but because the working environment permits the provision of medical services by doctors without their having to determine how to manage the operation of the hospital on a budget that is not adequate for the purposes and without having to follow repeated tender processes for the provision of services.
Unfortunately, while this project motivated the Kwa-Zulu Natal Department of Health to implement a PPP to provide certain facilities management services throughout the province, and was used as a point of reference to the Western Cape Department of Health, the model is not being used in hospitals that are desperate for facilities management, such as the Johannesburg Hospital. It is also hoped that when the Chris Hani Baragwanath Hospital Project, which is currently registered as a PPP, comes to the market the scope of the project does not cause it to be unduly delayed.
Similarly, while the two maximum security prison projects have been subject to scrutiny on the basis of perceived cost, the Department of Correctional Services only recently appointed transaction advisors to consider additional prisons being undertaken as PPPs, nearly 10 years after the original project agreements were signed.
While six projects were concluded during the course of 2006, the Government needs to dramatically increase the number of projects being implemented and concluded annually in order to address the backlog of services that can be addressed by the private sector.
17 July 2007
Article by Clare Corke
Public Private Partnerships – Government To Relook At Standardisation
In 2000, the PPP Unit of National Treasury published the first draft of the standardised terms for public private partnership (PPP) agreements ("Standardisation"). At the time that the Standardisation was first published for comment a number of concerns were raised by various entities involved in PPPs, including law firms, banks, construction entities and service providers. Many of these issues remained unresolved by March 2001, when the practice manual in relation to PPPs together with the official Standardisation was issued by the PPP Unit.
Since then the projects that have come to the market or closed have continued in the main to be plagued by these issues. In many instances these items have caused projects to be called unbankable by lenders and unpalatable by equity holders, as the risks being placed at the doors of lenders and equity holders cannot be managed effectively by them. Often, however, the risks cannot be managed or controlled by Government either, and are often risks of very low probability, but high impact in the event that they occur. This raises the question of who should bear the risk of an uncontrollable, unforeseen event occurring? Should it be the private sector, on the basis that they are earning a return and therefore should be obliged to bear the risk irrespective of the cost? Or should it be Government, on the basis that the risk is usually of low probability (save that off-site power shortages is and will continue to be a very real risk for the foreseeable future)? These issues have not been the subject of intense debate in a number of projects and a true market position has not been determined.
Accordingly, the review and amendment of Standardisation is critical to the future of PPP. Should Government be able to meet some of the expectations of the private sector, the cost of PPPs should be reduced and the procurement process should be eased. It is therefore hoped that the process will commence during the course of 2007 and that a revised Standardisation will be available for comment later this year for publication early in 2008.
Public Private Partnerships – An Opportunity Missed?
Public private partnerships (PPPs) have been promoted by the Government since before the promulgation of the Public Finance Management Act in 1999. But despite almost 10 years of PPPs, we have still not seen the influx of projects that many people anticipated and feel are needed to help address some of the infrastructure needs and service issues of the Government.
While there are a number of projects which indicate the potential benefits of PPPs to South Africa, there do appear to be difficulties in the roll out. Questions are continually asked as to whether PPPs can be implemented successfully in South Africa.
One project that does indicate the benefits of PPPs is the Inkhosi Albert Luthuli Hospital in Kwa-Zulu Natal, in which Impilo Consortium (Pty) Ltd was appointed not only to provide facilities management services, but also information technology and "state of the art" equipment. When it was first implemented there were concerns about whether a tertiary hospital should be the focus of a PPP. This project has however indicated the ability of the private sector to facilitate the provision of services within the public sector, and is a shining example of excellence within the national healthcare system. The success is due not only to the PPP, but because the working environment permits the provision of medical services by doctors without their having to determine how to manage the operation of the hospital on a budget that is not adequate for the purposes and without having to follow repeated tender processes for the provision of services.
Unfortunately, while this project motivated the Kwa-Zulu Natal Department of Health to implement a PPP to provide certain facilities management services throughout the province, and was used as a point of reference to the Western Cape Department of Health, the model is not being used in hospitals that are desperate for facilities management, such as the Johannesburg Hospital. It is also hoped that when the Chris Hani Baragwanath Hospital Project, which is currently registered as a PPP, comes to the market the scope of the project does not cause it to be unduly delayed.
Similarly, while the two maximum security prison projects have been subject to scrutiny on the basis of perceived cost, the Department of Correctional Services only recently appointed transaction advisors to consider additional prisons being undertaken as PPPs, nearly 10 years after the original project agreements were signed.
While six projects were concluded during the course of 2006, the Government needs to dramatically increase the number of projects being implemented and concluded annually in order to address the backlog of services that can be addressed by the private sector.
Thursday, August 23, 2007
Treasury yields rose yet again - Flight to safety or speculation?
Treasury Bill Yields Fall Most Since 1987 on Money Fund Demand
By Deborah Finestone and Elizabeth Stanton
Bill yields have fallen five straight days as money market funds dumped asset-backed commercial paper in favor of the shortest-maturity government debt. Three-month yields dropped the most since the stock market crash of 1987 and more than in the wake of the Sept. 11, 2001, terror attacks in the U.S, as funds shunned assets that may be linked to a weakening mortgage market.
The three-month Treasury bill yield fell 0.66 percentage point to 3.09 percent as of 5:06 p.m. in New York. It's the most since Oct. 20, 1987, when the yield fell 85 basis points on the day the stock market crashed, and eclipses the drop of 39 basis points on Sept. 13, 2001, the day the Treasury market reopened after the attacks. The yield has fallen from 4.69 percent on Aug. 13. The bills yielded about 7 percent in mid-October 1987 and 3.2 percent in the days before the September 2001 attacks.
``I've never seen it like this before,'' said Jim Galluzzo, who began trading short-maturity Treasuries 20 years ago and now trades bills at RBS Greenwich Capital in Greenwich, Connecticut. ``Bills right now are trading like dot-coms.''
`Get Into Treasuries'
The flight to government debt helped the U.S. Treasury sell $21 billion in three-month bills today at a high discount rate of 2.85 percent, the lowest since 2.8 percent on May 16, 2005.
Investors fled even money market funds, considered among the safest instruments, on concern that the funds, which hold $2.5 trillion, have invested in risky collateralized debt obligations backed by subprime mortgage loans.
``We had clients asking to be pulled out of money market funds and wanting to get into Treasuries,'' said Henley Smith, fixed-income manager in New York at Castleton Partners, which oversees about $150 million in bonds. ``People are buying T-bills because you know exactly what's in it.''
Institutional investors added $39.7 billion from Aug. 14 to Aug. 17 to money market funds holding primarily government securities, a 12 percent increase, according to Connie Bugbee, managing editor of the Money Fund Report newsletter in Westborough, Massachusetts. Assets in funds that may also hold commercial paper, certificates of deposit and floating-rate notes fell 2 percent, or $24.5 billion, in the same period.
TED Spread
Three-month Treasury bill yields have fallen to 2.40 percentage points less than the London interbank offered rate, from 1.74 percentage points on Aug. 17. The ``TED'' spread, as it is known, is larger than after the 1987 crash. TED originally stood for Treasury-Eurodollar.
The Federal Reserve Bank of New York said in a statement it won't re-invest the $5 billion of Treasury bill holdings maturing on Aug. 23 through its System Open Market Account to give it ``greater flexibility'' to manage reserves. It is the first time the Fed redeemed the bills since the 2001 terrorist attacks.
The move shows the Fed expects banks to borrow that much at the Fed's discount window, compared with an average $187 million borrowed daily in the past year, said Tony Crescenzi, chief bond market strategist for New York-based Miller Tabak & Co.
The yield on the benchmark two-year note fell 10 basis points to 4.08 percent. The price of the 4 5/8 percent security due in July 2009 rose about 1/8, or $1.25 per $1,000 face amount, to 100 31/32 .
Slower Economy
More than half of the 21 primary government security dealers that trade with the Fed now expect the central bank to cut its target interest rate by next month from the current level of 5.25 percent.
``The Fed is going to lower the funds rate, it's a question of when,'' said Thomas Tierney, head of U.S. Treasury trading at Citigroup Global Markets Inc. in New York. ``Credit's gotten tighter, and it's going to slow the economy.''
Interest-rate futures traders see a 100 percent chance the fed will lower its overnight lending rate between banks by its next meeting on Sept. 18. Seventy percent of those bets are for rates to drop to 4.75 percent, while the balance is for a cut to 5 percent.
The Fed on Aug. 17 cut the rate it charges banks for direct loans to banks by 0.5 percentage point to 5.75 percent. It was the first reduction in borrowing costs between scheduled meetings since 2001. The central bank said in a statement that risks to the economy have risen ``appreciably.''
By Deborah Finestone and Elizabeth Stanton
Aug. 20 (Bloomberg) -- Yields on U.S. Treasury bills fell the most in two decades on demand for the safest securities amid concern over a widening credit crunch.
Bill yields have fallen five straight days as money market funds dumped asset-backed commercial paper in favor of the shortest-maturity government debt. Three-month yields dropped the most since the stock market crash of 1987 and more than in the wake of the Sept. 11, 2001, terror attacks in the U.S, as funds shunned assets that may be linked to a weakening mortgage market.
``The market is totally, absolutely, completely in fear mode,'' said John Jansen, who sells Treasuries at CastleOak Securities LP in New York. ``People are afraid that lots and lots of mortgage paper and mortgage paper derivatives of all sorts is completely opaque and they can't price it.''
The three-month Treasury bill yield fell 0.66 percentage point to 3.09 percent as of 5:06 p.m. in New York. It's the most since Oct. 20, 1987, when the yield fell 85 basis points on the day the stock market crashed, and eclipses the drop of 39 basis points on Sept. 13, 2001, the day the Treasury market reopened after the attacks. The yield has fallen from 4.69 percent on Aug. 13. The bills yielded about 7 percent in mid-October 1987 and 3.2 percent in the days before the September 2001 attacks.
``I've never seen it like this before,'' said Jim Galluzzo, who began trading short-maturity Treasuries 20 years ago and now trades bills at RBS Greenwich Capital in Greenwich, Connecticut. ``Bills right now are trading like dot-coms.''
`Get Into Treasuries'
The flight to government debt helped the U.S. Treasury sell $21 billion in three-month bills today at a high discount rate of 2.85 percent, the lowest since 2.8 percent on May 16, 2005.
Investors fled even money market funds, considered among the safest instruments, on concern that the funds, which hold $2.5 trillion, have invested in risky collateralized debt obligations backed by subprime mortgage loans.
``We had clients asking to be pulled out of money market funds and wanting to get into Treasuries,'' said Henley Smith, fixed-income manager in New York at Castleton Partners, which oversees about $150 million in bonds. ``People are buying T-bills because you know exactly what's in it.''
Institutional investors added $39.7 billion from Aug. 14 to Aug. 17 to money market funds holding primarily government securities, a 12 percent increase, according to Connie Bugbee, managing editor of the Money Fund Report newsletter in Westborough, Massachusetts. Assets in funds that may also hold commercial paper, certificates of deposit and floating-rate notes fell 2 percent, or $24.5 billion, in the same period.
TED Spread
Three-month Treasury bill yields have fallen to 2.40 percentage points less than the London interbank offered rate, from 1.74 percentage points on Aug. 17. The ``TED'' spread, as it is known, is larger than after the 1987 crash. TED originally stood for Treasury-Eurodollar.
The Federal Reserve Bank of New York said in a statement it won't re-invest the $5 billion of Treasury bill holdings maturing on Aug. 23 through its System Open Market Account to give it ``greater flexibility'' to manage reserves. It is the first time the Fed redeemed the bills since the 2001 terrorist attacks.
The move shows the Fed expects banks to borrow that much at the Fed's discount window, compared with an average $187 million borrowed daily in the past year, said Tony Crescenzi, chief bond market strategist for New York-based Miller Tabak & Co.
The yield on the benchmark two-year note fell 10 basis points to 4.08 percent. The price of the 4 5/8 percent security due in July 2009 rose about 1/8, or $1.25 per $1,000 face amount, to 100 31/32 .
Slower Economy
More than half of the 21 primary government security dealers that trade with the Fed now expect the central bank to cut its target interest rate by next month from the current level of 5.25 percent.
``The Fed is going to lower the funds rate, it's a question of when,'' said Thomas Tierney, head of U.S. Treasury trading at Citigroup Global Markets Inc. in New York. ``Credit's gotten tighter, and it's going to slow the economy.''
Interest-rate futures traders see a 100 percent chance the fed will lower its overnight lending rate between banks by its next meeting on Sept. 18. Seventy percent of those bets are for rates to drop to 4.75 percent, while the balance is for a cut to 5 percent.
The Fed on Aug. 17 cut the rate it charges banks for direct loans to banks by 0.5 percentage point to 5.75 percent. It was the first reduction in borrowing costs between scheduled meetings since 2001. The central bank said in a statement that risks to the economy have risen ``appreciably.''
Wednesday, August 22, 2007
Cash rich Asian corporates to participate in M&A
Asian Corporate Takeovers to Rise as Buyout Firms Lose Edge
By Denise Kee
Aug. 22 (Bloomberg) -- Mergers and acquisitions by Asian companies will increase as competition from buyout firms declines, said Philip Lee, JPMorgan Chase & Co.'s chief executive officer for Southeast Asia.
The credit crunch caused by defaults on U.S. subprime mortgages will make it more expensive for private equity firms to raise funds for takeovers, he said in Singapore yesterday.
Announced mergers and acquisitions in Southeast Asia by buyout firms accounted for almost half of the $11.1 billion of deals in the 12 months ended Aug. 21, compared with about 10 percent a year earlier, Bloomberg data show. Lee said this trend is set to reverse.
``A lot of companies that are non-private equity and non- hedge funds didn't participate as much in the mergers & acquisition transactions because they were simply out-priced by some of the private equity companies,'' he said.
Low borrowing rates helped buyout firms typically raise two- thirds of the cost of a leveraged takeover by borrowing and then using the target company's cash flow to repay lenders.
``The good days of getting cheap credit will not be there, there will be re-pricing of risk,'' said Lee. ``But buying assets is cheaper than six months ago. There is a trade off between the valuation of acquisitions and fund-raising costs.''
More than 45 companies around the world postponed or reworked their debt sales in the past seven weeks and investors shunned loans and bonds used to fund buyouts, including Kohlberg Kravis Roberts & Co.'s planned takeover of U.K. pharmacy chain Alliance Boots Plc.
Banks including JPMorgan, Goldman Sachs Group Inc. and Deutsche Bank AG have been unable to sell debt for leveraged buyouts they have underwritten, according to Citigroup analyst Keith Horowitz in New York.
JPMorgan is stuck with $40.8 billion of debt, according to Horowitz's estimates, while Goldman is holding $31.9 billion and Deutsche Bank has $27.3 billion.
By Denise Kee
Aug. 22 (Bloomberg) -- Mergers and acquisitions by Asian companies will increase as competition from buyout firms declines, said Philip Lee, JPMorgan Chase & Co.'s chief executive officer for Southeast Asia.
The credit crunch caused by defaults on U.S. subprime mortgages will make it more expensive for private equity firms to raise funds for takeovers, he said in Singapore yesterday.
Announced mergers and acquisitions in Southeast Asia by buyout firms accounted for almost half of the $11.1 billion of deals in the 12 months ended Aug. 21, compared with about 10 percent a year earlier, Bloomberg data show. Lee said this trend is set to reverse.
``A lot of companies that are non-private equity and non- hedge funds didn't participate as much in the mergers & acquisition transactions because they were simply out-priced by some of the private equity companies,'' he said.
Low borrowing rates helped buyout firms typically raise two- thirds of the cost of a leveraged takeover by borrowing and then using the target company's cash flow to repay lenders.
``The good days of getting cheap credit will not be there, there will be re-pricing of risk,'' said Lee. ``But buying assets is cheaper than six months ago. There is a trade off between the valuation of acquisitions and fund-raising costs.''
More than 45 companies around the world postponed or reworked their debt sales in the past seven weeks and investors shunned loans and bonds used to fund buyouts, including Kohlberg Kravis Roberts & Co.'s planned takeover of U.K. pharmacy chain Alliance Boots Plc.
Banks including JPMorgan, Goldman Sachs Group Inc. and Deutsche Bank AG have been unable to sell debt for leveraged buyouts they have underwritten, according to Citigroup analyst Keith Horowitz in New York.
JPMorgan is stuck with $40.8 billion of debt, according to Horowitz's estimates, while Goldman is holding $31.9 billion and Deutsche Bank has $27.3 billion.
Fed's liquidity strategy to weed off foolish hedge funds and investors
Fed's Strategy of Increasing Liquidity Survives for a Third Day
By Craig Torres
Aug. 22 (Bloomberg) -- The Federal Reserve's strategy of increasing liquidity rather than resorting to a cut in the benchmark interest rate survived a third day.
Yields on Treasury bills rose yesterday after the New York Fed lowered the cost of borrowing securities from its own portfolio to ease a shortage in the market. The action followed a reduction in the Fed's rate on direct loans to banks on Aug. 17, the impact of which officials said they need time to assess.
Chairman Ben S. Bernanke wants to avoid an emergency easing of monetary policy, contrasting with predecessor Alan Greenspan, who cut the federal funds rate target three times in 1998 after the collapse of Long Term Capital Management LP. Richmond Fed Bank President Jeffrey Lacker said yesterday that policy must be guided by the outlook for economic growth and prices, not entirely by markets.
``We did use the fed funds rate and that may have been a mistake,'' said former Fed Vice Chairman Alice Rivlin, who voted for the 1998 rate cuts. ``It might have been smarter to try what they are trying.''
Lacker said in a speech to a conference in Charlotte, North Carolina yesterday that while the credit crunch and gyrations in financial markets has the potential to hurt growth, signs so far indicate business and consumer spending will continue.
In response to a question, Lacker also underscored the Federal Open Market Committee's determination not to insure poor investments with a cut in the federal funds rate.
`Our Responsibility'
``The Federal Reserve isn't responsible for the size of credit spreads,'' he said. ``We leave those to be market determined. Our responsibility and what we are capable of influencing on a sustained basis is inflation and growth.''
After the rate cuts in 1998, the economy strengthened and stock prices soared, Rivlin noted, leaving the Fed open to criticism that the reductions were a mistake. Rivlin is now director of the economic studies program at the Brookings Institution in Washington.
The Fed's current strategy showed some signs of success yesterday as yields on three-month Treasury bills climbed the most since 2000 and those on commercial paper backed by assets such as mortgages slipped.
The three-month bill yield increased 0.52 percentage point to 3.61 percent late yesterday as demand for the shortest-dated government debt waned. Top-rated asset-backed commercial paper maturing in one day yielded 5.92 percent, down from 5.99 percent, posting the first drop in three trading days.
``The flight to safety may be diminishing a bit,'' said Holly Liss, a bond saleswoman in Chicago at Citigroup Global Markets Inc. ``We're seeing more calming of the market as T-bill rates come back to normal.''
Jury Still Out
Lacker said the ``jury is still out'' on whether the Fed has done enough to improve trading in the $1.1 trillion market for asset-backed commercial paper.
Investors and economists still bet that Bernanke will have to reduce the benchmark lending rate between banks, now at 5.25 percent, by at least a quarter point on or before the Sept. 18 meeting.
``Financial volatility and the seizing up of credit markets raises the probability'' of a recession, said Steven Einhorn, vice chairman of New York hedge fund Omega Partners Inc. ``The Fed needs to be proactive and not wait.''
Einhorn said slowing inflation and growth of around 2 percent to 2.5 percent give the Fed room to cut interest rates.
`All of the Tools'
Senate Banking Committee Chairman Christopher Dodd said Bernanke agreed to use ``all of the tools at his disposal'' to restore stability in markets roiled by the subprime mortgage crisis. He added that he didn't ask Bernanke to cut the federal funds rate and that the Fed chief didn't pledge to do so.
Dodd, a Connecticut Democrat who is seeking his party's presidential nomination, said banks should take advantage of lower borrowing costs at the discount window. He spoke after meeting with Bernanke and U.S. Treasury Secretary Henry Paulson.
Yesterday, the New York Fed reduced the so-called minimum fee rate that bond dealers pay to borrow its Treasuries to 0.5 percent from 1 percent.
``We are doing it to provide additional liquidity to the Treasury financing market,'' said Andrew Williams, a spokesman for the New York Fed. He said the rate was the lowest in the history of the program, which has existed in its current form since 1999.
The central bank on Aug. 17 cut the so-called discount rate half a percentage point to 5.75 percent to direct more cash to companies starved for short-term financing while avoiding an emergency reduction in its broader lending-rate target.
Banks can borrow at the discount rate with a wide variety of collateral, including everything from mortgages -- the market that sparked the credit crunch after defaults rose to the highest in five years -- to municipal bonds.
Lacker told risk managers yesterday that the Fed's district banks would even accept boat loans as collateral. It's up to the banks to establish a value for the assets as they make the loan, he said.
By Craig Torres
Aug. 22 (Bloomberg) -- The Federal Reserve's strategy of increasing liquidity rather than resorting to a cut in the benchmark interest rate survived a third day.
Yields on Treasury bills rose yesterday after the New York Fed lowered the cost of borrowing securities from its own portfolio to ease a shortage in the market. The action followed a reduction in the Fed's rate on direct loans to banks on Aug. 17, the impact of which officials said they need time to assess.
Chairman Ben S. Bernanke wants to avoid an emergency easing of monetary policy, contrasting with predecessor Alan Greenspan, who cut the federal funds rate target three times in 1998 after the collapse of Long Term Capital Management LP. Richmond Fed Bank President Jeffrey Lacker said yesterday that policy must be guided by the outlook for economic growth and prices, not entirely by markets.
``We did use the fed funds rate and that may have been a mistake,'' said former Fed Vice Chairman Alice Rivlin, who voted for the 1998 rate cuts. ``It might have been smarter to try what they are trying.''
Lacker said in a speech to a conference in Charlotte, North Carolina yesterday that while the credit crunch and gyrations in financial markets has the potential to hurt growth, signs so far indicate business and consumer spending will continue.
In response to a question, Lacker also underscored the Federal Open Market Committee's determination not to insure poor investments with a cut in the federal funds rate.
`Our Responsibility'
``The Federal Reserve isn't responsible for the size of credit spreads,'' he said. ``We leave those to be market determined. Our responsibility and what we are capable of influencing on a sustained basis is inflation and growth.''
After the rate cuts in 1998, the economy strengthened and stock prices soared, Rivlin noted, leaving the Fed open to criticism that the reductions were a mistake. Rivlin is now director of the economic studies program at the Brookings Institution in Washington.
The Fed's current strategy showed some signs of success yesterday as yields on three-month Treasury bills climbed the most since 2000 and those on commercial paper backed by assets such as mortgages slipped.
The three-month bill yield increased 0.52 percentage point to 3.61 percent late yesterday as demand for the shortest-dated government debt waned. Top-rated asset-backed commercial paper maturing in one day yielded 5.92 percent, down from 5.99 percent, posting the first drop in three trading days.
``The flight to safety may be diminishing a bit,'' said Holly Liss, a bond saleswoman in Chicago at Citigroup Global Markets Inc. ``We're seeing more calming of the market as T-bill rates come back to normal.''
Jury Still Out
Lacker said the ``jury is still out'' on whether the Fed has done enough to improve trading in the $1.1 trillion market for asset-backed commercial paper.
Investors and economists still bet that Bernanke will have to reduce the benchmark lending rate between banks, now at 5.25 percent, by at least a quarter point on or before the Sept. 18 meeting.
``Financial volatility and the seizing up of credit markets raises the probability'' of a recession, said Steven Einhorn, vice chairman of New York hedge fund Omega Partners Inc. ``The Fed needs to be proactive and not wait.''
Einhorn said slowing inflation and growth of around 2 percent to 2.5 percent give the Fed room to cut interest rates.
`All of the Tools'
Senate Banking Committee Chairman Christopher Dodd said Bernanke agreed to use ``all of the tools at his disposal'' to restore stability in markets roiled by the subprime mortgage crisis. He added that he didn't ask Bernanke to cut the federal funds rate and that the Fed chief didn't pledge to do so.
Dodd, a Connecticut Democrat who is seeking his party's presidential nomination, said banks should take advantage of lower borrowing costs at the discount window. He spoke after meeting with Bernanke and U.S. Treasury Secretary Henry Paulson.
Yesterday, the New York Fed reduced the so-called minimum fee rate that bond dealers pay to borrow its Treasuries to 0.5 percent from 1 percent.
``We are doing it to provide additional liquidity to the Treasury financing market,'' said Andrew Williams, a spokesman for the New York Fed. He said the rate was the lowest in the history of the program, which has existed in its current form since 1999.
The central bank on Aug. 17 cut the so-called discount rate half a percentage point to 5.75 percent to direct more cash to companies starved for short-term financing while avoiding an emergency reduction in its broader lending-rate target.
Banks can borrow at the discount rate with a wide variety of collateral, including everything from mortgages -- the market that sparked the credit crunch after defaults rose to the highest in five years -- to municipal bonds.
Lacker told risk managers yesterday that the Fed's district banks would even accept boat loans as collateral. It's up to the banks to establish a value for the assets as they make the loan, he said.
Market expects Fed Funds rate to be cut to 5%
U.S. Three-Month Treasury Bill Yields Climb Most Since 2000
By Deborah Finestone and Elizabeth Stanton
Aug. 21 (Bloomberg) -- Yields on U.S. three-month Treasury bills climbed the most since 2000 as demand fell for the safest government securities.
Bill yields rose for the first day in six, after tumbling yesterday by the most since 1987. The Federal Reserve Bank of New York cut the fee bond dealers pay to borrow its Treasuries, in a bid to ease a shortage in the market for loans backed by the securities. Demand at the Treasury's sale today of $32 billion in four-week bills was the weakest since at least July 2001.
``The flight to safety may be diminishing a bit,'' said Holly Liss, a bond saleswoman in Chicago at Citigroup Global Markets Inc. ``We're seeing more calming of the market as T-bill rates come back to normal.''
The three-month bill yield climbed 0.48 percentage point to 3.57 percent at 4:28 p.m., rising for the first day since Aug. 13. The increase is the biggest since Dec. 26, 2000. Yields fell 0.66 percentage point yesterday, the most since the stock market crash of October 1987 as money-market funds dumped asset-backed commercial paper for the shortest-maturity government debt.
The Treasury today sold $32 billion of four-week bills, the largest amount since at least July 2001. The bills were sold at a high discount rate of 4.75 percent. The one-month bill yield fell as low as 1.272 percent yesterday, and was about 2.6 percent before the auction. In a sign of weak demand, the government received $1.11 in bids for each $1 sold, the lowest since at least July 2001.
Fed Cuts Fee
The New York Fed cut its so-called minimum fee rate to a record low 0.5 percent from 1 percent, saying in a statement that the move is ``temporary.''
``We are doing it to provide additional liquidity to the Treasury financing market,'' said Andrew Williams, a spokesman for the New York Fed. He said the rate was the lowest in the history of the program, which has existed in its current form since 1999. The New York Fed last lowered the fee rate on June 26, 2003, the day after policy makers cut their target overnight rate to a four-decade low of 1 percent.
The yield on the benchmark two-year note fell to a 23-month low today before Senate Banking Committee Chairman Christopher Christopher Dodd said Fed Chairman Ben S. Bernanke agreed to use ``all of the tools at his disposal'' to restore stability in financial markets roiled by the subprime mortgage crisis.
The senator addressed reporters after meeting with Bernanke and Treasury Secretary Henry Paulson in Washington today.
`Right Direction'
``The comment from Dodd and the decision from the Fed are all going in the right direction to bringing some calm back to the financing market,'' said Nicolas Beckmann, co-head of U.S. interest rates trading at BNP Paribas Securities Corp. in New York, one of the 21 primary securities dealers that trade with the Fed.
Two-year note yields fell 6 basis points to 4.02 percent. The price of the 4 5/8 percent security due in July 2009 rose about 1/8, or $1.25 per $1,000 face amount, to 101 3/32. The yield earlier touched the lowest since September 2005. The 10- year note yield declined 4 basis points to 4.59 percent.
``Bonds are in favor largely around anticipation the Fed will make some accommodation,'' said Kevin Giddis, head of fixed- income trading in Memphis, Tennessee, at Morgan Keegan Inc.
On Aug. 17, the central bank cut the rate it charges for direct loans to banks by 0.5 percentage point to 5.75 percent. It was the first reduction in borrowing costs between scheduled meetings since 2001. The central bank said in a statement that risks to the economy have risen ``appreciably.''
The Fed has kept its key monetary policy tool, the target for the overnight lending rate between banks, at 5.25 percent since June 2006.
Interest-rate futures show traders are betting the Fed will lower its overnight lending rate between banks this month. Traders see a 100 percent chance of a quarter-point cut to 5 percent, and a 51 percent chance of a half-point cut, according to the August futures contract.
By Deborah Finestone and Elizabeth Stanton
Aug. 21 (Bloomberg) -- Yields on U.S. three-month Treasury bills climbed the most since 2000 as demand fell for the safest government securities.
Bill yields rose for the first day in six, after tumbling yesterday by the most since 1987. The Federal Reserve Bank of New York cut the fee bond dealers pay to borrow its Treasuries, in a bid to ease a shortage in the market for loans backed by the securities. Demand at the Treasury's sale today of $32 billion in four-week bills was the weakest since at least July 2001.
``The flight to safety may be diminishing a bit,'' said Holly Liss, a bond saleswoman in Chicago at Citigroup Global Markets Inc. ``We're seeing more calming of the market as T-bill rates come back to normal.''
The three-month bill yield climbed 0.48 percentage point to 3.57 percent at 4:28 p.m., rising for the first day since Aug. 13. The increase is the biggest since Dec. 26, 2000. Yields fell 0.66 percentage point yesterday, the most since the stock market crash of October 1987 as money-market funds dumped asset-backed commercial paper for the shortest-maturity government debt.
The Treasury today sold $32 billion of four-week bills, the largest amount since at least July 2001. The bills were sold at a high discount rate of 4.75 percent. The one-month bill yield fell as low as 1.272 percent yesterday, and was about 2.6 percent before the auction. In a sign of weak demand, the government received $1.11 in bids for each $1 sold, the lowest since at least July 2001.
Fed Cuts Fee
The New York Fed cut its so-called minimum fee rate to a record low 0.5 percent from 1 percent, saying in a statement that the move is ``temporary.''
``We are doing it to provide additional liquidity to the Treasury financing market,'' said Andrew Williams, a spokesman for the New York Fed. He said the rate was the lowest in the history of the program, which has existed in its current form since 1999. The New York Fed last lowered the fee rate on June 26, 2003, the day after policy makers cut their target overnight rate to a four-decade low of 1 percent.
The yield on the benchmark two-year note fell to a 23-month low today before Senate Banking Committee Chairman Christopher Christopher Dodd said Fed Chairman Ben S. Bernanke agreed to use ``all of the tools at his disposal'' to restore stability in financial markets roiled by the subprime mortgage crisis.
The senator addressed reporters after meeting with Bernanke and Treasury Secretary Henry Paulson in Washington today.
`Right Direction'
``The comment from Dodd and the decision from the Fed are all going in the right direction to bringing some calm back to the financing market,'' said Nicolas Beckmann, co-head of U.S. interest rates trading at BNP Paribas Securities Corp. in New York, one of the 21 primary securities dealers that trade with the Fed.
Two-year note yields fell 6 basis points to 4.02 percent. The price of the 4 5/8 percent security due in July 2009 rose about 1/8, or $1.25 per $1,000 face amount, to 101 3/32. The yield earlier touched the lowest since September 2005. The 10- year note yield declined 4 basis points to 4.59 percent.
``Bonds are in favor largely around anticipation the Fed will make some accommodation,'' said Kevin Giddis, head of fixed- income trading in Memphis, Tennessee, at Morgan Keegan Inc.
On Aug. 17, the central bank cut the rate it charges for direct loans to banks by 0.5 percentage point to 5.75 percent. It was the first reduction in borrowing costs between scheduled meetings since 2001. The central bank said in a statement that risks to the economy have risen ``appreciably.''
The Fed has kept its key monetary policy tool, the target for the overnight lending rate between banks, at 5.25 percent since June 2006.
Interest-rate futures show traders are betting the Fed will lower its overnight lending rate between banks this month. Traders see a 100 percent chance of a quarter-point cut to 5 percent, and a 51 percent chance of a half-point cut, according to the August futures contract.
Tuesday, August 21, 2007
Allco Update
Allco Finance Profit Rises on Increased Investments (Update1)
By Stuart Kelly
Aug. 21 (Bloomberg) -- Allco Finance Group Ltd., an Australian manager of assets such as ships and property, said full-year profit more than doubled after increasing investments.
Net income rose to A$211.7 million ($170 million) in the 12 months ended June 30, from A$96.9 million a year earlier, the Sydney-based company said in a statement today.
The result beat the A$192.4 million median estimate of seven analysts surveyed by Bloomberg. Allco shares fell 10 cents, or 1.1 percent, to A$8.82 at 11:37 a.m. on the Australian stock exchange. The stock gained 24 percent yesterday as financial companies rose after weeks of declines amid a global credit crunch.
The company more than doubled assets under management to A$9.7 billion in its first year since the all-share purchase by Record Investments Ltd. of closely held Allco Finance Group in July 2006.
The company buys assets such as property, ships and aircraft that it can bundle into investment funds and manage for a fee. It is opening an office in Milan as it seeks more investments in Europe.
The firm agreed in March to buy $200 million of wind energy assets in Germany and France, and may look to bundle these into a new investment fund. On June 13, it agreed to buy 50 percent of Italy's Industria Petroli Meridionale Srl.
Allco this month said the impact of the rout in the U.S. subprime mortgage market on the company was ``negligible.''
The company, which also invests in aircraft, was part of the group that failed in a takeover bid for Qantas Airways Ltd., Australia's largest airline.
Allco will pay a second-half dividend of 24 cents, up from 21 cents a year ago.
By Stuart Kelly
Aug. 21 (Bloomberg) -- Allco Finance Group Ltd., an Australian manager of assets such as ships and property, said full-year profit more than doubled after increasing investments.
Net income rose to A$211.7 million ($170 million) in the 12 months ended June 30, from A$96.9 million a year earlier, the Sydney-based company said in a statement today.
The result beat the A$192.4 million median estimate of seven analysts surveyed by Bloomberg. Allco shares fell 10 cents, or 1.1 percent, to A$8.82 at 11:37 a.m. on the Australian stock exchange. The stock gained 24 percent yesterday as financial companies rose after weeks of declines amid a global credit crunch.
The company more than doubled assets under management to A$9.7 billion in its first year since the all-share purchase by Record Investments Ltd. of closely held Allco Finance Group in July 2006.
The company buys assets such as property, ships and aircraft that it can bundle into investment funds and manage for a fee. It is opening an office in Milan as it seeks more investments in Europe.
The firm agreed in March to buy $200 million of wind energy assets in Germany and France, and may look to bundle these into a new investment fund. On June 13, it agreed to buy 50 percent of Italy's Industria Petroli Meridionale Srl.
Allco this month said the impact of the rout in the U.S. subprime mortgage market on the company was ``negligible.''
The company, which also invests in aircraft, was part of the group that failed in a takeover bid for Qantas Airways Ltd., Australia's largest airline.
Allco will pay a second-half dividend of 24 cents, up from 21 cents a year ago.
CDS rose in Australia
Australian Corporate Bond Risk Rises, Credit-Default Swaps Show
By Laura Cochrane
Aug. 21 (Bloomberg) -- The perceived risk of owning Australian corporate bonds rose, credit-default swaps show.
Contracts on the iTraxx Australia Series 7 Index, a benchmark for protecting bonds against default and speculating on credit quality, rose 1 basis point to 43 basis points at 10.55 a.m. in Sydney, according to prices from JPMorgan Chase & Co. This means it costs $43,000 to protect $10 million of corporate debt from default.
Credit-default swaps are financial instruments based on bonds or loans. A rise indicates deteriorating investor perceptions of credit quality.
By Laura Cochrane
Aug. 21 (Bloomberg) -- The perceived risk of owning Australian corporate bonds rose, credit-default swaps show.
Contracts on the iTraxx Australia Series 7 Index, a benchmark for protecting bonds against default and speculating on credit quality, rose 1 basis point to 43 basis points at 10.55 a.m. in Sydney, according to prices from JPMorgan Chase & Co. This means it costs $43,000 to protect $10 million of corporate debt from default.
Credit-default swaps are financial instruments based on bonds or loans. A rise indicates deteriorating investor perceptions of credit quality.
"Rookie" mistake?
Bernanke's `Rookie Mistake' Forces Fed to Shift Focus (Update2)
By Craig Torres
Aug. 20 (Bloomberg) -- Federal Reserve policy makers, who declared that inflation was their paramount challenge just two weeks ago, have been forced to make financial-market stability the trigger for changes in interest rates.
By lowering the discount rate and issuing a statement conceding threats to the economy, Federal Open Market Committee members effectively ripped up the economic-outlook statement from their Aug. 7 meeting. Some economists describe the about-face, coming after months of assurances that the subprime-mortgage rout was contained, as Chairman Ben S. Bernanke's first serious error since taking office last year.
``It was a rookie mistake,'' said Kenneth Thomas, a lecturer in finance at the University of Pennsylvania's Wharton School in Philadelphia. The Fed ``underestimated liquidity needs'' of investors and the fallout from the housing recession, he said, adding, ``This demonstrates the difference between book-smart and street-smart.''
Bernanke, a former chairman of the economics department at Princeton University, has elevated the role of forecasts in Fed policy rather than amassing clues from dozens of market indicators as predecessor Alan Greenspan did. The Fed forecasts showed that ``moderate'' growth would continue, and that inflation remained the biggest danger. The credit collapse has undermined that stance, and Bernanke may cut the benchmark interest rate by at least a quarter-point at or before the Sept. 18 FOMC meeting, analysts say.
Tough to Model
``Sometimes, the dynamics change very, very quickly,'' said former Fed governor Laurence Meyer, who voted for the three reductions in 1998 after currencies in Asia, Russia and Latin America tumbled. Bernanke's shift ``tells us how difficult it is to translate financial turbulence into the macroeconomic forecast.''
The Fed on Aug. 17 lowered its discount rate -- what it charges banks for direct loans -- by 0.5 percentage point to 5.75 percent, in an effort to increase liquidity in longer-term loans and bonds.
The initial request for the move came from Fed district banks in New York and San Francisco. They are led respectively by Timothy Geithner and Janet Yellen, both former Clinton administration officials who dealt with the 1997-1998 currency crises. The Fed's Board of Governors in Washington is dominated by academics.
Meyer's Call
Meyer, vice chairman of Macroeconomic Advisors LLC in Washington, recommended prior to the Aug. 7 FOMC meeting that policy makers cease describing inflation as the biggest risk. By saying the risks to growth and inflation were roughly equal, the central bank would have given itself room to maneuver if markets -- already weakening -- continued to slide.
The committee said in its statement three days ago that ``the downside risks to growth have increased appreciably'' because of the tumult in markets. Officials abandoned the prediction of a ``moderate'' expansion, and inflation wasn't mentioned.
While leaving the main rate at 5.25 percent, the panel said it is ``prepared to act as needed to mitigate the adverse effects on the economy.''
Stocks rallied after the announcement, but credit markets remained unsettled. The Standard & Poor's 500 Index climbed 2.5 percent, the biggest rally in four years. By contrast, asset backed commercial paper yields jumped the most since the Sept. 11, 2001, terrorist attacks. Top-rated paper maturing Aug. 20 yielded 5.99 percent late on Aug. 17, up 39 basis points in a day. A basis point is 0.01 percentage point.
Most Since 1987
Today, stocks are falling and Treasuries climbing. The yield on three-month Treasury bills slid the most since 1987 as investors sought a haven in short-dated, government-guaranteed debt. The S&P 500 fell 0.7 percent to 1,435.23 at 2:23 p.m. in New York.
``The Fed has an easing bias, but it is not an easing bias dictated strictly by economic conditions,'' said Stephen Stanley, chief economist at RBS Greenwich Capital Markets in Greenwich, Connecticut. ``This is a financial-market issue, which is then bleeding into the economy.''
Last week's policy shift notwithstanding, Bernanke's moves to resolve the credit crunch so far have been restrained. Even then, and unlike the Greenspan era, it was the Fed doing the talking, not any one individual.
Injecting Cash
The Fed pumped $38 billion into the banking system on Aug. 10 to free up financing in short-term credit markets, and issued a six-line statement. The injection was the Fed's biggest since the meltdown began. By contrast, the European Central Bank added $130 billion in temporary reserves a day earlier. ECB President Jean-Claude Trichet followed up with media interviews designed to reassure investors.
``We're getting a nice further look at the new Bernanke Fed,'' said Ethan Harris, chief U.S. economist at Lehman Brothers Holdings Inc. in New York. ``He definitely wants to use the committee and these more formal directives,'' as opposed to Greenspan's preference for speeches laden with ``code words.''
The reduction in the discount rate, which is used less than the federal funds rate as a policy-making tool, wasn't directed at the broad economy so much as at trying to ease gridlock in credit markets. The Fed said it would accept everything from home-equity loans to municipal bonds as collateral for discount- window loans up to 30 days.
`Calamity' Needed
The decision to keep the benchmark overnight lending rate unchanged -- for now -- may be a sign that the central bank is still wary of bailing out bad bets by financial institutions and investors. St. Louis Fed President William Poole said in an interview on Aug. 15 that only a ``calamity'' would justify a rate cut between scheduled FOMC meetings.
``They knew what they were doing'' by maintaining the anti- inflation bias at their Aug. 7 meeting, said former Dallas Fed President Robert McTeer. ``I do not agree with it, but I think they were trying very hard not to have a Bernanke put. They were hard-pressed to keep that out of it. It became unrealistic.''
Traders and economists use the term ``Greenspan put'' to describe the priority the former chairman placed on financial- market stability. A put option provides the right, though not the obligation, to sell a security, currency or commodity within a set period.
Greenspan provided ample liquidity after the 1987 stock market crash, and he was one of the architects who arranged a financial backstop for Mexico after the 1994 peso devaluation. In 1998, the Fed also helped oversee the rescue of failed hedge fund Long Term Capital Management, and cut interest rates 75 basis points in three separate moves to cushion the blow of global financial turmoil.
Abandoning Forecasts
Former Fed officials say it's difficult for central bankers to judge when they should abandon their economic outlook, often arrived at through months of internal debate and calculation.
Bernanke, 53, is an expert in inflation-targeting and has spent much of his career in academia. He is flanked at the Washington-based Board of Governors by Randall Kroszner, a former University of Chicago Business School professor, and Frederic Mishkin, a monetary policy researcher and professor from the Graduate School of Business at Columbia University in New York.
Vice Chairman Donald Kohn, formerly the Fed's director of the Division of Monetary Affairs from 1987 to 2001, is the only governor with high-level experience in financial-crisis management. Kohn, 64, joined a conference call Geithner convened with bankers on Aug. 17 to persuade them to take advantage of the lower discount rate.
Geithner's Experience
Among executives of the district banks, Geithner, 46, has the most extensive background in responding to upheavals. During the Clinton years, he was an aide to Robert Rubin and Lawrence Summers, who both served as Treasury secretary. In that role, Geithner helped broker emergency loans for Thailand, Indonesia, South Korea, Russia and Brazil when their currencies sagged. While he was at the Treasury, the U.S. participated in interventions to strengthen the yen in 1998, and the euro in 2000.
``It is a team that is new to the challenge, but it is a pretty smart group,'' said Harris. Bernanke ``really studied for the job. He is familiar with the history of the Fed, the policy errors, and he is a Great Depression buff.'' Bernanke contributed to Depression research with a 1999 paper co-authored with Mark Gertler and Simon Gilchrist on how financial markets can worsen economic downturns.
With Friday's action, Bernanke and his colleagues have ``tip-toed in'' and are ``trying to strike the right balance between doing nothing and riding to the rescue,'' said Gary Schlossberg, senior economist at Wells Fargo Capital Management in San Francisco, which oversees $200 billion in assets. ``They've left the door open to a full-blown easing of monetary policy. The results are mixed so far, and early returns suggest we're not out of the woods yet.''
By Craig Torres
Aug. 20 (Bloomberg) -- Federal Reserve policy makers, who declared that inflation was their paramount challenge just two weeks ago, have been forced to make financial-market stability the trigger for changes in interest rates.
By lowering the discount rate and issuing a statement conceding threats to the economy, Federal Open Market Committee members effectively ripped up the economic-outlook statement from their Aug. 7 meeting. Some economists describe the about-face, coming after months of assurances that the subprime-mortgage rout was contained, as Chairman Ben S. Bernanke's first serious error since taking office last year.
``It was a rookie mistake,'' said Kenneth Thomas, a lecturer in finance at the University of Pennsylvania's Wharton School in Philadelphia. The Fed ``underestimated liquidity needs'' of investors and the fallout from the housing recession, he said, adding, ``This demonstrates the difference between book-smart and street-smart.''
Bernanke, a former chairman of the economics department at Princeton University, has elevated the role of forecasts in Fed policy rather than amassing clues from dozens of market indicators as predecessor Alan Greenspan did. The Fed forecasts showed that ``moderate'' growth would continue, and that inflation remained the biggest danger. The credit collapse has undermined that stance, and Bernanke may cut the benchmark interest rate by at least a quarter-point at or before the Sept. 18 FOMC meeting, analysts say.
Tough to Model
``Sometimes, the dynamics change very, very quickly,'' said former Fed governor Laurence Meyer, who voted for the three reductions in 1998 after currencies in Asia, Russia and Latin America tumbled. Bernanke's shift ``tells us how difficult it is to translate financial turbulence into the macroeconomic forecast.''
The Fed on Aug. 17 lowered its discount rate -- what it charges banks for direct loans -- by 0.5 percentage point to 5.75 percent, in an effort to increase liquidity in longer-term loans and bonds.
The initial request for the move came from Fed district banks in New York and San Francisco. They are led respectively by Timothy Geithner and Janet Yellen, both former Clinton administration officials who dealt with the 1997-1998 currency crises. The Fed's Board of Governors in Washington is dominated by academics.
Meyer's Call
Meyer, vice chairman of Macroeconomic Advisors LLC in Washington, recommended prior to the Aug. 7 FOMC meeting that policy makers cease describing inflation as the biggest risk. By saying the risks to growth and inflation were roughly equal, the central bank would have given itself room to maneuver if markets -- already weakening -- continued to slide.
The committee said in its statement three days ago that ``the downside risks to growth have increased appreciably'' because of the tumult in markets. Officials abandoned the prediction of a ``moderate'' expansion, and inflation wasn't mentioned.
While leaving the main rate at 5.25 percent, the panel said it is ``prepared to act as needed to mitigate the adverse effects on the economy.''
Stocks rallied after the announcement, but credit markets remained unsettled. The Standard & Poor's 500 Index climbed 2.5 percent, the biggest rally in four years. By contrast, asset backed commercial paper yields jumped the most since the Sept. 11, 2001, terrorist attacks. Top-rated paper maturing Aug. 20 yielded 5.99 percent late on Aug. 17, up 39 basis points in a day. A basis point is 0.01 percentage point.
Most Since 1987
Today, stocks are falling and Treasuries climbing. The yield on three-month Treasury bills slid the most since 1987 as investors sought a haven in short-dated, government-guaranteed debt. The S&P 500 fell 0.7 percent to 1,435.23 at 2:23 p.m. in New York.
``The Fed has an easing bias, but it is not an easing bias dictated strictly by economic conditions,'' said Stephen Stanley, chief economist at RBS Greenwich Capital Markets in Greenwich, Connecticut. ``This is a financial-market issue, which is then bleeding into the economy.''
Last week's policy shift notwithstanding, Bernanke's moves to resolve the credit crunch so far have been restrained. Even then, and unlike the Greenspan era, it was the Fed doing the talking, not any one individual.
Injecting Cash
The Fed pumped $38 billion into the banking system on Aug. 10 to free up financing in short-term credit markets, and issued a six-line statement. The injection was the Fed's biggest since the meltdown began. By contrast, the European Central Bank added $130 billion in temporary reserves a day earlier. ECB President Jean-Claude Trichet followed up with media interviews designed to reassure investors.
``We're getting a nice further look at the new Bernanke Fed,'' said Ethan Harris, chief U.S. economist at Lehman Brothers Holdings Inc. in New York. ``He definitely wants to use the committee and these more formal directives,'' as opposed to Greenspan's preference for speeches laden with ``code words.''
The reduction in the discount rate, which is used less than the federal funds rate as a policy-making tool, wasn't directed at the broad economy so much as at trying to ease gridlock in credit markets. The Fed said it would accept everything from home-equity loans to municipal bonds as collateral for discount- window loans up to 30 days.
`Calamity' Needed
The decision to keep the benchmark overnight lending rate unchanged -- for now -- may be a sign that the central bank is still wary of bailing out bad bets by financial institutions and investors. St. Louis Fed President William Poole said in an interview on Aug. 15 that only a ``calamity'' would justify a rate cut between scheduled FOMC meetings.
``They knew what they were doing'' by maintaining the anti- inflation bias at their Aug. 7 meeting, said former Dallas Fed President Robert McTeer. ``I do not agree with it, but I think they were trying very hard not to have a Bernanke put. They were hard-pressed to keep that out of it. It became unrealistic.''
Traders and economists use the term ``Greenspan put'' to describe the priority the former chairman placed on financial- market stability. A put option provides the right, though not the obligation, to sell a security, currency or commodity within a set period.
Greenspan provided ample liquidity after the 1987 stock market crash, and he was one of the architects who arranged a financial backstop for Mexico after the 1994 peso devaluation. In 1998, the Fed also helped oversee the rescue of failed hedge fund Long Term Capital Management, and cut interest rates 75 basis points in three separate moves to cushion the blow of global financial turmoil.
Abandoning Forecasts
Former Fed officials say it's difficult for central bankers to judge when they should abandon their economic outlook, often arrived at through months of internal debate and calculation.
Bernanke, 53, is an expert in inflation-targeting and has spent much of his career in academia. He is flanked at the Washington-based Board of Governors by Randall Kroszner, a former University of Chicago Business School professor, and Frederic Mishkin, a monetary policy researcher and professor from the Graduate School of Business at Columbia University in New York.
Vice Chairman Donald Kohn, formerly the Fed's director of the Division of Monetary Affairs from 1987 to 2001, is the only governor with high-level experience in financial-crisis management. Kohn, 64, joined a conference call Geithner convened with bankers on Aug. 17 to persuade them to take advantage of the lower discount rate.
Geithner's Experience
Among executives of the district banks, Geithner, 46, has the most extensive background in responding to upheavals. During the Clinton years, he was an aide to Robert Rubin and Lawrence Summers, who both served as Treasury secretary. In that role, Geithner helped broker emergency loans for Thailand, Indonesia, South Korea, Russia and Brazil when their currencies sagged. While he was at the Treasury, the U.S. participated in interventions to strengthen the yen in 1998, and the euro in 2000.
``It is a team that is new to the challenge, but it is a pretty smart group,'' said Harris. Bernanke ``really studied for the job. He is familiar with the history of the Fed, the policy errors, and he is a Great Depression buff.'' Bernanke contributed to Depression research with a 1999 paper co-authored with Mark Gertler and Simon Gilchrist on how financial markets can worsen economic downturns.
With Friday's action, Bernanke and his colleagues have ``tip-toed in'' and are ``trying to strike the right balance between doing nothing and riding to the rescue,'' said Gary Schlossberg, senior economist at Wells Fargo Capital Management in San Francisco, which oversees $200 billion in assets. ``They've left the door open to a full-blown easing of monetary policy. The results are mixed so far, and early returns suggest we're not out of the woods yet.''
Old article by McKinsey - What drives the stock market?
Do fundamentals—or emotions—drive the stock market?
Emotions can drive market behavior in a few short-lived situations. But fundamentals still rule.
Marc Goedhart, Timothy Koller, and David Wessels
(McKinsey Quarterly) There's never been a better time to be a behaviorist. During four decades, the academic theory that financial markets accurately reflect a stock's underlying value was all but unassailable. But lately, the view that investors can fundamentally change a market's course through irrational decisions has been moving into the mainstream.
With the exuberance of the high-tech stock bubble and the crash of the late 1990s still fresh in investors' memories, adherents of the behaviorist school are finding it easier than ever to spread the belief that markets can be something less than efficient in immediately distilling new information and that investors, driven by emotion, can indeed lead markets awry. Some behaviorists would even assert that stock markets lead lives of their own, detached from economic growth and business profitability. A number of finance scholars and practitioners have argued that stock markets are not efficient—that is, that they don't necessarily reflect economic fundamentals.1 According to this point of view, significant and lasting deviations from the intrinsic value of a company's share price occur in market valuations.
The argument is more than academic. In the 1980s the rise of stock market index funds, which now hold some $1 trillion in assets, was caused in large part by the conviction among investors that efficient-market theories were valuable. And current debates in the United States and elsewhere about privatizing Social Security and other retirement systems may hinge on assumptions about how investors are likely to handle their retirement options.
We agree that behavioral finance offers some valuable insights—chief among them the idea that markets are not always right, since rational investors can't always correct for mispricing by irrational ones. But for managers, the critical question is how often these deviations arise and whether they are so frequent and significant that they should affect the process of financial decision making. In fact, significant deviations from intrinsic value are rare, and markets usually revert rapidly to share prices commensurate with economic fundamentals. Therefore, managers should continue to use the tried-and-true analysis of a company's discounted cash flow to make their valuation decisions.
When markets deviate
Behavioral-finance theory holds that markets might fail to reflect economic fundamentals under three conditions. When all three apply, the theory predicts that pricing biases in financial markets can be both significant and persistent.
Irrational behavior. Investors behave irrationally when they don't correctly process all the available information while forming their expectations of a company's future performance. Some investors, for example, attach too much importance to recent events and results, an error that leads them to overprice companies with strong recent performance. Others are excessively conservative and underprice stocks of companies that have released positive news.
Systematic patterns of behavior. Even if individual investors decided to buy or sell without consulting economic fundamentals, the impact on share prices would still be limited. Only when their irrational behavior is also systematic (that is, when large groups of investors share particular patterns of behavior) should persistent price deviations occur. Hence behavioral-finance theory argues that patterns of overconfidence, overreaction, and overrepresentation are common to many investors and that such groups can be large enough to prevent a company's share price from reflecting underlying economic fundamentals—at least for some stocks, some of the time.
Limits to arbitrage in financial markets. When investors assume that a company's recent strong performance alone is an indication of future performance, they may start bidding for shares and drive up the price. Some investors might expect a company that surprises the market in one quarter to go on exceeding expectations. As long as enough other investors notice this myopic overpricing and respond by taking short positions, the share price will fall in line with its underlying indicators.
This sort of arbitrage doesn't always occur, however. In practice, the costs, complexity, and risks involved in setting up a short position can be too high for individual investors. If, for example, the share price doesn't return to its fundamental value while they can still hold on to a short position—the so-called noise-trader risk—they may have to sell their holdings at a loss.
Momentum and other matters
Two well-known patterns of stock market deviations have received considerable attention in academic studies during the past decade: long-term reversals in share prices and short-term momentum.
First, consider the phenomenon of reversal—high-performing stocks of the past few years typically become low-performing stocks of the next few. Behavioral finance argues that this effect is caused by an overreaction on the part of investors: when they put too much weight on a company's recent performance, the share price becomes inflated. As additional information becomes available, investors adjust their expectations and a reversal occurs. The same behavior could explain low returns after an initial public offering (IPO), seasoned offerings, a new listing, and so on. Presumably, such companies had a history of strong performance, which was why they went public in the first place.
Momentum, on the other hand, occurs when positive returns for stocks over the past few months are followed by several more months of positive returns. Behavioral-finance theory suggests that this trend results from systematic underreaction: overconservative investors underestimate the true impact of earnings, divestitures, and share repurchases, for example, so stock prices don't instantaneously react to good or bad news.
But academics are still debating whether irrational investors alone can be blamed for the long-term-reversal and short-term-momentum patterns in returns. Some believe that long-term reversals result merely from incorrect measurements of a stock's risk premium, because investors ignore the risks associated with a company's size and market-to-capital ratio.2 These statistics could be a proxy for liquidity and distress risk.
Similarly, irrational investors don't necessarily drive short-term momentum in share price returns. Profits from these patterns are relatively limited after transaction costs have been deducted. Thus, small momentum biases could exist even if all investors were rational.
Furthermore, behavioral finance still cannot explain why investors overreact under some conditions (such as IPOs) and underreact in others (such as earnings announcements). Since there is no systematic way to predict how markets will respond, some have concluded that this is a further indication of their accuracy.3
Persistent mispricing in carve-outs and dual-listed companies
Two well-documented types of market deviation—the mispricing of carve-outs and of dual-listed companies—are used to support behavioral-finance theory. The classic example is the pricing of 3Com and Palm after the latter's carve-out in March 2000.
Two types of market deviation—the mispricing of carve-outs and of dual-listed companies—are used to support behavioral-finance theory
In anticipation of a full spin-off within nine months, 3Com floated 5 percent of its Palm subsidiary. Almost immediately, Palm's market capitalization was higher than the entire market value of 3Com, implying that 3Com's other businesses had a negative value. Given the size and profitability of the rest of 3Com's businesses, this result would clearly indicate mispricing. Why did rational investors fail to exploit the anomaly by going short on Palm's shares and long on 3Com's? The reason was that the number of available Palm shares was extremely small after the carve-out: 3Com still held 95 percent of them. As a result, it was extremely difficult to establish a short position, which would have required borrowing shares from a Palm shareholder.
During the months following the carve-out, the mispricing gradually became less pronounced as the supply of shares through short sales increased steadily. Yet while many investors and analysts knew about the price difference, it persisted for two months—until the Internal Revenue Service formally approved the carve-out's tax-free status in early May 2002. At that point, a significant part of the uncertainty around the spin-off was removed and the price discrepancy disappeared. This correction suggests that at least part of the mispricing was caused by the risk that the spin-off wouldn't occur.
Additional cases of mispricing between parent companies and their carved-out subsidiaries are well documented.4 In general, these cases involve difficulties setting up short positions to exploit the price differences, which persist until the spin-off takes place or is abandoned. In all cases, the mispricing was corrected within several months.
A second classic example of investors deviating from fundamentals is the price disparity between the shares of the same company traded on two different exchanges. Consider the case of Royal Dutch Petroleum and "Shell" Transport and Trading, which are traded on the Amsterdam and London stock markets, respectively. Since these twin shares are entitled to a fixed 60-40 portion of the dividends of Royal Dutch/Shell, you would expect their share prices to remain in this fixed ratio.
Over long periods, however, they have not. In fact, prolonged periods of mispricing can be found for several similar twin-share structures, such as Unilever (Exhibit 1). This phenomenon occurs because large groups of investors prefer (and are prepared to pay a premium for) one of the twin shares. Rational investors typically do not take positions to exploit the opportunity for arbitrage.
Thus in the case of Royal Dutch/Shell, a price differential of as much as 30 percent has persisted at times. Why? The opportunity to arbitrage dual-listed stocks is actually quite unpredictable and potentially costly. Because of noise-trader risk, even a large gap between share prices is no guarantee that those prices will converge in the near term.
Does this indict the market for mispricing? We don't think so. In recent years, the price differences for Royal Dutch/Shell and other twin-share stocks have all become smaller. Furthermore, some of these share structures (and price differences) disappeared because the corporations formally merged, a development that underlines the significance of noise-trader risk: as soon as a formal date was set for definitive price convergence, arbitrageurs stepped in to correct any discrepancy. This pattern provides additional evidence that mispricing occurs only under special circumstances—and is by no means a common or long-lasting phenomenon.
Markets and fundamentals: The bubble of the 1990s
Do markets reflect economic fundamentals? We believe so. Long-term returns on capital and growth have been remarkably consistent for the past 35 years, in spite of some deep recessions and periods of very strong economic growth. The median return on equity for all US companies has been a very stable 12 to 15 percent, and long-term GDP growth for the US economy in real terms has been about 3 percent a year since 1945.5 We also estimate that the inflation-adjusted cost of equity since 1965 has been fairly stable, at about 7 percent.6
We used this information to estimate the intrinsic P/E ratios for the US and UK stock markets and then compared them with the actual values.7 This analysis has led us to three important conclusions. The first is that US and UK stock markets, by and large, have been fairly priced, hovering near their intrinsic P/E ratios. This figure was typically around 15, with the exception of the high-inflation years of the late 1970s and early 1980s, when it was closer to 10 (Exhibit 2).
Second, the late 1970s and late 1990s produced significant deviations from intrinsic valuations. In the late 1970s, when investors were obsessed with high short-term inflation rates, the market was probably undervalued; long-term real GDP growth and returns on equity indicate that it shouldn't have bottomed out at P/E levels of around 7. The other well-known deviation occurred in the late 1990s, when the market reached a P/E ratio of around 30—a level that couldn't be justified by 3 percent long-term real GDP growth or by 13 percent returns on book equity.
Third, when such deviations occurred, the stock market returned to its intrinsic-valuation level within about three years. Thus, although valuations have been wrong from time to time—even for the stock market as a whole—eventually they have fallen back in line with economic fundamentals.
Focus on intrinsic value
What are the implications for corporate managers? Paradoxically, we believe that such market deviations make it even more important for the executives of a company to understand the intrinsic value of its shares. This knowledge allows it to exploit any deviations, if and when they occur, to time the implementation of strategic decisions more successfully. Here are some examples of how corporate managers can take advantage of market deviations.
- Issuing additional share capital when the stock market attaches too high a value to the company's shares relative to their intrinsic value
- Repurchasing shares when the market under-prices them relative to their intrinsic value
- Paying for acquisitions with shares instead of cash when the market overprices them relative to their intrinsic value
- Divesting particular businesses at times when trading and transaction multiples are higher than can be justified by underlying fundamentals
Bear two things in mind. First, we don't recommend that companies base decisions to issue or repurchase their shares, to divest or acquire businesses, or to settle transactions with cash or shares solely on an assumed difference between the market and intrinsic value of their shares. Instead, these decisions must be grounded in a strong business strategy driven by the goal of creating shareholder value. Market deviations are more relevant as tactical considerations when companies time and execute such decisions—for example, when to issue additional capital or how to pay for a particular transaction.
Second, managers should be wary of analyses claiming to highlight market deviations. Most of the alleged cases that we have come across in our client experience proved to be insignificant or even nonexistent, so the evidence should be compelling. Furthermore, the deviations should be significant in both size and duration, given the capital and time needed to take advantage of the types of opportunities listed previously.
Provided that a company's share price eventually returns to its intrinsic value in the long run, managers would benefit from using a discounted-cash-flow approach for strategic decisions. What should matter is the long-term behavior of the share price of a company, not whether it is undervalued by 5 or 10 percent at any given time. For strategic business decisions, the evidence strongly suggests that the market reflects intrinsic value.
Emotions can drive market behavior in a few short-lived situations. But fundamentals still rule.
Marc Goedhart, Timothy Koller, and David Wessels
(McKinsey Quarterly) There's never been a better time to be a behaviorist. During four decades, the academic theory that financial markets accurately reflect a stock's underlying value was all but unassailable. But lately, the view that investors can fundamentally change a market's course through irrational decisions has been moving into the mainstream.
With the exuberance of the high-tech stock bubble and the crash of the late 1990s still fresh in investors' memories, adherents of the behaviorist school are finding it easier than ever to spread the belief that markets can be something less than efficient in immediately distilling new information and that investors, driven by emotion, can indeed lead markets awry. Some behaviorists would even assert that stock markets lead lives of their own, detached from economic growth and business profitability. A number of finance scholars and practitioners have argued that stock markets are not efficient—that is, that they don't necessarily reflect economic fundamentals.1 According to this point of view, significant and lasting deviations from the intrinsic value of a company's share price occur in market valuations.
The argument is more than academic. In the 1980s the rise of stock market index funds, which now hold some $1 trillion in assets, was caused in large part by the conviction among investors that efficient-market theories were valuable. And current debates in the United States and elsewhere about privatizing Social Security and other retirement systems may hinge on assumptions about how investors are likely to handle their retirement options.
We agree that behavioral finance offers some valuable insights—chief among them the idea that markets are not always right, since rational investors can't always correct for mispricing by irrational ones. But for managers, the critical question is how often these deviations arise and whether they are so frequent and significant that they should affect the process of financial decision making. In fact, significant deviations from intrinsic value are rare, and markets usually revert rapidly to share prices commensurate with economic fundamentals. Therefore, managers should continue to use the tried-and-true analysis of a company's discounted cash flow to make their valuation decisions.
When markets deviate
Behavioral-finance theory holds that markets might fail to reflect economic fundamentals under three conditions. When all three apply, the theory predicts that pricing biases in financial markets can be both significant and persistent.
Irrational behavior. Investors behave irrationally when they don't correctly process all the available information while forming their expectations of a company's future performance. Some investors, for example, attach too much importance to recent events and results, an error that leads them to overprice companies with strong recent performance. Others are excessively conservative and underprice stocks of companies that have released positive news.
Systematic patterns of behavior. Even if individual investors decided to buy or sell without consulting economic fundamentals, the impact on share prices would still be limited. Only when their irrational behavior is also systematic (that is, when large groups of investors share particular patterns of behavior) should persistent price deviations occur. Hence behavioral-finance theory argues that patterns of overconfidence, overreaction, and overrepresentation are common to many investors and that such groups can be large enough to prevent a company's share price from reflecting underlying economic fundamentals—at least for some stocks, some of the time.
Limits to arbitrage in financial markets. When investors assume that a company's recent strong performance alone is an indication of future performance, they may start bidding for shares and drive up the price. Some investors might expect a company that surprises the market in one quarter to go on exceeding expectations. As long as enough other investors notice this myopic overpricing and respond by taking short positions, the share price will fall in line with its underlying indicators.
This sort of arbitrage doesn't always occur, however. In practice, the costs, complexity, and risks involved in setting up a short position can be too high for individual investors. If, for example, the share price doesn't return to its fundamental value while they can still hold on to a short position—the so-called noise-trader risk—they may have to sell their holdings at a loss.
Momentum and other matters
Two well-known patterns of stock market deviations have received considerable attention in academic studies during the past decade: long-term reversals in share prices and short-term momentum.
First, consider the phenomenon of reversal—high-performing stocks of the past few years typically become low-performing stocks of the next few. Behavioral finance argues that this effect is caused by an overreaction on the part of investors: when they put too much weight on a company's recent performance, the share price becomes inflated. As additional information becomes available, investors adjust their expectations and a reversal occurs. The same behavior could explain low returns after an initial public offering (IPO), seasoned offerings, a new listing, and so on. Presumably, such companies had a history of strong performance, which was why they went public in the first place.
Momentum, on the other hand, occurs when positive returns for stocks over the past few months are followed by several more months of positive returns. Behavioral-finance theory suggests that this trend results from systematic underreaction: overconservative investors underestimate the true impact of earnings, divestitures, and share repurchases, for example, so stock prices don't instantaneously react to good or bad news.
But academics are still debating whether irrational investors alone can be blamed for the long-term-reversal and short-term-momentum patterns in returns. Some believe that long-term reversals result merely from incorrect measurements of a stock's risk premium, because investors ignore the risks associated with a company's size and market-to-capital ratio.2 These statistics could be a proxy for liquidity and distress risk.
Similarly, irrational investors don't necessarily drive short-term momentum in share price returns. Profits from these patterns are relatively limited after transaction costs have been deducted. Thus, small momentum biases could exist even if all investors were rational.
Furthermore, behavioral finance still cannot explain why investors overreact under some conditions (such as IPOs) and underreact in others (such as earnings announcements). Since there is no systematic way to predict how markets will respond, some have concluded that this is a further indication of their accuracy.3
Persistent mispricing in carve-outs and dual-listed companies
Two well-documented types of market deviation—the mispricing of carve-outs and of dual-listed companies—are used to support behavioral-finance theory. The classic example is the pricing of 3Com and Palm after the latter's carve-out in March 2000.
Two types of market deviation—the mispricing of carve-outs and of dual-listed companies—are used to support behavioral-finance theory
In anticipation of a full spin-off within nine months, 3Com floated 5 percent of its Palm subsidiary. Almost immediately, Palm's market capitalization was higher than the entire market value of 3Com, implying that 3Com's other businesses had a negative value. Given the size and profitability of the rest of 3Com's businesses, this result would clearly indicate mispricing. Why did rational investors fail to exploit the anomaly by going short on Palm's shares and long on 3Com's? The reason was that the number of available Palm shares was extremely small after the carve-out: 3Com still held 95 percent of them. As a result, it was extremely difficult to establish a short position, which would have required borrowing shares from a Palm shareholder.
During the months following the carve-out, the mispricing gradually became less pronounced as the supply of shares through short sales increased steadily. Yet while many investors and analysts knew about the price difference, it persisted for two months—until the Internal Revenue Service formally approved the carve-out's tax-free status in early May 2002. At that point, a significant part of the uncertainty around the spin-off was removed and the price discrepancy disappeared. This correction suggests that at least part of the mispricing was caused by the risk that the spin-off wouldn't occur.
Additional cases of mispricing between parent companies and their carved-out subsidiaries are well documented.4 In general, these cases involve difficulties setting up short positions to exploit the price differences, which persist until the spin-off takes place or is abandoned. In all cases, the mispricing was corrected within several months.
A second classic example of investors deviating from fundamentals is the price disparity between the shares of the same company traded on two different exchanges. Consider the case of Royal Dutch Petroleum and "Shell" Transport and Trading, which are traded on the Amsterdam and London stock markets, respectively. Since these twin shares are entitled to a fixed 60-40 portion of the dividends of Royal Dutch/Shell, you would expect their share prices to remain in this fixed ratio.
Over long periods, however, they have not. In fact, prolonged periods of mispricing can be found for several similar twin-share structures, such as Unilever (Exhibit 1). This phenomenon occurs because large groups of investors prefer (and are prepared to pay a premium for) one of the twin shares. Rational investors typically do not take positions to exploit the opportunity for arbitrage.
Thus in the case of Royal Dutch/Shell, a price differential of as much as 30 percent has persisted at times. Why? The opportunity to arbitrage dual-listed stocks is actually quite unpredictable and potentially costly. Because of noise-trader risk, even a large gap between share prices is no guarantee that those prices will converge in the near term.
Does this indict the market for mispricing? We don't think so. In recent years, the price differences for Royal Dutch/Shell and other twin-share stocks have all become smaller. Furthermore, some of these share structures (and price differences) disappeared because the corporations formally merged, a development that underlines the significance of noise-trader risk: as soon as a formal date was set for definitive price convergence, arbitrageurs stepped in to correct any discrepancy. This pattern provides additional evidence that mispricing occurs only under special circumstances—and is by no means a common or long-lasting phenomenon.
Markets and fundamentals: The bubble of the 1990s
Do markets reflect economic fundamentals? We believe so. Long-term returns on capital and growth have been remarkably consistent for the past 35 years, in spite of some deep recessions and periods of very strong economic growth. The median return on equity for all US companies has been a very stable 12 to 15 percent, and long-term GDP growth for the US economy in real terms has been about 3 percent a year since 1945.5 We also estimate that the inflation-adjusted cost of equity since 1965 has been fairly stable, at about 7 percent.6
We used this information to estimate the intrinsic P/E ratios for the US and UK stock markets and then compared them with the actual values.7 This analysis has led us to three important conclusions. The first is that US and UK stock markets, by and large, have been fairly priced, hovering near their intrinsic P/E ratios. This figure was typically around 15, with the exception of the high-inflation years of the late 1970s and early 1980s, when it was closer to 10 (Exhibit 2).
Second, the late 1970s and late 1990s produced significant deviations from intrinsic valuations. In the late 1970s, when investors were obsessed with high short-term inflation rates, the market was probably undervalued; long-term real GDP growth and returns on equity indicate that it shouldn't have bottomed out at P/E levels of around 7. The other well-known deviation occurred in the late 1990s, when the market reached a P/E ratio of around 30—a level that couldn't be justified by 3 percent long-term real GDP growth or by 13 percent returns on book equity.
Third, when such deviations occurred, the stock market returned to its intrinsic-valuation level within about three years. Thus, although valuations have been wrong from time to time—even for the stock market as a whole—eventually they have fallen back in line with economic fundamentals.
Focus on intrinsic value
What are the implications for corporate managers? Paradoxically, we believe that such market deviations make it even more important for the executives of a company to understand the intrinsic value of its shares. This knowledge allows it to exploit any deviations, if and when they occur, to time the implementation of strategic decisions more successfully. Here are some examples of how corporate managers can take advantage of market deviations.
- Issuing additional share capital when the stock market attaches too high a value to the company's shares relative to their intrinsic value
- Repurchasing shares when the market under-prices them relative to their intrinsic value
- Paying for acquisitions with shares instead of cash when the market overprices them relative to their intrinsic value
- Divesting particular businesses at times when trading and transaction multiples are higher than can be justified by underlying fundamentals
Bear two things in mind. First, we don't recommend that companies base decisions to issue or repurchase their shares, to divest or acquire businesses, or to settle transactions with cash or shares solely on an assumed difference between the market and intrinsic value of their shares. Instead, these decisions must be grounded in a strong business strategy driven by the goal of creating shareholder value. Market deviations are more relevant as tactical considerations when companies time and execute such decisions—for example, when to issue additional capital or how to pay for a particular transaction.
Second, managers should be wary of analyses claiming to highlight market deviations. Most of the alleged cases that we have come across in our client experience proved to be insignificant or even nonexistent, so the evidence should be compelling. Furthermore, the deviations should be significant in both size and duration, given the capital and time needed to take advantage of the types of opportunities listed previously.
Provided that a company's share price eventually returns to its intrinsic value in the long run, managers would benefit from using a discounted-cash-flow approach for strategic decisions. What should matter is the long-term behavior of the share price of a company, not whether it is undervalued by 5 or 10 percent at any given time. For strategic business decisions, the evidence strongly suggests that the market reflects intrinsic value.
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