**Section V FINANCIAL MANAGEMENT

****PART ONE. CORPORATE GOVERNANCE AND FINANCIAL ENGINEERING

In this part, we will examine the issues an investment banker deals with on a daily basis when assisting a company in its strategic decisions, which include:

organising a group;
launching an IPO (initial public offering);
selling assets, a subsidiary or the company;
merging or demerging;
restructuring and more.

We do hope that our readers will not spend whole nights on these topics, unlike investment bankers!

This section also sets out some ideas on the financing of start-ups. This might not be what investment bankers like doing most, unless they have to reinvent themselves as an entrepreneur, investor, or business angel!

As you will soon realise, financial engineering raises and solves many questions of corporate governance.

Chapter 40. SETTING UP A COMPANY AND FINANCING START-UPS

A really big adventure!

All groups were once upon a time start-ups, and some were even set up in such improbable places as a maid’s room (NRJ), a garage (HP) or a university dormitory (Facebook). The most talented of entrepreneurs, the luckiest, the hardest working, with the ability to learn from failures and with vision, will succeed in creating a group that survives, but the vast majority will fail. Fortunately, this fact does not prevent new entrepreneurs, every year, from embarking on this adventure. We’ve written this chapter for them so that they can avoid making bad financial choices that could put their entrepreneurial adventure in danger. As for anyone else who reads it, we hope that we’ll have sown a tiny seed which perhaps one day will grow into something bigger.

Section 40.1 FINANCIAL PARTICULARITIES OF THE COMPANY BEING SET UP

In our view, there are five:

1/ THE EXTREME VOLATILITY OF CAPITAL EMPLOYED, WHICH MEANS VERY HIGH RISK

Many entrepreneurs¹ who launch businesses have an idea or a product or a service but do not yet have an economic model that would enable them to cover their costs and get a reasonable return on their capital invested. When Larry Page and Sergey Brin developed their algorithms that were to give rise to Google, their aim was to come up with a more efficient search engine than those already in existence. They were not sure that they would succeed and they had no idea of how they could make this tool pay. It was only some years later that the idea of associating advertising with searches was born, resulting in a particularly efficient economic model.

This fundamental uncertainty about the relevance of a concept and the ability to find a money-earning demand for it is not specific to the Internet sector. The same situation can be found in the fields of biotechnology, industrial innovation and new services, as well as in commerce.

This is the reason why only 34% of companies created in the US survive 10 years after their inception.

*Source*: Business Employment Dynamics Report, Bureau of Labor, 2021

Far from being linear, the development of a start-up² goes through successive stages, which are all possible occasions for failure and/or a change in direction. An entrepreneur has an idea. Will they be able to raise the funds necessary for creating the prototype? If so, will it be possible to create functions that will give the product a competitive advantage? If so, will the entrepreneur find customers prepared to acquire the product at a price that more than covers costs? If so, will it be possible to shift to a mass-production phase without losing the quality of the prototype? If so, etc.

A “no” does not necessarily mean the end of the story, but perhaps a departure in a new direction after specific corrections have been made, or possibly having to go back to the drawing board. So new entrepreneurs have to be psychologically strong and have solid finances!

2/ THE CRUCIAL ROLE OF THE FOUNDER

An enterprise is often set up by one person (Marcel Dassault, Elon Musk, Richard Branson) or a small group of individuals who personally bear a very high level of risk, giving up a situation in which they are well established or renouncing the possibility of such a situation, for what for many of them will in the end turn out to be nothing more than a pipe dream. But they bring a project, a vision and a charisma that is indispensable for facing the unknown, adversity and challenges, and indispensable for convincing others (employees, investors) to follow them. Without the founder, the company would simply not exist.

From a financial point of view, a person starting up a company is the polar opposite of the ideal investor described by the CAPM in Chapter 19. The entrepreneur focuses on a single asset and takes all of the risks. The concept of diversification means nothing to them – it is all or nothing. They have a tiny chance of taking home the big prize and a huge risk of losing everything. But the entrepreneur does not reason in terms of probability like the financial manager does. Their aim is not financial (personal enrichment), but rather, and above all, humanistic (to create). They live in a completely different world.

The entrepreneur generally feels very passionate about their company – it is their creation – which is a far cry from the cold detachment of the financial manager for whom everything is just a question of risk and return. As we will see, this character trait of the entrepreneur is not without danger when their desire to control pushes them to take on too much debt or to put the brakes on the company’s growth.

3/ THE NEED FOR EXTERNAL FINANCING

Very few start-ups immediately generate positive cash flow. Most often, they initially make losses and some have to wait several years before they are able to record their first euro of sales. And when they do start recording positive earnings, investments (in fixed assets and working capital) are rarely fully covered by cash flows.

Since their free cash flow is negative, it is imperative that they find external financing, as generally the entrepreneur does not have sufficient assets to finance their adventure on their own.

4/ A MORE ACTIVE ROLE FOR INVESTORS

Investors hope that they have invested in the next unicorn (valuation greater than $1bn), centaur (valuation greater than $100m), or at the very least pony (valuation greater than $10m), while remaining aware that out of 10 investments that they make, seven to eight will yield nothing, one or two will earn a reasonable return and the tenth could earn 10 or 100 times the investment, saving all of the rest.

According to Cambridge Associates, the post-fee IRR of US venture capital funds is between 10 to 15% per year. Funds created in 2009 yield 20% in the upper quartile and only 5% in the lower quartile. The standard deviation is 12%.

Given that they are taking very high risks, they will monitor their investments very closely, providing the entrepreneur with advice and contacts to help steer the company in the right direction. The entrepreneur is very much in favour of a high level of involvement by investors as they bring what the entrepreneur lacks – experience, contacts, distance, advice on taking difficult decisions and … capital. The loneliness of the entrepreneur is not a myth.

Since the company will raise funds several times before it succeeds in generating positive cash flows, investors have every interest in ensuring that the company follows its road map so as to be able to form an opinion before it takes any decision to reinvest. Their close involvement alongside the manager is thus not disinterested. It is made a lot easier by the fact that, generally, there are not very many of them.

5/ A HIGHLY SPECULATIVE VALUATION WHICH IS THUS VOLATILE

Unsurprisingly, the extreme volatility of capital employed can be seen in the share price, even without the leverage effect, with very sharp share price variations. These variations are the sign of high risk that is specific to this stage of the company’s development. This is illustrated by the share price performances of Innate Pharma, a biotechnology start-up, and Sanofi, one of the world leaders in the pharmaceutical sector.

Innate Pharma was created in 1999 and has since then raised around €305m through ten capital increases. In June 2021, its market capitalisation stood at €234m, compared with €107bn for Sanofi.
*Source*: Euronext

The sudden changes in Innate Pharma’s share price indicate disappointing results or breakthroughs in its medical research programme.

Section 40.2 SOME BASIC PRINCIPLES FOR FINANCING A START-UP

1/ EQUITY CAPITAL, MORE EQUITY CAPITAL AND EVEN MORE EQUITY CAPITAL

When the economic model of the company is not clearly established and its exploitation does not require assets to be held which have a value that is independent of the activity (real estate, commercial lease), the only reasonable way for a company to finance itself is with equity capital.

Debt, because of the regular payment of interest and the repayment of capital, is quite unsuitable when cash flow is unpredictable and negative over an undetermined period. Entrepreneurs need time to test their products or services, correct errors, make adaptations in line with feedback from the first customers, drop 80% of what’s been done if necessary and head off in another direction. Entrepreneurs are completely wrapped up in their adventures and cannot allow themselves to be distracted or have their timeframes dictated by debt, ticking away like a time bomb.

We have seen too many talented entrepreneurs seeking to avoid being diluted in the capital of their companies by issuing too much debt too early. At this stage of the company’s development, the challenge is not to avoid dilution or to minimise it, but to demonstrate that the company is viable. Better to have a small stake in a company that has had the time it needs to prove that it is viable, than a large stake in a company that is heading for bankruptcy or whose liabilities have to be restructured, as in this case the entrepreneur dilution will be massive.

We cannot stress this point enough.

Once the economic model has been found and its viability has been more or less assured, the company can then take out debt.

It is only if the start-up uses assets whose value is independent of its activity – such as vehicles or equipment with a secondary market – that it can finance them partially using debt. This is the case in sectors like retail, transport and restaurants where business models are proven. The initial investment is often higher than in the Internet or personal services sectors. Debt then makes it possible to get sufficient financing together, which would be difficult using only equity. If this is the case, it should be as long-term as possible, ideally through a leasing agreement so as to avoid putting pressure on the entrepreneur.

This can also be the case for a company that needs to finance a large working capital for its growth. Thus, the use of factoring or discounting of receivables can enable a start-up to finance its growth.

2/ ONE OR SEVERAL ROUNDS OF FINANCING?

Between 1999 and 2020, Innate Pharma, the biotechnology start-up mentioned above, raised €305m in equity from venture capital funds or the public (it has been listed since 2006) in ten capital increases. One every two years. Wouldn’t it have been simpler to carry out a single capital increase of €305m in 1999, thus giving the company peace of mind with regard to its financing?

No. This would not have been in the interests of either the investors or the entrepreneur.

The former because they are reluctant to give the entrepreneur a blank cheque and will only give the financial resources necessary for getting to the next step of the entrepreneurial adventure: development of a prototype, opening and operation for a few months of the first store, reaching 100,000 members for a social network, etc. If the step is successfully reached, a new round of financing will be organised with the same investors and/or new ones, giving the company the financial resources necessary for reaching the next step. Here again, investors will most often only consider committing to a new round of financing if this new step is reached.

If the next step is not reached, investors will step in and decide whether any corrective measures introduced by the entrepreneur look like they are sufficiently solid to warrant continuing the adventure in this new direction and participating in a new (last?) round of financing. If not, the adventure will probably stop there.

This system using several rounds of financing enables investors to control the entrepreneur, to resolve potential conflicts of interest and to allocate their funds to the most promising projects. The interest for entrepreneurs, after an initial failure, is to persevere, come what may, as long as the funds that are being used are not being provided by them. The fear for investors would be that entrepreneurs get themselves into more and more difficulties, wasting funds that could be better used on other projects run by other teams. Here we can see the mechanisms of agency theory, discussed in Chapter 26.

For the entrepreneur, massive fundraising for forecasted financing requirements over several years of activities is not a panacea either. As the company has not yet proved anything – or very little – the issue price of shares is likely to be very low and the entrepreneur will be significantly diluted. On the other hand, in a succession of financing rounds, since each one marks the success of a step, the entrepreneur and the investors in the previous rounds will be in a good position to negotiate a higher share price at each round, thus limiting the dilution of the shareholders and also the entrepreneur.

3/ GOODWILL AT THE START OR AT THE EXIT?

Goodwill is the difference between the value of equity and the amount of equity invested. Its conceptual basis is the ability of the firm to generate, over a certain period, returns that are higher than those required by investors, given the risk (see Chapter 31).

The entrepreneur often considers that they are contributing the idea, the ability to implement the idea, and funds (although not a lot). Investors, for their part, only contribute funds. Accordingly, it will only seem logical to the entrepreneur to receive better treatment than the investors when shares and voting rights are being allocated, enabling them to retain a majority of voting rights in the project. This is why often, during the first round of financing, there is a higher issue price for shares for investors than for the founders. The difference is often considerable, especially if there is a lot of buzz around this new company. We’ve seen investors pay 100 times more for their shares than the entrepreneurs, which is a lot for a company that has yet to prove itself!

This practice is not without danger. As soon as the emerging company, after a few quarters of activity, is unable to stick to its roadmap and fails to meet its first targets, the question of a second round of financing is raised very quickly, while the funds raised in the first round are in the process of being totally depleted.

The relationship between the entrepreneur and the investors could deteriorate rapidly. The investors have made a capital loss because of the entrepreneur who has not delivered what was promised in the business plan, while the entrepreneur has made a capital gain thanks to the goodwill paid by the investors, who discover that there was no real foundation for this goodwill. Although all of the shareholders will have to get together to study how to get things back on track, and to correct or call into question all or part of the strategy implemented until now, there is the risk that any such meeting will be marred by a poisonous atmosphere. This can result in a deadlock at a time when it is vital that things keep moving.

The initial investors, unhappy with the situation, will then find it very difficult to agree to participate in a second round of financing, even though the subscription of new shares will enable them to lower the average cost price of their shares. They often prefer to accept their losses and dilution and move on to other opportunities, rather than go back to their investment committees to explain that they were wrong the previous time about the relevance of the concept and the price paid, but that this time, they’re right, even though the entrepreneur has just acknowledged a first failure. We are now no longer in the realm of pure rationality but have moved into the realm of behavioural finance! (See Section 15.6.)

Since our entrepreneur probably doesn’t have the resources to finance the new direction of the company, new investors will have to be found. The task of convincing them will be particularly arduous, as the signal sent by the failure of the initial investors to participate in this new round of financing is extremely negative. There is a high probability of this search for financing ending in failure. If the search for funds is fruitful, the shares in the second round of financing will be issued at a lower price than the initial round and the entrepreneur will then be massively diluted.

This is the lesser of two evils, because if the search for new investors yields no results, the entrepreneur will be forced to sell the company in very bad conditions, or to liquidate it, which is what happens most frequently.

We could consider, in order to avoid such situations, not asking investors to pay goodwill at the start during the first rounds of financing, but getting them to pay it when they exit, on the basis of the results achieved. Concretely, the shares would be issued when the company is set up, at the same price for all shareholders. Entrepreneurs will get investors to give them call options on a part of their new shareholding at a symbolic exercise price, or stock options, or warrants which will enhance the value of their shares in the future.

But there will be conditions to this enhancement – a given level of investor returns (IRR achieved in the event of sale or a new round of financing). Goodwill will then be paid by investors in the form of dilution of their rate of return, only if it is effectively delivered.

In the very likely event of something going wrong along the way, the situation can be looked at coolly and calmly by the initial shareholders who, since they have all paid the same price for their shares, will have the same interests at heart.

However, we won’t hide the fact that this will be difficult to accept for a passionate entrepreneur, who sees himself as a new Louis Vuitton or Jack Ma (Alibaba) and who hasn’t necessarily given the subject much thought.

More fundamentally, it raises the issue of the motivation and the incentive of the entrepreneur whose role in “their” company risks being symbolic, while the accretive instruments are not exercised, which will only happen in a few years. The risk is that they may consider themselves more as an employee than as an entrepreneur, and that would mean certain death for the emerging company! An entrepreneur should never behave like an employee. They should always be thinking about their project, night and day, like a soul possessed! Yes, we’re still in the realm of behavioural finance!

The whole question can be summed up as follows: “Goodwill, yes, but not too much”, so as to retain potential for enhancement of the share, capital increase after capital increase, and to avoid deadlocks or the implementation of ratchet clauses with disastrous effects for the entrepreneur. In the end, an overly optimistic business plan is not in the interests of entrepreneurs, who could find themselves sitting on a hand grenade from which they themselves have pulled the pin!

It should be noted that the creation of shares with multiple voting rights for founders makes it possible to raise large sums of money by circumventing this problem of dilution of power, whilst distinguishing it from goodwill.

Section 40.3 INVESTORS IN START-UPS

1/ INVESTORS IN EQUITY CAPITAL

The first among them is the entrepreneur, with their life savings, sometimes topped up by a bank loan that is secured by their home. They can spend the first months of the adventure with an incubator which will provide them with premises and services remunerated by a few percentage points of capital. The idea then becomes a project.

Friends and family are often among the initial investors, probably less motivated by the idea of making money, but more by loyalty! This type of investment is referred to as love money, which usually raises a few tens of thousands of euros.

Crowdfunding can be used by the entrepreneur to raise funds through specialised Internet platforms from a very large number of private investors, the most motivated of whom will invest a few hundred or a few thousand euros each. This will enable the entrepreneur to test the concept on a large scale. However, they will be lucky to raise a few hundred thousand euros in this way and struggle to raise more.

Business angels are often former company managers and shareholders. They invest a few tens or hundreds of thousands of euros per project, often called “seed money”. They also provide advice to the entrepreneur and give them access to their networks.

Venture capital funds can provide the entrepreneur with larger amounts of financing, from €0.5m to several tens of millions of euros (sometimes hundreds of millions), if the project has very high development potential.

Some industrial groups have created internal investment funds (or joint funds for several groups in the same industry sector) with the dual aim of financing innovation and keeping a strategic watch on developments in their sector, such as Novartis, Intel, Pfizer, Orange, GE or Danone. In such cases, we refer to corporate venture.

The first round of financing from financial or industrial venture capital funds is called Series A, the second round is called Series B, the third round is called Series C, and so on.

Raising funds on the stock market by listing a company is a real possibility for companies, especially in the high-tech, Internet, biotech and medtech sectors.

Each type of investor plays a role at the different stages of the development of the young company:

Most often investors subscribe to shares, sometimes preferred shares, given the different rights that may be granted to them, as we shall see. While waiting for a financing round that is overdue, they may be led to subscribe to a bridge financing, often taking the form of bonds redeemable in shares based on a price that will be that of the next expected financing round, minus a more or less significant discount (15 to 30%) to encourage subscription when the value of the company is unclear. Paradoxically, these bonds are often called convertible bonds, which is an abuse of language since they cannot be redeemed in cash. Alternatively, warrants are sometimes issued for the same amount, giving the right to subscribe to the nominal amount of a variable number of shares at a discount when the financing round is completed.

2/ INVESTORS IN DEBT

There are practically no investors in debt prepared to finance start-ups and, as we saw in Section 40.2, it is not in the interest of the entrepreneur to take out debt until they have demonstrated the validity of their business model.

It is only if the start-up uses or generates assets that have a value that is independent of its operations (vehicles, real estate, business) that it can make use of leasing (see Chapter 21). If it generates sales, it can finance its working capital using discounting or factoring (Chapter 21). Companies with significant R&D expenses may factor their research tax credits. An unallocated bank loan (i.e. financing the company in general rather than specific assets) will only be found if the entrepreneur provides guarantees with a value that is independent of the project. In some countries, state bodies can guarantee loans granted by commercial banks to start-ups.

3/ OTHER SOURCES OF FINANCING

These are more marginal and are often a form of supplementary financing, like subsidies, repayable advances in the event of success, honour loans granted by associations or foundations, competitions for start-ups organised by local authorities or foundations, grants by local authorities, research tax credits, etc.

Section 40.4 THE ORGANISATION OF RELATIONSHIPS BETWEEN THE ENTREPRENEUR AND THE FINANCIAL INVESTORS

The relationship over time between the investors and the entrepreneur(s) is set out in the shareholders’ agreement signed at the time when the funds are handed over. See Chapter 41 for standard clauses of a shareholders’ agreement which are not used in the case of a start-up.

A shareholders’ agreement is the result of a negotiation and sets out the balance between demand for and supply of venture capital at the time that it is signed. It also reflects the power of attraction of a given start-up project or of a given entrepreneur.

1/ CLAUSES BINDING THE FOUNDER-MANAGERS

Any investor in a start-up will tell you that the main motivation behind the investment is the quality of the founding team. Accordingly, it is not surprising that investors set, as a condition for investing, the condition that the managers commit themselves fully and over the long term to this adventure. We also find clauses preventing the founders from holding other positions in other companies or from selling their shares during a certain period (lock-up); clauses that make provision for the loss of their shares and other incentives if they leave the company before a certain period (vesting), along with agreements not to compete; and clauses that give the company the intellectual property rights created by the founders.

Over and above the shareholders’ agreement, we also see mechanisms that create incentives for the founding managers, in such a way that even if they are heavily diluted by several capital increases, they remain highly motivated – stock options, call options, warrants, multiple voting rights, etc.

2/ CLAUSES THAT ARE THE CONSEQUENCE OF GOODWILL BEING PAID AT THE START

If goodwill was paid at the start, the investors will want to prevent the founders from selling the young company too soon, on the basis of a valuation that enables them to recover only a part of their investment while the founders could make a comfortable capital gain (see Exercise 2 for an illustration). In order to avoid this situation, provision can be made that the income from the sale of the company goes first to the investors, in the amount of their investment (sometimes capitalised using a minimum rate of return), and is then shared out between investors and founders whose interests are then aligned.

This provision, known as the preferential liquidity clause, is also used in the event of a resale or liquidation several years after the first round, to protect the most recent investors who have normally paid the highest price. A sale of the company at a price lower than the last round of financing might be convenient for the previous shareholders, including the founders, who have lower cost prices, but would put the most recent investors at a loss. To avoid this situation, and because they agree to pay a higher price thereby reducing the dilution of the current shareholders, the most recent investors will often ask for a preferential liquidity clause. However, in order to allow founders and investors from previous rounds of financing to be able to retrieve their funds even in the event of a low resale price, a partial equal distribution is most often included at the beginning along the following lines:

20% of the price is usually shared pro rata among all shareholders, including the founders (“carve out”).
The remainder of the sale’s proceeds are allocated first to investors from the most recent fundraising round, until repayment of their investment, with returns possibly capitalised, and after deducting any amounts received in the first allocation.
Finally, the remainder (if any) is distributed to all the other shareholders (including the founders) in due proportion to their holdings.

This clause only comes into play if the sale (or liquidation) price is insufficient to allow the investors of the last round to recover their investment (sometimes with capitalisation), via a normal distribution of the proceeds of the sale in proportion to their holdings.

The preferential liquidity clause is undoubtedly a protection for investors against valuation inflation, at least until the next round of financing. It is also undoubtedly a factor in the valuation inflation of successful start-ups, as investors are less concerned about the level of valuation since they are protected from overvaluation. Current shareholders and founders accept it because it allows for higher, more flattering and less dilutive valuations, and because they hope that the company’s development will lead to a further increase in its value and that this clause will therefore not come into play.

The preferential liquidity clause tends to eliminate the ratchet clause, whose implementation dilutes management too massively. This clause allows investors in the first rounds to receive free shares in subsequent rounds of financing carried out at prices lower than their entry price (an illustration of this is provided in Exercise 4).

3/ CLAUSES RELATED TO THE LIQUIDITY OF THE INVESTMENT

There are different clauses that seek to ensure that investors are able to sell their stakes in such a way as to reap the benefits of their investment. This is, moreover, one of the stated aims of an investment fund, which itself is often required, at the latest when it is wound up, to distribute the income from its investments.

Accordingly, investors can get the founders to agree to the sale of all of their shares in the company after a certain period, if the majority shareholders have not provided them with sufficient liquidity for their investment. A sale of the majority of the shares will enable them to get a better price than if they had only offered a (generally) minority stake for sale (see Section 31.6). Having said that, implementing this clause is very difficult because if the entrepreneur doesn’t want to sell despite having pledged to, they will not be very convincing when trying to get a buyer to make an offer.

Very often, the investors want to be able to sell all or part of their shares before the founders sell theirs, in the case of an IPO or a planned sale by the founders. If they are not given this priority, they may ask for the option to sell the same percentage of their stakes as the founders in the event of a sale (tag-along clause) or if there is a change in control over the company. A drag-along clause is nearly always introduced to provide a group of majority shareholders representing a given percentage of the capital with the option of forcing the other shareholders to sell their shares on the same terms as those offered to them by a buyer. Such a buyer may condition its offer on obtaining all of the capital and in this case, the majority shareholders will not want to have to cope with being blackmailed by a minority shareholder.

4/ CLAUSES RELATED TO CONTROL BY INVESTORS OVER COMPANY DECISIONS

Demonstrating that they are keen to be more closely associated with the running of the young company and the risks that they are prepared to take, investors often require a level of information that is accurate, wide, frequent and adapted to the situation and the activity of the company.

Additionally, provision can be made that certain important decisions (such as modification of the articles of association (by-laws), hiring of key staff, modification of the company’s strategy, investments, acquisitions or disposals, etc.) can only be taken by a qualified majority, giving investors a de facto veto right.

Section 40.5 THE FINANCIAL MANAGEMENT OF A START-UP

There are two principles that underlie the financial management of a start-up: keep a very close watch on the cash position and plan the next round of fundraising very well.

Cash on the assets side of the balance sheet, when there is no monthly cash income, measures the number of months of survival of the company before it is obliged to carry out another round of fundraising. This is called the burn rate. How much time does the company have to reach its next step or to shift from plan A, which has failed, to plan B, which has to be invented and implemented?

Unless the existing shareholders have the financial resources necessary to cover the financing of the next round and agree to do so, the manager of the start-up would be well advised to launch the process of looking for new investors six to nine months at the latest before their cash runs out. Since a round of financing most often covers requirements for the next 12 to 24 months, it comes around quickly. The search for new investors and the conviction needed are very time-consuming, especially for a manager who doesn’t have a financial director to help them.

Launching a new round of financing early is often too early: the company has not yet shown that it has reached a new step in its development since the last round of fundraising. Waiting until later means taking the risk of running out of cash during the final phase of negotiations with investors, at the risk of having to admit defeat.

Section 40.6 THE PARTICULARITIES OF VALUING YOUNG COMPANIES

It is obviously very difficult to value a company that has not yet proved the relevance of its business model, which has a high probability of disappearing in the short term, and for which projections are so uncertain that sometimes one might ask whether they’re worth the paper they’re printed on.

One might thus think that the real option method seen in Chapter 30 is particularly well suited to valuing the young company because the way it works in stages is very similar to the successive stages of development that the young company must go through. In practice, this is not the case at all and it is practically never used in this field. Drawing up a business plan that makes sense and that is also optimistic is complicated, but asking an entrepreneur to draft different versions, including one which leads to bankruptcy, is counter-productive. Do we really want to demoralise and discourage the entrepreneur at a time when they need to be boosted in order to meet the challenges they are facing? Of course not!

Valuation by discounting free cash flows (see Chapter 31) is not very widespread, even though the basic raw material for this method, the business plan, is often available. In order to avoid using this method, investors raise the pretext of the extreme volatility of business plans for start-ups, given that there is very little chance of new companies sticking to them and the fact that they reflect the best of possible outcomes, rather than the most likely. Conceptually, though, there is nothing that prevents this method from being used by looking at the probabilities of several projections.

As for the multiples method (see Chapter 31), given that its use is conditional on the existence of comparable listed companies, it is de facto unusable for valuing very young companies, which are all different from each other and very rarely listed on the stock exchange. Additionally, the fact that most of them have negative earnings would render the operation impossible.

Our reader may be surprised by the very crude nature of the valuation of start-ups, which is more a matter of convention than of calculation. At least for its first rounds of financing, the value of a start-up usually results from a multiple of the amount of funds sought to reach the next level in 12 to 24 months, and/or what amounts to the same thing, the percentage of dilution that the founders agree to.

Practice has shown that a pre-money valuation (i.e. before the capital increase) of 1 to 1.5 times the amount sought is the sign of an unfavourable period for entrepreneurs corresponding to a relative scarcity of capital ready to invest at this stage of company development. In order to finance the next 12 to 24 months, entrepreneurs must be satisfied with 50% to 60% of the company’s capital. They will therefore very quickly lose control, as it is unlikely that there will be just one fund raising. Beyond four times, and the opposite happens and we’re probably in a bubble period. The entrepreneur then succeeds in selling only 20% at most of the share capital during this round of financing.

In normal times we are between 2 and 3, and the founders are diluted from 25% to 33% of the capital.

	Funds raised (m€)
Pre-money value (m€)	0.5	1	1.5	2	2.5	3
1	2
	33%
1.5	3	1.5
	25%	40%
2	4	2	1.3
	20%	33%	43%
2.5	5	2.5	1.7	1.3
	17%	29%	38%	44%
3		3	2	1.5	1.2
		25%	33%	40%	45%
4		4	2.7	2.0	1.6	1.3
		20%	27%	33%	38%	43%
5		5	3.3	2.5	2	1.7
		17%	23%	29%	33%	38%
7.5			5.0	3.8	3.0	2.5
			17%	21%	25%	29%
10				5	4	3.3
				17%	20%	23%

The table above shows in each box the multiplier coefficient of the fundraising round, and the level of dilution suffered by the founders (which also corresponds to the ownership percentage of investors). We have not filled in the boxes that seem to us to be outliers, where the founders lose control from the first round of investment, or where the valuation bubble stretches to the moon!

We remind our horrified reader that the risk to the investor at this very early stage is not overvaluation, but bankruptcy.

For start-ups that have survived and progressed to an advanced stage of development, venture capital professionals have developed a method that is rather pragmatic and efficient, if a bit simplistic, which they use for valuing young companies, known as the venture capital method. As you will see, it is a hybrid of the multiples and discounted free cash flow methods.

We start by estimating the probable value of the company’s equity in four to seven years, when it will have reached a level of maturity to allow it either to be listed or to be sold to a third party, most frequently an industrial player. This timeframe corresponds to the exit of the venture capitalist and to the fact that the company is no longer a start-up (hopefully) but a developing company. This future value is calculated by applying the P/E ratio today, observed for companies in this stage of development, to net earnings forecast in the business plan at this period (for more on the P/E ratio, see Chapter 22); for example, 15 times net earnings of €8m, i.e. €120m.

Secondly, and in order to determine the present value, this future value of equity is discounted to a value today, using a high discount rate since the company is at an early stage of its development.³ The rates most frequently observed are as follows:

Phase	Discount rate	Equivalent to multiply the investment by	Over … years
Start-up (Seed)	60%	11.2	7
First round	50%	7.6	5
Second round	40%	3.8	4
Third round	30%	2.2	3
Before IPO	20%	1.4	2

So, for a pure start-up, with a business plan period of seven years, the value today of the equity is €120m / (1 + 60%)⁷ = €4.5m. This result is post-money as it assumes that the company has found the financing necessary for developing its activities. If today it needs €1.5m, the value of its equity is €4.5 – €1.5 = €3m. The investor who contributes these funds gets 33% (1.5 / 4.5) of the company’s equity. If the company’s capital is made up of a million shares, the investor will have to be issued with 500,000 new shares at a unit price of €3.

The reader will not be surprised at how high these rates are and will have difficulty reconciling them with those provided by the CAPM in Chapter 19 or with the average IRR obtained by venture capital funds (between 15% and 30%), and rightly so, as they are of another order.

If they appear to be high, it is because they integrate the risk of the start-up going bankrupt. They are applied to a level of earnings that does not correspond to the average of different scenarios, but to a business plan that reflects, by construction, the success of the company. However, over a five-year period, at least 40% of companies will have disappeared and out of those that are left, a large number will not have lived up to expectations. Accordingly, the high discount rate takes into consideration the risk that the projections will turn out to have been too optimistic, which is most often the case.

The rate of return required by the investor also takes into account the illiquidity of the investment (see Section 19.4) and also remunerates the non-financial contributions by the investor (operational or managerial advice, network access, etc.).

Our rather simplistic model assumes that a single round of fundraising was necessary before reaching a stage where the company could be sold or listed. Let’s assume that there is a second round of fundraising of €5m in year three. At the time of this fundraising, the post-money valuation of the company made by the second investor, who would require a rate of return of 40%, would be: €120m / (1 + 40%) = €31.2m, which results in a percentage for this second investor of 5 / 31.2 = 16%.

The terminal value remains €120m since it assumes, if it is to be achieved, a second round of fundraising. Our first investor will be diluted by this second capital increase. Accordingly, they thus need to hold a larger part of the capital after their contribution of funds, to set off the dilutive effect of the second capital increase and to obtain their rate of return of 60%. This stake is calculated as follows: 33% / (1 – 16%) = 39.3%. Instead of 500,000 new shares issued in the first round of financing, which would give 33% of the share capital to our first investor, 647,000 new shares⁴ should be issued. Since the latter is still bringing €1.5m to the table, this means that the shares are issued at a unit price of €1.5m / 0.647m = €2.32, and no longer €3, when there is no subsequent dilution.

If, in seven years’ time, the value of the company’s equity capital is indeed €120m, our first investor, who took a 39.3% stake in the capital when the company was started up, which was then diluted three years later to 33%, can sell their stake for €40m. For an investment of €1.5m made seven years earlier, they have, in fact, obtained their rate of return of 60% per year. As for the second investor who invested €5m in the third year and who got 16% of the capital, the sale of these shares in year seven for 16% × €120m = €19.2m gives them their required rate of return of 40% per year.

The venture capital method is also used backwards. A purchase price of shares is offered to you and you want to find the implicit rate of return of this investment if the business plan is met and given your estimation of the final value of the company. You then compare it with the minimum rate of return that you estimate is justified, given the risk of the investment, in order to take your investment decision. Here we find the IRR of Chapter 17.

Section 40.7 EXAMPLE INSPIRED BY A REAL CASE: EXAMPLE.COM

The simplified joint stock company Example SAS was set up eight years ago by two friends with the aim of developing a new-generation social network around the website Example.com, which offers a very powerful yet simple tool based on complex algorithms that had required years of development.

The first round of financing brought together friends and business angels, who contributed €0.6m. Dilution of capital was only 17% thanks to a high level of goodwill, since the managers only contributed €0.1m. This situation is explained by the following: in addition to the quality of the entrepreneurs, algorithms had been pre-developed, giving a clear idea of the development potential, a worldwide market was being targeted and ambitions were high, and finally the entrepreneurs had declined to be paid a salary during the first two years.

On the basis of the launch of the alpha version of the site Example.com one year later, which demonstrated that the algorithms were correct, Example SAS carried out a second capital increase of €1m, which was followed by the original investors, at a share price that was 50% higher. Because Example SAS was keen to speed up its development, which would involve increasing its losses and its working capital, it made the choice to carry out this capital increase relatively quickly, even though its cash position would have enabled it to defer it for a year. Sometimes it is better to stand fast than to run and to avoid financial stress that could have operational consequences. For example, it is easier to recruit a good IT developer when your cash can cover 24 months of cash burn rather than three!

A third capital increase was carried out one year later, which raised €1.9m. Five new investors (mainly business angels) participated in this capital increase alongside some of the original investors. The launch of the beta version of the site and the development of the community, which was growing at 30% per month, played a determining role in the success of this operation.

Example preferred to wait until the last moment to carry out its fourth capital increase, which at €6m was a large one, nearly double the equity raised previously. When it was finalised, Example SAS only had three months of cash left! The iPad version had just been launched with success and the community had reached 460,000 members, which works out at a monthly growth rate of 18%. The share price could thus be maximised: +40% compared with the capital increase carried out 18 months previously, resulting in dilution of only 30%, but growth in book equity of 1250%. This should be the last capital increase before profits start rolling in.

The funds raised enabled Example to test two revenue models, premium and advertising, which had been partially successful but which failed to lead to equilibrium. Four years later, a final capital increase of €2m was subscribed, at a price per share that was 60% lower than that of the previous capital increase. The challenge for Example will be to break into two new markets that are seen as buoyant markets – the university and the media markets. This is a shift that will require a resizing of the company and a change in profile for a large portion of its workforce. Initial results are promising.

Today, there are 3 million Example users worldwide, with 50% in the USA, 25% in France, and the rest of the world accounting for the last quarter. The two founders, who had brought 1% of the funds raised, hold 35% of the shares and the investors, who brought 99% of the funds, hold 65% of the shares.

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

The start-up phase is the most risky phase in the economic life of a company, with financial aspects that are strongly influenced by the particularities of this phase: extreme volatility of capital employed as most often the economic model still has to be built, which results in a highly speculative and unstable value; need for external financing because cash flow is rarely positive before several years; crucial role of the founder, who is a virtual demigod, and whose behaviour is the antithesis of that put forward by the CAPM; investors who are more closely involved than they are in an investment in a listed company in order to be able to help the investor by giving advice and connecting them with their networks.

Faced with the very high risk of starting up a company, the virtually exclusive means of financing must be equity capital, because this is the only type of financing that will give the entrepreneur the time needed to validate the concept and find their economic model, which rarely happens on the first try. Most frequently, financing using equity capital is provided in several rounds of financing, on condition that the company passes a new stage of development. This allows the entrepreneur and the investors from the first rounds of financing to hope for dilution with the best price conditions. Goodwill is in general paid at the start by investors. The founders will therefore be less diluted but they will be taking a major risk of deadlock if the business plan is not met, which is the rule rather than the exception when it comes to start-ups.

Depending on the stage of development reached by the young company, its investors will be, other than the founders, their family members, business angels, venture capitalists or industrial players, and in the event of success, the stock exchange. Unless the company uses assets which have a value that is independent of its operating, debt has no place in the financing of start-ups.

Shareholders’ agreements of the young company mainly include clauses relating to the founders, to the consequence of any goodwill paid at the start, to the liquidity of the investment and to access to information.

In terms of financial management, the emphasis is placed on the amount of cash on the balance sheet, in order to be able to measure the number of months before a next round of financing, the timing of which is crucial – neither too soon nor too late.

Finally, in terms of valuation, because it is practically impossible to come up with reliable forecasts, the usual valuation methods are not used and a hybrid method made up of the multiples and the discounted cash flows method has been developed for valuing start-ups, or more simply a multiple of funds raised for early stage start-ups.

QUESTIONS

1/How should an internet-of-things start-up be financed? And a pizza chain?
2/What is an optimistic entrepreneur? What are the conclusions to be drawn?
3/What is the counterpart of goodwill paid at the outset for a start-up?
4/What are the advantages of the venture capital method for valuing a company that is in the process of starting up?
5/What are the drawbacks of the venture capital method for valuing a company that is in the process of starting up?
6/Why are discount rates required by investors in start-ups so high?
7/Why are discount rates required by investors in start-ups rarely reached?
8/Why do entrepreneurs accept very high rates of return required by investors?
9/What is a business plan that eventually corresponds to reality?
10/How many months can a company that only has €450,000 in cash left survive if its monthly consumption is €90,000? Is it time to launch the next round of financing?
More questions are waiting for you at www.vernimmen.com.

EXERCISES

1/An investor proposes to contribute €1m to a start-up and to obtain 20% of its capital. What is the pre-money and post-money valuation of this company?
2/A start-up is financed using €1m. The entrepreneur provides €0.2m and obtains 75% of the shares, and business angels provide the rest of the equity and hold 25% of the capital. Eight months later, the entrepreneur is in a position to sell the company for €2m. By how much has their investment multiplied? And the business angels? Redo your calculations, assuming that the shareholders’ agreement in this case states that proceeds from the sale must first be allocated to the business angels until repayment of their investment before being shared among all of the shareholders, pro rata to the number of their shares. State your views.
3/Using the data from the previous exercise, what is the amount of goodwill that is generated by the capital increase?
4/A company issues 1,000,000 shares at €1 to the founders, and 800,000 shares at €10 to investors. Eighteen months later, it carries out a second capital increase in favour of an investment fund, which invests €5m, ending up with 36% of the capital. What is the breakdown of capital before and after the second capital increase, according to whether a full ratchet clause applies or not? State your views.
5/A company issues 1,000,000 shares at €1 of which 200,000 are for the founders and 800,000 are for the investors. The investors grant the founders call options with an exercise price of €1 on a third of their stake, if the IRR obtained when they sell their shares is between 25% and 30%, on half of their stake if the IRR is between 30% and 35% and on two-thirds if it is higher than 35%. After five years, the investors have the opportunity to sell their shares for €3.7. What is the IRR before and after the founders exercise their options? And if the sale price were €3.73? State your views. How can this be remedied?

ANSWERS

Questions

1/Using equity capital given its risk. A bit of medium-term debt is possible as the company has assets with a value that is independent from its operation – equipment, commercial lease.
2/A pleonasm. Pessimists do not start up companies. The business plan does not represent the most likely outcome or the average outcome, but the best possible outcome. Accordingly, it is difficult to rely on it when valuing the company.
3/A higher level of financial risk for the entrepreneur who will have very little room for error, since they have promised such a lot. Preferential liquidity clauses in the shareholders’ agreement.
4/It is easy to understand and widely used. Based on the use of very high discount rates, it is well adapted to the congenital optimism of entrepreneurs and avoids discussion on the business plan, which risks leading nowhere.
5/It is simple and factors in the optimism of the business plan without criticising.
6/Because they are not used to value a company on the basis of an average or likely business plan but solely on the basis of a glowing version, which does not take into account the strong probability of failure. Which is the same as saying that they represent a strong probability of failure.
7/Because it is very rare for the business plan used to calculate the value of the company to correspond eventually to reality.
8/Because they know that their business plan has very little chance of being realised.
9/A miracle!
10/Five months. There is not a moment to lose and it might already be too late!

Exercises

Detailed Excel solutions to the exercises are available at www.vernimmen.com.

1/€1m = 20% of post-money equity; equity is thus €5m post-transaction. So, pre-money equity amounts to €5m − €1m = €4m.
2/The entrepreneur multiplies their investment by 7.5 (75% × 2 / 0.2) and the business angels by 0.6 (25% × 2 / 0.8), so the latter have lost out. After application of the shareholders’ agreement, the entrepreneur multiplies their investment by 4.5 (75% × (2 − 0.8) / 0.2) and the business angels by 1.4: (0.8 + 25% × (2 − 0.8)) / 0.8. The gain for the entrepreneur falls from €1.3m to €0.7m, which should dissuade them from selling too quickly.
3/€2.2m = 0.8m / 25% − 0.8m − 0.2m.
4/Situation at the outset: founders = 56%, investors = 44%.
Without full ratchet: founders = 37%, investors = 26%, fund = 37%.
With full ratchet: founders = 28%, investors = 44%, fund = 28%.
But since the fund is asking for 36% and not 28% in exchange for its contribution of €5m, the final breakdown is founders = 6%, investors = 58%, fund = 36%. The ratchet clause has resulted in the drastic dilution of the founders, whose motivation will have to be rekindled, one way or another.
5/29.9%; 22.9%; 30.1%; 18.6%. Although the company’s performance is marginally better, the return for the investor is, in the end, not as good (18.6% vs. 22.9%). Rather than making provision for intervals, it is better to have milestones (at 25% of IRR, exercise of 0% of options; at 30% one-third is exercised; at 35% half, etc.) and then make provision for linear interpolations between these points (at 26%, 6.66% of options are exercised, at 27%, 13.32%, etc.).

BIBLIOGRAPHY

For more on research on start-ups and venture capital:

M. Da Rin, T. Hellmann, M. Puri, A survey of venture capital research, TILEC Discussion Paper No. 2011-044, 2011.
M. Da Rin, U. Hege, G. Llobet, U. Walz, The law and finance of venture capital financing in Europe: Findings from the RICAFE research project, European Business Organization Law Review, 7(2), 525–547, June 2006.
P. Gompers, A. Kovner, J. Lerner, D. Scharfstein, Performance persistence in entrepreneurship, Journal of Financial Economics, 96(1), 18–32, April 2010.
D. Hsu, What do entrepreneurs pay for venture capital affiliation?, Journal of Finance, 59(4), 1805–1844, August 2004.
F. Kerins, J. Kiholm Smith, R. Smith, Opportunity cost of capital for venture capital investors and entrepreneurs, Journal of Financial and Quantitative Analysis, 39(2), 385–405, June 2004.
W. Kerr, J. Lerner, A. Schoar, The consequences of entrepreneurial finance: Evidence from angel financings, Review of Financial Studies, 27(1), 20–55, January 2014.
R. Rajan, Presidential address: The corporation in finance, Journal of Finance, 4(67), 1173–1217, August 2012.
A. Robb, D. Robinson, The capital structure decisions of new firms, Review of Financial Studies, 27(1), 153–179, 2014.

On the valuation of start-ups:

A. Damodaran, Valuing young, start-up and growth companies: Estimation issues and valuation challenges, Working Paper 2009, www.ssrn.com.
U. Hege, S. Michenaud, The valuation and financing of internet start-ups, in E. Brousseau and N. Curien (eds), Economics of the Internet, Cambridge University Press, 142–169, 2007.

On more general aspects:

S. Ante, Creative Capital: Georges Doriot and the Birth of Venture Capital, Harvard Business Press, 2008.
S. Bernstein, A. Korteweg, K. Laws, Attracting early-stage investors: evidence from a randomized field experiment, Journal of Finance, 72(2), 509–538, April 2017.
Lee S., P. Persson, Financing from family and friends, Review of Financial Studies, 29(9), 2341–2387, September 2016.
S. Kaplan, P. Strömberg, Financial contracting theory meets the real world: An empirical analysis of venture capital contracts, Review of Economic Studies, 70(2), 281–315, April 2003.
PitchBook, 2019 Annual European Venture Report, 2020.
M. Ramsinghani, The Business of Venture Capital: Insights from Leading Practitioners on the Art of Raising a Fund, Deal Structuring, Value Creation, and Exit Strategies, 2nd edn, Wiley, 2014.
A. Schwienbacher, Venture capital investment practices in Europe and the United States, Financial Markets Portfolio Management, 22(2), 195–217, July 2008.

www.investeurop.eu (the website of the European Venture Capital Association).

www.thegalionproject.com (for finding a standard contract for raising funds from investors).

NOTES

1 In this chapter we use the terms founder, creator or manager of a start-up as synonyms for entrepreneurs.
2 Synonym in this chapter for young company.
3 For more on discounting, see Chapter 16.
4 647,000 / (1,000,000 + 647,000) = 39.3%.

Chapter 41. SHAREHOLDERS

What a cast of characters!

Section 41.1 SHAREHOLDER STRUCTURE

Our objective in this section is to demonstrate the importance of a company’s shareholder structure. While the study of finance generally includes a clear description of why it is important to value a company and its equity, analysis of who owns its shares and how shareholders are organised is often neglected. Yet in practice this is where investment bankers often look first.

There are several reasons for looking closely at the shareholder base of a company. Firstly, the shareholders theoretically determine the company’s strategy, but we must understand who really has power in the company, the shareholders or the managers. You will undoubtedly recognise the mark of “agency theory”. This theory provides a theoretical explanation of shareholder–manager problems.

Secondly, we must know the objectives of the shareholders when they are also the managers. Wealth? Power? Fame? In some cases, the shareholder is also a customer or supplier of the company. In an agricultural cooperative, for example, the shareholders are upstream in the production process. The cooperative company becomes a tool serving the needs of the producers, rather than a profit centre in its own right. This is probably why many agricultural cooperatives are not very profitable.

Lastly, disagreement between shareholders can paralyse a company, particularly a family-owned company.

As a last word, do not forget, as seen in Chapter 26, that in the financial world everything has a price, or better, everything can create or destroy value.

1/ DEFINITION OF SHAREHOLDER STRUCTURE

The shareholder structure (or shareholder base) is the percentage ownership and the percentage of voting rights held by different shareholders. When a company issues shares with multiple voting rights or non-voting preference shares or represents a cascade of holding companies, these two concepts are separate and distinct. A shareholder with 33% of the shares with double voting rights will have more control over a company where the remaining shares are widely held than will a shareholder with 45% of the shares with single voting rights if two other shareholders hold 25% and 30%. A shareholder who holds 20% of a company’s shares directly and 40% of the shares of a company that holds the other 80% will have rights to 52% of the company’s earnings but will be in the minority for decision-taking. In the case of companies that issue equity-linked instruments (convertible bonds, warrants, stock options) attention must be paid to the number of shares currently outstanding versus the fully diluted number of potential shares.

Studying the shareholder structure depends very much on the company being listed or not. In unlisted companies, the equilibrium between the different shareholders depends heavily on shareholders’ agreements which are often in place, but rarely public and difficult to gain access to for the external analyst, impacting the relevancy of their analysis. For a listed company, shareholder attendance at previous general meetings should be analysed. If attendance has been low, a shareholder with a large minority stake could have de facto control, like Bolloré at Vivendi, in which it only has 29% of the voting rights.

Lastly, we should mention nominee (warehousing) agreements even though they are rarely used these days. Under a nominee agreement, the “real” shareholders sell their shares to a “nominee” and make a commitment to repurchase them at a specific price, usually in an effort to remain anonymous. A shareholder may enter into a nominee agreement for one of several reasons: transaction confidentiality, group restructuring or deconsolidation, etc. Conceptually, the nominee extends credit to the shareholder and bears counterparty and market risk. If the issuer runs into trouble during the life of the nominee agreement, the original shareholder will be loath to buy back the shares at a price that no longer reflects reality. As a result, nominee agreements are difficult to enforce. Moreover, they can be invalidated if they create an inequality among shareholders. We do not recommend the use of nominee agreements. The modern form for listed companies is the equity swap.¹

2/ LEGAL FRAMEWORK

Theoretically, in all jurisdictions, the ultimate decision-making power lies with the shareholders of a company. They exercise it through the assembly of a shareholders’ Annual General Meeting (AGM). Nevertheless, the types of decisions can differ from one country to another. Generally, shareholders decide on:

appointment of board members;
appointment of auditors;
approval of annual accounts;
distribution of dividends;
changes in articles of association (i.e. the constitution of a company);
mergers;
capital increases and share buy-backs;
dissolution (i.e. the end of the company).

In most countries – depending on the type of decision – there are two types of shareholder vote: ordinary and extraordinary.

At an Ordinary General Meeting (OGM) of shareholders, shareholders vote on matters requiring a simple majority of voting shares. These include decisions regarding the ordinary course of the company’s business, such as approving the financial statements, payment of dividends and appointment and removal of members of the board of directors.

At an Extraordinary General Meeting (EGM) of shareholders, shareholders vote on matters that require a change in the company’s articles of association: share issues, mergers, asset contributions, demergers, share buy-backs, etc. These decisions require a qualified majority. Depending on the country and on the legal form of the company, this qualified majority is generally two-thirds or three-quarters of outstanding voting rights.

The main levels of control of a company in various countries are as follows:

	Supermajority	Type of decision
Brazil	1/2	Changes in the objective of the company Merger, demerger Dissolution Changes in preferred share characteristics
China	2/3	Increase or reduction of the registered capital Merger, split-up Dissolution of the company Change of the company form
France	2/3	Changes in the articles of association Merger, demerger Capital increase and decrease Dissolution
Germany	3/4	Changes in the articles of association Reduction and increase of capital Major structural decisions Merger or transformation of the company
India	3/4	Merger
Italy	—	Defined in the articles of association
Netherlands	2/3	Restrictions in pre-emption rights Capital reduction
Russia	3/4	Changes in the articles of association Reorganisation of the company Liquidation Reduction and increase in capital Purchase of own shares Approval of a deal representing more than 50% of the company’s assets
Spain	—	Defined in the articles of association
Switzerland	2/3	Changes in purpose Issue of shares with increased voting powers Limitations of pre-emption rights Change of location Dissolution
UK	3/4	Altering the articles of association Disapplying members’ statutory pre-emption rights on issues of further shares for cash Capital decrease Approving the giving of financial assistance/purchase of own shares by a private company or, off market, by a public company Procuring the winding up of a company by the court Voluntarily winding up a company
USA	—	Defined on a state level and frequently in the articles of association

Shareholders holding less than the blocking minority (if this concept exists in the country) of a company that has another large shareholder with a majority, have a limited number of options open to them. They cannot change the company objectives or the way it is managed. At best, they can force compliance with disclosure rules, or call for an audit or an EGM. Their power is most often limited to being that of a naysayer. In other words, a small shareholder can be a thorn in management’s side, but no more. Nevertheless, the voice of the minority shareholder has become a lot louder and a number of them have formed associations to defend their interests. Shareholder activism has become a defence tool where the law had failed to provide one.

It should be noted that in some countries (Sweden, Norway, Portugal) minority shareholders can force the payment of a minimum dividend. In some countries, all shareholders, irrespective of the number of shares they hold, have the right to ask questions in writing at the General Meeting. The company must answer them publicly at the latest on the day of the meeting.

A shareholder who holds a blocking minority (one-quarter or one-third of the shares plus one share depending on the country and the legal form of the company) can veto any decision taken in an extraordinary shareholders’ meeting that would change the company’s articles of association, company objects or called-up share capital.

A blocking minority is in a particularly strong position when the company is in trouble, because it is then that the need for operational and financial restructuring is the most pressing. The power of blocking minority shareholders can also be decisive in periods of rapid growth, when the company needs additional capital.

The notion of a blocking minority is closely linked to exerting control over changes in the company’s articles of association. Consequently, the more specific and inflexible the articles of association are, the more power the holder of a blocking minority wields.

3/ THE DIFFERENT TYPES OF SHAREHOLDERS

(a) The family-owned company

By “family-owned” we mean that the shareholders have been made up of members of the same family for several generations and, often through a holding company, exert significant influence over management. This is still the dominant model in Europe. The following table shows the shareholder base of the 50 largest companies by market capitalisation in several countries (2021):

Shareholding	Germany	Switzerland	USA	France	Italy	UK
Widely spread	50%	54%	84%	43%	20%	82%
Family (and non-listed)	20%	32%	14%	31%	38%	6%
State and local authorities	10%	8%	0%	14%	22%	4%
Financial institution	2%	4%	0%	6%	12%	6%
Other listed firms	18%	2%	2%	6%	8%	2%

Source: Company data, FactSet.

However, this type of shareholder structure is on the decline for several reasons:

some new or capital-intensive industries, such as energy/utilities and banks require so much capital that a family-owned structure is not viable over the long term. Indeed, family ownership is more suited to consumer goods, retailing, services, processing, etc.;
financial markets have matured and financial savings are now properly rewarded, so that, with rare exceptions, diversification is a better investment strategy than concentration on a specific risk (see Section 18.6);
increasingly, family-owned companies are being managed on the basis of financial criteria, prompting the family group either to exit the capital or to dilute the family’s interests in a larger pool of investors that it no longer controls. This trend requires a nuanced view as, in recent years, certain young companies whose founders remain very important shareholders (Contentsquare, Doordash, Iliad, and so on) have taken up a prominent role within the economy.

Family shareholding sometimes reappears in the form of family offices, emanating from large industrial families (Desmarais in Canada, Quandt in Germany, Frère in Belgium, etc.) that invest in financial fundamentals, but with a much longer-term perspective than traditional funds.

Some research has demonstrated that family-owned companies register on average better performance than non-family-owned companies. Having most of your wealth in one single company or group is a strong incentive to properly monitor its managers or to act responsibly as its manager.

(b) Business angels

See Chapter 40.

(c) Private equity funds

Private equity funds, financed by insurance companies, pension funds or wealthy investors, play a major role. In most cases these funds specialise in a certain type of investment: venture capital, development capital, LBOs (see Chapter 47) or turnaround capital, which correspond to a company’s different stages of maturity.

Venture capital funds focus on bringing seed capital, i.e. equity, to start-ups to finance their early developments.

Development capital funds become shareholders of high-growth companies that require substantial funds.

LBO funds invest in companies put up for sale by a group looking to refocus on its core business or by a family-held group faced with succession problems, or help a company whose shares are depressed (in the opinion of the management) to delist itself in a public-to-private (P-to-P) transaction. LBO funds are keen to get full control over a company (but control can be exercised by 2 or 3 funds) in order to reap all of the rewards and also to make it possible to restructure the company as they think best, without having to worry about the interests of minority shareholders. Therefore, they usually prefer the target companies not to be listed (or to be delisted if the target was public), but the fund itself can be listed.

Turnaround funds work with distressed companies, helping them to turn themselves around.

Activist funds have made a speciality of putting public pressure on poorly performing or badly structured groups, proposing corrective measures to improve their value. In 2020, for example, Amber was proposing a complete overhaul of Lagardère’s board of directors, a change of strategy and the abandonment of the limited partnership status that protects the founder’s heir, who has not demonstrated the same qualities. This has been implemented in 2021.

Managed by teams of investment professionals whose compensation is largely linked to performance, these funds have a limited lifespan (no more than 10 years). Before the fund is closed, the companies that the fund has acquired are resold, floated on the stock exchange or the fund’s investments are taken over by another fund.

Some private equity funds take a minority stake in listed companies, a PIPE (private investment in public equity), helping the management to revitalise the company so as to make a capital gain. For example, in 2019, Searchlight Capital took a 26% stake in Latécoère and changed the CEO in 2020. In 2020–2021, the creation of SPACs by private equity funds allowed them to invest in companies on a minority basis when they went public using this technique.

Private equity funds play an important role in the economy and are a real alternative to a listing on the stock exchange. They solve agency problems by putting in place strict reporting from the management, which is incentivised through management packages and the pressure of debt (LBO funds).

They also bring a cash culture to optimise working capital management and limit capital expenditure to reasonably value-creating investments. Private equity funds are ready to bring additional equity to finance acquisitions with an industrial logic. They also bring to management a capacity to listen, to advise and to exchange, which is far greater than that provided by most institutional investors. They are professional shareholders who have only one aim – to create value – and they do not hesitate to align the management of companies they invest in with that objective.

(d) Institutional investors

Institutional investors are banks, asset managers, insurance companies, pension funds and unit trusts that manage money on behalf of private individuals. Most of the time they individually own minor stakes (less than 10%), but they play a much bigger role as they define the stock market price of companies in which they collectively represent the major part of their floating capital.

Because of new regulations on corporate governance (see Chapter 43), they vote at AGMs more frequently, especially to defeat resolutions they do not like, notably regarding excessive compensation.

(e) Financial holding companies

Large European financial holding companies such as Deutsche Bank, Paribas, Mediobanca, Société Générale de Belgique, etc. played a major role in creating and financing large groups. In a sense, they played the role of the (then-deficient) capital markets. Their gradual disappearance or mutation has led to the breakup of core shareholder groups and cross-shareholdings. Today, in emerging countries (Korea, India, Colombia), large industrial and financial conglomerates play their role (Samsung, Tata, Votorantim, etc.).

(f) Employee-shareholders

Many companies have invited their employees to become shareholders. In most of these cases, employees hold a small proportion of the shares, although in a few cases the majority of the shares. This shareholder group, loyal and non-volatile, lends a degree of stability to the capital and, in general, strengthens the position of the majority shareholder, if any, and of the management.

The main schemes to incentivise employees are:

Direct ownership. Employees and management can invest directly in the shares of the company. In LBOs, private equity sponsors bring the management into the shareholding structure to minimise agency costs.
Employee stock ownership programmes (ESOPs). ESOPs consist in granting shares to employees as a form of compensation. Alternatively, the shares are acquired by shareholders but the firm will offer free shares so as to encourage employees to invest in the shares of the company. The shares will be held by a trust (or employee savings plan) for the employees. Such programmes can include lock-up clauses to maintain the incentive aspect and limit flowback (see Section 25.2). In this way, the shares allocated to each employee will vest (i.e. become available) gradually over time.
Stock options. Stock options are a right to subscribe to new shares or shares held by the company as treasury stocks at a certain point in time.

For service companies and fast-growing companies, it is key to incentivise employees and management with shares or stock options, as the key assets of such companies are their people. For other companies, offering stock to employees can be part of a broader effort to improve employee relations (all types of companies) and promote the company’s image internally. The success of such a policy largely depends on the overall corporate mood. In large companies, employees can hold up to 10%. Lehman, the US investment bank, was one of the listed companies with the largest employee shareholdings (c. 25%) when it went into meltdown in 2008.

Regardless of the type of company and its motivation for making employees shareholders, you should keep in mind that the special relationship between the company and the employee-shareholder cannot last forever. Prudent investment principles dictate that the employee should not invest too heavily in the shares of the company that pays their salaries, because in so doing they, in fact, compound the “everyday life” risks they are running.²

Basically, the company should be particularly fast-growing and safe before the employee agrees to a long-term participation in the fruits of its expansion. Most often, this condition is not met. Moreover, just because employees hold stock options does not mean they will be loyal or long-term shareholders. The LBO models we will study in Chapter 47 become dangerous when they make a majority of the employees shareholders. In a crisis, the employees may be keener to protect their jobs than to vote for a painful restructuring. When limited to a small number of employees, however, LBOs create a stable, internal group of shareholders.

(g) Governments

In Europe and the USA, governments’ role as the major shareholders of listed groups is fading, even if they are still majority shareholders of large industry players (Deutsche Bahn, EDF, Enel) or playing a key role in some groups like Deutsche Telekom, Airbus or Eni. State ownership had a period of revival thanks to the economic crisis, as some groups were taken over to avoid collapse (General Motors, RBS) or funds were injected through equity issues to reinforce financial institutions (Citi, ING, etc.).

At the same time, sovereign wealth funds, mostly created by emerging countries and financed thanks to reserves from staples, are gaining importance as long-term shareholders. They are normally very financially minded, but their opacity, their size (often between €50bn and €500bn) and their strong connections with mostly undemocratic states are worrying to some. As of end 2020, they had c. $9,070bn under management, and slowly growing. The most well-known include The Government Pension Fund of Norway, Norges ($1,290bn), China Investment Company (CIC, $1,045bn), SAFE Investment Company and Hong Kong Monetary Authority ($978bn) from China, Abu Dhabi Investment Authority (ADIA, $745bn), GIC and Temasek in Singapore ($710bn), Kuwait Investment Authority (KIA, $562bn), etc. They are majority shareholders of a number of firms (Singapore Airlines, P&O, etc.) and minority shareholders in some listed firms such as the London Stock Exchange, Glencore, KKR, Carlyle, Foncia, etc.

(h) Crossholdings

Crossholdings peaked before the 1990s when capitalism was often capital-less. Today, the very few examples (Renault owns 43% of Nissan, which owns 15% of Renault, Spotify owns 9% of Tencent Music, which owns 7.5% of Spotify) are there to promote industrial synergies, or even to prepare for a closer future relationship, and not for financial or power reasons.

4/ SHAREHOLDERS’ AGREEMENT

Minority shareholders can protect their interests by crafting a shareholders’ agreement with other shareholders.

A shareholders’ agreement is a legal document signed by several shareholders to define their future relationships. It complements the company’s articles of association. Most of the time, the shareholders’ agreement is confidential except for listed companies in countries which require its publication in order for it to be valid.

They mainly contain two sets of clauses:

clauses that organise corporate governance: breakdown of directors’ seats, the nomination of the chairperson, of the CEO, of the auditors; how major decisions are taken, including capex; financing, acquisitions, share issues, dividend policy; how to vote during annual general meetings; what kind of information is disclosed to shareholders, etc.;
clauses that organise the sale or purchase of shares in the future: lock-up, right of first refusal if one shareholder wants to exit, drag-along (to force the disposal of 100% of the shares if the majority shareholders or several shareholders holding a majority stake between them wish to exit) or tag-along (to allow minority shareholders to benefit from the same transaction conditions if the majority shareholder is selling), caps and floors, etc.
For shareholders’ agreement on start-ups, please see Section 40.4.

Section 41.2 HOW TO STRENGTHEN CONTROL OVER A COMPANY

Defensive measures for maintaining control of a company always carry a cost. From a purely financial point of view, this is perfectly normal: there are no free lunches!

With this in mind, let us now take a look at the various takeover defences. We will see that they vary greatly depending on the country, on the existence or absence of a regulatory framework and on the powers granted to companies and their executives. Certain countries, such as the UK and, to a lesser extent, France and Italy, regulate anti-takeover measures strictly, while others, such as the Netherlands and the USA, allow companies much more leeway.

Broadly speaking, countries where financial markets play a significant role in evaluating management performance, because companies are more widely held, have more stringent regulations. This is the case in the UK and France.

Conversely, countries where capital is concentrated in relatively few hands have more flexible regulation. This goes hand in hand with the articles of association of the companies, which ensure existing management a high level of protection. In Germany, half of the seats on the board of directors are reserved for employees, and board members can be replaced only by a 75% majority vote.

Paradoxically, when the market’s power to inflict punishment on companies is unchecked, companies and their executives may feel such insecurity that they agree to protect themselves via the articles of association. Sometimes this contractual protection is to the detriment of the company’s welfare and of free market principles. This practice is common in the US.

Defensive measures fall into four categories:

Separate management control from financial control:
- different classes of shares: shares with multiple voting rights and non-voting shares;
- holding companies;
- limited partnerships.
Control shareholder changes:
- right of approval;
- pre-emption rights.
Strengthen the position of loyal shareholders:
- reserved capital increases;
- share buy-backs and cancellations;
- mergers and other tie-ups;
- employee shareholdings;
- warrants.
Exploit legal and regulatory protection:
- regulations;
- voting caps;
- strategic assets;
- change-of-control provisions.

In order to defend itself, a company must know who its shareholders are. This is relatively easy for unlisted companies for which shares must be nominative, but a lot more complicated for listed companies, where most of the shares are bearer shares (the identity of the shareholder is unknown to the company). In this way, some companies are able to make provision for the notification obligation, set out in the articles of association, when a minimum threshold (0.5%, for example) of the share capital has been breached, which is in addition to statutory obligations starting at 3 or 5% in most countries (see Section 45.3).

1/ SEPARATING MANAGEMENT CONTROL FROM FINANCIAL CONTROL

(a) Different classes of shares: shares with multiple voting rights and non-voting shares

As an exception to the general rule, under which the number of votes attributed to each share must be directly proportional to the percentage of the capital it represents (principle of one share, one vote), companies in some countries have the right to issue multiple-voting shares or non-voting shares.

In the Netherlands, the USA, Luxembourg, and the Scandinavian countries, dual classes of shares are not infrequent. The company issues two (or more) types of shares (generally named A shares and B shares) with the same financial rights but with different voting rights.

French corporate law provides for the possibility of double-voting shares but, contrary to dual-class shares, all shareholders can benefit from the double-voting rights if they hold the shares for a certain time.

Multiple-voting shares can be particularly powerful; for example, the founders of Alphabet (ex. Google) have 53.1% of voting rights of Alphabet while they hold only 11.6% of the shares. Ford, Snap, Lyft, Facebook, and Roche, have also put in place this type of capital structure. These dual-class shares can appear as unfair and contrary to the principle that the person who provides the capital gets the power in a company. Some countries (Italy, Spain, Belgium and Germany) have outlawed dual-class shares.

(b) Holding companies

Holding companies can be useful but their intensive use leads to complex, multi-tiered shareholding structures. As you might imagine, they present both advantages and disadvantages.

Suppose an investor holds 51% of a holding company, which in turn holds 51% of a second holding company, which in turn holds 51% of an industrial company. Although they hold only 13% of the capital of this industrial company, the investor uses a cascade of holding companies to maintain control of the industrial company.

A holding company allows a shareholder to maintain control over a company, because a structure with a holding disperses the minority shareholders. Even if the industrial company were floated on the stock exchange, the minority shareholders in the different holding companies would not be able to sell their stakes.

Maximum marginal personal income tax is generally higher than income taxes on dividends from a subsidiary. Therefore, a holding company structure allows the controlling shareholder to draw off dividends with a minimum tax bite and use them to buy more shares in the industrial company.

Technically, a holding company can “trap” minority shareholders; in practice, this situation often leads to an ongoing conflict between shareholders. For this reason, holding companies are usually based on a group of core shareholders intimately involved in the management of the company.

A two-tiered holding company structure often exists, where:

a holding company controls the operating company;
a top holding company holds the controlling holding company. The shareholders of the top holding company are the core group. This top holding company’s main purpose is to buy back the shares of minority shareholders seeking to sell some of their shares.

Often, a holding company is formed to represent the family shareholders prior to an IPO.

(c) Limited share partnerships (LSPs)

A limited share partnership is a company where the share capital is divided into shares, but with two types of partners:

several limited partners with the status of shareholders, whose liability is limited to the amount of their investment in the company. A limited share partnership is akin to a public limited company in this respect;
one or more general partners, who are jointly liable, to an unlimited extent, for the debts of the company. Senior executives of the company are usually general partners, with limited partners being barred from the executive suite.

The company’s articles of association determine how present and future executives are to be chosen. These top managers have the most extensive powers to act on behalf of the company in all circumstances. They can be fired only under the terms specified in the articles of association. In some countries, the general partners can limit their financial liability by setting up a (limited liability) family holding company. In addition, the LSP structure allows a change in management control of the operating company to take place within the holding company. For example, a father can hand over the reins to his daughter, while the holding company continues to perform its management functions.

Thus, theoretically, the chief executive of a limited share partnership can enjoy absolute and irrevocable power to manage the company without owning a single share. Management control does not derive from financial control as in a public limited company, but from the stipulations of the by-laws, in accordance with applicable law. Several large listed companies have adopted limited share partnership form, including Merck KGaA, Henkel, Michelin and Hermès.

(d) Non-voting shares

Issuing non-voting shares is similar to issuing dual-class shares because some of the shareholders will bring capital without getting voting power. Nevertheless, issuing non-voting shares is a more widely spread practice than issuing dual-class shares. Actually, in compensation for giving up their voting rights, holders of non-voting shares usually get preferential treatment regarding dividends (fixed dividend, higher dividend compared to ordinary shares, etc.). Accordingly, non-voting (preference) shares are not perceived as unfair but as a different arbitrage for the investor between return, risk and power in the company. For more, see Section 24.3.

2/ CONTROLLING SHAREHOLDER CHANGES

(a) Right of approval

The right of approval, written into a company’s articles of association, enables a company to avoid “undesirable” shareholders or shift the balance between shareholders. This clause is frequently found in family-owned companies or in companies with a delicate balance between shareholders. The right of approval governs the relationship between partners or shareholders of the company; be careful not to confuse it with the type of approval required to purchase certain companies (see below).

Technically, the right of approval clause requires all partners to obtain the approval of the company prior to selling any of their shares to a third party, or to another shareholder if explicitly provided for in the approval clause. The company must render its decision within a specified time period. If no decision is rendered, the approval is deemed granted.

If it refuses, the company, its board of directors, executive committee, senior executives or a third party must buy back the shares within a specified period of time, or the shareholder can consummate the initially planned sale.

The purchase price is set by agreement between the parties, or in the event that no agreement is reached, by independent appraisal.

Right of approval clauses might not be applied when shares are sold between a shareholder, their spouse or their immediate family and descendants.

Most of the time, right of approval clauses for listed companies are prohibited as they run contrary to the fluidity implied in being a public company.

(b) Pre-emption rights

Equivalent to the right of approval, the pre-emption clause gives a category of shareholders or all shareholders a priority right to acquire any shares offered for sale. Companies whose existing shareholders want to increase their stake or control changes in the capital use this clause. The board of directors, the chief executive or any other authorised person can decide how shares are divided amongst the shareholders.

Technically, pre-emption rights procedures are similar to those governing the right of approval.

Most of the time, pre-emption rights do not apply in the case of inherited shares, liquidation of a married couple’s community property, or if a shareholder sells shares to their spouse, immediate family or descendants.

Right of approval and pre-emption rights clauses constitute a means of controlling changes in the shareholder structure of a company. If the clause is written into the articles of association and applies to all shareholders, it can prevent any undesirable third party from obtaining control of the company. These clauses cannot block a sale of shares indefinitely, however. The existing shareholders must always find a solution that allows a sale to take place if they do not wish to buy.

3/ STRENGTHENING THE POSITION OF LOYAL SHAREHOLDERS

(a) Reserved share issues

In some countries, a company can issue new shares on terms that are highly dilutive for the existing shareholders. For example, to fend off a challenge from the newspaper group Gannet, the Tribune Publishing group (publisher of The Chicago Tribune and The Los Angeles Times) issued 13% of its share capital in May 2016 to Patrick Soon-Shiong, placing the billionaire as Tribune’s second-largest shareholder.

The new shares can be purchased either for cash or for contributed assets. For example, a family holding company can contribute assets to the operating company to strengthen its control over this company.

(b) Mergers

Mergers are, first and foremost, a method for achieving strategic and industrial goals. As far as controlling the capital of a company is concerned, a merger can have the same effect as a reserved capital increase, by diluting the stake of a hostile shareholder or bringing in a new friendly shareholder. We will look at the technical aspects in Chapter 46.

The risk, of course, is that the new shareholders, initially brought in to support existing management, will gradually take over control of the company.

(c) Share buy-backs and cancellations

This technique, which we studied in Chapter 37 as a financial technique, can also be used to strengthen control over the capital of a company. The company offers to repurchase a portion of outstanding shares with the intention of cancelling them. As a result, the percentage ownership of the shareholders who do not subscribe to the repurchase offer increases. In fact, a company can regularly repurchase shares. For example, Bic and Norilsk Nickel have used this method several times in order to strengthen the control of large shareholders.

(d) Employee shareholdings

Employee-shareholders generally have a tendency to defend a company’s independence when there is a threat of a change in control. A company that has taken advantage of the legislation favouring different employee share-ownership schemes can generally count on a few percentage points of support in its effort to maintain the existing equilibrium in its capital. In 2007, for example, the employee-shareholders of the construction group Eiffage rallied behind management in its effort to see off Sacyr’s rampant bid.

(e) Warrants

The company issues warrants to certain investors. If a change in control threatens the company, investors exercise their warrants and become shareholders. This issue of new shares will make a takeover more difficult, because the new shares dilute the ownership stake of all other shareholders. The strike price of the warrant is usually very attractive but the warrants can only be exercised if a takeover bid is launched on the company.

This type of provision is common in the Netherlands (ING or Philips), France (Peugeot, Bouygues) and the US. In 2018, both Bouygues’ and Peugeot’s AGM authorised their boards to issue such warrants should they find it necessary.

4/ LEGAL AND REGULATORY PROTECTION

(a) Regulations

Certain investments or takeovers require approval from a government agency or other body with vetoing power. In most countries, sectors where there are needs for specific approval are:

financial institutions;
activities related to defence (for national security reasons);
media;
etc.

Golden shares are special shares that enable governments to prevent another shareholder from increasing its stake above a certain threshold, or the company from selling certain of its assets (Distrigas, Telecom Italia, Eni are some examples).

(b) Voting caps

In principle, the very idea of limiting the right to vote that accompanies a share of stock contradicts the principle of “one share, one vote”. Nevertheless, in some countries, companies can limit the vote of any shareholder to a specific percentage of the capital. In some cases, the limit falls away once the shareholder reaches a very large portion of the capital (e.g. 50% or 2/3).

For example, Danone’s articles of association stipulate that no shareholder may cast more than 6% of all single voting rights and no more than 12% of all double voting rights at a shareholders’ meeting, unless they own more than two-thirds of the shares. Voting caps are commonly used in Europe, specifically in Switzerland (12 firms out of the 50 largest use them), France, Belgium, the Netherlands and Spain. Nestlé, Total, and Novartis all use voting caps.

This is a very effective defence. It prevents an outsider from taking control of a company with only 20% or 30% of the capital. If they truly want to take control, they have to “up the ante” and bid for all of the shares. We can see that this technique is particularly useful for companies of a certain size. It makes sense only for companies that do not have a strong core shareholder.

(c) Strategic assets (poison pills)

Strategic assets can be patents, brand names or subsidiaries comprising most of the business or generating most of the profits of a group. In some cases the company does not actually own the assets but simply uses them under licence. In other cases these assets are located in a subsidiary with a partner who automatically gains control should control of the parent company change hands. Often contested as misuse of corporate property, poison pill arrangements are very difficult to implement, and in practice are generally ineffective. In 2021, Suez tried to fend off Veolia’s bid by housing its French water business in a foundation in the Netherlands to make it non-transferable.

(d) Change-of-control provisions

Some contracts may include a clause whereby the contract becomes void if one of the control provisions over one of the principles of the contract changes. The existence of such clauses in vital contracts for the company (distribution contract, bank debt contract, commercial contract) will render its takeover much more complex.

Some “golden parachute” clauses in employment contracts allow employees to leave the company with a significant amount of money in the event of a change of control, which consequently has a dissuasive effect.

Section 41.3 STOCK MARKET OR INVESTMENT FUND SHAREHOLDING?

The disenchantment with stock markets and the rise of unlisted investments is a fundamental trend that is not about to stop. While the number of listed companies worldwide has stagnated since 2015 at just over 50,000, in the United States it has been declining since 1997, now less than half the number of the companies listed on the stock exchange as in 1997.

*Source*: Data from World Federation of Exchanges

As nature abhors a vacuum and with companies less attracted by the stock market, investment in unlisted, or private, equity is growing apace. Its precise definition is unclear and differs from one source to another. Let’s say that it covers all investments made through investment funds in unlisted companies or companies that become unlisted on that occasion, or in unlisted assets (such as real estate or natural resources).

Preqin estimates that private equity funds raised in 2020 amounted to $989bn significantly higher than pre-2008 records:

*Source*: Data from Preqin, quoted in ‘Global private equity report 2021’, Bain & Company

Even if 2020 was a record year for IPOs ($353bn), the funds provided by private equity remain much higher.

1/ THE ORIGIN OF INVESTMENT FUNDS

The origins of unlisted investment in its modern form can be traced back to the United States when, after the Second World War, a Harvard management professor, Georges Doriot, set up the world’s first venture capital company, AR&D, in the Boston area. With funds provided in particular by the John Hancock insurance company and MIT, AR&D financed DEC from its beginnings in 1957, which was a huge success and became the second largest computer manufacturer in the world before its takeover in 1999 by Compaq, which itself merged with HP in 2002.

In the United Kingdom, private equity initially took the form of minority investments to help SMEs or second tier companies to grow and turn into groups. The unlisted, fund-managed sector developed later in continental Europe, where development capital had been pre-empted at the beginning of the 20th century by listed financial companies, the best known of which were Mediobanca, Paribas, Suez, Générale de Belgique, Deutsche Bank, Commerzbank, etc.

Then in the 1980s, a genetic mutation took place in the world of unlisted investing with the appearance and then the development of LBO funds³ taking full control of a target, a new occurrence as unlisted investing had previously limited itself to minority stakes. The refocusing of listed groups, spurred on by the development of the concept of value creation, the end of the large conglomerates (General Electric plc, Saint-Gobain, ITT, etc.), and the succession of family businesses created in the immediate post-war period, provided a breeding ground for the development of this new form of private equity.

The long phase of falling interest rates and the correlative rise in valuation multiples (which favours financial performance), the renewed motivation of the managers of acquired divisions (often managed very loosely) through management packages, and the focus on cash and profitability, combined with the leverage effect of debt, explain the very high returns on investment that attract and retain investors. Over the years, the success of LBOs has been considerable, so much so that for many, private equity has become synonymous with LBO funds. From being a temporary lock between a family shareholder or a division of a group and the stock market or another group, LBOs have become a means of long-term ownership of companies with the development of secondary and tertiary LBOs, etc., such as Optven for example.

Buoyed by their success, some of the historical LBO funds (KKR, Blackstone, Apollo, Ardian, etc.) are expanding their activities to include investments in private debt, infrastructure, development capital, venture capital, real estate, distressed companies, natural resources, minority stakes in listed companies, etc. As a result, McKinsey estimates that in 2019 private equity, in its broadest sense, will manage $6,500bn, up 12% over 2018.

Although it has been growing since 2002 at twice the rate of world market capitalisation, and has multiplied its outstandings by more than seven since then, the unlisted market still represents only around 7% of world market capitalisation ($109,210bn at the end of 2020), compared with half as much in 2000.

Although this share may seem small, we no longer meet investors today who say they are not interested in private equity. On the contrary, most want to increase the proportion of their assets allocated to this type of investment, which has now become mainstream.

So much so that a number of major investors, sovereign wealth funds, family offices and pension funds have developed their own tools and structures for investing in the unlisted market in a traditional manner.

2/ THE GROWING COMPLEXITY OF LIFE ON THE STOCK MARKET

Market windows are periods when the stock market felt able to subscribe to capital increases or to welcome new recruits into its ranks. Outside those ranks, there was no salvation and the only thing to do was wait. Hence sometimes after a few months of preparing a financial transaction, it has to be cancelled on the eve of the launch! All this because a competitor’s quarterly results are 2% below expectations and its share price has fallen 10–15%, or because a central bank has not announced the expected quarter-point drop in its refinancing rate. You have to have nerves of steel and have your plan B ready.

Most listed companies with a market capitalisation below €1bn are not covered by analysts or are only included in studies that paraphrase their publications. The rise of passive management⁴ (around 20% of assets under management in Europe and 45% in the United States), which simply duplicates an index without basing its investment choices on financial analysis, is the primary reason. The Mifid II Directive, which came into force in Europe in 2018, by seriously reducing the quantity, or even quality, of research published on listed companies, has reinforced this trend. The share of transactions taken by high-frequency trading (HFT), which can exceed 50% of volumes, increases the suspicion that prices are disconnected from companies’ actual performance.

*Source*: Data from Company data, FactSet

While it seems to us to be completely unjustified to claim that stock markets are affected by short-termism, or that listed companies are affected by propagation of this defect,⁵ the fact remains that:

Business life is often a succession of setbacks, of changes in strategy necessary for survival or of seizing opportunities. When you’re listed, it’s hard to escape a 10–20% drop in price in one day, which is not always justified. It’s hard not to think that some people sell first and think later. While this decline will be corrected over time, managing the effect on employee morale is an extra task.
Governance of listed companies has improved significantly over the years⁶ and is often of better quality than governance of family businesses, cooperatives or subsidiaries of groups. However, it is still often marked by complacency with independent directors chosen de facto and de jure by the majority shareholder or manager. There is not always sufficient debate and challenging of ideas. And poor governance sooner or later has consequences for the company’s operations.
There are fewer and fewer shareholders with whom the managers of listed companies can discuss strategy and figures, since some shareholders simply duplicate a stock market index and others often delegate to agencies the task of studying meeting resolutions.
The stock market allows you to vote with your feet (by selling your securities) when you disagree with a strategy or with the execution thereof. But sometimes a manager or a team just has to be replaced and this often happens too late in the day when there aren’t any strong voices on the board of directors or among the shareholders of a listed company.
A listed company may find it difficult to take on debt beyond the levels accepted on the stock exchange (say more than 3 times EBITDA), and it may not always be the right time for the desired capital increase. In short, the “easy” financing that comes with being listed may be somewhat theoretical.
To be listed is to be on a market and to be subject to its fluctuations (market risk), sometimes independently of a company’s actual health.

3/ INVESTMENT FUNDS HAVE TAKEN CARE OF THEIR WEAK POINTS AND KEPT THEIR STRONG POINTS

In recent years, private equity funds have been working on their weak point: the illiquidity of their securities, which corresponds most closely to the maturity of their funds. This is a bit like squaring the circle, because how do you allow investors to exit a fund before it matures, while at the same time allowing the fund to have the time it needs to create value in its holdings by improving margins, digital transformation, acquisition and integration of competitors?

Faced with this need, unlisted funds have specialised in or have created funds specialising in secondary transactions (such as Ardian in Europe) to buy all or part of their shares from private equity investors before the normal maturity of the funds. This provides liquidity to those who need it, in amounts that are constantly increasing and that reached $87bn in 2020.

An investor in an unlisted fund can sell its shares in an LBO fund at a discount of less than 5% of the estimated value, about 10% for a fund invested in real estate and 15–20% for a venture capital fund with much more volatile assets. These levels are well below the discounts we see for listed conglomerates or investment companies.

At the same time, private equity funds have not let their guard down on their strong points:

They continue to have their own mode of governance⁷ which constitutes a real competitive advantage. Unlike investors in listed companies, that hold very small minority stakes in scores (or even hundreds) of listed companies, whose managers they see only occasionally, private equity fund managers monitor only a few investments, which gives them a degree of understanding of these companies that facilitates intense and regular dialogue with their managers – fruitful discussions between informed people. The strategy is then better defined and controlled. In addition, management packages offered to the managers of the companies in which they invest, combine the carrot and the stick to align their interests with the progression of the company’s value that they and their teams will create;
They continue to offer risk-adjusted rates of return, after manager compensation, that are on average at least equal to those of listed investments, with the best of them well above. For example, the French private equity industry reports an average rate of return after costs of 11.2% per annum over the last 15 years, and 9.9% over 30 years (i.e. an 18.7-fold increase in value);
They continue to be part of an average investment period of five years, which gives management time to implement a strategy, and if the horizon of the managers’ business plans does not correspond to that of a private equity shareholder fund, it is not uncommon for the latter to sell its stake to another fund whose liquidation deadline falls after the end of the business plan.

4/ HOW DOES THE COMPANY POSITION ITSELF IN THIS MATCH BETWEEN LISTED AND UNLISTED COMPANIES?

Today, above a valuation range of around €10–15bn, only the stock market is likely to offer liquidity to investors who want to sell their shares. Admittedly, before 2008, LBOs were valued at around €30bn.⁸ But that was before 2008, although they will most certainly be back.

It will take some time before private equity funds have the financial means to take an interest in the giants of the stock market, worth more than €50bn or €100bn and which represent the bulk of market capitalisation in value terms. And even if they had these means, current conditions do not suggest significant value creation, with a few exceptions. Most of these groups are currently well managed and difficult to consolidate among themselves, given the antitrust problems involved.

With a valuation below €10–15bn, everything becomes possible again. As an illustration, in 2019, KKR bought the free float of the German media group Axel Springer to take it off the stock market in a transaction that values it at €6.8bn, i.e. 40% above the stock market price. The same controlling shareholder and the same managers are thus moving from listed to unlisted. This example is far from an isolated one as we also have Ahlsell, Wessanen, Merlin, etc.

Under what conditions could such a small company stay and prosper on the stock market? We see several:

Run a simple, easily understandable business, with rated peers to facilitate comparisons and avoid discounts;
Avoid carrying too much specific risk;
Have a free float of at least 30 to 40%, because free float counts more on the stock market than market capitalisation;
Have a story to tell investors (equity story), and tell it, whether it is one of growth like Cogelec, consolidation of a sector like Euronext, or dividend yield like Pearson;
Seek out several funds and favour a fragmented shareholding structure (the Stock Exchange) in order to remain in charge of your own house, rather than one fund investment, even a minority one, which leads to a certain amount of shared control.

Otherwise, we believe there is a high risk of a discounted valuation, which is not a short- or medium-term problem if control is retained and if there is no need for financing. Given the growing size of asset managers on the stock exchange, the largest of them (Blackrock) manages $7,300bn and the largest European (Amundi) €1,790bn, liquidity is concentrated on large caps with small and mid-caps being neglected. For the latter, valuation multiples are often significantly lower than for large stocks and the required rates of return are higher in view of a growing liquidity premium.⁹

At the same time, the regulatory constraints of listing are increasing without the cost/benefits balance tilting significantly towards the latter: IFRS standards on turnover and rentals, the MAR Directive, internal insider listings, etc. The aim is to protect investors, specifically private individuals, who are less and less frequently direct shareholders of listed companies (one third of listed companies’ shareholders in the United States, around 10% in France). You have to be really motivated to stay listed when you’re a small or medium-sized company, and you are not likely to carry out an ICO,¹⁰ where, in order to attract buyers, the regulatory environment is very light, although not very consistent with the rest!

5/ IN THE END, A POROUS BORDER BETWEEN THE LISTED AND THE UNLISTED

We believe that listed and unlisted companies will continue to coexist in a complementary fashion, with private equity increasing its dominance in the segment up to around €10bn in value, and listed investment prevailing beyond that.

The boundary between these two modes of shareholding and governance is porous and we see a lot of toing and froing. Private equity firms have no qualms about selling companies on the stock market for which they no longer see any significant value-creation potential, especially if the stock market then generously values the companies, or those whose size is testing their limits. But private equity can also have its funds listed on the stock market and even hope one day to have them listed at a discount equal to or lower than that offered by secondary funds. A large listed investment fund controlling SMEs and second tier companies probably makes more sense to investors, and some companies, than a direct listing of the latter.

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

Shareholder structure explains how power is distributed among a company’s different shareholders or groups of shareholders. Major shareholder categories are as follows:

family shareholders. This model is in decline. New industries require too much capital for a family-owned structure to be viable. Funding requirements make capital markets become increasingly important;
business angels who invest at the most risky stage of a company: its creation or shortly afterwards;
investment funds (private equity) whether they are venture funds, LBO funds, capital development funds, etc.;
institutional shareholders (insurance companies, pension funds, unit trusts, etc.) who are becoming less passive;
employee-shareholders. Normally these shareholders are loyal and non-volatile, lending a degree of stability to the capital;
governments, the importance of which is rising due to sovereign wealth funds mainly originating from emerging markets.

Defensive measures for maintaining control of a company’s capital carry a cost, because they prevent investors from taking advantage of the potential opportunities a takeover might create.

These measures include:

separating management control from financial control through double-voting shares, holding companies, limited share partnerships, investment certificates and non-voting shares;
controlling shareholder changes through right of approval clauses or pre-emption rights;
strengthening the position of loyal shareholders by carrying out reserved capital increases, buying back shares, merging, encouraging employees to become shareholders and issuing warrants;
exploiting legal and regulatory opportunities: specific regulations, voting right limitations and poison pills.

The best protection against a change of control is a good operating performance and a high share price which make shareholders happy and loyal.

In recent years, the decline in the number of listed companies and the increase in the number of companies controlled by investment funds has reflected the increased competitive advantage of these funds due to their intrinsic characteristics (governance, profitability, time horizon), while the constraints on listed companies have continued to increase. As a result, below a value of €1bn, listing a company becomes very complicated. Above €10bn, investment funds find it more difficult to gain a footing for the moment.

QUESTIONS

1/What techniques can be used for choosing shareholders?
2/What sort of general meeting must be held to approve capital transactions?
3/What power does a shareholder with a blocking minority have?
4/How would compensating employees in stock run contrary to financial theory?
5/What advantages are there in buying 100% of the capital of a limited share partnership?
6/A company manager has a 55% stake in his unlisted company, in which a competitor also has a 32% stake. The former is keen to dilute the shareholding of the latter, without diluting his own stake at the same time. What should he do?
7/Why is the shareholding of a family-run business unstable in the long term? What is the likely future of such a business? How can this process be slowed down?
8/Two managers have a 25% and a 75% stake respectively in a company. They are keen to bring in a capital investor with the minimum dilution to their shareholdings. How should they go about solving this problem?
9/Can business angels accompany the company in its development phase?
10/What is the best protection against an unwanted change of control?
11/Are investment funds and stock exchange listings antagonistic?
More questions are waiting for you at www.vernimmen.com.

EXERCISE

ANSWERS

Questions

1/Approval, pre-emption, A and B shares, etc.
2/EGM (where applicable) as articles of association have to be altered.
3/Blocking decisions at EGMs.
4/Their risks are then not diversified.
5/Very weak, as it does not give the power to choose/remove the top management. It makes it possible to put pressure on management, a communication battle then begins!
6/Reserved capital increase if some minority shareholders vote with him so as to get the EGM’s approval, contribution of assets, etc.
7/The principle of portfolio diversification renders the principle of a family shareholding structure unstable. It will be sold to pay taxes (wealth and inheritance taxes). Create a family holding company that can buy out the outgoing shareholders.
8/By creating a holding company or issuing convertible bonds.
9/No because, on the one hand, they often do not have the financial means and, on the other hand, when the company reaches this stage, they prefer to divest in order to reinvest in the start-ups which are their primary target.
10/Have excellent management and valuation that discourages temptations because it would be difficult to do better.
11/They compete for companies worth less than €10bn, which may be listed for a while, then pass into the hands of several investment funds before eventually returning to the stock market.

BIBLIOGRAPHY

On shareholding structure:

A. Brav, J. Wei, F. Partnoy, R. Thomas, Hedge fund activism, corporate governance and firm performance, Journal of Finance, 63(4), 1729–1775, August 2008.
C. Ciccotello, The state of the public corporation: Not so much an eclipse as an evolution, Journal of Applied Corporate Finance, 26(4), 8–21, Autumn 2014.
D. Davydoff, D. Fano, L. Qin, Who Owns the European Economy?, OEE-IODS, 2013.
C. Doidge, K. Kahle, G. Karolyi, R. Stulz, Eclipse of the public corporation or eclipse of the public markets?, Journal of Applied Corporate Finance, 30(1), 64–82, Spring 2018.
T. Gormley, D. Keim, Passive investors, not passive owners, Journal of Financial Economics, 121(7), 111–141, July 2016.
J. Hellwege, Ch. Pirinski, R. Stulz, Why do firms become widely held? An analysis of the dynamics of corporate ownership, Journal of Finance, 62(3), 995–1028, June 2007.
M. Jensen, Eclipse of the public corporation, Harvard Business Review, 67, 61–74, September 1989.
S. Kaplan, Are U.S. companies too short-term oriented? Some thoughts, Journal of Applied Corporate Finance, 30(4), 8–18, Autumn 2018.
R. Masulis, C. Wang, F. Xie, Agency problems at dual class companies, Journal of Finance, 64(4), 1697–1728, August 2009.
S. Myers, Outside equity, Journal of Finance, 55(3), 1005–1037, June 2000.
M. Pagano, P.F. Volpin, Managers, workers and corporate control, Journal of Finance, 60(2), 841–868, April 2005.
A. Schwienbacher, Venture capital investment practices in Europe and the United States, Financial Market and Portfolio Management, 22(3), 195–217, 2008.

On family companies:

H. Almeida, D. Wolfenzon, A theory of pyramidal ownership and family business groups, Journal of Finance, 61(6), 2637–2680, December 2006.
M. Bertrand, S. Johnson, K. Samphantarak, A. Schoar, Mixing family with business: A study of Thai business groups and the families behind them, Journal of Financial Economics, 88(3), 466–498, June 2008.
J. Franks, C. Mayer, P. Volpin, H. Wagner, The life cycle of family ownership: International evidence, Review of Financial Studies, 25(6), 1675–1712, June 2012.
B. Maury, Family ownership and firm performance: Empirical evidence from Western European corporations, Journal of Corporate Finance, 12(12), 321–341, January 2006.
R. Morck et al., History of Corporate Ownership: The Rise and Fall of Great Business Families, NBER, 2004.
B. Villalonga, R. Amit, How do family ownership, control and management affect firm value?, Journal of Financial Economics, 80(2), 385–417, May 2006.
B. Villalonga, R. Amit, Family control of firms and industries, Financial Management, 39(3), 863–904, Autumn 2010.

On how to strengthen control over a company:

G. Aminadav, E. Papaioannou, Corporate control around the world, Journal of Finance 75(3), 1191–1246, June 2020.
M. Goktan, R. Kieschnick, A target’s perspective on the effects of antitakeover provisions in takeovers after recognizing its choice in the process, Journal of Corporate Finance, 18(5), 1088–1103, December 2012.
J. Rauh, Own company stock in defined contribution pension plans: A takeover defense?, Journal of Financial Economics, 81(2), 379–410, August 2006.

On investment funds:

Bain & Co, Global Private Equity Report 2020, Bain & Company, 2020.
McKinsey, A year of disruption in the private markets, McKinsey Global Private Markets Review 2021, 2021.

NOTES

1 See Section 45.3.
2 Enron’s and Lehman’s employees can confirm this!
3 See Section 46.2.
4 See Section 18.9.
5 See, for example, Kaplan (2018).
6 See Chapter 43.
7 See Section 47.3.
8 See Section 47.2.
9 See Section 19.4.
10 See Section 25.3.

Chapter 42. CHOOSING A CORPORATE STRUCTURE

There is nothing immutable or fixed about the organisation of a company. It is capable of adapting to changes in corporate strategy, access to financial resources, and market developments and moods, as well as any ambitions of its controlling shareholders. By way of example, the Schneider Electric group of today focused entirely on energy management and automation, and with 100% control of almost all its subsidiaries worldwide, no longer has anything in common with the Schneider of the early 1980s which was active in the steel industry, the nuclear industry, mechanics, textiles, watchmaking, electricity, and construction to name a few. Most importantly, the old Schneider Electric group (at the time heavily in debt) didn’t always have control of these companies and was itself controlled via a myriad of holding companies, indirectly owned by the Schneider family.

Generally speaking, investors like simplicity and transparency, which allows for better understanding and easier valuation, whilst simplifying everyone’s life and reducing risk (Schneider today). But markets are pragmatic and they can accept complex structures if growth and profitability are present (Alibaba, Liberty Media, Bollore).

A word of caution to our readers: whilst complex structures might solve certain problems or allow for certain opportunities to be seized, they are rarely without additional costs in the form of discounts and undervaluations. Sooner or later, they will have to be reviewed, corrected, and often broken into pieces, especially if the group is listed.

Section 42.1 ORGANISING A DIVERSIFIED COMPANY

The answer to this question depends first of all on the level of sophistication of financial markets. In a debt-ridden economy, financial markets are poorly developed, and it is difficult to finance new activities because equity is scarce. In such economies, it is frequently well-established groups that replace the financial markets; indeed, thanks to their self-financing capabilities, they can finance new activities internally. This can be seen currently in India with Reliance (petrochemicals, media, telecom, health, finance, construction, etc.), in Algeria with Cevital (food processing, supermarkets, electronics and appliances, steel, glass, construction, automotive, services, media) or in Colombia with Argos (cement, insurance, food processing, etc.).

Certain groups from emerging countries resolve the problem of under-sizing and inefficiency in the local equity capital market by going public in Europe or the United States. But this is only possible for the largest and most international companies (such as the Indian Vedanta or the Russian Evraz groups).

When a country moves from a debt-based economy to a financial market economy, the view on diversification of a company’s activities changes: lenders are in favour of it because the diversification of a company’s activities reduces its specific risk and therefore the lenders’ risk.

Equity investors are naturally more sceptical: they know that specific risk is not remunerated (see Section 19.1), reducing it would not be beneficial either, and that there are no financial synergies. Diversification therefore creates value only if the company can use its operational know-how to gain a competitive advantage in a new business, thereby generating synergies. Unfortunately, practice has shown that alongside some brilliant successes – Amazon becoming a web services host (AWS) or Bouygues succeeding in telecoms – there are countless value-destroying failures: Allianz in banking (Dresdner), Murdoch in social networks (MySpace), etc.

If diversification fails, the company will be under pressure to turn the page by selling the division in question (L’Oréal and The Body Shop in 2017). If diversification is successful, the listed company may be perceived as a conglomerate, with the risk of a discount appearing. We see, more often than not, that the market value of a listed conglomerate is lower than the sum of the values of the assets that make it up; the difference represents the conglomerate discount.

The discount generally reflects investors’ fears that resources will be poorly allocated. In other words, the group might support ailing divisions beyond what might be reasonable and in which profitability is mediocre or below their cost of capital, and consequently underinvest in the most promising sectors. Moreover, investors are now keen on “pure play” stocks and prefer to diversify their holdings themselves. Finally, there is the problem of head office costs, which absorb part of the value of the conglomerate.

When a discount persists, and to avoid a hostile takeover bid, four solutions are available:

Convince the market of the synergies the diversified strategy creates.
Split up the company (demerger by spinning-off an asset, distributing the new shares to existing shareholders of the conglomerate, and listing the new asset¹).
Piece by piece sale.
Demonstrate value by listing a portion of the capital of the undervalued division (Qualtics listed by SAP two years after its acquisition and valued at three times the acquisition price).

There is a very small number of conglomerates that are valued without a discount (Berkshire Hathaway, Amazon) because investors are convinced that they are efficiently managed.

Successful diversification is often a precursor to a change in the group’s line of business, even if it means selling the old business (from the electronics engineer Racal to the telecom group Vodafone), or splitting into two independent entities (FiatChrysler and Ferrari, Dow Dupont and Corteva), or even via a sale/merger, such as the pharmaceutical business of L’Oréal, which was merged with Sanofi.

For family companies, the question remains as to where the diversification takes place: at the level of the shareholders or the operating company.

The family shareholders may only diversify their assets if they can increase dividends from the operating company without penalising it (Quandt, Benetton families), or sell part of its shares without jeopardising family control (J. Ratcliffe).

Otherwise, the operating company will have to be diversified like Bouygues (construction, telecoms, television) to allow for both asset diversification and maintaining family control. However, this supposes that the family’s control is strong enough to dissuade a hostile takeover bid if a conglomerate discount starts to appear. In our example, Bouygues is protected by its strong internal culture and poisons pills such as TF1 broadcasting rights, or Bouygues Télécom telephone licences.

For some families, diversification is a luxury their already reduced control does not allow (e.g. Volkswagen where the Piëch and Porsche families only control 31.3% of the shares through a 50% owned holding company).

Section 42.2 TO BE OR NOT TO BE LISTED

Whether or not to float a company on the stock exchange is a question that concerns, first and foremost, the shareholders rather than the company. But technically, it is the company that requests a listing on the stock exchange.

When a company is listed, its shareholders’ investments become more liquid, but the difference for shareholders between a listed company and a non-listed company is not always that significant. Companies listed on the market gain liquidity at the time of the listing, since a significant part of the equity is floated. But thereafter, for small or medium-sized companies, only a few dozen or hundred shares are usually traded every day, unless the market “falls in love” with the company and a long-term relationship begins.

In addition to real or potential liquidity, a stock market listing gives the minority shareholder a level of protection that no shareholders’ agreement can provide. The company must publish certain information; the market also expects a consistent dividend policy. If the majority shareholders sell their stake, the rights of minority shareholders are protected (see Section 45.3).

Conversely, a listing complicates life for the majority shareholder. It is true that liquidity gives them the opportunity to sell some of their shares in the market without losing control of the company. Listing can also allow the majority shareholder to get rid of a bothersome or restless minority shareholder by providing a forum for the minority shareholders to sell their shares in an orderly manner, or if they are simply looking for an exit. But in return, a majority shareholder will no longer be able to ignore financial parameters such as P/E multiples, EPS, dividends per share, etc. (see Chapter 22) when determining strategy. Researchers² have shown that listed companies invest less than unlisted companies and are less responsive to investment opportunities because of the short-sightedness of their shareholders.

Once a majority shareholder has taken the company public, investors will judge the company on its ability to create value and communicate financial information properly. Delisting a company to take it private again is a long drawn-out process (see Section 44.6). So, for management, being listed results in a lot more restrictions in terms of transparency and communication.

For the company, a stock market listing presents several advantages:

the company becomes widely known to other stakeholders (customers, suppliers, etc.). If the company communicates well, the listing constitutes a superb form of “free” advertising, on an international scale;
the company can tap the financial markets for additional funding and acquire other companies, using its shares as currency. This constitutes invaluable flexibility for the company;
the company finds it easier to involve employees in the success of the company, incentivising them through stock options, stock-based bonuses, etc.
in a group, a parent company can obtain a market value for a subsidiary by listing it (we will then speak of a carve-out) in the hope that the value will be high enough to have a positive impact on the value of the parent company’s shares;

Listing on the stock exchange thus increases the company’s financial flexibility, but this comes at the price of implementing stringent governance measures and adopting IFRS standards, all of which is costly and difficult to fully assess prior to making a decision.

Now for the warning flags: a stock market listing does not guarantee happy shareholders. If only a small percentage of the shares are traded, or if total market capitalisation is low, i.e. less than €1bn, large institutional investors will not be interested, especially if the company is not included in a benchmark index. Volatility on the shares will be relatively high because the presence of just a few buyers (or sellers) will easily drive up (down) the share price significantly.

Section 42.3 HAVING MINORITY SHAREHOLDERS IN SUBSIDIARIES?

It is simpler for a group to own 100% of the subsidiaries it controls outright. In this case, decisions can be taken without the consultation (or even approval) of a third party, legal formalities are reduced, and the benefits of implementing an effective strategy accrue entirely to the sole shareholder group. Moreover, in this case, the management of liquidity within the group is simplified because the dividend payout is made without “leaks” represented by the dividends paid to minority shareholders; the implementation of intra-group loans does not pose a problem either.

1/ THE REASONS

Nevertheless, a group may sometimes bring in (retain) minority shareholders to the capital of some of its subsidiaries. The motivations for welcoming a financial minority shareholder or carrying out an IPO of a subsidiary are generally different from those for bringing in an industrial partner.

Indeed, the affiliation of subsidiaries to another group can generate industrial, commercial or other synergies; and when the benefits identified go beyond mere financial reasons, the sharing of capital can generate tangible benefits.

But all is not rosy since accepting that a subsidiary opens its capital to a partner or in the financial market can generate risks of conflicts of interest (intra-group or partner transfer pricing, level of risk-taking, remuneration of intellectual property, etc.).

(a) Raising funds

Opening up the capital of a subsidiary can enable the group to raise equity capital in an attractive way, especially when it is difficult to find new equity at the level of the parent company. For example, AB Inbev IPOed its Asian subsidiary Budweiser Brewing Company APAC and got $5bn to pay down debts in 2019. Cooperative or mutualist groups may also list a subsidiary to raise equity capital they would struggle to get otherwise.

Groups can also use it to finance an acquisition without carrying out a capital increase (Schneider and a division of Larsen & Toubro). The buyer can also use a vendor loan to acquire the entire capital, or ask the selling shareholder to retain a share of the capital.

Finally, it is a preferred means of growth for family groups whose controlling shareholder does not have the financial means to achieve its strategic ambitions. The result is an organisation chart similar to that of the Frère group in Belgium:

The game consists of finding minority partners (at the different levels of the structure) during the growth phase; then, once the waterfall of subsidiaries have reached maturity and the cash flows have become more consequent, offer them an exit and close the structures.

(b) Externalise the value of an asset and facilitate external growth

Groups sometimes hold particularly prized assets in their midst, whose valuation multiple may be disproportionate to that of the group as a whole. This high valuation is due to the significant anticipated growth of a given activity.

In such a situation, the group may be undervalued if the size and shape of this attractive subsidiary is not properly understood by investors. The simplest way to revalue the entire group is to sell a share of the crown jewels, thereby externalising the value of this nugget.

Moreover, in such a case, it is value destructive for the group to raise equity at the parent company level to finance the subsidiary’s development. This amounts to issuing undervalued shares (those of the parent company) to purchase assets valued at a normal price. It is better to be able to pay in shares of the subsidiary, which is as fairly valued as the target. In 2019, this is what led Volkswagen to open up the capital of its truck subsidiary Traton, in which it retained an 88% stake, to facilitate seizing external growth opportunities (Navistar in 2020).

(c) Sharing significant risk

A controlling shareholder may not want to endanger their group when undertaking an important and risky project. They may then agree to share the profits of the project to relieve themselves of some of the risk. Thus, when the Drahi group expanded into the USA in 2015 by taking over cable operators Cablevision and Suddenlink for $26.8bn, it shared the investment with BC Partner and CPP Investment, which combined held 30% of the capital, before listing it on the stock market in 2017.

(d) Reducing the contribution of a subsidiary to the earnings of the group

Without wishing to proceed with an outright sale, a group may decide to reduce its exposure to any one of its assets by selling a fraction of its capital to third parties. Vivendi sold 20% of the capital of UMG in 2019 and 2020, keeping temporarily 80%.

(e) Preparing for a future divestment

Minority shareholders entering the capital, or better still, initiating an IPO as discussed in the previous paragraph, also makes it possible to impose greater management rigour and specific governance requirements intended for listed companies. This can therefore be a first step towards a divestment by the majority shareholder and independence for the subsidiary.

The listing of a 28% stake in AXA Equitable holdings in 2018 was clearly presented by AXA as a first step towards a complete divestment. This plan was pursued in 2019 with several share sales eventually bringing AXA’s stake in its former US subsidiary bank to below 10%.

(f) Relying on a partner with industrial knowledge or geographic advantages

Accepting an industrial minority partner requires considering multiple facets of the partnership. The partner may contribute more than just capital; it will generally be selected for its ability to contribute to creating value in the subsidiary by facilitating its integration into the economy, improving relations with local authorities, obtaining market share and driving synergies, for example in distribution. The Richemont group purchased 30% of Kering’s eyewear division, which Kering had spent years developing to improve the quality of its Gucci eyewear products. Richemont then gave this division the supply contract for Cartier’s eyewear products.

In a number of countries (China, Indonesia, United Arab Emirates, etc.) and sectors, the creation of wholly owned local subsidiaries is not always possible and a local partner is required, even if it is just a nominee shareholder. To develop its fuel cells business in China, Bosch chose to form a JV with Qingling Motors in 2021

When a local stock exchange exists, authorities can be very sensitive to the local subsidiary being listed (Nexans in Morocco, Nestlé in Côte d’Ivoire, etc.).

(g) Having a tool for motivating employees

Traditional motivational tools for employees in general and management in particular are mostly based on share performance (free shares, performance shares, stock options). In a large group, the specific performance of a subsidiary’s management may be quite largely diluted in the overall performance of the group (e.g. DWS within Deutsche Bank, its asset management arm). The managers of a fast-growing business may then have the impression that they are not being properly compensated when receiving shares in the parent company.

2/ THE HOLDING COMPANY DISCOUNT

By multiplying the number of minority partners and subsidiaries listed on the stock exchange, the group runs the risk of losing its clarity and legibility for analysts and investors, of being assimilated to a holding company and then suffering a holding company discount, which is naturally to be avoided as it leads to a destruction of value due to the group’s structure.

A holding company is a company that owns minority or majority investments in listed or unlisted companies either for purely financial reasons or for the purpose of control. Berkshire Hathaway, Siemens and Exor are examples.

A holding company trades at a discount when its market capitalisation is less than the sum of the investments it holds. For example, a holding company holds assets worth 100, but it only has a market capitalisation of 80. The size of the discount varies with prevailing stock market conditions. In bull markets, holding company discounts tend to contract, while in bear markets they can widen to more than 30%.

Here are four reasons for this phenomenon:

the portfolio of assets of the holding company is imposed on investors who cannot choose it;
the free float of the holding company is usually smaller than that of the companies in which it is invested, making the holding company’s shares less liquid;
administrative inefficiencies: the holding company has its own management costs which, discounted over a long period, constitute a liability to be subtracted from the value of the investments it holds. Imagine a holding company valued at €2bn with administrative costs of €10m p.a. If those costs are projected to infinity and discounted at 8% p.a., their present value is €125m, or 6.25% of the value of the holding company.
tax inefficiencies: capital gains on the shares held by the holding company may be taxed twice – first at the holding company level, then at the level of the shareholders. In most countries, but not all, sales of a large stake (above 5%) are often taxed at a low rate to avoid double taxation.

3/ THE EVOLUTION OF THE SHARE STRUCTURE OVER TIME

Any partnership must find its balance. Since the minority position is not the easiest to be in, it is often the case that minority shareholders will sooner or later seek an exit.

For “industrial” minority shareholders, their contribution dwindles over time and their disinterest eventually results in a de facto subsidiary wholly controlled and run by the majority group. Sometimes a minority shareholder will adopt counterproductive behaviour to force the majority shareholder to offer it an exit if one has not been contractually provided for.
For a financial partner, the need for an eventual exit is obvious. Most of the time, they will require a form of liquidity that is contractualised a priori in a shareholders’ agreement: a put option, a commitment to go public or to perform a joint sale, etc.

Section 42.4 JOINT VENTURES

Most technological or industrial alliances take place through joint ventures, often held 50/50, or through joint partnerships that perform services at cost for the benefit of their shareholders. For example, General Electric and Safran created CFM International in 1972 to produce the CFM56 aircraft engine, and have together become the world leaders in the sector.

Several benefits can be identified: economies of scale, complementary experiences, learning, protection from larger competitors, creating a strategic future opportunity.

The shining example of CFM should not mislead our reader. Most joint ventures are sooner or later unwound, because the reasons that justified their creation and pushed groups to join together on an equal footing disappear over the course of time. Dissolution is then the best solution to avoid boardroom paralysis. Either the joint venture is doing well and one of the shareholders will want to take control of it, or it is doing badly and one of the shareholders will want to get out of it (or will at least refuse to bail out the losses and will therefore be gradually diluted). Thus, in 2019, the Stellantis group (Peugeot-Fiat) bought out the shares of its Chinese partner Changan in the joint venture manufacturing and marketing DS in China. Sales were disappointing and the partners no longer had the same outlook on the brand’s potential. Preparing for the potential future exit of one partner is key when creating a joint venture. Joint venture agreements often have exit clauses intended to resolve conflicts. Some examples are:

put and call clauses. These are used in particular if one of the shareholders is likely to be a long-term shareholder (industrial) and the other less long term (financial). The exercise price of the option can either be predetermined, be based on a formula or be determined by an expert independent of the shareholders. The joint venture that Valeo and Siemens created in 2016 foresees a call and a put in 2022, suggesting a potential 100% takeover by Valeo.
a buy–sell exit provision, also called a Dutch clause or a shotgun clause. For example, shareholder A offers to sell their shares at price X to shareholder B. Either B agrees to buy the shares at price X or, if they refuse, they must offer their stake to A at the same price X.

Section 42.5 BEING IN THE MINORITY

Although the vocation of a group is not to be a minority shareholder, there are nevertheless several situations where groups hold minority interests. There are several possible reasons for this:

the group wants to gain a foothold in a new activity, and starts by taking a minority stake in a company, even if it later takes control once the business model is refined. This is what groups are doing today with digital start-ups (Facebook in Unacademy, Daimler in ChargePoint, etc.);
the group wants to “lock in” an asset by taking a stake in a company it wants to eventually take control of (Vivendi in Lagardère, eyeing its Hachette subsidiary). It consequently gets a foot in the door;
a legal provision prohibiting in certain sectors of activity holding more than a certain percentage (49% for a television channel in France, for example); Certain countries (such as Algeria or Indonesia) do not allow a foreign group to be a majority owner of a local company;
the relative value of the contributions when setting up a joint venture did not allow the group to obtain at least 50%. Thus Diageo holds 34% of the spirits subsidiary Moët Hennessy alongside LVMH at 66%;
to seal a strategic or operational partnership between groups through the acquisition or exchange of minority shareholdings in order to give it greater weight. For example, since 2018, Tencent has owned 5% of Ubisoft, whose products it distributes in China;
because it is the remnant of a business being divested. Thus L’Oréal owns 9.2% of Sanofi, which is the successor to its 100% ownership of Synthélabo, which has been reduced over time by mergers and sales;
because a minority can lead to or determine the control of a group with a very fragmented shareholder base (Mediobanca in Generali) or in the case of a limited partnership (for example, for certain specialist real estate companies, the status of general manager offers a varying degree of control).

From a financial point of view, these minority shareholdings are seldom properly valued. When they are below the equity method threshold (a priori 20%, see Section 6.1), they may be completely forgotten by investors, especially if they do not pay dividends, if their historical cost price is low, or if their strategy is not explained clearly to investors.

The equity method of consolidation is not the holy grail, since the share of profit or loss accounted for by the equity method is not included in EBITDA, nor EBIT or free cash flow, which are aggregates frequently used for valuation purposes (Chapter 31) and in the analysis of indebtedness (Chapter 12). This is in addition to the acquisition of the shareholding reducing the company’s liquidity. Hence the deterioration in value if analysts do not do their job properly. To avoid this problem, it is in the company’s best interest to include the profits accounted for using the equity method in the operating profit as permitted by IFRS.

Our reader will note the asymmetry with the situation where the company disposes of a minority interest in one of its subsidiaries. Operating income and EBITDA are unchanged, but the company’s net debt has been reduced thanks to the cash received, which has a positive impact on the value of the company and its financial situation for those who run their calculations too quickly.

In any case, the value of a minority shareholding will be better protected if a shareholders’ agreement is signed with the majority shareholder and if the minority company is represented on the board.

Section 42.6 THE FINANCIAL STRUCTURE WITHIN THE GROUP

In arranging financing, the CFO must first determine where to situate the net debt within the group, and then which entities will use external financing and which entities will be financed by intra-group loans. These are two separate decisions because a group entity that indebts itself may well have zero net debt if it then lends to other group entities.

With regard to positioning the net debt, it is a good principle of financial management and internal governance to ensure that the surplus cash of subsidiaries systematically flows back to the parent company at least once a year. In this way, it can allocate financial resources between the different units in the best interests of the group, create or acquire new ones, and avoid the formation of internal baronies (based on the principle that the one who has the money has the power). It is therefore not advisable to locate the net debt within the parent company, leading to a poor parent and rich children.

The choice of the internal financing structure will depend on various parameters:

Tax aspects that consist of four main variables: the tax rate on profits in the country where they are generated, the tax cost of paying dividends (taxes and withholding taxes) in that country, the tax cost of collecting dividends in the receiving country, and finally the social acceptability of possibly having structures in countries considered as tax havens. Thus, for an American group, until 2017, it was expensive to repatriate dividends from countries where the corporate tax rate was lower than the federal rate of 35%, because it had to pay an additional tax to the Treasury for the difference. This is why Apple’s subsidiary in Ireland (official corporate tax rate of 12.5%) was so cash-rich and Apple Inc. so indebted! Several countries have put into place tax measures to limit intra-group indebtedness of subsidiaries (earning stripping rules in the US, thin capitalisation rules in the UK).
This will allow cash to accumulate in subsidiaries, thus imposing some form of internal financial structure on the CFO.
Legal constraints: These can, particularly currency exchange constraints, handicap the upward flow of liquidity from subsidiaries, forcing the development of wealthy subsidiaries within a group. As an example, even though no law or regulation stops the outflow of capital in China, the financial system (banks in particular) does so when asked by the government. Local subsidiaries are therefore obliged to keep their cash or invest it locally. Thus, since it is generally easier to send interest and loan repayments upwards than dividends, in a constrained legal environment internal debt is preferred.
The geography of the assets: if the assets are to be used as collateral for financing (see Section 39.1), the debt capacity will naturally depend on the legal ownership of the assets. The group will then indebt its operating subsidiaries (or possibly the holding companies holding listed securities, if any).
The motivation of local management: adopting LBO logic, the group’s management may wish its subsidiaries to be in debt as a matter of principle in order to create a “healthy pressure” for their management to generate cash flows at least sufficient to service the debt. This motivation will be all the more important as the debt will be owed to third parties. It is always possible to make arrangements with the parent company in the event of a default on an inter-company loan, but it is more complicated to do so with one’s bankers.
The presence of minority shareholders: it is often simpler to finance subsidiaries in which there are minority shareholders with external debt. Indeed, intra-group financing by debt in proportion to ownership percentages is complicated to implement, while financing solely by the majority shareholder raises the question of the interest rate to be charged in the context of normal governance.

The simplicity of a group’s financial structure generally goes hand in hand with its maturity. Most large groups are financed almost exclusively by bond debt issued by the parent company (Section 39.1), which then finances its subsidiaries through intra-group loans. Bond investors prefer to lend to the highest level of the group, which has access to all the cash flows, since they do not, at least for investment grade issuances, have any security on its assets.

Conversely, SMEs that use bank financing are more likely to use the assets of subsidiaries (receivables, inventories or even real estate assets) to secure lenders and thus obtain more attractive terms: factoring, securitisation of receivables and inventory, leasing of fixed assets.

The quality of the signature also plays an important role in the choices made by the CFO. The more financially sound the group is, the less it needs to secure its financing with assets, allowing the financing to be carried out at the level of the parent company. This makes steering easier for the central finance department.

The more financially strained groups use all available means to obtain financing and therefore use their liquid assets, generally located in the subsidiaries, as much as possible. Although this will make it more complex to monitor financing, the financial directors of subsidiaries have broader and often more motivating roles. At this level, an important and structural decision is whether or not to place non-recourse (on the group’s cash flows) financing with subsidiaries.

If third party indebtedness at the subsidiary level is high, lenders at the parent company level will see a specific risk that the rating agencies will also take into account. The subsidiaries’ lenders will have direct access to the assets in the event of liquidation whilst the parent company’s lenders will be naturally subordinated. They will only be able to recover a share of the value of these assets after the subsidiaries’ lenders have fully recovered their debts. This is structural subordination that worsens rapidly as the risk of bankruptcy increases.

But the CFO’s job does not stop there. Once they have conceived and set up this financial structure within the group, they will have to bring it to life. This means supplementing it with intra-group loans to supply units that do not have sufficient external financing. But also to determine the desirable and achievable dividend payouts from a financial, legal and tax point of view. The intra-group financial structure will live and evolve in line with the subsidiaries’ cash flow generation and the upwards flow of dividend payments.

Section 42.7 THE LEGAL STRUCTURE WITHIN THE GROUP

1/ TAX INFLUENCE

The hot topic in today’s global environment is transfer pricing. As a result of globalisation, it has become extremely rare for a product or service to be designed, manufactured and distributed in a single country, with components coming only from that country. More often than not, a product or service is designed in one country, manufactured in another country, often with components from several countries, and then distributed in a multitude of countries. Hence the ability, thanks to transfer pricing, to locate in any given country (the one with the least burdensome tax regime) the bulk of the value created.

Management fees, trademark and patent licences are other tools used to support this tax strategy for group organisation.

Countries which have seen their tax bases shrink as a result of these practices, have tracked down the most obvious abuses (predominantly the GAFAM), and now require precise, detailed and convincing documentation from any company to justify these schemes and the pricing used.

Schemes aimed at evading part of the tax burden, even perfectly legal ones, are less and less tolerated by citizens and are more and more frequently singled out, which is not without negative consequences to a company’s image and business (see Apple, McDonald’s, Google).

Optimising transfer pricing or the ownership location of intellectual property for trademark or patent royalties is not just a legal and fiscal choice. It requires a real operational change that commits the group to a long-term strategy (even though tax rules may change).

Beyond the tax aspects, these cash flows have the advantage for the majority shareholders not to be earned by the minority shareholders. Thus, it was financially far more effective for Disney to receive management fees from Euro Disney rather than to receive its share of dividends.

To conclude this subject, our reader should be aware that tax optimisation often goes against the very notion of simplicity, and that it is sometimes very complex and costly to unravel a structure set up for tax reasons.

We know of more than one group that has failed to dispose of a business for this reason or has done so with great difficulty.

2/ GEOGRAPHIC OR BUSINESS LINES HOLDINGS?

A group with several types of businesses may consider whether it is better to organise itself legally by having one holding company per country or geographical area, grouping together the companies carrying out each of the group’s businesses in the country or area; or whether it is better to set up vertical internal holding companies for each business, grouping together all the companies carrying out that business worldwide.

The first type of organisation is probably the one that maximises synergies within a group, since these are usually primarily geographical: purchasing power from national suppliers, shared administrative services, etc.

The second type of organisation makes it easier for minority shareholders to enter a given business unit, or even to take it public or sell it, which is more complicated to carry out under a geographical organisation. On the other hand, it is probably more costly, as it makes it more difficult to achieve internal synergies.

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

The organisation of a group evolves over time according to its strategy and constraints. If simplicity and legibility are the key to an accurate valuation, it may happen that the group strays from this line for a more or less lengthy period of time.

Diversification of activities is more frequent in groups controlled by a single shareholder, who thus reduces their risk, than for a listed company without a controlling shareholder, for which there is strong pressure from investors to avoid diversifying, as they have little appreciation for diversification that they can achieve themselves on their own terms. Failing this, the holding discount is the penalty.

A stock market listing allows shareholders to achieve a certain liquidity for their investment in the company. However, this liquidity is only real for large companies or only at the time of the IPO for smaller companies. For the company, an IPO provides access to new sources of financing, enhances its reputation and can create financial interest for its managers and employees in the improvement of its value. However, it implies having a strategy linked to financial parameters.

Opening up the capital of subsidiaries to minority shareholders provides leverage to raise funds, enables the value of an asset to be externalised and whilst facilitating external growth, can prepare for a phased divestment, reduces the weighting of an asset in the group’s results, allows the subsidiary to take more risks, gain a partner offering synergies, and motivates the subsidiary’s employees. If it is used too frequently, the company runs the risk of becoming a holding company with the discount that goes with it.

Being a minority shareholder in another company is most often an option for a non-financial group for future developments, even if from a financial point of view, these holdings are often poorly valued because they are not well known and identified by investors.

It is a good principle of financial management that the parent company of a group should be the one that takes on debt in order to lend to its subsidiaries and that net debt at its level should be as low as possible in order to maintain financial flexibility.

For a long time, international groups have been structured to reduce the tax friction associated with dividends paid by subsidiaries. Transfer pricing, a means of shifting margins around within the group often based on tax considerations, has taken over in group structuring. It is now very much in the hot seat because manipulating it is increasingly poorly viewed by society and is now strictly controlled by governments.

QUESTIONS

1/What are the reasons for a company to IPO?
2/Which investors benefit from the diversification of a group? And who loses?
3/Is diversification more common in countries with debt or financial market economies? Why?
4/What is the advantage of a “Dutch clause”?
5/What can investors fear in a holding group?
6/Is having an industrial or financial minority shareholder the same thing?
7/Why do some conglomerates continue to exist, despite the value destruction they bring? Is this sustainable?
8/What is the advantage of cascading ownership structures for the majority shareholder? What about for everyone else?
9/What is the difference between the holding discount and the conglomerate discount?
10/Is a joint venture sustainable ad vitam eternam?
11/What protects the value of a minority stake held by a group?
12/How is the manipulation of transfer prices a solution to dividend control in some emerging countries?
13/Is the holding company discount a foregone conclusion?
14/Is a parent company with low net debt the opposite of a parent company that borrows on behalf of its subsidiaries?
15/What does a listed group often do with free cash flow that has become copious after years of lean years during which it has opened up the capital of its subsidiaries to minority shareholders?
16/What is the percentage interest of a shareholder in an asset that they own 51% of through four holding companies that all have 49% minority shareholders? Do you then better understand the expression “Working for peanuts”?
You’ll find more questions at www.vernimmen.com.

EXERCISE

ANSWERS

Questions

1/Access new sources of funding. Increase its visibility for its customers, suppliers, employees. Facilitate employee and management incentives. Offer liquidity to its shareholders (especially if there are minority shareholders).
2/Lenders because their risk is reduced. Shareholders, because a diversified group is more difficult to manage and is rarely more efficient than a single-business group.
3/In indebted economies with poorly developed financial markets, large groups are a substitute to financial markets.
4/Discouraging strategic differences between shareholders and, in the event of divorce, obtaining a fair price for both parties.
5/A misallocation of funds to the benefit of the worst performing divisions and to the detriment of the best.
6/No, the industrial investor can bring synergies but will quite possibly want to take control in the long term; the financial investor will sooner or later want to exit to show a profit.
7/Because of the incentives it provides its owners and management: power, prestige. No, because sooner or later the pressure from the shareholders will be felt.
8/Secure control with limited means. Choose the assets you want to be a shareholder of.
9/See Section 42.1 and 42.3.
10/Rarely. Either it succeeds, in which case one of the partners will want to buy the other’s share so as to keep the profits for itself. Or it fails or plods along and one of the partners will want to exit to turn the page on the investment.
11/A shareholders’ agreement with the majority shareholder, a position on the board of directors. Takeover regulations if the company is listed.
12/By transferring the transfer pricing margin out of the country, there is no longer any significant profit to be repatriated as a dividend.
13/Yes, because Warren Buffett’s holding company is almost the only one to be quoted on exchanges at a premium to its revalued net assets.
14/No, because if it borrows to lend to its subsidiaries, the parent company’s net debt may be low.
15/It buys out minority shareholders to increase its stake in its subsidiaries to 100%.
16/(51%)⁵ = 3.5%. Each time the value of the asset increases by 100 thanks to their good management, they only get 3.5% richer. So they are working for the other investors more than for themselves!

Exercise

1/This problem is based on a fallacy, i.e. a false reasoning that has the appearance of truth.
It is wrong to say that it is equivalent to having one company growing by 0% or two divisions of identical size growing by 5% and −5 %, even though it is true that 5% − 5% = 0%. Indeed, very quickly the two divisions will no longer generate the same free cash flow because of their diverging growth rates. For example, after five years, the flow of the first is 128 and that of the second 77. It will no longer be possible to say that the group’s growth rate is the average between 5% and −5%, i.e. 0%. It will be the weighted average of 5% and −5%, but with different weightings from the initial 50% − 50%. Moreover, in the long term, the group’s growth rate will converge towards 5%, since by constantly decreasing by 5% every year, the second division will eventually disappear: in year 50, its flow will be 8 against 1,147 for the first division. A few years later, only the first division will be left, which will become the group as a whole, and will therefore grow at 5%.
Therefore the discounted cash flow valuation of the group is 2,667 and not 2,000. But to do this, the CFO will need to do some pedagogical work by communicating on the performance of the two divisions, or by listing the first one on the stock exchange, or even splitting the group into two parts to avoid significant undervaluation (25% in our example).

BIBLIOGRAPHY

For further information concerning group organisation:

R. Aggarwal, A. Samwick, Why do managers diversify their firms? Agency reconsidered, Journal of Finance, 58(1), 71–118, February 2003.
B. Cornell, Liu Q., The parent company puzzle: when is the whole worth less than one of the parts?, Journal of Corporate Finance, 7(4), 341–366, December 2001.
H. Cronqvist, M. Nilsson, Agency costs of controlling minority shareholders, Journal of Financial Quantitative Analysis, 38(4), 695–719, December 2003.
Lin C., Ma Y., Xuan Y., Ownership structure and financial constraints: evidence from a structural estimation, Journal of Financial Economics, 102(2), 416–431, November 2011.
S. Myers, Financial architecture, European Financial Management, 5(2), 133–141, July 1999.

For further information concerning initial public offerings:

J. Asker, J. Farre-Mensa, A. Ljungqvist, Corporate investment and stock market listing: A puzzle?, Review of Financial Studies, 28(2), 342–390, February 2015.
F. Bancel, U. Mittoo, Why do European firms go public?, European Financial Management, 15(4), 844–884, September 2009.
A. Boot, R. Gopalan, A. Thakor, The entrepreneur’s choice between private and public ownership, Journal of Finance, 61(2), 803–836, April 2006.
C. Doidge, K. Kahle, G.A. Karolyi, R. Stulz, Eclipse of the public corporations or eclipse of the public markets?, Journal of Applied Corporate Finance 30(1), 8–16, Winter 2018.
A. Subrahmanyam, S. Titman, The going public decision and the development of financial markets, Journal of Finance, 54(3), 1045–1082, June 1999.

NOTES

1 See Section 46.3.
2 Asker et al. (2015).

Chapter 43. CORPORATE GOVERNANCE

Or on being politically correct

Problems with corporate governance arise as a result of changes in the capital structure and organisation of companies. Corporate governance is not an issue for companies where the manager is the sole shareholder. But gradually the founding shareholder’s stake will be diluted and corporate governance issues will arise between the majority shareholder, who is also usually the manager, and minority shareholders. When a company starts out as family owned and evolves into a company with a fragmented shareholding of institutional and retail investors, new problems of corporate governance will arise. These will relate to control that the shareholders have over the managers, who will have less freedom as a result of the fragmented shareholding structure.

Section 43.1 WHAT IS CORPORATE GOVERNANCE?

1/ DEFINITION

Broadly speaking, corporate governance is the organisation of the control over, and management of, a firm. It covers:

the definition of the legal framework of the firm: specifically, the organisation, the functioning, the rights and responsibilities of shareholders attending meetings and the corporate bodies responsible for oversight (board of directors or executive board and supervisory board);
the rules for appointing and remunerating managers and directors;
management rules and any conflicts of interest;
the organisation of control over the management and the running of the company: internal controls, regulatory controls, auditing;
the relations between managers and shareholders;
the rights and responsibilities of other stakeholders (lenders, customers, suppliers, employees);
the disclosure of financial information on the firm and the role and responsibility of external analysts: financial analysts, rating agencies and legal and financial advisors.

In a narrower definition, the term “corporate governance” is used to describe the link that exists between shareholders and management. From this point of view, developments in corporate governance mainly involve the role and functioning of boards of directors or supervisory boards.

We would suggest¹ that corporate governance covers all of the mechanisms and procedures surrounding decisions relating to the creation and sharing of value. They concern four main areas: shareholders’ rights, transparency of information, organs of management and control and the alignment of compensation.

2/ RECOMMENDATIONS AND GUIDELINES

It should always be remembered that the organisation of corporate governance is determined, first and foremost, by company law, which defines the field of possibilities:

prerogatives of the market regulator;
listed companies’ information obligations (shareholders’ agreements, etc.);
vote by shareholders on managers’ compensation;
composition of the board of directors (maximum number of directorships in public limited companies);
possibility of separating the function of chairman of the board of directors from that of CEO;
transparency with regard to conditions for preparing and organising the work of the board of directors and internal control procedures.

Over the years, a number of recommendations and guidelines have been added to the purely regulatory and legislative framework, in the form of reports and best practice codes (commissioned and/or drafted by employer bodies, investor associations, governments and government agencies, stock exchanges, etc. in various countries). It is important to note that these codes remain recommendations and guidelines only,² and are not legally binding laws or regulations.

The main recommendations and guidelines in terms of corporate governance all focus on key issues: transparency in the way that the board and management operate, the role, composition and functioning of the board and the exercise of shareholder power at general meetings.

However, each country has its own category when it comes to companies and their shareholders:

employee rights in Germany (and also in Denmark, Austria and Sweden);
the role of banks and conglomerates in Japan and South Korea;
very widely held shareholdings in the UK or USA;
etc.

(a) Transparency

The first recommendation is for transparency in the way the company’s management and supervisory bodies operate.

Transparency surrounding the compensation of managers and directors is also recommended. As we saw in Section 26.3, the way in which firms compensate management plays a key role in reducing conflict between shareholders and managers.

In some countries, shareholders vote on management compensation (say on pay). It is either a consultative vote (Germany, Spain, USA) or a binding one (France, Sweden, the Netherlands, Switzerland, UK).

With the granting of variable compensation or stock options, managers have a financial interest that coincides with that of shareholders, to whom they are accountable. Stock options are not, however, a cure-all, as the short-term vision they encourage may sometimes tempt management to conceal certain facts when disclosing financial information and, in extreme cases, they may even consider committing fraud. This has resulted in the development of alternative products, such as the granting of free shares, the payment of part of their compensation in shares, etc., or by tightening the conditions for exercising stock options and selling the underlying shares, and linking them to criteria that are not only financial, such as ESG criteria.

The principle of transparency also applies to transactions carried out by management in the shares of the company. These have to be made public due to the signals that they may give out.

Finally, in reaction to the payments made to managers who had failed (Technip FMC, Sanofi, UBS, etc.), which were, and rightly so, shocking in terms of both the amount and the principle, it is often recommended that these “golden parachutes” only be paid in the event of forced departure and linked to a change in control or strategy and for an amount that does not, in general, exceed one or two years’ salary. Sometimes this compensation is subordinate to performance conditions.

(b) The role of an independent board

Corporate governance codes all recommend that a firm’s corporate strategy be defined by a body (board of directors or supervisory board) which enjoys a certain degree of independence from management.

Independence is achieved by limiting the number of managers who sit on the board, and by setting a minimum number of independent directors.

For example, in the UK the latest recommendation is that at least half of the directors of listed companies should be independent. There are very few companies with no or hardly any independent directors on the board.

The definition of the term “independent director” is the subject of much controversy. As an example, the Bouton report defines an independent director as follows: “Directors are independent when they have no link of any nature whatsoever with the company, the group or management, which could compromise them in the exercise of their free will.” Even though this definition makes it clear that a member of management or a majority shareholder representative would not be considered independent, it allows for a great deal of leeway, which means that deciding whether or not a director is indeed independent is not as easy as it might appear.

The importance given to the need for independent directors on the board tends to overshadow the importance of other more vital matters, such as their competence, their availability and their courage when it comes to standing up to management. These qualities are indispensable throughout the financial year, whereas their independence only becomes an issue in situations of conflict of interest, which fortunately are the exception rather than the rule.

The importance of independent directors is highlighted by the appointment of an independent director to the position of vice chairman of the board or lead independent director (Nike, GSK, Danone, etc.), especially when the roles of Chairman of the Board and Chief Executive Officer are fulfilled by the same individual.

The lead independent director plays a leadership role for the independent directors and has a little more power than the others. They may put up items for discussion on the board’s agenda, call a meeting of the board members without the presence of senior management, or even, if they believe that the CEO is no longer up to the task, take steps to have the latter replaced. They are also often in charge of the dialogue with non-controlling shareholders on governance topics.

Lawyers will surely forgive us for pointing out that the development of corporate governance has brought an end to the idea of the board of directors as an entity invested with the widest of powers, authorised to act in all circumstances in the name of the company. This gives the impression that the board was responsible for running the company, which was quite simply never the case. This erroneous idea put management in a position where it was able to call all of the shots. These days, boards are designed to determine the direction the company will take and to oversee the implementation of corporate strategy. This is a much more modest mandate, but also a lot more realistic. The board is asked to come up with fewer but better goods.

(c) The functioning of the board and of directors’ committees

Corporate governance codes insist on the creation of special committees that are instructed by the board to draw up reports. These committees generally include:

an audit committee (inspects the accounts, monitors the internal audit, selects the external auditors);
a compensation committee (managers, sometimes directors);
a selections or appointments committee (paves the way for the succession of the managing director and/or CEO, puts forward proposals for new directors);
a strategic and/or financial committee (large capex plans, mergers and acquisitions, financing issues);
a risk committee;
an ethics and/or governance and/or social responsibility committee.

(d) The exercise of shareholder power during general meetings

It is clear that anything that stands in the way of the exercise of shareholder power will be an obstacle to good corporate governance. Such obstacles can come in various forms:

the existence of shares with multiple voting rights that may enable minority shareholders with only a tiny stake in the capital to impose their views by wielding their extra voting rights (see Section 41.2);
the existence of preferred shares with no voting rights attached.³ The control held by the Hoffmann family over the Swiss pharmaceutical group Roche is greatly facilitated by the existence of non-voting shares accounting for 81.5% of the share capital;
the restriction of voting rights in meetings by introducing caps on the number of votes cast during general meetings. For example, at Danone, a single investor cannot represent more than 6% or 12%⁴ of the voting rights;⁵
administrative or material restrictions on exercising voting rights by proxy or by postal vote.

On the other side, making it compulsory for institutional shareholders to vote in general meetings of shareholders, or allowing shareholders to vote without having to freeze their shares a few weeks before the meeting, can clearly improve voting habits and enhance shareholder democracy.

The rise of securities lending may raise the issue of representativeness of general meetings. Shareholders who have lent their securities cannot vote at General Meetings, while still maintaining their economic exposure; the opposite is true for those who have borrowed securities. This is why securities lending exceeding a percentage of voting rights must be declared in some countries.

3/ A ONE-TIER OR A TWO-TIER BOARD: AN UNRESOLVED ISSUE

The way in which power within the board is organised is, in itself, a much debated topic. The need for a body that is independent of the management of the company remains an open question. We can observe three main types of organisation:

board of directors with a chief executive officer acting also as chairperson of the board. This means that a great deal of power is concentrated in the hands of one person, who is head of the board and who also manages the company. This is known as a one-tier structure and is in place at groups such as ExxonMobil, Amazon and Telefónica;
board of directors with an executive or a non-executive chairperson and a separate chief executive officer. This sort of dual structure has been adopted by Infosys, Sony and Vodafone;
supervisory board and executive board: this two-tier structure is in place at Sanofi, BMW and Philips.

*Source*: Data from Board Governance, International Comparison, Spencer Stuart, 2020

A board on which the control and management roles are exercised by two different people should, in theory, be more effective in controlling management on behalf of the shareholders. Is this always the case in practice? The answer is no, because it all depends on the quality and the probity of the men and women involved. Enron had a chairman and chief executive officer, and L’Oréal has a chief executive officer also acting as chairman of the board. The former went bankrupt in a very spectacular way as a result of fraud and the latter is seen as a model for creating value for its shareholders.

So it is much better to have an outstanding manager, and possibly even compromise a bit when it comes to corporate governance, by giving the manager the job of both running the company and chairing the board, rather than to have a poor manager. Even if extremely well controlled by the chair of the board, a poor manager will remain a poor manager!

An additional question arises when it comes to the choice of the chairperson of the board: can they be the former CEO? Certainly not in the UK. If this were the case, the margin for manoeuvre of the new CEO would be restricted, as the chairperson will be tempted to keep some kind of management role. The chairperson is usually recruited from outside the company, and is often a former CEO of a company in another sector who will spend one or two days a week performing the job of chairperson.

In France or Germany,⁶ for example, this is often the case, on the basis of the fact that the new chairperson’s experience and knowledge of the company will be highly valuable. The split between the two functions often comes at the time of succession, so that the new CEO can prove their skills. Most of the time, the two functions are generally brought back together (Schneider, Total), but there are exceptions (Sanofi).

It cannot be denied that great strides forward have been taken in the area of corporate governance, even if there is still progress to be made in some emerging countries with less experience in dealing with listed companies and minority shareholders. Associations of minority shareholders, or minority shareholder defence firms, which also provide shareholders with advice on how to vote in general meetings, have often acted as a major stimulus in this regard.

The fact that, in developed countries, many groups have simplified their structures has made this a lot easier: these days, it is usually only the parent company that is listed, which eliminates the possibility of conflicts of interest between the parent company and minority shareholders of its subsidiaries;⁷ cross-holdings between groups which used to swap directors have been unwound;⁸ assets used by the group but which belong to the founders have been apportioned to the group.

4/ ESG GOVERNANCE IN THE COMPANY

It is a bit of a mirroring device to talk about ESG governance because the “G” in ESG represents governance. Thus, the purpose of ESG is to ensure good governance of the company.

But structuring actions to improve the company’s impact on the environment and society and maintaining good governance requires the establishment of governance. In some countries, the first link can be integrated into the company’s articles of association, which can adopt a raison d’être allowing the company to commit resources to a goal other than the creation of value for its shareholders and thus set itself precise environmental and social objectives.

To go further, the company may decide to become a B-Corp or similar mission-driven company. The B-Lab provides certification to corporates that meet certain criteria in matters of sustainability and inclusion.

Some people argue that retaining the status of a B-Corp or mission-driven company can act as a poison pill to avoid takeovers. We do not think so; first of all, because those companies must nevertheless take care of their financial performance. Non-performing companies will not be able to ensure their mission in the long term. Moreover, abandoning the mission or the B-Corp status is even easier than adopting it …

Section 43.2 CORPORATE GOVERNANCE AND FINANCIAL THEORIES

1/ THEORY OF MARKETS IN EQUILIBRIUM

The classic theory is of little or no help in understanding corporate governance. What it does is reduce the company to a black box, and draws no distinction between the interests of the different parties involved in the company.

2/ AGENCY THEORY

Agency theory is the main intellectual foundation of corporate governance. The need to set up a system of corporate governance arises from the relationship of agency that binds shareholders and managers. Corporate governance is the main means of controlling management available to shareholders. What corporate governance aims to do is to structure the decision-making powers of management so that individual managers are not able to allocate revenues to themselves at the expense of the company’s shareholders, its creditors and employees and, more generally, society as a whole.

Governance also aims at reducing the natural information asymmetry that exists between management and shareholders, corporate governance also covers financial communication in the very broadest sense of the term, including information provided to shareholders, work done by auditors, etc.

A good system of corporate governance, i.e. a good set of rules, should make it possible to:

limit existing or potential conflicts of interest between shareholders and management;
limit information asymmetry by ensuring transparency of management with regard to shareholders.

Unsurprisingly, agency theory shows that in firms where there are few potential conflicts of interest between shareholders and management and where information asymmetry is low, i.e. in small and medium-sized companies where, more often than not, the manager and shareholder is one and the same person, corporate governance is not an issue.

3/ ENTRENCHMENT THEORY

Agency theory suggests mechanisms for controlling and increasing the efficiency of management. Entrenchment theory¹¹ is based on the premise, somewhat fallacious but sometimes very real, that mechanisms are not always enough to force management to run the company in line with the interests of shareholders. Some managers’ decisions are influenced by their desire to hold onto their jobs and to eliminate any competition. Their (main) aim is to make it very expensive for the company to replace them, which enables them to increase their powers and their discretionary authority. This is where the word “entrenchment” comes from. Managerial entrenchment and corporate governance do not make good bedfellows.

Section 43.3 VALUE AND CORPORATE GOVERNANCE

An initial response to the question “Does good corporate governance lead to value creation?” is provided by a survey of institutional investors carried out by McKinsey.¹² The investors surveyed stated that they would be prepared to pay more for shares in a company with a good system of corporate governance in place. The premium investors are prepared to pay in countries where the legal environment already provides substantial investor protection is modest (12%–14% in Europe and North America), but very high in emerging countries (30% in Eastern Europe and Africa).

The very large number of studies on the subject focus on the problem of coming up with a definition of good corporate governance. Existing studies merely rely on ratings provided by specialised agencies to back up their conclusions, which in our view provides no new insight into the subject.

Their results¹³ show that good corporate governance does lead to the creation of shareholder value. Bauer, Guenster and Otten have shown that the shares of groups listed on the FTSE 300 that were given a good rating for their corporate governance performed significantly better than groups with “weak” corporate governance. These results tie in with results for US companies put forward by Gompers.

The results are all the more revealing when one considers that local law does not guarantee satisfactory corporate governance. For example, it would appear that a Russian group that adopts (and communicates) an efficient system of corporate governance will create value (Black 2001).

More generally, Anderson and Reeb in the USA and Harbula in France have shown that the financial performance of companies with one main shareholder (for example, a family) is better than average. But the best-performing companies are those with one major shareholder and also a fairly large free float. Ideally, the main shareholder should hold a stake of between 30% and 50% in the company’s share capital. This may seem counterintuitive, in as far as family-owned companies are generally less transparent and comply less willingly with the rules of corporate governance. On the other hand, majority or dominant shareholders are very motivated to ensure that their firms are successful, given that such firms often represent both the tools of their trade and their entire fortune!

Research focuses mostly on the correlation between good corporate governance and high valuations. Very few studies have been able to demonstrate any real correlation between corporate governance and the long-term financial performance of the company. But then nobody has shown that corporate governance has a negative impact on financial performance either!

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

Broadly speaking, corporate governance is the organisation of the control over, and management of, a firm. A narrower definition of corporate governance covers the relationship between the firm’s shareholders and management, mainly involving the functioning of the board of directors or the supervisory board.

Corporate governance is determined, first and foremost, by company law, but there are also a number of reports and best-practice codes that complement the recommendations and guidelines contained in the strictly legal framework.

These recommendations and guidelines deal with subjects such as transparency in the functioning of the board of directors, the choice of directors, the role and independence of the board, and the setting up of specialised committees to help the board in its work.

Corporate governance is one of the main means of reducing agency costs arising out of the potentially damaging relationship between shareholders and management.

Studies on corporate governance and value tend to demonstrate that good corporate governance will create value. This is even more the case for large firms based in countries where the legal framework is very loose. For small firms, the cost of introducing a sophisticated system of corporate governance can be prohibitive. Generally, there is less need for such a system in smaller firms where the managers are often the main shareholders (which prevents conflicts of interest) and there are very rarely minority shareholders.

QUESTIONS

1/Which financial theory best explains the development of corporate governance?
2/Why has corporate governance mainly developed at listed companies?
3/How do stock options help in aligning the interests of managers with those of shareholders? What are their limitations?
4/Name a firm where practically half of the 18 directors were independent, which did not prevent it from discovering peculiar practices after their CEO was arrested.
5/What is the danger when a board has specialised committees?
6/What should an overworked director who has only been able to attend every other board meeting do?
7/What is the most important – an independent director, a hard-working director, a competent director or a courageous director? What is the ideal?
8/In which kind of countries is it more important for a firm to have a system of corporate governance in place?
9/What is the link between corporate governance and the cost of capital?
10/Does the regular rotation of a firm’s statutory auditors improve corporate governance?
11/Is corporate governance relevant at companies over which the state exercises full control?
12/What are your views on a firm that replaces its one-tier board with a two-tier board and then, a few years later, reverts to a one-tier board, like Vinci did, or which asks its CEO to be chair of the board as well before reverting to the previous system a few years later, like Nestlé did?
13/Is it a good idea, with a view to providing directors with better information, for the auditor to be a director of the company as well?
14/What are the pros and cons of separating the position of chair of the board from that of CEO?
You’ll find more questions at www.vernimmen.com.

ANSWERS

Questions

1/Agency theory.
2/Agency costs are lower at unlisted companies (less widely held capital, shareholders closer to management). It could be too expensive for small firms to introduce sophisticated corporate governance systems.
3/They provide an incentive to managers to create value for shareholders of which they will capture a part through their stock options. Drawbacks are focusing management’s attention on the value of their stock options and not on the value of the share: no dividend, high risk taken, especially since the stock-options were given for free to managers and not acquired.
4/Renault-Nissan. The independence of directors is not sufficient if they miss lucidity and courage facing a charismatic CEO who has a stunning career.
5/The other directors may not always assume their full responsibility and the committee may turn into a decision-making body instead of a body that prepares all of the directors for making decisions.
6/Resign. The position of director is not just a fancy title, it’s a job like any other.
7/A competent and courageous director. If possible, all four!
8/In countries where ownership rights are less secure, i.e. emerging countries.
9/Good corporate governance should reduce the cost of capital, because it eliminates the risk of poor management and/or fraud, which would penalise minority shareholders.
10/On paper, yes, because it means that a new set of eyes will be looking at recurrent problems. But this has not been borne out by academic research.
11/Yes, there is no reason why not, since conflicts of interest can also exist between the state and the managers of state-run companies.
12/It’s an intelligent move, demonstrating the ability to adapt to change. Sometimes a change in structure is needed when there’s a new manager at the head of a group.
13/No, as a matter of fact, it’s not allowed. Nobody can be a judge and a party to the project.
14/Separating the role of control and management, of long-term decisions and day-to-day management, doubles the number of top corporate officers. Personal conflicts may arise which make it unmanageable.

BIBLIOGRAPHY

On corporate governance:

R. Aggarwal, I. Erel, M. Ferreira, P. Matos, Does governance travel around the world? Evidence from institutional investors, Journal of Financial Economics, 100(1), 154–181, April 2011.
T. Clarke, International Corporate Governance: A Comparative Approach, 2nd edn, Routledge, 2017.
H. Demsetz, The structure of ownership and the theory of the firm, Journal of Law & Economics, 26(2), 375–390, June 1983.
Heidrick & Struggles, Board Monitor Europe 2019, 2019.
B. Hermalin, M. Weisbach, Information disclosure and corporate governance, Journal of Finance,67(11), 195–233, February 2012.
M. Jensen, W. Meckling, Theory of the firm: Managerial behavior, agency costs and ownership structure, Journal of Financial Economics, 3(4), 305–360, October 1976.
R. La Porta, F. Lopez de Silanes, A. Shleifer, R. Vishny, Law and finance, Journal of Political Economy, 106(6), 1133–1155, December 1998.
R. Leblanc, The Handbook of Board Governance, Wiley, 2016.
R. Mork, A History of Corporate Governance around the World: Family Business Groups to Professional Managers, University of Chicago Press, 2007.
B. Tricker, Corporate Governance: Principles, Policies and Practices, 4th edn, Oxford University Press, 2019.
www.ecgi.org, the website of the European Corporate Governance Institute.
www.icgn.org, the website of the International Corporate Governance Network.
www.oecd.org, the website of the OECD, which devotes a large section to corporate governance issues.

On stock options and variable remuneration:

M. Goergen, L. Renneboog, Managerial compensation, Journal of Corporate Finance, 17(4), 1068–1077, September 2011.
A. Morgan, A. Poulser, Linking pay to performance-compensation proposal in the S&P 500, Journal of Financial Economics, 62(3), 489–523, December 2001.
McKinsey, Global Investor Opinion Survey on Corporate Governance, 2002.

On directors and managers:

R. Fahlenbrach, A. Low, R. Stulz, Why do firms appoint CEOs as outside directors?, Journal of Financial Economics, 97(1), 12–32, July 2010.
R. Masulis, S. Mobbs, Are all inside directors the same? Evidence from the external directorship market, Journal of Finance, 66(3), 823–872, June 2011.
B.D. Nguyen, K.M. Nielsen, The value of independent directors: Evidence from sudden death, Journal of Financial Economics, 98(3), 550–567, December 2010.
A. Shleifer, R.W. Vishny, Management entrenchment: The case of manager-specific investments, Journal of Financial Economics, 25(1), 123–139, 1989.
www.boardmember.com, an information resource for senior officers and directors of publicly traded corporations.

On value and corporate governance:

R.C. Anderson, D.M. Reeb, Founding-family ownership and firm performance: Evidence from the S&P 500, Journal of Finance, 58(3), 1301–1328, June 2003.
R. Bauer, N. Guenster, R. Otten, Empirical evidence on corporate governance in Europe. The effect on stock returns, firm value and performance, Journal of Asset Management, 5(2), 91–104, August 2004.
L. Bebchuk, A. Cohen, A. Ferrell, What matters in corporate governance, Review of Financial Studies, 22(2), 783–827, February 2009.
B. Black, The corporate governance behavior and market value of Russian firms, Emerging Markets Review, 2(2), 89–108, 2001.
M. Cremers, A. Ferrell, Thirty years of shareholders rights and firm value, Journal of Finance, 69(3), 1167–1196, June 2014.
V. Cuñat, M. Gine, M. Guadalupe, The vote is cast: The effect of corporate governance on shareholder value, Journal of Finance, 67(5), 1943–1977, October 2012.
C. Doidge, G. Karolyi, R. Stulz, Why do countries matter so much for corporate governance?, Journal of Financial Economics, 86(1), 1–39, October 2007.
A. Durnev, E. Han Kim, To steal or not to steal: Firm attributes, legal environment and valuation, Journal of Finance, 60(3), 1461–1493, June 2005.
P. Gompers, J. Ishii, A. Metrick, Corporate governance and equity prices, Quarterly Journal of Economics, 118(1), 107–155, February 2003.
P. Harbula, The ownership structure, governance and performance of French companies, Journal of Applied Corporate Finance, 19(1), 88–101, Winter 2007.
M. Jensen, W. Meckling, Theory of the firm: Managerial behavior, agency costs and ownership structure, Journal of Financial Economics, 3(4), 305–360, October 1976.
R. La Porta, F. Lopez de Silanes, A. Shleifer, R. Vishny, Investor protection and corporate valuation, Journal of Finance, 57(3), 1147–1170, June 2002.

NOTES

1 Based on the OECD approach.
2 In some countries, such as the UK and France, listed companies are required to disclose whether or not they implement codes of corporate governance, which is clearly a very strong incentive for them to do so! This is called the “Comply or Explain” principle.
3 See Section 24.3.
4 Depending on whether the shares the investor holds carry double voting rights or not.
5 This restriction will no longer apply if, following a takeover, a third party is in possession of more than 66.7% of the shares.
6 After a period of two years, unless approved by 25% of shareholders.
7 Take the example of Allianz, which bought out the minority shareholders of its listed subsidiary Euler Hermes, making it a wholly owned subsidiary.
8 For example, Deutsche Bank is no longer a large shareholder in large German groups.
9 See Section 33.2.
10 See Section 45.3
11 Initially developed by A. Shleifer and R. Vishny.
12 McKinsey Investor Opinion Survey, 2002.
13 See Bibliography.

Chapter 44. INITIAL PUBLIC OFFERINGS (IPOS)

Welcome to the wonderful world of listed companies!

Theoretically, the principles of financial management that we have developed throughout this book find their full expression in the share price of the company. They apply to unlisted companies as well, but for a listed company, market approval or disapproval – expressed through the share price – is immediate. Being listed enables companies to access capital markets and have a direct understanding of the market value of their companies.

Being listed enables a company to raise funds in a few weeks or even a few days because:

financial analysts periodically publish studies reviewing company fundamentals, reinforcing the market’s efficiency;
listing on an organised market enables financial managers to “sell” the company in the form of securities that are bought and sold solely as a function of profitability and risk. Poor management is punished by poor share price performance or worse – from management’s point of view – by a takeover offer which leads to a change in management;
listed companies must publish up-to-date financial information and file an annual report (or equivalent) with the market authority.

We refer the reader interested in the reasons for an IPO to Section 42.2 where we discuss this topic.

Section 44.1 PREPARATION OF AN IPO

It usually takes at least six months between the time the shareholders decide to list a company and the first trading in its shares.

This six-month period provides an opportunity for management to revisit some financial decisions made in the past that were appropriate for an unlisted, family-owned company or for a wholly owned subsidiary of a group, but which would not be suitable for a listed company with minority shareholders, such as:

preparing accounts in line with accounting standards required for listed companies which may be different from the ones used by private companies, and introduce reporting procedures that cover the whole of the entity to be listed;
reviewing the group’s legal structure in order to ensure that vital assets (brands, patents, customer portfolios, etc.) are fully owned by the group and that the group’s legal form and articles of association are compatible with listing (no simplified joint-stock companies and no pre-emptive rights or special agreements in the articles);
reviewing the group’s operating structure, ensuring that it is an independent group with its own means of functioning and that it does not retain the structure of a division of a group or a family-run business (terminate employment contracts with non-operational family members, take out necessary insurance policies, draw up management agreements, etc.);
drawing up a shareholders’ agreement if needed (see Chapter 41);
introducing corporate governance appropriate for a listed company (independent directors, control procedures, board of director committees, etc. – see Chapter 43);
reviewing the company’s financial structure in order to ensure that it is similar to that of other listed companies in the same sector. This applies particularly to companies under LBO, which will have to partially deleverage via a share issue, at the latest at the time of listing;
adopting a well-thought-out dividend policy that is sustainable over the long term and that will not compromise the group’s development (see Chapter 36);
introducing a scheme for providing employees with access to the company’s shares through the allocation of free shares and/or stock options, etc. (see Chapter 42);
defining the company strategy in a form that is simple and easy to communicate, which will become the equity story to be told to the market at the time of listing.

From the start of this phase, the company should seek the assistance of an investment bank, which will act as a link between the company and the market. The company will also have to retain the services of a law firm, an accounting firm and possibly a PR agency.

The overall cost of the IPO is between €0.5m and €1m in fixed costs (lawyers, communications agency, roadshows) plus between 5% and 7% of funds raised as fees for the bank syndicate.

Even with this help, the management team will have a very heavy overload of work during these six months because the operational side will not have to be sacrificed for all that!

Section 44.2 EXECUTION OF THE IPO

1/ CHOOSING A MARKET

With rare exceptions, the natural market for the listing is the company’s home country. This is where the company is best known to local investors, who are the most likely to give it the highest value. There are obviously a few exceptions, such as L’Occitane and Prada, which elected for a Hong Kong listing (given that both companies’ activity is highly developed in Asia) and Criteo, which chose New York to facilitate its US expansion and where most of its peers were listed. But only a very small number of companies from major European countries are not listed in their home country.

Having said that, some stock exchanges act as magnets for some sectors, such as New York for technology companies or London for mining groups.

The next question is whether there should be a second listing on a foreign market. Listing on a foreign market generally triggers direct and indirect costs without any guarantee of greater liquidity or a higher valuation of the company.

Only groups from emerging countries, when their local market is underdeveloped (Russia, Latin America, etc.), gain a clear advantage from a listing in New York, London, Paris or Hong Kong. The Nigerian e-commerce group Jumia is a good example, with its listing in New York in 2019. The Swiss-based mining and trading group Glencore chose London (and Hong Kong) as most mining groups are listed in London.

2/ SIZING THE IPO

Over and above the choice of a stock market (or several) for listing, a certain number of parameters will have to be fixed, including the size of the IPO and the choice between a primary offer (share issue), a secondary offer (sale of shares by existing shareholders) or a mix of the two.

These decisions will be made based on the following:

whether existing shareholders want to convert all or part of their stakes into cash;
whether the company needs funds to finance its growth or to deleverage;
the need to put a sufficient number of shares on the market so that the share can offer a certain amount of liquidity;
the need to limit the negative signal of the transaction.

These constraints can sometimes turn out to be contradictory. For example, the sale of all of the existing shares on the market by existing shareholders is rarely considered, as this would send a very negative signal to the market. So, when the IPO includes the sale by one or more major shareholders of some of their shares, they will generally be asked to undertake to hold onto the shares that have not been sold for a given period (6–12 months) so as to avoid any heavy impact on the market if they were to sell large volumes of shares immediately after the IPO. This undertaking, or lock-up clause, acts as a reassurance to the market and tempers the negative signal of the operation.

It may also be a good idea to combine the sale of shares by existing shareholders with a capital increase, even if the company has no immediate need of funds. The message sent by an IPO through a capital increase is, by definition, more positive. The newly listed company will be able to speed up its development and to tap a new source of funding, which is why most IPOs are partly primary, whether to a larger or smaller degree.

THE 10 LARGEST IPOS WORLDWIDE OF ALL TIME

Rank	Company	Stock exchange	Sector	Proceeds ($bn)	Year
1	Saudi Aramco	Saudi Arabian stock exchange	Oil	25.6	2019
2	Alibaba	New York (NYSE)	Ecommerce	25	2014
3	Agricultural Bank of China (ABC)	Shanghai and Hong Kong	Bank	22	2010
4	Softbank	Tokyo Stock Exchange (TSE)	Conglomerate	21.3	2018
5	Industrial and Commercial Bank of China (ICBC)	Shanghai and Hong Kong	Bank	19.1	2006
6	NTT DoCoMo	Tokyo Stock Exchange (TSE)	Telecom and Internet	18.1	1998
7	Visa	New York (NYSE)	Financials	17.9	2008
8	AIA	Hong Kong (HKEx)	Insurance	17.8	2010
9	Enel	Milan and New York (NYSE)	Utility	16.5	1999
10	Facebook	New York (NASDAQ)	Internet	16.0	2012

Source: Dealogic.

3/ IPO TECHNIQUES

While the classic method of listing remains the constitution of an order book (see Chapter 25), two new techniques have developed strongly in recent years: direct listing and merger with a SPAC (Special Purpose Acquisition Company).

Direct listing is a simple IPO method: a company wishing to become listed simply lists its shares on a regulated market and lets supply (from shareholders wishing to monetise their investment) and demand (from investors wishing to buy shares) set the equilibrium price. In the United States, a reference price is indicated but is not binding. This technique does not therefore require the intervention of a bank as is the case for IPOs by setting up an order book.

This technique is normally less costly than an IPO through the creation of an order book because the company saves the banks’ fees and, above all, the operation is theoretically carried out without any discount for the selling shareholders.

But direct listing does not only have advantages. First of all, the company cannot raise funds by this method, only existing shares are exchanged. Furthermore, the sale of large blocks of shares is not possible or not optimal. Indeed, investor demand may be relatively limited in the absence of a major marketing exercise carried out by the banks in building up the order book (book building with meetings with investors, distribution of analysts’ notes, etc.). Finally, in the absence of a method for price discovery before listing (which is in reality book building), and of mechanisms for limiting price variations (greenshoe, lock up), the volatility of the price during the first few weeks of listing is likely to be significantly higher in the case of a direct listing than in the case of a traditional IPO.

A direct listing is therefore reserved for a certain type of company: one that is already well known to investors (and therefore generally large), with an already large shareholder base (often consisting in part of the company’s employees), wishing to provide liquidity to its shareholders, but not needing to raise funds.

Spotify chose this IPO mode in 2018 followed by Slack in 2019 and Asana and Palentir in 2020. In Europe this technique has been used mainly in the case of spin-offs (e.g. ArcelorMittal/Aperam, HiPay/HiMedia).

SPACs or “blank cheques companies” are shells that get listed with the intention of acquiring and merging within 18–24 months with a private operating company (which will then become a listed company). The shareholders of SPACs have the right to vote for or against the acquisition (known as despacking). This is obviously crucial as it allows the SPAC to fulfil its mission. If the management of a SPAC fails to find a suitable target within 18–24 months, the vehicle is dissolved and the funds returned to the shareholders. At the time of despacking, shareholders may also choose to have their initial investment returned to them. Paradoxically, this latter option actually encourages them to vote for the deal regardless of their views on the transaction. If they think the deal is going well, they vote for it and stay; if not, they vote yes and exit and ask for their shares to be returned. But by asking for the exit, they can jeopardise the operation because if the SPAC does not have enough funds to complete the acquisition, it is cancelled.

It is quite rare that the transaction is completed for an amount less than or equal to the amount raised by the SPAC initially (a few hundred million euros). If the target is larger, either the target’s shareholders remain shareholders (majority or not) in the listed company, or the SPAC raises funds again from institutional investors at the time of the acquisition (this is known as PIPE, Private Investment in Public Equity). This is a second validation by the market of the rationale and price of the acquisition.

The management of SPAC receives almost 20% of the shares for free when SPAC is created and listed. The management invests limited funds (a few million dollars or euros) but they are really at risk, because if SPAC does not despack, the funds are lost (these funds pay for the operating costs of SPAC and the costs of its listing).

When the initial shareholders of the SPAC target are paid in SPAC shares, the operation has the same result as a classical IPO with some differences:

For the exiting shareholders, selling to a SPAC means saving the IPO discount since the company is sold privately.
For the remaining shareholders, if the company has to raise funds during the operation, the IPO discount must be set against the dilution linked to the free shares of the SPAC’s management and the warrants (issued at the time of the IPO and allowing to subscribe to new shares at a higher price, generally $11.5 for shares issued at $10).
For institutional investors, they do not benefit from the IPO discount but they guarantee themselves a place in the operation, which an allocation in a classic IPO would not have allowed.
The real losers are the investment banks who receive a much lower fee than in a traditional IPO.

These new methods still suffer from an image problem: direct listing exists in Europe, but mainly for small companies; SPACs are often regarded as the operations of financial pirates. But their institutionalisation in the US, with 219 SPACs raising $79bn (compared with $67bn for traditional IPOs in 2020), may change this image. Although their acceleration at the beginning of 2021 (340 SPACs raising $106.6bn) may give rise to fears of a speculative boom that will deflate, without them falling back into the margins. A few SPACs have gone public in Europe.

Atypically, some small unlisted companies are being absorbed by a listed structure, without operational activities or having previously sold them (a “shell”), in order to access the listing more quickly and at lower cost (AAA in 2021). But in most cases, a free float has to be recreated.

Section 44.4 UNDERPRICING OF IPOS

If statistics are to be believed, the share price of a newly floated company generally – but there are a number of exceptions – sees a small rise over the IPO price in the days following flotation (see Section 25.2). It would also appear that this discount at which shares are sold or issued at the time of an IPO is volatile over time, compared with an equilibrium value – high in the 1960s, lower in the 1970s to 1980s, and then high again in the 2000s before dropping in recent years. Following research, many different explanations for this discount have been put forward. The main ones are:

This underpricing is theoretically due to the asymmetry of information between the seller and the investors or intermediaries. The former has more information on the company’s prospects, while the latter have a good idea of market demand. A deal is therefore possible, but price is paramount.
Signal theory says that the sale of shares by the shareholders is a negative signal, so the seller has to “leave some money on the table” in return for ensuring that the IPO goes off smoothly and to investors’ satisfaction.
Asymmetrical information amongst the different investors. “Informed” investors will only be interested in good deals and will not be tempted by overvalued IPOs. Less well-informed investors, who will thus be involved in all financings, will find that they are better served in unattractive operations. They will not be as present on more attractive deals. In seeking to retain all the investors who provide valuable and necessary liquidity to the market, IPOs are carried out at a discount.
There are some who argue (not very convincingly) that underpricing can limit the risk of legal disputes with investors who would feel as if they had been swindled because they’d made a bad investment.

Section 44.5 HOW TO CARRY OUT A SUCCESSFUL IPO

The fact that a number of IPOs are cancelled or postponed (2018–2020 has seen, amongst others, tech start-ups WeWork and Airbnb in the USA, petrochemical company Sibur in Russia) shows that this is a tricky process and that success is not always guaranteed.

A successful IPO is the combination of a number of factors:

the intrinsic quality of the company: market share, growth and clarity of the activity, management experience, capital structure, should not be unusual, etc. These factors are assessed on the basis of comparable companies that are already listed, since the listing of the company is offering a new choice to investors within the same investment universe;
a clear and convincing explanation of the sellers’ motivations, as the market will always fear that they are selling their shares because their best results have already been achieved. This is why a flotation through a share issue for financing investments is preferable to the sale of shares (signalling theory);
agreement on the price, which is much easier to achieve when the stock markets are performing well, and very difficult to achieve when they are performing badly. This is the most frequent reason for cancelling an IPO.

From a tactical point of view, and when the stock markets are performing badly, marketing is crucial. Readers, who have been aware since Chapter 1 that a good financial director is first and foremost a good marketing manager, will not be surprised! Marketing involves:

familiarising investors with the stock market candidate a few months before the roadshows themselves begin, through informal meetings (pilot fishing);
entry into the company’s capital by investors seen as cornerstone investors a few weeks before the IPO when the regulations allow this, or during the IPO but with a guaranteed allocation, which will encourage other investors to follow suit. This is particularly prevalent in Asia. Thus, Thailand’s largest retailer, Central Retail Corp, welcomed Singapore sovereign wealth fund GIC and funds run by Capital Research Management as international cornerstone investors backing its IPO in January 2020; an anchor investor is an institutional investor placing a large order in the order book, thereby acting as a valuation driving force. The Monetary Authority of Singapore acted as an anchor investor in the March 2020 IPO of SBI Cards.
tight management of communication over the envisaged price. For example, Glencore let it be known that it was considering a flotation of over $60bn and when a lower price was announced, this was perceived as good news. This is called behavioural finance! It is true that the difficulty of valuing this complex group made this manoeuvre much easier;
a price seen as lower than the equilibrium value, enabling investors to hope for capital gains after a few months. For example, Shurgard fixed its IPO price at the bottom of the indicative bracket. Seven days after listing, the share price stabilised at 13% above the IPO price.

Sometimes the market is a buyers’ market, and these buyers do not hesitate to twist the arm of investors seeking liquidity. It is just as well to be aware of this and not try to play another game if you want to list a company on the stock exchange.

The first days of listing are crucial, because starting a stock market career with a share price that is lower than the IPO price (Uber in May 2019) does not make a very good impression on investors. On the other hand, slightly undervaluing the share when it is listed means that the price will rise by a few percentage points during its first days of listing. This puts everybody in a good mood!

Finally, in the long term the company and its managers will have to learn to live with daily constraints on their behaviour imposed by the periodical distribution of financial information, by managing earnings so as not to disappoint investors and thereby risk lower levels of investment than an unlisted company might face, and because they will be taking fewer risks in general. Furthermore, all shareholders must be treated equally, and managers are going to have to get used to the value of the company being published every day; sometimes this value will be low even though results are good. This can have an impact on the morale of employees and on shareholders’ assets, and it could lead to a change of control in the event of major changes in the capital structure.

That’s just life on the stock exchange!

Section 44.6 PUBLIC TO PRIVATE

A company (or the shareholders) will first start considering a public-to-private move when the reasons why it decided to list its shares in the first place, for the most part, become irrelevant. It has to weigh the cost of listing – direct costs: stock exchange fees, publication of annual reports, meetings with analysts, employment of investor relations staff; and indirect costs: requirement to disclose more information to the public and to competitors, market influence on strategy, management’s time spent talking to the market, etc. – against the benefits of listing when deciding whether the company should remain listed or not. This is especially the case if:

the company no longer needs large amounts of outside equity and can self-finance future financing requirements. The company no longer has any ambition to raise capital on the market or to pay for acquisitions in shares;
the stock exchange no longer provides minority shareholders with sufficient liquidity (which is often rapidly the case for smaller companies which only really benefit from liquidity at the time of their IPO). Listing then becomes a theoretical issue and institutional investors lose interest in the share;
the annual cost of the listing (starting at €200k for a small company and running into millions for larger ones) has become too expensive in comparison with the benefits;
the company no longer needs the stock exchange in order to increase awareness of its products or services.

The second type of reason why companies delist is financial. Large shareholders, whether majority shareholders or not, may consider that the share price does not reflect the intrinsic value of the company. Turning a problem into an opportunity, such shareholders could offer minority shareholders an exit, thus giving them a larger share of the creation of future value.

The operation can be complex. Indeed, beyond the technical constraints, it will depend on the ability of the majority shareholder to convince the minority shareholders to sell their shares. Alternatively, for companies with dispersed capital, it will be necessary to find a new investor ready to make an offer, usually with recourse to debt. Delisting is possible if the majority shareholder exceeds a threshold, often 90% or 95%, as it is then obliged to acquire the rest of the shares. This is known as a squeeze-out. In practice, this amounts to forcing minority shareholders to sell any outstanding shares. Because this is a form of property expropriation, the price of the operation is analysed very closely by the market regulator. In most countries, a fairness opinion has to be drawn up by an independent, qualified financial expert.

If investors are below the squeeze-out threshold, they first have to launch an offer on the company’s shares, hoping to go above the squeeze-out threshold so as to be able to take the company private. This is a P-to-P, public-to-private, deal.

Following a change of control, the new majority shareholder who wishes to hold 100% of the capital of its new subsidiary in order to more easily implement the expected synergies will then have to proceed with a delisting through a squeeze-out.

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

An IPO is a complex process that generally takes around six months to complete. During the preparation phase, the whole of the company’s legal, operational and financial structure has to be reviewed, its corporate governance needs to be adapted, financial statements may have to be drawn up in line with the relevant accounting principles and a strategy has to be defined in the form of an equity story for the market.

A company is generally listed in its country of origin. The choice of the market segment on which the company will be listed will be determined by the size of the company and by any constraints weighing on it.

The number of shares offered on the market will depend on the sizing of the IPO, and whether the shares will be shares sold by existing shareholders and/or new shares in the company’s capital that are issued at the time. This will depend on the financial needs of the company, the shareholders’ desire for control and their liquidity needs, and market constraints.

At the time of the IPO, shares are generally sold on the market at a discount compared with the first listed price. Different theoretical explanations, based mainly on information asymmetry, have been put forward to explain this.

IPOing a company is a complex process and success cannot be taken for granted. Even at the last minute, a forced postponement or a cancellation may be necessary.

SPACs are an increasingly popular form of stock market listing. It involves an unlisted company acquired or merging with an ad-hoc structure with no activity that has gone public a few quarters earlier with this objective.

Delisting may be a good option when the company no longer requires funds or when liquidity has become too low. Delisting can also be a complex process and an independent expert has to be brought in to draw up a fairness opinion on the squeeze-out price.

QUESTIONS

1/Why might a majority shareholder prefer to sell its stakes in a company through an IPO rather than a straight sale to an investor?
2/Why would a company with an 85% stake in a subsidiary launch a takeover bid for the remaining shares?
3/Why do companies that list their shares on the stock market have, more often than not, to change their corporate governance?
4/Why is it difficult for a sole shareholder to sell 100% of their shares when the company undertakes an IPO?
5/In response to a question about his expectations of Hermès’ new financial strategy at the time of its IPO, Jean-Louis Dumas, Hermès’ CEO, replied that he hoped that his grandchildren would be proud of him. Comment.
6/What are the risks run by a company that carries out an IPO just because IPOs are fashionable?
7/What are the risks of an IPO?
8/What will a company with a large number of shareholders that does not want to get a listing on the stock exchange have to do sooner or later?
9/Verallia is the world’s third largest producer of glass packaging for food and beverages. A former subsidiary of Saint-Gobain, it was acquired in an LBO by the Apollo investment fund in 2015 and was floated on the stock market in October 2019. Verallia achieved sales of €2.4bn in 2018, up 6%, EBITDA of €544m (+14%), current operating income of €221m (+39%) and net income of €49m (×3.5). Net bank and financial debt at 30 June 2019 was €1.7bn, after capitalisation by Apollo of a €250m loan to Verallia. Expected EBITDA for 2019 was €610m.
The IPO took the form of a placement of existing shares for €963m. The IPO price was €27; 5 days later, the share price was €27.1. At this price, the market capitalisation was €3.2bn with a free float of 39%.
Why could Verallia’s IPO have taken the form of a secondary offering? Could it have taken the form of a full primary offering?
10/What is the impact of Verallia’s IPO on its income statement? On its balance sheet?
11/Is it surprising that Verallia’s share price remain stable in the days following the IPO, given that Apollo had kept 62% of its shares?
More questions are waiting for you at www.vernimmen.com.

ANSWERS

Questions

1/There might not be a buyer prepared to pay a control premium. This enables the shareholder to sell only a minority stake, thus holding on to majority control, while cashing in part of their shares. The company remains independent and is not absorbed by a larger group.
2/In order to get rid of minority shareholders and to implement group synergies.
3/Because there are now outside shareholders and an obligation to follow the rules applies to listed companies.
4/Because of the very negative signal that this would send out.
5/This highlights the conflict between the very financial approach of minority shareholders and a wider approach of managing shareholders. The two are not irreconcilable, as Hermès shares have been an excellent investment since they were listed on the stock exchange.
6/The risk of severe disappointment as there will be no advantage for the company compared with all of the restrictions involved in listing.
7/In the short term, failure during the course of the process as stock markets fall and the possible price of the placement could seem very low to existing shareholders. Over the longer term, a change in the group’s culture, and a change in control (takeover bid).
8/Sooner or later, the company will have to be sold in order to provide shareholders with liquidity or an internal stock exchange will have to be organised among shareholders so that those wishing to sell their shares can do so without having to sell to third parties.
9/With a net debt/EBITDA ratio of 2.8, Verallia has a high but not excessive level of debt. This would have been possible, but not in the interest of Apollo, which would not have been able to sell some of its shares.
10/None (except for the IPO costs) since the transaction did not include a primary tranche that would have provided Verallia with additional equity.
11/LBO funds that do not sell their entire stake in an IPO, like Apollo, are careful not to overvalue the company on this occasion, as they will have to sell the remainder of their shares some time later, which will be more complicated if the investors who participated in the IPO have lost value.

BIBLIOGRAPHY

For more about taking companies public:

S. Benninga, M. Helmantel, O. Sarig, The timing of initial public offerings, Journal of Financial Economics, 75(1), 115–132, January 2005.
S. Bernstein, Does going public affect innovation?, Journal of Finance, 70(4), 1365–1403, August 2015.
J. Brau, S. Fawcett, Initial public offerings: An analysis of theory and practice, Journal of Finance, 61(1), 399–436, February 2006.
J. Brau, S. Fawcett, Evidence on what CFOs think about the IPO process: Practice, theory and managerial implications, Journal of Applied Corporate Finance, 18(3), 107–117, Summer 2006.
T. Chemenamu, J. He, IPO waves, product market competition, and the going public decision: Theory and evidence, Journal of Financial Economics, 101(2), 382–412, August 2011.
J. Chod, E. Lyandres, Strategic IPOs and product market competition, Journal of Financial Economics, 100(1), 45–67, April 2011.
A. Hovakimian, I. Hutton, Merger-motivated IPOs, Financial Management, 39(4), 1547–1573, Winter 2010.
H. Hsu, A. Reed, J. Rocholl, The new game in town: Competitive effects of IPOs, Journal of Finance, 65(2), 495–528, April 2010.
Y. Le Fur, P. Quiry, Interview with the finance director of a listed biotech company, The Vernimmen.com Newsletter, 121, 1–4, July 2019.
M. Lowry, Why does IPO volume fluctuate so much?, Journal of Financial Economics, 67(1), 3–40, January 2003.
M. Pagano, A. Roell, J. Zechner, The geography of equity listings: Why do companies list abroad?, Journal of Finance, 57(6), 2651–2694, December 2002.
L. Pastor, P. Veronesi, Rational IPO waves, Journal of Finance, 60(4), 1713–1757, August 2005.
A. Poulsen, M. Stegemoller, Moving from private to public ownership: Selling out to public firms versus initial public offerings, Financial Management, 37(1), 81–101, Spring 2008.
www.renaissancecapital.com

On discounts on IPOs:

D. Chambers, E. Dimson, IPO underpricing over the very long run, Journal of Finance, 64(3), 1407–1444, June 2009.
F. Derrien, IPO pricing in “hot” market conditions: Who leaves money on the table?, Journal of Finance, 60(1), 487–521, February 2005.
A. Ellul, M. Pagaro, IPO underpricing and after-market liquidity, Review of Financial Studies, 2(19), 381–421, Summer 2006.
J. Ritter, I. Welch, A review of IPO activity, pricing, and allocations, Journal of Finance, 57(4), 1795–1828, August 2002.
K. Rock, Why new issues are underpriced, Journal of Financial Economics, 15(1&2), 187–212, January–February 1986.
P. Roosenboom, Valuing and pricing IPOs, Journal of Banking and Finance, 36(6), 1653–1664, June 2012.

On public to private:

W. Bessler, F. Kaen, P. Kurmann, J. Zimmermann, The listing and delisting of German firms on NYSE and Nasdaq: Were there any benefits?, Journal of International Financial Markets, Institutions & Money, 22(4), 1024–1053, October 2012.
A. Boot, R. Gopalan, A. Thakor, Market liquidities, investor participation, and managerial autonomy: Why do firms go private?, Journal of Finance, 63(4), 2013–2059, August 2008.
A. Chevalier, A. Saunajust, Why do firms go private?, Bankers, Markets and Investors, 113, 39–58, July–August 2011.
I. Martinez, S. Serve, Reasons for delisting and consequences: A literature review and research agenda, Journal of Economic Surveys, 31(3), 733–770, July 2017.

Chapter 45. TAKING CONTROL OF A COMPANY

A peek behind the scenes of investment banking

At any given time, a company can have several valuations, depending on the point of view of the buyer and the seller and their expectations of future profits and synergies. This variety sets the stage for negotiation but, needless to say, a transaction will take place only if common ground can be found – i.e. if the seller’s minimum price does not exceed the buyer’s maximum price.¹

The art of negotiation consists of allocating the value of the anticipated synergies between the buyer and the seller, and in finding an equilibrium between their respective positions, so that both come away with a good deal. The seller receives more than the value for the company on a standalone basis because they pocket part of the value of the synergies the buyer hopes to unlock. Similarly, the buyer pays out part of the value of the synergies, but has still not paid more than the company is worth to them.

Transactions can also result from erroneous valuations. A seller might think the company has reached a peak, for example, and the buyer that it still has growth potential. But generally, out-and-out deception is rarer than you might think. It’s usually only in hindsight that we say we made a killing and that the party on the other side of the transaction was totally wrong!

In this chapter we will focus on the acquisition of one company by another. We will not consider industrial alliances, i.e. commercial or technology agreements negotiated directly between two companies which do not involve a transaction of the equity of either of them. Before examining the various negotiation tactics and the purchase of a listed company, let us first take a look at the merger and acquisition phenomenon and the economic justification behind a merger.

Section 45.1 THE RISE OF MERGERS AND ACQUISITIONS

1/ MERGER AND ACQUISITION WAVES

Acquisitions can be paid for either in cash or in shares. Generally speaking, share transactions predominate when corporate valuations are high, as they were in 1999–2000, because absolute values do not have to be determined.

However, in less propitious times, payment in cash is highly appreciated, both by sellers, who delight in receiving hard cash which will not lose its value on the stock market, and by buyers, who are not keen to issue new shares at a price that to them would seem to be discounted. Between 2007 and 2013, cash was back in fashion!

Conversely, when the market is bearish, cash payments are more attractive to both parties. The seller receives cold, hard cash, which will not lose value as shares might, while the buyer is reluctant to issue new shares at prices they consider to be a discount to their intrinsic value.
*Source*: Data from Thomson One Deals, Factset

As shown in the above graph, mergers and acquisitions tend to come in waves:

In the 1960s, conglomerates were all the rage. ITT, Gulf and Western, Fiat, Schneider and many others rose to prominence during this period. The parent company was supposedly able to manage the acquired subsidiaries better, plus meet their capital needs. Most transactions were paid for with shares.
In the 1980s, most acquisitions were paid for in cash. Many of the big conglomerates formed in the 1960s were broken up. They had become less efficient, poorly managed and valued at less than the sum of the values of their subsidiaries.
In the 1990s and 2000s, companies within the same sector joined forces, generally in share transactions: Procter & Gamble/Gillette, Pfizer/Wyeth, Arcelor/Mittal, Cadbury/Kraft, etc.
In the 2010s, the logic is the same and payments are mostly in cash: Kraft/Heinz, SABMiller/AB Inbev, Lactalis/Parmalat, Air Liquide/Airgas, etc. Since 2014, as the stock market has been regaining momentum, we are seeing more and more payments in shares: Peugeot-FiatChrysler, Lafarge-Holcim, Luxottica-Essilor, Worldline-Ingenico, Sprint-T-Mobile.

It seems to us that there are three main principles that explain the cyclical nature of mergers:

when the economic situation is depressed or very bad, companies focus on their operating activities, seeking to cope with problems and to restructure. When the economy improves, they regain confidence, are more open minded and ready to consider mergers and acquisitions, which are always complicated to implement. But because the economic situation is good, they are prepared to take a risk;
the availability of equity or debt financing is crucial because an acquisition requires financing. When share prices are low, shareholders are not very keen on being diluted in conditions that are bad for them and it is difficult to carry out capital increases. Also, if share prices are low, this means that it is unlikely that the economy is booming, making it difficult to obtain debt financing. High share prices are often the consequence and the cause of more easily obtainable financing, a clear sign of optimism!;
finally, herd behaviour will encourage companies in a given sector to carry out mergers when they see another sector player initiating a merger, so that they will not be the only ones creating cost and/or revenue synergies which could give them a clear competitive advantage. This could be witnessed in 2020 in the payment industry (e.g. Worldline-Ingenico, Nexi-Sia, Rapyd-Korta).

Putting the purely financial elements aside, the determinants of mergers and acquisitions can be macroeconomic, microeconomic or human factors, as we will now see.

2/ MACROECONOMIC FACTORS

There are several determining macroeconomic factors:

Periods of innovation and technological change are often followed by merger waves. During the innovation period (computers in the 1970s, the Internet or renewable energies today), many new companies are founded. Inevitably, however, the outlook for the growth and survival of these start-ups will fade, leading to a period of consolidation (Criteo buying Manage). Moreover, start-ups’ heavy financing needs may prompt them to seek the support of a major group that, in turn, can take advantage of the growth in the start-ups’ business (Peugeot buying TravelCar, a carsharing rental platform).
Many companies are undergoing a change in market scope. Thirty years ago, their market was national; now they find that they must operate in a regional (European) or more often worldwide context (Syngenta-ChemChina). Adapting to this change requires massive investment in both physical and human capital, leading to much higher financing needs (pharmaceuticals). As competition increases, companies that have not yet merged must grow rapidly in order to keep up with their now larger rivals. Critical mass becomes vital (Occidental Petroleum-Anardako). The policy of creating national champions in the 2000s encouraged this race for size (GDF-Suez becoming Engie).
Legislative changes have fostered restructuring in many industries. A broad trend towards deregulation began in the 1980s in the US and the UK, profoundly changing many sectors of the economy, from air transport to financial services to telecommunications. In Europe, a single market was created in conjunction with a policy of deregulation in banking, energy and telecommunications. European governments further scaled back their presence in the economy by privatising a number of publicly held companies. In many cases, these companies then became active participants in mergers and acquisitions (EDF, Orange, ENI).
The increasing importance of financial markets has played a fundamental role in corporate restructuring. In the space of 30 years, European companies have evolved from primarily credit-based systems, where banks were the main suppliers of funds, to financial market systems, characterised by disintermediation (see Section 15.1). This structural change took place in conjunction with a shift in power from banks and other financial companies (Mediobanca, Deutsche Bank, Paribas, Générale de Belgique) to investors. Accordingly, shareholders now exert pressure on corporate managers to produce returns in line with their expectations:
- in the event of a disappointing performance, shareholders can sell their shares and, in doing this, depress the share price. Ultimately, this can lead to a restructuring (Aviva) or a takeover (Monsanto);
- conversely, companies must convince the market that their acquisitions (Occidental Petroleum-Anadarko) are economically justified.
Low population growth in Europe, combined with strict immigration control, has made it more difficult for firms to grow organically. In response, managers in search of new growth drivers will try to find M&A opportunities (Lactalis-Greenland in Egypt).

3/ MICROECONOMIC FACTORS

There are a number of different determining microeconomic factors:

By increasing their size and production volumes, companies reduce their unit costs, in particular their R&D, administration and distribution costs (Nestle-Bountiful). Moreover, a higher production volume will put the company in a better position to negotiate lower costs with its suppliers (Tesco-Booker).
Mergers can increase a company’s market share and boost its revenues dramatically. To the extent that companies address complementary markets, merging will enable them to broaden their overall scope. There are two forms of complementarity:
- geographic (Banijay-Endemol). The two groups benefit from their respective presence in different regions;
- product (SandroMaje-DeFursac). The group can offer a full palette of products to its customers.
Although riskier than organic growth, mergers and acquisitions enable a company to save valuable time. In growing sectors of the economy, speed (the first-mover advantage) is a critical success factor. Once the sector matures, it becomes more difficult and more expensive to chip away at competitors’ market share, so acquisitions become a matter of choice (Altice-CableVision). The idea is also to get rid of a competitor (S&P-HIS Markit). When a company is expanding internationally or entering a new business, a strategic acquisition is a way to circumvent barriers to entry, both in terms of market recognition (LVMH-Tiffany) and expertise (Apple-Voysis).
By gaining additional stature, a company can more easily take new risks in a worldwide environment. The transition from a domestic market focus to worldwide competition requires companies to invest much more. The financial and human risks become too great for a medium-sized company (oil and gas exploration, pharmaceutical research). An acquisition (paid in shares) instantly boosts the company’s financial resources and reduces risk, facilitating decisions about the company’s future growth (Unilever-Onnit).
The need for cash, because groups are in difficulty (Bombardier, ThyssenKrupp), because they need to deleverage (HNA, Wanda in China) or because they regularly need to make capital gains (sale of Deutsche Glasfaser by KKR) are other reasons why M&A deals happen.
When groups decide to refocus on their core business, we also see assets being disposed of (Nestlé’s disposal of Haagen-Dazs).
In addition to the economic criteria prompting companies to merge, there is also the human factor. Many companies founded between 1955 and 1980, which were often controlled by a single shareholder manager, are now, not surprisingly, encountering problems of succession. In some cases, another family member takes over (ArcelorMittal, Swatch, Benetton, Reliance). In other cases, the company may have to be sold if it is to survive (Norbert Dentressangle).

4/ THE LARGER CONTEXT

Mergers and acquisitions, regardless of how tricky they are to manage, form part and parcel of a company’s life and serve as a useful tool for growth.

Mergers and acquisitions, although tricky to manage, are part of the lifecycle of a company and are a useful growth tool.

Synergies are often overestimated; their cost and time to implement underestimated. For example, making information systems compatible or restructuring staff can be notoriously difficult.

Numerous research works have measured the value created by M&A deals and how this value is shared between shareholders of the buyer and of the target. They demonstrate that value is created for the target’s shareholders because of the control premium paid. For the buyer’s shareholders, the results are more mixed, even if they tend to show a recent improvement since the beginning of the 2000s, when it was widely assumed that two-thirds of mergers were failing. Excluding some resounding failures (acquisition of Alstom’s energy division by GE or the Monsanto by Bayer), which heavily bias the results, M&A deals would appear value-creative because of some largely successful deals such as Sanofi/Genzyme, Office Depot-OfficeMax, Peugeot-Opel. Quality and speediness of the integration process are the key factors for successful M&A deals.

Section 45.2 CHOOSING A NEGOTIATING STRATEGY

A negotiating strategy aims at achieving a price objective set in accordance with the financial value derived from our valuation work presented in Chapter 31. But price is not everything. The seller might also want to limit the guarantees they grant, retain managerial control, ensure that their employees’ future is safe, etc.

Depending on the number of potential acquirers, the necessary degree of confidentiality, the timing and the seller’s demands, there is a wide range of possible negotiating strategies. We present below the two extremes: private negotiation and auction. Academic researchers² have established that none of these strategies is better than another. Our personal experience tells us the same thing: the context dictates the choice of a strategy.

1/ PRIVATE NEGOTIATION

The seller or their advisor contacts a small number of potential acquirers to gauge their interest. After signing a confidentiality agreement (or non-disclosure agreement, NDA), the potential acquirers might receive an information memorandum describing the company’s industrial, financial and human resource elements. Discussions then begin. It is important that each potential acquirer believes they are not alone, even if in reality they are. In principle, this technique requires extreme confidentiality. Psychological rather than practical barriers to the transaction necessitate the high degree of confidentiality.

To preserve confidentiality, the seller often prefers to hire a specialist, most often an investment banker, to find potential acquirers and keep all discussions under wraps. Such specialists are usually paid a success fee that can be proportional to the size of the transaction. Strictly speaking, there are no typical negotiating procedures. Every transaction is different. The only absolute rule about negotiating strategies is that the negotiator must have a strategy.

The discussion focuses on:

how much control the seller will give up (and the status of any remaining minority shareholders);
the price;
the payment terms;
any conditions precedent;
representations and warranties; and
any contractual relationship that might remain between the seller and the target company after the transaction.

As you might expect, price remains the essential question in the negotiating process. Everything that might have been said during the course of the negotiations falls away, leaving one all-important parameter: price. We now take a look at the various agreements and clauses that play a role in private negotiation.

(a) Memorandum of understanding (MOU) or letter of intent (LOI)

When a framework for the negotiations has been defined, a memorandum of understanding is often signed to open the way to a transaction. A memorandum of understanding is a moral, not a legal, commitment. Often, once the MOU is signed, the management of the acquiring company presents it to its board of directors to obtain permission to pursue the negotiations.

The MOU is not useful when each party has made a firm commitment to negotiate. In this case, the negotiation of the MOU slows down the process rather than accelerating it.

(b) Agreement in principle

The next step might be an agreement in principle, spelling out the terms and conditions of the sale. The commitments of each party are irrevocable, unless there are conditions precedent – such as approval of the regulatory authorities. The agreement in principle can take many forms.

(c) Financial sweeteners

In many cases, specific financial arrangements are needed to get over psychological, tax, legal or financial barriers. These arrangements do not change the value of the company.

Sometimes, for psychological reasons, the seller refuses to go below some purely symbolic value. If they draw a line in the sand at 200, for example, whereas the buyer does not want to pay more than 190, a schedule spreading out payments over time sometimes does the trick. The seller will receive 100 this year and 100 next year. This is 190.9 if discounted at 10%, but it is still 200 to their way of thinking. Recognise that we are out of the realm of finance here and into the confines of psychology, and that this arrangement fools only those who want to be fooled.

This type of financial arrangement is window-dressing to hide the real price. Often companies build elaborate structures in the early stages of negotiation, only to simplify them little by little as they get used to the idea of buying or selling the company. Far from being a magical solution, such sweeteners give each party time to gravitate towards the other. In these cases it is only a stage, albeit a necessary one.

The following techniques are part of the investment banker’s stock in trade:

set up a special-purpose holding company to buy the company, lever up the company with debt, then have the seller reinvest part of the funds in the hope of obtaining a second gain (this is an LBO,³ see Chapter 47);
have the buyer pay for part of the purchase price in shares, which can then be sold in the market if the buyer’s shares are listed;
pay for part of the purchase price with IOUs;
link part of the purchase price to the sale price of a non-strategic asset the buyer does not wish to keep, or on the outcome of a significant ongoing litigation;
an earnout clause, which links part of the transaction price to the acquired company’s future financial performance. The clause can take one of two forms:
- either the buyer takes full control of the target company at a minimum price, which can only be revised upwards; or
- the buyer buys a portion of the company at a fixed price and the rest at a future date, with the price dependent on the company’s future profits. The index can be a multiple of EBIT, EBITDA or pre-tax profit.

Earnout provisions are very common in transactions involving service companies (advertising agencies, M&A boutiques), where people are key assets. Deferral of part of the price will entice them to stay and facilitate the integration process, although it can create management problems during the earnout period.

2/ AUCTION

In an auction, the company is offered for sale under a predetermined schedule to several potential buyers who are competing with each other. The objective is to choose the one offering the highest price. An auction is often private, but it can also be announced in the press or by a court decision.

Private auctions are run by an investment bank in the following manner. Once the decision is taken to sell the company, the seller often asks an audit firm to produce a vendor due diligence (VDD, also called a long form report) to provide a clear view of the weak points of the asset from legal, tax, accounting, environmental, strategic and regulatory points of view. The VDD will be communicated to buyers later on in the process. For the moment, a brief summary of the company is prepared (a “teaser”). It is sent, together with a NDA, to a large number of potentially interested companies and financial investors.

In the next stage (often called “Phase I”), once the potential buyers sign the non-disclosure agreement,⁴ they receive additional information, gathered in an information memorandum (“info memo”). Then they submit a non-binding offer indicating the price, its financing, any conditions precedent and eventually their intentions regarding the future strategy for the target company.

At that point of time (“Phase II”), a “short list” of up to half a dozen candidates at most is drawn up by the seller and their advisor on the basis of price, other sales conditions, and their confidence in the capability and willingness of the candidates to successfully conclude the sale. Selected buyers receive still more information and possibly a schedule of visits to the company’s industrial sites and meetings with management. Often an electronic data room is set up, where all economic, financial, regulatory, environmental and legal information concerning the target company is available for perusal. Access to the data room is very restricted; for example, no copies can be made. At the end of this stage, potential investors submit binding offers.

At any time, the seller can decide to enter into exclusive negotiations for a few days or a few weeks. For a given period of time, the potential buyer is the only candidate. At the end of the exclusive period, the buyer must submit a binding offer (in excess of a certain figure) or withdraw from the negotiations. Exclusivity is usually granted on the basis of a pre-emptive offer, i.e. a financially attractive proposal.

Together with the binding offers, the seller will ask the bidder(s) to propose a markup (comments) to the disposal agreement (called the share purchase agreement, SPA)⁵ previously provided by the seller. The ultimate selection of the buyer depends, naturally, on the binding offer, but also on the buyer’s comments on the share purchase.

The seller selecting an auction process to dispose of the company may believe that it will lead to a high price because buyers are in competition with each other. In addition, it makes it easier for the seller’s representatives to prove that they did everything in their power to obtain the highest possible price for the company, be it:

the executive who wants to sell a subsidiary;
a majority shareholder whose actions might be challenged by minority shareholders; or
the investment banker in charge of the transaction.

Competition sometimes generates a price that is well in excess of expectations. Moreover, an auction is faster, because the seller, not the buyer, sets the pace.

However, the auction creates confidentiality problems. Many people have access to the basic data, and denying rumours of a transaction becomes difficult, so the process must move quickly. Also, as the technique is based on price only, it is exposed to some risks, such as several potential buyers teaming up with the intention of splitting the assets among them. Lastly, should the process fail, the company’s credibility will suffer. The company must have an uncontested strategic value and be in sound financial condition. The worst result is that of an auction process which turns sour because financial results are not up to the estimations produced a few weeks before, leaving only one buyer who knows they are now the only buyer.

A well-processed auction can take three to five months between intention to sell and the closing. It is sometimes shorter when an investment fund sells on to another fund.

3/ THE OUTCOME OF NEGOTIATIONS

In the end, whatever negotiating method was used, the seller is left with a single potential buyer who can then impose certain conditions. Should the negotiations fall apart at this stage, it could spell trouble for the seller because they would have to go back to the other potential buyers, hat in hand. So the seller is in a position of weakness when it comes to finalising the negotiations. The principal remaining element is the representations and warranties provisions that are part of the share purchase agreement.

Representations and warranties (“reps & warranties”) are particularly important because they give confidence to the buyer that the profitability of the company has not been misrepresented. It is a way of securing the value of assets and liabilities of the target company as the contract does not provide a detailed valuation.

Representations and warranties are not intended to protect the buyer against an overvaluation of the company. They are intended to certify that all of the means of production are indeed under the company’s control, that the financial statements have been drawn up in accordance with accounting principles and that there are no hidden liabilities.

Well-worded representations and warranties clauses should guarantee to the buyer:

the substance of fixed assets (and not their value);
the real nature and the value of inventories (assuming that the buyer and the seller have agreed on a valuation method);
the real nature of other elements of working capital;
the amount and nature of all of the company’s other commitments, whether they are on the balance sheet (such as debts) or not.

They also facilitate the sharing of known risks within the company at the time of the sale (disputes, defaulting customers) between buyer and seller.

The representations and warranties clause is generally divided into two parts.

In the first part (representations), the seller makes commitments related to the substance of the company that is to be sold.

The seller generally represents that the target company and its subsidiaries are properly registered, that all the fixed assets on the balance sheet, including brands and patents, or used by the company in the ordinary course of business, actually exist. As such, representations and warranties do not guarantee the book value of the fixed assets, but their existence.

The seller represents that inventories have been booked correctly, and that depreciation and provisions have been calculated according to GAAP.⁶ The seller declares that the company is up to date in tax payments, salaries and other accruals and that there are no prejudicial contracts with suppliers, customers or employees. All elements already communicated to the buyer, in particular exceptional items such as special contracts, guarantees, etc., are annexed to the clause and excluded from it because the buyer is already aware of them.

Lastly, the seller represents that during the transitional period between the last statement date and the sale date the company was managed in a prudent manner. In particular, the seller certifies that no dividends were distributed or assets sold, except for those agreed with the buyer during the period, that no investments in excess of a certain amount were undertaken, nor contracts altered, etc.

This is known as the locked-box system, where the price is definitively set on the basis of the latest financial statements provided by the seller and reviewed by the buyer. Otherwise, the company’s accounts will have to be closed at the time of sale and price adjustments will have to be made if the equity (or, to simplify the process, the net debt and working capital) recorded is different from that guaranteed by the seller.

In the second part of the clause (warranties), the selleragrees to cover any additional liabilities that were not disclosed to the buyer (which the buyer was unable to factor in when setting the price), that occurred prior to the sale and come to light after the sale, and to do so for a given period (usually three years). Thresholds and a predetermined cap are set. In some cases, it is possible to set off such liabilities against provisions which then fall away or against income from assets sold at a higher price than expected. Warranties are often accompanied by a holdback (part of the purchase price is put in an escrow account)⁷ or a bank guarantee.

The representations and warranties clauses are the main addition to the sale agreement but, depending on the agreement, there may be many other additions, so long as they are legally valid – i.e. not contrary to company law, tax law or stock market regulations requiring equal treatment of all shareholders. A non-exhaustive list would include:

means of payment;
status and future role of managers and executives;
audit of the company’s books. On this score, we recommend against performing an audit before the two parties have reached an agreement. An audit often detects problems in the company, poisoning the atmosphere, and can serve as a pretext to abandoning the transaction.
minority shareholders’ agreement; etc.

Of course, the parties to the contracts should also call upon legal experts to ensure that each clause is legally enforceable.

The final step is the actual consummation of the deal. It often takes place at a later date, because certain conditions must be met first: accounting, legal or tax audit, restructuring, approval of domestic or foreign competition commissioners, etc.

Sometimes a link-up is not allowed for competition (anti-trust) reasons (Sainbury’s–Asda merger in the UK, Alstom–Siemens in Europe) or control of foreign investments on companies considered as strategic (Carrefour–Alimentation Couche Tard, Broadcom–Qualcomm). Accordingly, these concerns must be anticipated very early on in the merger process and the parties must be assisted by specialised lawyers.

In Europe, the thresholds are €5bn for the combined sales of the parties and €250m for sales made on a combined basis in Europe by at least two parties. An exception exists when all companies concerned generate more than two thirds of their gross revenue within the EU, and within the same single country (the two-thirds rule).

Finally, in the USA, the Hart–Scott–Rodino law allows for notification to be waived if the value of the target is less than \$92m. Many types of transactions are, nonetheless, exempted; for example, deals worth less than \$368m between companies with sales of less than \$184m, target’s sales of less than \$18.4m, etc.

4/ THE DUAL-TRACK PROCESS

In order to improve its negotiation position or because the likely outcome of the sale process is unclear, the seller may decide to pursue a dual-track process: it will launch a sale process and the preparation of an IPO in parallel. At the latest possible moment, it will choose to sell to the one offering the best price, be it the stock market or a buyer. This is why in 2018, Delachaux cancelled its IPO and replaced an investment fund (CVC) with a Canadian investor (CDPQ).

Section 45.3 TAKING OVER A LISTED COMPANY

The first idea that comes to mind when buying or taking a significant stake in a listed company would be to pick up shares on the stock market until you are strong enough to negotiate with the other shareholders and the management team. This solution seems attractive since it would allow you to take control without having to buy all the securities. This is why the law and the stock exchange authorities have imposed certain constraints on the purchase of securities on the stock exchange.

First of all, there is an obligation to declare the crossing of thresholds: when a shareholder exceeds a certain percentage of the capital or voting rights of a listed company, a disclosure obligation is imposed on them. Then there is an obligation to launch a public offer on all outstanding shares when certain thresholds are crossed.

These principles governing takeovers of listed companies are found in most countries with various degrees of constraint from one country to another.

1/ STAKE-BUILDING

To succeed in acquiring a listed company, the first step can be to start building a block in the company. This is how Vivendi acquired 30% of Gameloft before launching a full offer on the rest of the shares.

There are three methods available to investors seeking to accumulate shares:

gradually buying up shares on the market. Shares are purchased at the market price and the identity of sellers is generally unknown;
acquiring blocks of shares, which involves negotiating the purchase of large blocks of shares with identified sellers;
an equity swap or total return swap (TRS), which is a contract to swap the stock performance (dividends, capital gains and losses) between a bank (which pays the performance to the investor) and an investor (who wishes to take a risk on the performance of a share without holding it, and who pays interest to the bank) or the opposite. The bank hedges this operation by buying shares on the market. At the end of the swap term, the investor buys the bank’s shares at the price paid by the latter. This is how Elliott acquired a 2% stake (in addition to the 3.75% stake it held in shares) in Telecom Italia in 2018.

The following conditions must be met for an acquisition of an attractive percentage at a reasonable price:

the share capital of the target company must be dispersed, with no controlling shareholder actually controlling the company;
the operation must be carried out in secret to avoid defensive measures being taken by shareholders opposed to the acquirer of the securities and to prevent the target’s share price from soaring;
the volume of daily transactions in the security must be large enough to allow for large purchases without causing a market imbalance.
Sometimes the purchase of securities is made by several investors acting in concert (see below) and sometimes over a long period of time.

In order to prevent the acquirer from taking control of a company in that way, most market regulations require investors in a listed company to publicly declare when they pass certain thresholds in the capital of a company. If the acquirer fails to declare these shares, voting rights are lost.

The first threshold is most often 3% (UK, Switzerland, Spain, Germany, Italy, etc.).

Regulatory disclosure requirements allow minority shareholders to monitor stake-building and prevent an acquirer from getting control of a company little by little. These requirements are also helpful for the management to monitor the shareholder structure of the company. By-laws can set additional thresholds to be declared (generally lower thresholds than required by law).

Regulatory threshold disclosure requirements are the following:

China	5% and multiples of 5% above
France	5%, 10%, 15%, 20%, 25%, 30%, 33.3%, 50%, 66.6%, 90%, 95%
Germany	3%, 5%, 10%, 15%, 20%, 25%, 30%, 50%, 75%
India	5%, then 2% till 25%, then any share above 25%
Italy	3%, 5%, multiples of 5% above up to 30%, then 50%, 66.6%,90%,
Netherlands	3%, 5%, 10%, 15%, 20%, 25%, 30%, 40%, 50%, 60%, 75%, 95%
Spain	3%, 5%, multiples of 5% thereafter, then 50%, 60%, 70%, 75%, 80%, 90%
Switzerland	3%, 5%, 10%, 15%, 20%, 25%, 33.3%, 50%, 66.6%
UK	3% and multiples of 1% above
US	5% and multiples of 1% above

2/ TYPE OF OFFER

It is very unusual for an acquirer to gain control of a public company without launching a public offer on the target. Such offers are made to all shareholders over a certain period of time (2–10 weeks depending on the country). Public offers can be split between:

share offers or cash offers;
voluntary or mandatory offers;
hostile or recommended offers.

(a) Cash or share offers

The table below summarises the criteria relevant for assessing whether a bidder wants to propose shares or cash in a public offer:

	Payment in cash	Payment in shares	Comments
Allocation of synergies	Target company’s shareholders benefit from synergies only via the premium they receive	Target company’s shareholders participate in future synergies	In a friendly share exchange offer, the premium might be minimal if the expected synergies are high
Psychological effects	Cash lends credibility to the bid and increases its psychological value	Payment in shares has a “friendly” character
Purchaser’s financial structure	Increases gearing	Does not increase gearing	The size of the deal sometimes requires payment in shares
Shareholder structure	No impact unless the deal is subsequently refinanced through a share issue	Shareholders of the target become shareholders of the enlarged group	Sometimes, shareholders of the target get control of the new group in a share-for-share offer
Impact on purchaser’s share price	After the impact of the announcement, no direct link between the purchaser’s and target’s share price	Immediate link between purchaser’s and target’s share price, maintained throughout the bid period	A share exchange offer gains credibility when the two companies’ share prices align with the announced exchange ratio
Signal from buyer’s point of view	Positive: buyer’s stock is undervalued. Debt financing: positive signal	Negative: buyer’s stock is overvalued	If the size of the target only makes possible a share-for-share deal, no signal
Accounting effects	Increases EPS and its growth rate if the inverse of the target’s P/E ratio including any premium is greater than the after-tax cost of debt of the acquirer	Increases EPS if the purchaser’s P/E ratio is higher than the target’s, premium included	EPS is not a relevant indicator of value creation, see Chapter 27
Purchaser’s tax situation	Interest expense deductible	No impact, except capital gain if treasury shares are used	Taxation is not a determining factor
Seller’s tax situation	Taxable gain	Gain on sale can be carried forward
Index weighting	No change	Higher weighting in index (greater market capitalisation)	In the case of a share exchange, possible re-rating owing to size effect

In practice, the choice is not so black and white. The purchaser can offer a combination of cash and shares (mixed offers), cash as an alternative to shares, or launch a “mix and match” offer, as we will see.

(b) Hostile or recommended offers

The success or failure of an offer can depend largely on the attitude of the target’s management and the board of directors towards the offer.

To maximise the chances of success, the terms of an offer are generally negotiated with the management prior to the announcement, and then recommended by the board of the company. The offer is then qualified as friendly or recommended.

In some cases, the management of the target is not aware of the launch of an offer; it is then called an unsolicited offer. Facing this sudden event, the board has to convene and decide whether the offer is acceptable or not. If the board rejects the offer, it becomes hostile. This does not mean that the offer will not succeed, but just that the bidder will have to fight management and the current board of directors during the offer period to convince shareholders.

Most unsolicited offers end up as recommended offers, but only after the bidder has sweetened the offer in one way or another (generally by offering a higher price).

Around 15% of offers are deemed hostile and large groups such as Pfizer, Sanofi, Diageo, Enel, etc. were created through unsolicited offers.

(c) Voluntary or mandatory offers

The concept of the mandatory offer does not exist in every country. Nevertheless, in most countries, when a buyer passes a certain threshold or acquires the control of the target, they are required by stock exchange regulation to offer to buy back all the shareholders’ shares. It is one of the founding rules of stock exchange regulations. It should be noted that in the US, there is no mandatory offer and an acquirer can theoretically buy a majority of the capital of a listed company without having to launch an offer to the minority shareholders.

Generally, the constraints for a mandatory offer are tighter than for a voluntary offer. For example, in the UK the mandatory offer will be in cash, or at least a cash alternative will be provided. Obviously, the conditions of the offer that the acquirer is allowed to set in a mandatory offer are limited because they are defined by the regulations.

3/ CERTAINTY OF THE OFFER

It would be very disruptive for the market if an acquirer were to launch an offer and withdraw it a few days later. All market regulations try to ensure that when a public offer is launched, shareholders are actually given the opportunity to tender their shares.

Therefore, market regulation requires that a cash offer is fully funded when it is launched. Full funding ensures that the market does not run the risk of a buyer falling short of financing when the offer is a success! This funding usually takes the form of a guarantee by a bank (generally the bank presenting the offer commits that if the acquirer does not have the funds the bank will pay for the shares).

Another principle is that offers should be unconditional. In particular, the bidder cannot set conditions to the execution of the offer that remains in their hands (as an example, an offer cannot be conditional upon board approval of the acquirer). Nevertheless, in most countries, the offer can be subject to a minimum acceptance (which generally cannot be too high) and regulatory approval (including antitrust). In a few countries (the UK, the Netherlands, the US), the offer can be subject to a material adverse change (MAC) clause, which can only be invoked in extreme cases.⁸

4/ DOCUMENTATION AND MARKET AUTHORITY ROLE

The main role of market authorities is to guarantee the equal treatment of all shareholders and the transparency of the process.

In that regard, market authorities will have a key role in public offers:

They set (and often control) the standard content of the offer document. This document must contain all relevant information allowing the target’s shareholders to take a proper decision.
They supervise the process timetable.
In most countries their green light is necessary for the launch of the offer (they therefore control the price offered).

5/ DEFENSIVE MEASURES

In theory, a company whose shares are being secretly bought up on the stock market generally has a greater variety and number of defensive measures available to it than a company that is the target of a takeover bid. The reason behind this disparity is the secrecy surrounding shares bought up on the market compared with rules of equality and transparency applied to takeover bids.

If a company becomes aware that its shares are being bought up on the market, it is entitled to invoke all of the means of shareholder control described in Chapter 41. It can also get “friendly” investors to buy up its shares in order to increase the percentage of shares held by “friends” and push up its share price, thus making it more expensive for the hostile party to buy as many shares as it needs. Of course, the company will also need to have the time required to carry out all of these transactions, which generally involve waiting periods.

In the case of a takeover bid, there are fewer defensive measures available and they also depend on regulations in force in each country. In some countries (the UK and the Netherlands), all defensive measures taken during a takeover period (excluding attempts to identify other bidders) must be ratified by an EGM held during the offer period. Proxies granted by the general meeting of shareholders to the board prior to the offer period may be suspended. In some countries, any decision taken by the corporate and management bodies before the offer period that has not been fully or partially implemented, which does not fall within the normal course of business and which is likely to cause the offer to fail, must be approved or confirmed by the general meeting of the target’s shareholders.

Furthermore, in some countries, as soon as the takeover bid has been launched, the parties involved are required to ensure that the interests of the target’s employees are taken into account, to ensure that all shareholders are treated equally and that no upheaval on the stock markets is caused, to act in good faith and to comply with all regulations governing takeover bids.

The target company can either defend itself by embarking on an information campaign, explaining to shareholders and to the media how it will be able to create greater value in the future than the premium being offered by the predator, or it can use more active defensive measures, such as:

finding a third party ready to launch a competing takeover bid, called a “white knight”;
launching its own takeover bid on the hostile bidder;
getting “friends” to buy up its shares;
carrying out a capital increase or buying or selling businesses;
warrants;
legal action.

Just how far a board of directors is prepared to go to sabotage a takeover bid is determined by each board facing a predator. It could be depriving its shareholders of a potential capital gain and shareholders may question the responsibility of directors.

A competing takeover bid must be filed a few days before the close of the initial bid. The price offered should be at least a few percentage points higher than the initial bid. There is always the possibility that the initial bidder will make a higher bid, so there is no guarantee that the competing offer will succeed. Likewise, the “white knight” can sometimes turn grey or black when the rescue offer actually succeeds. We saw this in 2019 when Thales came to the “rescue” of Gemalto which was “under attack” by Atos.

A share purchase or exchange offer by the target on the hostile bidder, known as a Pac-Man defence, is only possible if the hostile bidder itself is listed and if its shares are widely held. In such cases, industrial projects are not that different given that an offer by X on Y results in the same economic whole as an offer by Y on X. This marks the start of a communications war (advertisements, press releases, meetings with investors), with each camp explaining why it would be better placed to manage the new whole than the other.

The buying up of shares by “friends” is often highly regulated and generally has to be declared to the market authority, which monitors any acting in concert or which may force the “friend” to file a counter-offer!

A capital increase or the issue of marketable securities is often only possible if this has been authorised by the general meeting of shareholders prior to the takeover bid, because generally there won’t be enough time to convene an EGM to fit in with the offer timetable. In any event, a reserved issue is often not allowed.

Warrants, described in Chapter 41, are a strong dissuasive element. The negative consequences of warrants being issued for the company launching a hostile takeover bid mean that it is generally prepared to negotiate with the target – neutralisation of the warrants in exchange for a higher offer price.

US experience has shown that “poison pill” warrants strengthen the negotiating position of the target’s management, although they don’t ensure its independence. If warrants are, in fact, issued, then the matter of director responsibility will be raised, since the directors will effectively have caused shareholders to lose out on an opportunity to get a higher price for their shares.

The transfer of an important asset into a special structure to prevent its disposal. This is the method used by Suez to try to fend off the Veolia bid.

Legal action could be taken to ensure that market regulations are complied with or on the basis of misleading information if the prospectus issued by the hostile bidder appears to criticise the target’s management. There is also the possibility of reporting the hostile bidder for abuse of a dominant position or insider trading if unusual trades are made before the offer is launched, for failing to comply with the principle of equality of shareholders or for failing to protect the interests of employees if the target has made risky acquisitions during the offer period. The real aim of any legal proceedings is to gain time for the target’s management given that, in general, it takes a few months or quarters for the courts to issue rulings on the facts of a case.

6/ THE LARGER CONTEXT

The various anti-takeover measures generally force the bidder to sweeten their offer, but rarely to abandon it. What can happen is that an initially hostile bid can turn into a friendly merger (SABMiller/AB Inbev, Veolia-Suez). Whether a hostile offer is successful or a white knight comes to the rescue, events invariably lead to the loss of the target company’s independence.

Which, then, are the most effective defensive measures? In recent bids involving large companies, those that have taken the initiative far upstream have been at a clear advantage. A good defence involves ensuring that the company is always in a position to seize opportunities, to anticipate danger and to operate from a position of strength so as to be able to counterattack if need be.

7/ SUMMARY OF SOME NATIONAL REGULATIONS

The EU directive on public offers lays down the principle that a shareholder who has assumed effective control over a company must bid for all equity-linked securities. It is up to individual countries to set a threshold of voting rights that constitutes effective control.

The directive states very specifically the floor price of a mandatory bid: the highest price paid by the new controlling shareholder in the 6–12 months prior to the bid (the exact period is set by national regulations). A mandatory bid can be in either cash or shares (if the shares are listed and are liquid).

So far as defence tactics are concerned, the European directive left European states free to:

ban or not ban the boards of target companies from taking anti-takeover defensive measures during the bid, such as poison pills, massive issuing of shares, etc., without approval from an extraordinary general meeting;
suspend or not suspend during an offer shareholders’ agreements or articles of association limiting voting rights, transfers of shares, shares with multiple voting rights, rights of approval or of first refusal;
authorise targets to put in place anti-takeover measures without the approval of their shareholders if the buyer does not need similar approval from its own shareholders to put in place similar measures at its own level.

Multiple voting rights and/or restrictions on voting rights disappear as of the first general shareholders’ meeting after a bid that has given a bidder a qualified majority of the company. This does not apply to golden shares that have been deemed compatible with European law.⁹

The table below summarises the principal rules applicable to takeover bids in some countries:

Country	Regulator	Threshold for mandatory bid	Minimum percentage mandatory bid must encompass	Bid conditions allowed?	Bid validity after approval	Squeeze-out¹⁰ possible?
China	China Securities Regulatory Commission (www.csrc.gov.cn)	30%	5%		30-60 days	No. Minority shareholders have the right to sell to the buyer after an offer giving them at least 75% of shares, at the offer price
France	AMF, Autorité des Marchés Financiers (www.amf-france.org)	30% of shares or voting rights, 1% p.a. between 30% and 50% of shares or voting rights	100% of shares and equity-linked securities	Usual suspects.¹² None if bid mandatory	25–35 trading days	Yes, if >90% of voting rights and shares
Germany	BAFin, Bundesanstalt für Finanzdien-stle-istungsauf-sicht (www.bafin.de)	30% of voting rights	100%	Usual supects.¹² None if mandatory bid	4–10 weeks	Yes, if >95% of shares
India	Securities and Exchange Board of India (www.sebi.gov.in)	25% of shares or voting rights, 5% p.a. beyond, acquisition of control	26% at least	Minimum acceptance	20 days	Yes, if the higher of 90% of shares or stake of the controlling shareholder + 50% of the float is reached
Italy	CONSOB, Commissione Nazionale per le Società e la Borsa (www.consob.it)	25% or 30% of shares, 5% p.a. beyond 30% up to 50%	100% of voting shares	Usual suspects¹²	15–40 trading days	Yes, if >95% of voting rights
Netherlands	AFM, Autoriteit Financiele Markten (www.afm.nl)	30% of voting rights	100% of shares and equity-linked securities	Minimum acceptance	>8 trading weeks and <10 weeks	Yes, if >95% of shares
Spain	CNMV, Comisión Nacional del Mercado de Valores (www.cnmv.es)	30% and 50% or less if right to nominate more than half of the directors or any increase of 5% between 30% and 50%	100%	Usual suspects¹²	3–14 weeks	Yes, if >90% of the voting rights and higher than 90% success rate for the public offer
Switzerland	COPA, Commission des Offres Publiques d’Achat (www.takeover.ch)	33.33% of voting rights¹¹	100% of shares	Usual suspects¹²	20–40 trading days	Yes, if >90% of voting rights
UK	Takeover Panel (www.thetakeoverpanel.org.uk)	30% of voting rights and any increase between 30% and 50%	100% of shares and all instruments convertible or exchangeable into shares	Usual suspects¹² and MAC clause that must be approved by regulator	21–60 trading days	Yes, if >90% of the shares¹³
USA	SEC, Securities and Exchange Commission (www.sec.gov)	None, except Maine (20%), Pennsylvania (25%) and South Dakota (50%)	None	Usual suspects¹² and MAC clause	>20 trading days	Yes with normal or super-majority

10 That is, possibility for the majority shareholder to force the buy-back of minority shareholders and delist the company if minority shareholders represent only a small part of the capital.

11 No threshold (opt-out) or a threshold up to 49% if the by-laws of the target company permit.

12 Minimum acceptance, antitrust authorisations, authorisation of shareholders to issue shares.

13 The Scheme of Arrangement allows for 75% to agree to an acquisition for it to go through.

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

M&A deals tend to come in waves. Their determinants are macroeconomic (globalisation, deregulation, technological evolution), microeconomic (search for size, for new markets, gains of time), human (succession issues) or structural (liquidation of an investment fund).

The art of negotiation consists of allocating the value of the synergies expected from a merger or acquisition between the buyer and the seller. There are two basic methods of conducting the negotiations:

private negotiation, which preserves a high level of confidentiality, at the cost of having significant competition during the sales process;
a private auction, which heightens the competition between buyers, but is more restrictive for the seller.

Regardless of the chosen procedure, certain elements are common to every deal:

memorandums of understanding and agreements in principle serve to describe the general agreement found between the parties and are a milestone along the path to full commitment of the parties to the deal;
representations and warranties guarantee to the buyer that all of the means of production belong to the company and that there are no hidden liabilities; the seller certifies substantive aspects of the company and the amount of equity capital;
in some cases, earnout clauses link a portion of the purchase price to the company’s future profits;
the final outcome of negotiations is the signing of a share purchase agreement.

Stake-building can be the first step to acquiring control over a listed company. But it can be slow and faces the requirement of declaring the crossing of ownership and voting rights thresholds.

A public offer is the usual way to acquire a listed company. It is based on two fundamental principles: transparency and equal treatment of shareholders. It can be in cash or in shares, hostile or friendly, voluntary or mandatory.

In each country, the acquisition of listed companies is conducted under the supervision of a stock-market watchdog. A directive harmonises the main principles of takeover bids in the European Union.

QUESTIONS

1/What are the advantages and drawbacks of private negotiation?
2/What are the advantages and drawbacks of a private sale by auction?
3/What is the advantage of a public purchase or share exchange offer for a minority shareholder?
4/What advantages does a public offer have for the acquirer over an acquisition on the market? What are the drawbacks?
5/Can a company make an offer to buy another company that is for sale without having any real intention of closing the deal? Why? What protection is there for the seller?
6/What will be key to making an M&A deal a successful event in a company’s history?
7/Why are earnout clauses so popular with companies in the service sector?
8/All things being equal, what is the downside of a deal being kept highly confidential?
9/When is it a good idea to go for a private auction?
10/How can a buyer be protected against any hidden liabilities and debts that the target may have?
11/What is the purpose of representations and warranties? What are the limits of such clauses?
12/What is the logical result of a successful hostile stake-building on the market?
13/What concern of market authorities is addressed by a suspension of trading after notice of an offer has been filed?
14/Why are defence mechanisms against hostile takeover bids very strictly regulated?
15/On the basis of financial theory, how can the role of an investment bank in a deal be summarised?
More questions are waiting for you at www.vernimmen.com.

ANSWERS

Questions

1/Advantage: negotiations are kept confidential. Drawback: potential candidates may be left out.
2/Advantage: organisation of a market. Drawback: lack of confidentiality.
3/The minority shareholder is protected as they will be able to sell their shares at the same price as the majority shareholder.
4/The acquirer does not cause the share price to rise. The drawback is that if a stock market battle unfolds, they will not be in such a good position.
5/Yes. To obtain information. Memorandums of understanding and of agreement, confidentiality agreements.
6/The integration process post-acquisition.
7/The deal itself can have an unpredictable impact on human resources – the company’s main assets.
8/The sale price might be lower.
9/When the business for sale is very profitable, and attractive to both trade buyers and financial investors.
10/Representation and warranties.
11/They provide a guarantee for the assets and liabilities of the company. Under no circumstances can such clauses guarantee the fairness of the price paid for the business.
12/A takeover bid.
13/The fair and equal dissemination of information.
14/Anti-takeover measures can deprive shareholders of the capital gains that come out of the free process of auctions.
15/Management of information asymmetry.

BIBLIOGRAPHY

To know more about M&A deals:

A. Boone, J.H. Mulherin, How are firms sold?, Journal of Finance, 62(2), 847–875, April 2007.
D. Davis, M&A Integration, John Wiley & Sons, Inc., 2012.
A. Gorbenko, A. Malenko, Strategic and financial bidders in takeover auctions, Journal of Finance, 69(6), 2513–2555, December 2014.
J. Rosenbaum, J. Peral, Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions, 3rd edn, John Wiley & Sons, Inc., 2020.
M. Sirower, The Synergy Trap, Free Press, 1997.
iclg.com/practice-areas/merger-control-laws-and-regulations, main aspects of antitrust and takeover rules for 50 countries.

For research works on M&A deals:

K. Ahern, D. Daminelli, C. Fracassi, Lost in translation? The effect of cultural values on merger around the world, Journal of Financial Economics, 117, 165–189, July 2015.
N. Aktas, E. de Bodt, R. Roll, Negotiations under threat of an auction, Journal of Financial Economics, 98(2), 241–255, November 2010.
V. Cuno, M. Giné, M. Guadelupe, Price and probability: decomposing the takeover effects of antitakeover provisions, Journal of Finance 75(5), 2591–2629, October 2020.
M. Danielson, J. Karpoff, Do pills poison operating performance?, Journal of Corporate Finance, 12(3), 536–559, June 2006.
M. Dong, D. Hirshleifer, S. Richardson, S.H. Teoh, Does investors’ misvaluation drive the takeover market?, Journal of Finance, 61(2), 725–762, April 2006.
R. Duchin, B. Schmidt, Riding the merger wave: Uncertainty, reduced monitoring and bad acquisitions, Journal of Financial Economics, 107(1), 69–88, January 2013.
I. Erel, R. Liao, M. Weisbach, Determinants of cross-border mergers and acquisitions, Journal of Finance, 67(3), 1045–1082, June 2012.
M. Faccio, R. Masulis, The choice of payment method in European mergers & acquisitions, Journal of Finance, 60(3), 1345–1388, June 2005.
G. Gorton, M. Kahl, R. Rosen, Eat or be eaten: A theory of mergers and firm size, Journal of Finance, 64(3), 1291–1344, June 2009.
S. Grossman, O. Hart, Takeover bids, the free rider problem, and the theory of the corporation, Bell Journal of Economics, 11(1), 42–64, Spring 1980.
U. Hege, S. Lovo, M. Slovin, E. Sushka, Equity and cash in intercorporate asset sales: Theory and evidence, Review of Financial Studies, 22(1), 681–714, February 2009.
M. Jensen, Agency costs of free cash flow, corporate finance, and takeovers, American Economic Review, 76(2), 323–329, May 1986.
M. Jensen, R.S. Ruback, The market for corporate control: The scientific evidence, Journal of Financial Economics, 11(1), 5–50, April 1983.
D. Kisgen, J. Qian, W. Song, Are fairness opinions fair?, Journal of Financial Economics, 91(2), 179–207, February 2009.
V. Maksimovic, G. Phillips, N.R. Prabhala, Post-merger restructuring and the boundaries of the firm, Journal of Financial Economics, 102(2), 317–343, November 2011.
M. Rhodes-Kropf, S. Viswanathan, Market valuation and merger waves, Journal of Finance, 59(6), 2685–2718, December 2004.
R. Roll, The hubris hypothesis of corporate takeovers, Journal of Business, 59(2), 197–216, April 1986.
S. Rossi, P. Volpin, Cross-country determinants of mergers and acquisitions, Journal of Financial Economics, 74(2), 277–304, November 2004.
G. Schwert, Hostility in takeovers: In the eyes of the beholder?, Journal of Finance, 55(6), 2599–2640, December 2000.
A. Shleifer, R. Vishny, Stock market driven acquisition, Journal of Financial Economics, 70(3), 295–311, December 2003.
M. Sirower, A. Rappaport, Stock or cash: The trade-offs for buyers and sellers in mergers and acquisitions, Harvard Business Review, 77, 147–158, November–December 1999.

To measure the relevancy of M&A deals:

A. Agrawal, J. Jaffe, The post-merger performance puzzle, Advances in Mergers and Acquisitions, 1, 7–41, 2000.
S. Bhagat, M. Dong, D. Hirshleifer, R. Noah, Do tender offers create value? New methods and evidence, Journal of Financial Economics, 76(1), 3–60, April 2005.
I. Erel, Y. Jang, M. Weisbach, Do acquisitions relieve target firms’ financial constraints?, Journal of Finance, 70(1), 289–328, February 2015.
I. Loughran, A. Vijh, Do long-term shareholders benefit from corporate acquisitions?, Journal of Finance, 52(5), 1765–1790, December 1997.
S. Moellers, F. Schlingemann, R. Stulz, Firm size and the gains from acquisitions, Journal of Financial Economics, 73(2), 201–228, August 2004.
S. Moellers, F. Schlingemann, R. Stulz, Wealth destruction on a massive scale? A study of acquiring-firm returns in the recent merger wave, Journal of Finance, 60(2), 757–782, April 2005.
P. Savor, Q. Lu, Do stock mergers create value for acquirers?, Journal of Finance, 64(3), 1061–1098, June 2009.

NOTES

1 This is known as the ZOPA (zone of possible agreement).
2 See Boone and Mulherin (2007).
3 Leveraged buyout.
4 Implying they will use the information disclosed during the selling process only to make an offer and will not tell a third party they are studying this acquisition.
5 Or sale and purchase agreement.
6 Generally Accepted Accounting Principles.
7 A special bank account for the deposit of funds, to which the beneficiary’s access is subject to the fulfilment of certain conditions.
8 In a UK takeover bid situation, 9/11 was not deemed to be such a case.
9 European law strictly limits national government leeway on golden shares. Golden shares are nonetheless still possible in some sectors and special cases, such as the defence industry.

Chapter 46. MERGERS AND DEMERGERS

Chapter 46
MERGERS AND DEMERGERS

When the financial manager celebrates a wedding (or a divorce!)

At first glance, this chapter might seem to repeat the previous ones in that selling a company almost always leads to linking it up with another. In everyday language we often talk of the merger of two companies, when in reality one company typically takes control of the other, using the methods described in Chapter 45. In fact, all that we have previously said about synergies and company valuations will be used in this chapter. The only fundamental difference we introduce here is that 100% of the seller’s consideration will be in shares of the acquiring company and not in cash.

In addition, because markets nowadays prefer “pure-play” companies, demergers have come back into fashion. We will take a look at them in Section 46.3.

Section 46.1 ALL-SHARE DEALS

In this section, we will examine the general case of two separate companies that decide to pool their operations and redistribute roles. Before the business combination can be consummated, questions of valuation and power-sharing among the shareholders of the new entity must be resolved. Financially, the essential distinguishing feature among mergers and acquisitions is the nature of the consideration paid: 100% cash, a combination of cash and shares or 100% shares. Our discussion will focus on the last of these forms. Finally, we will not address the case of a company that merges with an already wholly owned subsidiary, which raises only accounting, tax and legal issues and no financial issues.

1/ THE DIFFERENT TECHNIQUES

(a) Legal merger

A legal merger is a transaction by which two or more companies combine to form a single legal entity. In most cases, one company absorbs the other. The shareholders of the acquired company become shareholders of the acquiring company and the acquired company ceases to exist as a separate legal entity.

From legal and tax points of view, this type of business combination is treated as a contribution of assets and liabilities, paid in new shares issued to the ex-shareholders of the acquired company.

(b) Contribution of shares

Consider the shareholders of Companies A and B. Shareholders of Company B, be they individuals or legal entities, can enter into a deal with Company A wherein they exchange their shares of B for shares of A. In this case, Companies A and B continue to exist, with B becoming a subsidiary of A and the shareholders of B becoming shareholders of A.

Financially and economically, the transaction is very close to the sale of all or part of Company B funded by an equivalent issue of new Company A shares, reserved for the shareholders of Company B.

For listed companies, the most common approach for achieving this result is a share exchange offer, as described in Section 45.3.

(c) Asset contribution

In a contribution (or transfer) of assets, Company B contributes a portion (or sometimes all) of its assets (and liabilities) to Company A in return for shares issued by Company A.

In a legal merger, the shareholders of Company B receive shares of Company A. In a transfer of assets, however, Company B, not the shareholders thereof, receives the shares of Company A. The position of Company B shareholders is therefore substantially different, depending on whether the transaction is a legal merger or a simple transfer of assets. In the transfer of assets, Company B remains and becomes a shareholder of Company A. Shareholders of B do not become direct shareholders of A. In the legal merger, shareholders of B become direct shareholders of A.

If Company B contributes all of its assets to A, B becomes a holding company and, depending on the amount of the assets it has contributed, can take control of A. This procedure is often used in corporate restructurings to transfer certain activities to subsidiaries.

Economically, there is no difference between these transactions. The group created by bringing together A and B is economically identical regardless of how the business combination is effected.

As an example of asset contribution, you can have a look at the EssilorLuxottica transaction in 2017. Delfin, controlled by Leonardo Del Vecchio, contributed its 61% stake in Luxottica to Essilor in exchange for 31% of the new EssilorLuxottica.

Economically speaking, there is no distinction between these different transactions: the group formed by the merger of companies A and B is economically identical regardless of the form it takes. In examples 2, 3, and 4, the shareholders of A and B are directly or indirectly shareholders in the new group.

2/ ANALYSIS OF THE DIFFERENT TECHNIQUES

For simplicity’s sake, we will assume that the shares of both companies are fairly priced and that the merger does not create any industrial or commercial synergies. Consequently, there is no value creation as a result of the merger.

(a) From the point of view of the company

Companies A and B have the following characteristics:

(€m)	Enterprise value	Value of shareholders’ equity agreed in the merger
Company A	900	450
Company B	500	375

Depending on the method used, the post-transaction situation is as follows:

(€m)	A acquires B shares for cash¹	A merges with B	A issues new shares in exchange for B shares and B becomes a 100% subsidiary of A	A issues new shares in exchange for assets and liabilities of B
Value of A’s new capital employed (now A + B)	1,400	1,400	1,400	1,400
Value of A’s shareholders’ equity	450	825	825	825
Percentage of A held by A shareholders	100%	54.5%	54.5%	54.5%
Percentage of A held by B shareholders	—	45.5%	45.5%	45.5%²

Enterprise value and consolidated operating income are the same in each scenario. Economically, each transaction represents the same business combination of Companies A and B. It can be noted that when the target is a listed company, a 100% successful share exchange offer is financially equivalent to a legal merger.

Financially, however, the situation is very different, even putting aside accounting issues. If A pays for the acquisition in shares, then the shareholders’ equity of A is increased by the shareholders’ equity of B. If A purchases B for cash, then the value of A’s shareholders’ equity does not increase.

We reiterate that our reasoning here is strictly arithmetic and we are not taking into account any impact the transaction may have on the value of the two companies. If the two companies were already correctly priced before the transaction and there are no synergies, their value will remain the same. If not, there will be a change in value. The financial mechanics (sale, merger, etc.) have no impact on the economics of a business combination. This is self-evident, but it is worth recalling.

An acquisition paid for in cash does not increase a group’s financial clout, but an all-share transaction creates a group with financial means, which tends to be the sum of that of the two constituent companies.

(b) From the point of view of shareholders

A cash acquisition changes the portfolio of the acquired company’s shareholders, because they now hold cash in place of the shares they previously held. It does not change the portfolio of the acquiring company’s shareholders, nor their stake in the company.

An all-share transaction is symmetrical for the shareholders of A and B. No one receives any cash. When the dust settles, they all hold claims on a new company born out of the two previous companies. Note that their claims on the merged company would have been exactly the same if B had absorbed A. In fact, who absorbs whom is not so important; it is the percentage ownership the shareholders end up with that is important. Moreover, it is common for one company to take control of another by letting itself be “absorbed” by its smaller “target”.

Merger synergies are not shared in the same way. In a cash acquisition, selling shareholders pocket a portion of the value of synergies immediately (depending on the outcome of the negotiation). The selling shareholders do not bear any risk of implementation of the synergies. In an all-share transaction, however, the value creation (or destruction) of combining the two businesses will be shared according to the relative values negotiated by the two sets of shareholders.

For the shareholders of Company B, a contribution of shares, with B remaining a subsidiary of A, has the same effect as a legal merger of the two companies. An asset contribution of Company B to Company A is also very similar to a legal merger. The only difference is that, in an asset contribution, the claim of Company B’s ex-shareholders on Company A is via Company B, which becomes a holding company of Company A.

3/ PROS AND CONS OF PAYING IN SHARES

In contrast to a cash acquisition, there is no cash outflow in an all-share deal, be it an exchange of shares, an asset contribution in return for shares or a demerger with a distribution of shares in a new company. The transaction does not generate any cash that can be used by shareholders of the acquired company to pay capital gains taxes. For this reason, it is important for these transactions to be treated as “tax-free”.

What is the advantage of paying in shares? Sometimes company managers want to change the ownership structure of the company so as to dilute an unwelcome shareholder’s stake, constitute a group of core shareholders or increase their power by increasing the company’s size or prestige. More importantly, paying in shares enables the company to skirt the question of financing and merge even with very large companies. Some critics say that companies paying in shares are paying for their acquisitions with “funny money”; we think that depends on the post-merger ownership structure and share liquidity. Most importantly, it depends on the ability of the merged company to harness anticipated synergies and create value. In Section 45.3, we provide a table setting out the pros and cons of payment in shares versus cash.

Section 46.2 THE MECHANICS OF ALL-SHARE TRANSACTIONS

1/ EXCHANGE RATIO AND RELATIVE VALUE RATIO

To carry out a merger, you need to determine the exchange ratio, i.e. the ratio of the number of shares of one company to be issued for each share of the other company received.

When both companies have similar activities, the ratios of their earnings per share, cash flow per share, dividend per share, book equity per share, shares prices (when they are listed) are computed. Some even compute ratios of sales per share, EBITDA per share, EBIT per share. This is relevant only if the capital structures of both companies are similar.

When companies have dissimilar activities, like a diversified group and a one-product group or a holding company and an industrial group, then a full valuation of the two companies to be merged is generally performed according to the methods described in Chapter 31. Such a valuation is usually done on a standalone basis, no synergy being taken into account. As far as possible, the same valuation methods should be used to value each company and compute a parity per method.

Let us take another look at Companies A and B, with the following key figures:

	Earnings per share	Share price	Dividend per share
A (acquirer)	€3.33	€100	€1
B (acquiree)	€9.33	€176	€2.3
Exchange ratio	2.80	1.76	2.30

The final exchange ratio agreed upon may be 2.

Let’s now move from the per-share level, which has allowed us to compute the exchange ratio, to the level of shareholders’ equity value agreed in the merger. The ratio of shareholders’ equity value of Company A to shareholders’ equity value of Company B is called the relative value. A relative value of 0.8333 (B’s value, 375, being equal to 0.833 A’s value, 450) gives to the current B shareholders a stake of 0.833 / (0.833 + 1) = 45.5% in the merged entity. Hence, A shareholders will get a stake of 1 / (0.8333 + 1) = 54.5%. 0.833 corresponds to the ratio of the values of shareholders’ equity agreed in the merger, €450m and €375m, respectively.

If the relative value ratio agreed in the merger had been 0.9, A shareholders would have obtained a stake of 52.6% in the merger entity and B shareholders a stake of 47.4%.

Once relative values are determined, calculating the exchange ratio is a simple matter:

The 1,875,000 B shares will be exchanged for 1,875,000 × 2 = 3,750,000 new A shares issued by A to remunerate B shareholders. After the merger the outstanding share capital of A will be made up of 4,500,000 + 3,750,000 = 8,250,000 shares.

2/ DILUTION OR ACCRETION CRITERIA

To help refine our analysis, let us suppose that Companies A and B have the following key financial elements:

(€m)	Sales	Net income	Book equity	Value of shareholders’ equity
A	1,500	15	250	450
B	2,500	17.5	225	330

Putting aside for one moment potential industrial and commercial synergies, the financial elements of the new Company A + B resulting from the merger with B are as follows:

(€m)	Sales	Net income	Book equity	Value of shareholders’ equity
Group A + B	4,000	32.5	475	780

In theory, the value of the new entity’s shareholders’ equity should be the sum of the value of the shareholders’ equity of A and B. In practice, it is higher or lower than this amount, depending on how advantageous investors believe the merger is.

Using the agreed relative value ratio of 0.833 (B value is 0.833 the value of A), our performance measures for the new group are as follows:

(€m)	Group net income	Group book equity	Theoretical value of group shareholders’ equity
The ex-shareholders of A have a claim on: vs. before the transaction:	17.7 15	259 250	425 450
The ex-shareholders of B have a claim on: vs. before the transaction:	14.8 17.5	216 225	355 330
TOTAL Before transaction: After transaction:	32.5 32.5	475 475	780 780

As a result of the agreed relative value ratio, the ex-shareholders of B suffer a dilution (reduction) in book equity, as their portion declines from €225m to €216m, and in their share of the net income of the new entity. At the same time, they enjoy an accretion in their share of the new group’s theoretical market capitalisation from €330m to €355m. This is because A has accepted as a value for B’s equity (€375m) a value above B’s market value of equity of €330m, whilst A was valued during negotiations at the actual market value of its equity (€450m). This is likely to be a compensation for the loss of control of B shareholders, who are now in a minority position in the new group.³ Naturally, the situation is the opposite for the ex-shareholders of A.

Turning our attention now to the earnings per share of Companies A and B, we observe the following:

	Value of shareholders’ equity (€m)	Net income (€m)	P/E ratio⁴	Number of shares (million)	Earnings per share (€)
Company A	450	15	30	4.5	3.33
Company B	330	17.5	18.9	1.875	9.33

On the basis of the relative value ratio agreed in the merger of 0.833 (375 / 450), the earnings per share of the new group A now stands at (15 + 17.5) / (4.5 + 3.75), or €3.94 per share. EPS has risen from 3.33 to 3.94, representing an increase of slightly less than 20%. The reason is that the portion of earnings deriving from ex-Company B is purchased with shares valued at A’s P/E multiple of 30 (450 / 15), whereas B is valued at a P/E multiple of 21 (375 / 17.5). Company A has issued a number of shares that are relatively low compared with the additional net income that B has contributed to A’s initial net income.

But let’s not fool ourselves. This EPS growth is not synonymous with value creation. If the merger had gone the other way (B absorbs A), we would have seen dilution, even though economically speaking the end result would have been identical.

The reasoning is similar for other performance metrics, such as cash flow per share.

3/ NEGOTIATION ZONE AND SYNERGIES

As an all-share merger consists conceptually of a purchase followed by a reserved capital increase, the sharing of synergies is a subject of negotiation just as it is in the case of a cash purchase.

In our example, let us suppose that synergies between A and B will increase the after-tax income of the merged group by €10m from the first year onwards.

The big unknown is the credit and the value investors will ascribe to these synergies:

€300m – i.e. a valuation based on A’s P/E ratio of 30;
€189m – i.e. a valuation based on B’s P/E ratio of 18.9;
€240m – i.e. a valuation based on a P/E ratio of 24, the average of the P/Es of A and B (780 / 32.5);
some other value.

Two factors lead us to believe that investors will attribute a value that is lower than these estimates:

The amount of synergies announced at the time of the merger is only an estimate and the announcers have an interest in maximising it to induce shareholders to approve the transaction. In practice, making a merger or an acquisition work is a managerial challenge. You have to motivate employees who may previously have been competitors to work together, create a new corporate culture, avoid losing customers who want to maintain a wide variety of suppliers, etc. Experience has shown that:
- more than half of all mergers fail on this score;
- actual synergies are slower in coming;
- the amount of synergies is lower than originally announced.
Sooner or later, the company will not be the only one in the industry to merge. Because mergers and acquisitions tend to come in waves, rival companies will be tempted to merge for the same reasons: to unlock synergies and remain competitive. As competition also consolidates, all market participants will be able to lower prices or refrain from raising them, to the joy of the consumer. As a result, the group that first benefited from merger synergies will be forced to give back some of its gains to its customers, employees and suppliers.

Based on this information, let’s assume that the investors in our example value the €10m p.a. in synergies at a P/E of 12, or €120m. The value of shareholders’ equity of the new group is therefore:

Value is created in the amount of 900 − 780 = €120m. This is not financial value creation, but the result of the merger itself, which leads to cost savings and/or revenue enhancements, i.e. synergies. The €120m synergy pie will be shared between the shareholders of A and B.

At the extreme, the shareholders of A might value B at €450m. In other words, they might attribute the full present value of the synergies to the shareholders of B. The relative value ratio would then be at its maximum, 1.⁵ Note that in setting the relative value ratio at 0.833, they had already offered the ex-shareholders of B 66%⁶ of the value of the synergies!

The relative value ratios of 0.579 (330 / (450 + 120)) and 1 constitute the upper and lower financial boundaries of the negotiable range. If they agree on 0.579, the shareholders of A will have kept all of the value of the synergies for themselves. Conversely, at 1, all of the synergies accrue to the shareholders of B.

The relative value choice determines the relative ownership stake of the two groups of shareholders, A’s and B’s, in the post-merger group, which ranges from 36.7%/63.3% to 50%/50%, and consequently the value of their respective stakes.

Determining the value of potential synergies is a crucial negotiating stage. It determines the maximum merger premium that Company A will be willing to pay to the shareholders of Company B:

large enough to encourage shareholders of B to approve the merger;
small enough to still be value-creating for A’s shareholders.

4/ THE “BOOTSTRAP GAME”

Until now, we have assumed that the market capitalisation of the new group will remain equal to the sum of the two initial market capitalisations. In practice, a merger often causes an adjustment in the P/E, called a rerating. As a result, significant transfers of value occur to and between the groups of shareholders. These value transfers often offset a sacrifice with respect to the post-merger ownership stake or a post-merger performance metric.

If we assume that the new Group A continues to enjoy a P/E ratio of 30 (ignoring synergies), as did the pre-merger Company A, its market capitalisation will be €975m. The ex-shareholders of A, who appeared to give up some relative value with regard to the post-merger market cap metric, see the value of their share of the new group rise to €531m,⁷ whereas they previously owned 100% of a company that was worth only €450m. As for the ex-shareholders of B, they now hold 45.5% of the new group, a stake worth €444m, versus 100% of a company previously valued at only €330m.

Whereas it seemed A’s shareholders came out losing, in fact it’s a win–win situation. The transaction is a money machine! The limits of this model are clear, however. A’s pre-merger P/E ratio of 30 was the P/E ratio of a growth company. Group A will maintain its level of growth after the merger only if it can light a fire under B and convince investors that the new group also merits a P/E ratio of 30.

This model works only if Company A keeps growing through acquisition, “kissing” larger and larger “sleeping beauties” and bringing them back to life. If not, the P/E ratio of the new group will simply correspond to the weighted average of the P/E ratios of the merged companies.

You have probably noticed by now that it is advantageous to have a high share price, and hence a high P/E ratio. They allow you to issue highly valued paper to carry out acquisitions at relatively low cost, all the while posting automatic increases in earnings per share. You undoubtedly also know how to recognise an accelerating treadmill when you see one.

The potential immediate rerating after the merger does not guarantee creation of shareholder value. In the long run, only the new group’s economic performance will enable it to maintain its high P/E multiple.

5/ WHICH WAY SHOULD THE MERGER GO?

Is A going to absorb B or the reverse? Several factors have to be taken into account.

Whether the company is listed or not is a factor, since in a merger between a listed and an unlisted company, it is likely that the listed company will take over the unlisted one in order to simplify administrative procedures and to avoid an exchange of shares for the hundreds, thousands or even hundreds of thousands of shareholders of the listed company.

There are, of course, legal considerations when agreements signed by the acquired company contain a change-of-control clause.

There are also psychological reasons why sometimes it makes more sense to continue trading under the name or structure of an entity which has been in existence for a very long time and which has great sentimental value for management and shareholders. In such cases, it is the oldest structure that becomes the acquiring company (although the name of the acquiring company could also just be changed).

There are also some managers who believe that they will be in a better position within the new structure if their company is the acquiring company rather than the acquired company. There are others who wish to make a symbolic statement about where the power lies, which can then become a politically sensitive issue if the two groups are not of the same nationality.

Then there are those who are obsessed with EPS, who are keen for the acquiring company to be the one with the highest P/E ratio so the merger will be accretive in terms of EPS. Our readers know how cautious we are when it comes to EPS.⁸

In some countries, the tax issue is the main factor in deciding which way the merger should go. The acquired company loses all of its tax-loss carryforwards, while the acquiring company is allowed to hold onto its own. Elsewhere, it is possible for the company resulting from the merger of two companies to hold onto the tax-loss carryforwards of the company that is acquired, provided that the merger is not being carried out solely for tax reasons. This reduces the importance of the tax issue in deciding who should take over whom.

6/ ACCOUNTING FOR MERGERS

In a merger (or share contribution), there are two types of values which may or may not coincide: the financial value which serves as a reference for determining the relative weight, and the amount at which the assets are contributed for accounting purposes to the acquiring company (or beneficiary of the contributions).

Where the two merging companies do not have the same shareholders, the assets and liabilities of the company being acquired should be included at their market value in the accounts of the acquiring company.

On the other hand, when the two merging entities have the same shareholder (intra-group transaction), the assets and liabilities of the absorbed company are included at their book value in the accounts of the absorbing company, in the corporate and consolidated accounts.

Section 46.3 DEMERGERS AND SPLIT-OFFS

1/ PRINCIPLES

The principle of a demerger is simple. A group with several divisions, in most cases two, decides to separate them into distinct companies (some use the term carve-in for the separation of two activities within the same group). The shares of the newly created companies are distributed to the shareholders in exchange for shares of the parent group. The shareholders, who are the same as the shareholders of the original group, now own shares in two or more companies and can buy or sell them as they see fit.

There are two basic types of transactions, depending on whether, once approved, the transaction applies to all shareholders or gives shareholders the option of participating.

A demerger is a separation of the activities of a group: the original shareholders become the shareholders of the separated companies. The transaction can be carried out by distributing the shares of a subsidiary in the form of a dividend (a spin-off), or by dissolving the parent company and distributing the shares of the ex-subsidiaries to the shareholders (a split-up). Immediately after the transaction, the shareholders of the demerged companies are the same, but ownership evolves very quickly thereafter.
In a split-off, shareholders have the option to exchange their shares in the parent company for shares in a subsidiary. To avoid unnecessary holdings of treasury shares, the shares tendered are cancelled. A split-off is a share repurchase paid for with shares in a subsidiary rather than in cash. If all shareholders tender their shares, the split-off is identical to a demerger. If the offer is relatively unsuccessful, the parent company remains a shareholder of the subsidiary.

2/ WHY DEMERGE?

Broadly speaking, studies on demergers have shown that the shares of the separated companies outperform the market, both in the short and long term.

In the context of the efficient markets hypothesis and agency theory, demergers are an answer to conglomerate discounts (see Section 42.1) or groups that are too diversified. In this sense, a demerger creates value because it solves the following problems:

Allocation of capital within a conglomerate is suboptimal, benefiting divisions in difficulty and penalising healthy ones, making it harder for the latter to grow.
The market values primary businesses correctly but undervalues secondary businesses. A demerger can also help a group to dispose of an asset that is hard to sell (Osram for Siemens, South 32 for BHP Billiton).
The market has trouble understanding conglomerates, a problem made worse by the fact that virtually all financial analysts are specialised by industry. With a very large number of listed companies, investors prefer simplicity. In addition, large conglomerates communicate less about smaller divisions, thus increasing the information asymmetry.
Lack of motivation of managers of non-core divisions.
Small base of investors interested by all the businesses of the group.
The conglomerate has operating costs that add to the costs of the operating units without necessarily creating value.

Demergers expose the newly created companies to potential takeovers. Prior to the demerger, the company might have been too big or too diverse. Potential acquirers might not have been interested in all of its businesses, and the process of acquiring the entire company and then selling off the unwanted businesses is cumbersome and risky. A demerger creates smaller, pure-play companies, which are more attractive in the takeover market. Empirically, it has been shown that demerged subsidiaries do not always outperform. This is the case when the parent company has completely divested its interest in the new company or has itself become subject to a takeover bid.

Lastly, lenders are not great fans of demergers. By reducing the diversity of activities and consequently potentially increasing the volatility of cash flows, they increase the risk for lenders. At one extreme, the value of their debt decreases if the transaction is structured in such a way that one of the new companies carries all the debt, while the other is financed by equity capital only.

In practice, however, debtholders are rarely spoiled that way. Loan agreements and bond indentures generally stipulate that, in the event of a demerger, the loan or the bonds become immediately due and payable.

Consequently they are in a position to negotiate demerger terms that are not unfavourable to them. This explains why empirical studies have shown that, on average, demergers lead to no transfer of value from creditors to shareholders.

Because of their complexity and the detailed preparation they require (over at least six months), demergers are less frequent than mergers. Examples of demergers include Dow DuPont (Chemicals) into Dow, Dupont, and Corteva; PPR into Kering and Fnac, followed by Kering and Puma (retail and fashion); Metro (wholesale retailer) and Ceconomy (consumer electronics); and for split-offs, Pfizer/Zoetis (animal health); Vivendi/UMG.

Demerging is not a panacea. If one of the demerged businesses is too small, its shares will suffer a deep liquidity discount. The same can be said if the demerger leads to the companies disappearing from a stock market index. In emerging countries, the diversification of groups seems to be a success factor (see Chapter 42).

If we wanted to be cynical, we might say that demergers represent the triumph of sloth (investors and analysts do not take the time to understand complex groups) and selfishness (managers want to finance only the high-performance businesses).

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

Business combinations, commonly referred to as mergers and acquisitions, can take many forms. The most important distinction among them is the method of payment: (i) cash or cash and shares; (ii) 100% in shares.

All-share deals can take several forms:

legal merger: two or more companies are combined to form a single company. In general, one company is dissolved and absorbed into the other;
contribution of shares: the shareholders of Company B exchange their shares for shares of Company A;
asset contribution: Company B transfers a portion of its assets to Company A in exchange for shares issued by Company A.

The economics of the business combination are independent of the financial arrangements. That said, in an all-share deal the resources of the two entities are added together, increasing the merged company’s financial capacity, compared with what it would have been after the conclusion of a cash deal. Also, in an all-share deal, all the shareholders of the resulting group share the risks of the merger. When the deal is negotiated, the companies are valued and the relative value ratio and exchange ratio are set. The exchange ratio is the number of shares of the acquiring company that will be exchanged for the tendered shares of the acquired company. The relative value ratio determines the position of each group of shareholders in the newly merged group.

The higher a company’s P/E ratio is, the more tempted it will be to carry out acquisitions by issuing shares, because its earnings per share will automatically increase. But be careful! No value is automatically created. The increase in EPS is only a mathematical result deriving from the difference between the P/E ratios of the acquirer and the acquiree. At the same time, the P/E ratio of the new entity declines, because the market capitalisations of the new group should theoretically correspond to the sum of the market capitalisation of the two companies prior to the merger. Sometimes the new company’s P/E ratio stays the same as the acquiring company’s P/E ratio. We call this the “magic kiss” effect, because it implies that the company has only to “wake up” the “sleeping beauty” it has acquired. In each case, the value of the merger synergies is added to the value of the new company. How they are shared by the two groups of shareholders determines the premium the acquiring company will pay to the target’s shareholders to persuade them to participate in the deal.

A demerger is a simple concept. A diversified group decides to separate into distinct companies and to distribute the shares of the new companies to shareholders in return for shares of the parent group. It is often an answer to too low a valuation for a group with too far-flung activities.

The value created by a demerger can be analysed as follows:

unlocking the value trapped in the conglomerate discount (efficient markets hypothesis);
increasing the motivation of the managers of the newly independent company (agency theory).

A demerger results in companies being more exposed to takeover bids.

QUESTIONS

1/What is the fundamental difference between a merger and a sale:
- for the shareholder of the acquired company?
- for the acquiring company?
- for the shareholder of the acquiring company?
- for the acquired company?
2/Unlike what happens when a company is sold, when companies merge their shareholders’ equity is added together. Why?
3/In your view, what are the possible reasons behind a merger? And a demerger?
4/Ignoring tax issues, would a shareholder with a 51% controlling interest in a company be better off buying another company or merging with it?
5/Is the dilution of EPS that follows all mergers generally greater or less than that which follows a standard share issue?
6/Why is the determination of the exchange ratio important?
7/What is the difference between the relative value ratio and the exchange ratio?
8/When negotiating, is agreement first reached on the relative value or on the calculation method?
9/Why do shareholders in an acquired company agree to the dilution of their shareholdings after completion of the merger?
10/Where does the creation of value lie in a merger?
11/Why are the legal procedures related to mergers so onerous?
12/In what circumstances can a demerger lead to creation of shareholder value? And value for creditors?
13/Can the success of a merger be judged by comparing the market performance of the new entity with that of the reference index?
14/Can the success of a merger be judged by looking at the change in share price of the companies when the merger is announced?
You’ll find more questions at www.vernimmen.com.

EXERCISES

1/Alpha AG is wholly owned by Mr Alpha and Beta AG is wholly owned by Mr Beta. The key figures for the two companies are as follows:
Net profit Equity value Book equity
Alpha 60 750 800
Beta 30 1,500 400
Alpha acquires Beta. Calculate the shareholdings (as a percentage) of Mr Alpha and Mr Beta using net profits, equity value and book equity. What are your conclusions?
2/Below are the key figures for Gamma plc and Delta plc:
Net profit Book equity P/E Number of shares
Gamma 20 60 50 2,000
Delta 40 300 8 1,000
1. Gamma acquires Delta. The criterion selected for calculation purposes is equity value. Calculate the old and new EPS, equity per share and the percentage of the shareholdings of the former shareholders of Gamma in the new entity.
2. Redo the calculations with a P/E ratio for Gamma of only 15, and then 6.
3. What are the minimum and maximum relative values if the synergies that come out of the merger increase the profits of the new group by 10, and if the new group is valued on the basis of a P/E ratio of 21? What would the ratios be then?
4. What is the value of Epsilon, the new name for the merged Gamma and Delta (still with synergies of 10) if it is valued on the basis of a P/E ratio of 50?
5. What is the value created and what does it represent?

ANSWERS

Questions

1/The shareholder of the acquired company receives shares instead of cash. The acquiring company issues shares instead of reducing cash (or incurring debt), its shareholding structure is modified. The shareholder of the acquiring company loses some control, but the risk is shared. The acquired company no longer exists as a separate legal entity.
2/By definition, since assets and liabilities are pooled together with no cash payment.
3/Synergies, defence against an unwelcome attack. Reduction of the conglomerate discount, focus on core business, defence against an unwelcome attack.
4/Having the company buy the target, so as not to lose its controlling interest in it.
5/This isn’t where the problem lies. What’s important is to know whether the merger will create value and not whether EPS will be diluted.
6/Because it is the basis for sharing the creation of value and sharing power inside the new group.
7/Relative value is the value of one of the companies compared with the other. Exchange ratio is the number of shares in the acquiring company that are exchanged for one share in the acquired company.
8/On relative value and then on the calculation methods which would lead to the determination of the agreed relative value. On the surface, it looks like the opposite is true.
9/Because they form part of a larger whole that is likely to generate synergies and because the merger could result in the P/E of the new entity being revalued.
10/In the synergies created by the merger.
11/In order to ensure the equal treatment of shareholders – the rights of all shareholders should be respected.
12/When there is a conglomerate discount that will disappear. Rarely for creditors.
13/Only after taking into account the beta of the group which may be different from 1.
14/Yes if the markets are in equilibrium and if the information has not leaked prior to the announcement.

Exercises

A detailed Excel version of the solutions is available at www.vernimmen.com.

1/
Net profits Value Shareholders’ equity
Mr Alpha’s share 2/3 1/3 2/3
Mr Beta’s share 1/3 2/3 1/3
The criteria selected are crucial as they can lead to different relative weights and share allocations.
2/(a) and (b)
Old (for Gamma) New (P/E = 50) New (P/E = 15) New (P/E = 6)
EPS 0.01 0.0227 0.0145 0.0082
Equity per share 0.03 0.136 0.087 0.049
% of control held by Gamma shareholders 100% of Gamma 75.8% 48.4% 27.3%
The higher a company’s P/E ratio, the more it will get out of a merger.
1. If Gamma shareholders get all of the synergies: relative value of 3.59 and exchange ratio of 0.557 Gamma shares for 1 Delta share. If Gamma shareholders sell all of the synergies: relative value of 2.13 and exchange ratio of 0.940 Gamma shares for 1 Delta share.
2. Value of the whole = 50 × (40 + 20 + 10) = 3,500.
3. Wealth created = 2,180. The wealth created is a result of synergies (500) and the revaluation of Delta (1,680).

BIBLIOGRAPHY

On mergers:

U. Hege, E. Sushka, Equity or cash? The signal sent by the way you pay, Harvard Business Review, 87(5), 22, May 2009.
U. Hege, S. Lovo, M. Slovin, Equity and cash in intercorporate asset sales: Theory and evidence, Review of Financial Studies, 22(2), 681–714, February 2009.

On demergers:

P. Anslinger, S. Klepper, S. Subramaniam, Breaking up is good to do, McKinsey Quarterly, 1, 16–27, 1999.
P. Cusatis, J. Miles, J. Woolridge, Restructuring through spin-offs, Journal of Financial Economics, 33(3), 293–311, June 1993.
H. Desai, P. Jain, Firm performance and focus: Long-run stock market performance following spin-offs, Journal of Financial Economics, 54(1), 75–101, October 1999.
O. Ezekoye, J. Thomsen, Going, going, gone: A quicker way to divest assets, McKinsey & Company, August 2018.
S. Krishnaswami, V. Subramaniam, Information asymmetry, valuation, and the corporate spin-off decision, Journal of Financial Economics, 53(1), 73–112, July 1999.
W. Maxwell, R. Rao, Do spin-offs expropriate wealth from bondholders?, Journal of Finance, 58(5), 2087–2108, October 2003.
V. Mehrotra, W. Mikkelson, M. Partch, The design of financial policies in corporate spin-offs, Review of Financial Studies, 16(4), 1359–1388, Winter 2003.
C. Veld, Y. Veld-Merkoulova, Do spin-offs create value? The European case, Journal of Banking & Finance, 28(5), 1111–1135, May 2004.

A clinical study of a spin-off:

R. Parrino, Spin-offs and wealth transfers: The Marriott case, Journal of Financial Economics, 43(2), 241–274, February 1997.

More on the value of synergies:

A. Agrawal, R. Varma, A. West, Making M&A deal synergies count, McKinsey, October 2017.
K. Barraclough, D. Robinson, T. Smith, R. Whaley, Using option prices to infer overpayments and synergies in M&A transactions, Review of Financial Studies, 26(3), 695–722, March 2013.
Boston Consulting Group, Divide and conquer: How successful M&A deals split the synergies, BCG, 2013.
M. Bradley, A. Desai, E. Kim, Synergetic gains from corporate acquisitions and their division between the stockholders of target and acquiring firms, Journal of Financial Economics, 21(1), 3–40, February 1988.
H. Leland, Financial synergies and the optimal scope of the firm: Implication for mergers, spin-offs, and structured finance, Journal of Finance, 62(2), 765–807, April 2007.

NOTES

1 The acquisition of B is financed by debt, not a capital increase.
2 In fact, Company B, not its shareholders, holds 45.5% of A.
3 And just because A agrees in merger negotiations to value B for a given value (€375m) this doesn’t mean that the A shares that B shareholders will receive in exchange will be worth €375m. In this example they are only worth €355m. The shareholders of B, by becoming shareholders of the new group, bear their share (45.5%) of the €45m (375 − 330) overvaluation: 45.5% × €45m = €20m corresponding to the difference between their valuation at parity (€375m) and the value of A’s shares after the merger (€355m).
4 Price/earnings ratio.
5 (330 + 120) / 450.
6 (45.5% × 900 − 330) / 120.
7 54.5% × 975.
8 See Section 27.5.

Chapter 47. LEVERAGED BUYOUTS (LBOs)

Chapter 47
LEVERAGED BUYOUTS (LBOs)

Leverage on management!

A leveraged buyout (LBO) is the acquisition of a company by one or several private equity funds who finance their purchase with a significant amount of borrowed funds. Most of the time, LBOs bring improvements in operating performance as the management is highly motivated (high potential for capital gains) and under pressure to rapidly pay down the debt incurred.

Why are financial investors willing to pay more for a company than a trade buyer that can extract synergies? Are they miracle workers? Watch out for smoke and mirrors. Value is not always created where you think it will be. Agency theory will be very useful, as the main innovation of LBOs is new corporate governance, which, in certain cases, is more efficient than that of listed or family companies.

Section 47.1 LBO STRUCTURES

1/ PRINCIPLE

The basic principle is to create a holding company, the sole purpose of which is to hold shares. The holding company borrows money to buy another company, often called the “target”. The holding company will pay interest on its debt and pay back the principal from the cash flows generated by the target. In LBO jargon, the holding company is often called NewCo or HoldCo.

Operating assets are the same after the transaction as they were before it. Only the financial structure of the group changes. Equity capital is sharply reduced and the previous shareholders sell part or all of their holding.

From a strictly accounting point of view, this setup makes it possible to benefit from the effect of financial gearing (see Chapter 13).

Now let us take a look at the example of the organic product group Wessanen¹ (brands Bjorg, Clipper, Altereco, etc.), acquired in September 2019 by the LBO fund PAI and the investor Charles Jobson for an enterprise value of €929m. Wessanen generated 2018 sales of €628m and an EBITDA of €58m. The acquiring holding company was set up with €484m of equity and €445m of debt.

Best Food of Nature debt is made up of a 7-year loan for €390m, and a second-lien debt maturing in 2027 (i.e. one year later) for €55m.

The balance sheets are as follows:

Revalued balance sheet of Wessanen		Best Food of Nature’s unconsolidated balance sheet		Group’s consolidated balance sheet
Operating assets €929m	Shareholders’ equity €929m	Shares of Wessanen €929m	Shareholders’ equity €484m	Operating assets €929m	Shareholders’ equity €484m
			Debt €445m		Debt €445m

Note that consolidated shareholders’ equity, on a revalued basis, is now 55% lower than it was prior to the LBO.

The profit and loss statement, meanwhile, is as follows:

(€m)	Wessanen	Best Food of Nature	Consolidated
Earnings before interest and tax	58	44²	58
− Interest expense at 5%	0	22	22
− Income tax at 25%	14	0	9³
= Net income	44	22	27

Best Food of Nature does not pay corporate income tax as dividends paid by Wessanen are tax-free coming from income already taxed at the Wessanen level.

2/ TYPES OF LBO TRANSACTIONS

Leveraged buyout (LBO) is the term for a variety of transactions in which an external financial investor uses leverage to purchase a company. Depending on how management is included in the takeover arrangements, LBOs fall into the following categories:

a (leveraged) management buyout or (L)MBO is a transaction undertaken by the existing management together with some or all of the company’s employees;
if new management is put in place, it will be called a management buy-in or MBI;
when outside managers are brought in to reinforce the existing management, the transaction is called a BIMBO, i.e. a combination of a buy-in and a management buy-out. This is the most common type of LBO in the UK;
an owner buyout (OBO) is a transaction undertaken by the largest shareholder to gain full control over the company.

3/ TAX ISSUES

Obtaining tax consolidation between the holding company and the target is one of the drivers of the overall structure, as it allows financial costs paid by the holding company to be offset against pre-tax profits of the target company, reducing the overall corporate income tax paid.

In some countries, it is possible to merge the holding company and the target company soon after the completion of the LBO. In other countries this is not the case, as the local tax administration argues it is contrary to the target’s interest to bear such a debt load. Provided tax consolidation is possible between the target and Holdco, this has no material consequence. If tax consolidation is not possible because, for example, the Holdco stake in the target company has not reached the required minimum threshold, then a debt push down may be necessary.

In order to perform a debt push down, the target company pays an extraordinary dividend to Holdco or carries out a share buy-back financed by debt, allowing Holdco to transfer part of its debt to the target company where financial expenses can be offset against taxable profits. If the target company is still listed, an independent financial expert is likely to be asked to deliver a solvency opinion testifying that the target debt load does not prevent it from properly operating in the foreseeable future.

4/ EXIT STRATEGIES

The lifespan of an LBO depends both on the speed at which the LBO fund can improve the company’s performance and its capacity to sell it on to a third party or on the stock market. It is rarely less than two years in periods of euphoria and it can be as long as seven or eight years during lean times. There are several exit strategies:

Sale to a trade buyer. Our general comment here is that in most cases financial investors bought the company because it had not attracted trade buyers at the right price. When the time has arrived for the exit of the financial buyer, either the market or the company will have had to have changed for a trade buyer to be interested. The private equity firm Apollo exited its investment in Endemol in 2020 through a sale to Banijay.
Initial public offering. This strategy must be implemented in stages, and it does not allow the sellers to obtain a control premium; most of the time they suffer from an IPO discount. It is more attractive for senior management than a trade sale. In 2019, Verallia was IPOed by Apollo and Bpifrance.
Sale to another financial investor, who, in turn, sets up another LBO. These “secondary” LBOs are becoming more and more common and we also see tertiary or even quaternary LBOs such as B&B. Hence, in 2021, EQT bought back the laboratory group Cerba to Partners Group and PSP.
A leveraged recapitalisation (or dividend recap). After a few years of debt reduction thanks to cash flow generation, the target takes on additional debt with the purpose of either paying a large dividend or repurchasing shares, thereby improving the performance of the fund and its IRR. The result is a far more financially leveraged company. These had disappeared after 2008 following debt markets’ disfavour for LBOs, but have reappeared again since 2013, an example being Apria in 2021.

A debt to equity swap allowing debtholders to gain control of the company when its debt load becomes too heavy to be repaid by the company’s cash flows which, most of the time, have slumped compared to projections. Existing shareholders have refused to put in more equity to pay back part of the debt but they have agreed to allow a share issue to take place and to be diluted.
A bankruptcy when cash flows generated by the operating company are insufficient to allow for enough dividends to be paid to Holdco and when debtholders and shareholders cannot reach an agreement on a capital restructuring (new equity, lower interest rates, longer repayment schedule, etc.).

If the company has grown or become more profitable on the financial investors’ watch, it will be easier for them to exit. Improvement may take the form of an internal growth strategy by geographical or product extension, a successful redundancy or cost-cutting plan or a series of bolt-on acquisitions in the sector. Size is important if flotation is the goal, because small companies are often undervalued on the stock market, if they manage to get listed at all.

That being said, a company whose LBO has failed as a result of an inability to pay off its debt is often in a pitiful state. The investment tap has been turned off, the most talented staff have seen the writing on the wall and have left and the remaining staff lack motivation. Turning such a company around presents a serious challenge!

Section 47.2 THE PLAYERS

The LBO market has become highly structured since the early 1990s. All the direct players (funds, banks, investors) and indirect players (financial, legal, strategic and management advisors) treat the LBO business as a specific business with dedicated teams. Industrialists and managers have become familiar with this type of structure.

1/ POTENTIAL TARGETS

The transactions we have just examined are feasible only with certain types of target companies. The target company must generate profits and cash flows that are sufficiently large and stable over time to meet the holding company’s interest and debt payments. The target must not have burdensome investment needs. Mature companies that are relatively shielded from variations in the business cycle make the best candidates: food, retail, water, building materials, real estate, cinema theatres and business listings providers are all prime candidates.

THE WORLD’S 10 LARGEST LBOs

Target	Date	Sector	Equity sponsor	Value ($bn)
TXU	2007	Energy	KKR/TPG	45
Equity Office	2006	Real Estate	Blackstone	36
HCA	2006	Health	Bain/KKR	33
RJR Nabisco	1988	Food	KKR	30
Heinz	2013	Food	Berkshire Hathaway/3G Capital	28
Kinder Morgan	2006	Energy	Carlyle	27
Harrah’s Entertainment	2006	Casino	Apollo/TPG	27
First Data	2007	Technology	KKR	27
Clear Channel	2006	Media	Bain/Thomas Lee	27
Alltel	2007	Telecom	TPG/Goldman Sachs	27

Source: Data from Thomson Financial

The group’s LBO financing already packs a hefty financial risk, so the industrial risks had better be limited. Targets are usually drawn from sectors with high barriers to entry and minimal substitution risk. Targets are often positioned on niche markets and control a significant portion of them.

Traditionally, LBO targets were “cash cows”. As the euphoria subsided however, a shift has been observed towards companies exhibiting higher growth or operating in sectors with opportunities for consolidation (build-up). As the risk aversion of investors decreases, some private equity funds have carried out LBOs in more difficult sectors.

Targets must now also show a satisfactory environmental, social and governance (ESG) policy, as these items are now fully included in the investment criteria of the funds and their investors.

2/ THE SELLERS

Recently, more than half of all targets have been companies already under an LBO, sold by one private equity investor to another, for the second, third or more times, such as Cerba, Armacell, etc.

There are many European SMEs that were set up or grew substantially in the 1960s and 1970s, run by a majority shareholder-manager. These shareholder-managers are now reaching retirement age and may be tempted by LBO funds for the disposal of their companies, rather than selling them to a direct competitor (often seen as the devil incarnate) or seeking a stock market exit, which may be difficult. All the more so when the company bears the family name, which may disappear if it is sold to another industrial player.

Some sectors are so concentrated that only LBO funds can buy a target as the antitrust authorities would never allow a competitor to buy it or would impose severe disposals, making such an acquisition unpalatable to many trade buyers. The larger transactions fall into the latter category (Venelia, AkzoNobel’s chemicals division).

Finally, some listed companies that are undervalued (often because of liquidity issues or because of lack of attention from the investment community because of their size) sometimes opt for public-to-private (P-to-P) LBOs. In the process, the company is delisted from the stock exchange. Despite the fact that these transactions are complex to structure and generate high execution risk, they are becoming more and more common thanks to the drop in market values (Wessanen).

3/ LBO FUNDS ARE THE EQUITY INVESTORS

Setting up an LBO requires specific expertise, and certain investment funds specialise in them. These are called private equity sponsors, because they invest in the equity capital of unlisted companies.

LBOs are particularly risky because of their high gearing. Investors will therefore undoubtedly require high returns. Indeed, required returns are often in the region of 15% p.a. In addition, in order to eliminate diversifiable risk, these specialised investment funds often invest in several LBOs.

In Europe alone, there are over 100 LBO funds in operation. The US and UK LBO markets are more mature than those of Continental Europe. The Asian market is nascent. For this reason, Anglo-Saxon funds such as BC Partners, Blackstone, Carlyle, Cinven, CVC, TPG and KKR dominate the market, particularly when it comes to large transactions. In the meantime, the purely European funds, such as Eurazeo, Industri Kapital and PAI, are holding their own, generally specialising in certain sectors or geographic areas.

To reduce their risk or increase their target size, LBO funds also invest alongside another LBO fund or their own investors (they form a consortium) or an industrial company (sometimes the seller) with a minority stake. In this case, the industrial company contributes its knowledge of the business and the LBO fund its expertise in financial engineering, the legal framework and taxation.

Most of the private equity sponsors contribute equity for between 30% and 50% of the total financing. The time (first half of 2007) when they accounted for 20% of financing is over! In order to facilitate the transfer of cash, part of the equity could also take the form of highly subordinated convertible bonds, which will be converted in the event of the company experiencing financial difficulties. Interest on such bonds is tax-deductible.

Materially, LBO funds are organised in the form of a management company (the general partner or GP) that is held by partners who manage funds raised from institutional investors⁴ or high-net-worth individuals (the limited partners, or LPs). When funds need to be raised quickly, a bank may advance the funds pending the raising of equity (an equity bridge). LBO funds then call on the limited partners for the funds that they have committed to bringing, as investments are made. LPs also sometimes invest directly alongside the fund, which strengthens its intervention capacity. This is known as co-investment.

When a fund has invested more than 75% of the equity it has raised, another fund is launched. Each fund is required to return to investors all of the proceeds of divestments as these are made, and the ultimate aim is for the fund to be liquidated after a given number of years, and at the latest 10 years.

The management company, in other words the partners of the LBO funds, is paid on the basis of a percentage of the funds invested (c. 2% of invested funds) and a percentage of the capital gains made (often close to 20% of the capital gain) above a minimum rate of return of 6% to 8% (the hurdle rate), known as carried interest.

Some funds decide to list their shares on the stock market, like Blackstone did in 2007,⁵ while others such as 3i and Wendel are listed for historical reasons.

4/ THE LENDERS

For smaller transactions (less than €10m), there is a single bank lender, often the target company’s main bank or a small group of its usual bankers (club deal).

For larger transactions, debt financing is more complex. The LBO fund negotiates the debt structure and conditions with a pool of bankers. Most of the time, bankers propose a financing to all candidates (even the one advising the seller). This is staple financing.

The high degree of financial gearing requires not only traditional bank financing, but also subordinated lending and mezzanine debt, which lie between traditional financing and shareholders’ equity. This results in a four-tier structure: traditional, secured loans called senior debt, to be repaid first; subordinated or junior debt, to be repaid after the senior debt; mezzanine financing, the repayment of which is subordinated to the repayment of the junior and senior debt; and, last in line, shareholders’ equity.

Sometimes, shareholders of the target grant a vendor loan to the LBO fund (part of the price of which payment is deferred) to help finance the transaction.

(a) Senior debt

Senior debt generally totals three to five times the target’s EBITDA.⁶ It is composed of several tranches, from least to most risky:

tranche A is repaid in equal instalments over six to seven years;
tranches B and C are repaid over a longer period (seven to eight years for the B tranche and eight to nine years for the C tranche) after the A tranche has been amortised. Tranche C has a tendency to disappear.

Each tranche has a specific interest rate, depending on its characteristics (tranches B and C will be more expensive than tranche A because they are repaid after and are therefore more risky). This rate is relatively high (several hundred base points above the Euribor; 100 base points = 1%).

For senior debt, guarantees are held on the target’s shares, along with covenants. When it is a cov-lite (covenant light) transaction, then they have been reduced or are non-existent!

When the debt amount is high, the loan will be syndicated to several banks (see Section 25.8). The senior debt can take the form of a single tranche B: Term loan B which can then be placed not only with banks but also with institutional investors.

An alternative (or complement) is to issue Senior Secured Notes (Senior High Yield Notes) if the size of the transaction is sufficient, without them being subordinated, such as those we will see in the next paragraph.

Collateralised debt obligation (CDO) funds have been created, which subscribed or bought tranches of LBO debt. Their investors are mainly insurance companies, hedge funds and pension funds.

(b) Junior or subordinated debt

High-yield bond (subordinated notes) issues are sometimes used to finance LBOs, but this technique is reserved for the largest transactions so as to ensure sufficient liquidity. In practice the lower limit is around €150m. An advantage of this type of financing is that it carries a bullet repayment and a maturity of 7–10 years. Given the associated risk, high-yield LBO debt, as the name suggests, offers investors high interest rates, as much as 600 basis points over government bond yields. There has definitely been an upsurge in high-yield bonds used to fund LBOs since late 2009. This is a window of opportunity that shut very suddenly at the start of the Covid-19 crisis but reopened quite quickly in summer 2020.

Mezzanine debt also comes under the heading of (deeply) subordinated debt, but is unlisted and provided by specialised funds. As we saw in Chapter 24, certain instruments accommodate this financing need admirably. These “hybrid” securities include convertible bonds, mandatory convertibles, warrants, bonds with warrants attached, etc.

Given the associated risk, investors in mezzanine debt – “mezzaniners” – demand not only a high return, but also a say in management. Accordingly, they are sometimes represented on the board of directors.

Returns on mezzanine debt take three forms: a relatively low interest rate (5%–6%) paid in cash; a deferred interest or payment in kind (PIK) for 5%–8%; and a share in any capital gain when the LBO fund sells its stake.

Most of the time, mezzanine debt is made of bullet bonds⁷ with warrants attached. Mezzanine financing is a true mixture of debt and shareholders’ equity. Indeed, mezzaniners demand returns more akin to the realm of equity investors, around 10% to 12% p.a.

Subordinated and mezzanine debt offer the following advantages:

they allow the company to lift gearing beyond the level acceptable for bank lending;
they are longer term than traditional loans and a portion of the higher interest rate is paid through a potential dilution. The holders of mezzanine debt often benefit from call options or warrants on the shares of the holding company;
they make upstreaming of cash flow from the target company to the holding company more flexible. Mezzanine debt has its own specific terms for repayment, and often for interest payments as well. Payments to holders of mezzanine debt are subordinated to the payments on senior and junior debt;
they make possible a financing structure that would be impossible by using only equity capital and senior debt.

LBO financing spreads the risk of the project among several types of instruments, from the least risky (senior debt) to the most risky (common shares). The risk profile of each instrument corresponds to the preferences of a different type of investor.

(c) Securitisation

LBOs are sometimes partly financed by securitisation (see Chapter 21). Securitised assets include receivables and/or inventories when there is a secondary market for them. The securitisation buyout is similar to the standard securitisation of receivables, but aims to securitise the cash flows from the entire operating cycle.

(d) Other financing

For small and medium-sized LBOs, senior and junior debt can be replaced by a unitranche debt. This is a bullet debt subscribed by an investment fund specialised in debt, whose cost is around 5%–8%, i.e. between the cost of a senior debt and that of a junior debt. Contrary to Term loan B, unitranche debt is not liquid.

Financing at the level of the operating company generally tops up the financing of Holdco:

either through a revolving credit facility (RCF), which can help the company deal with any seasonal fluctuation in its working capital requirements;
an acquisition facility, which is a line of credit granted by the bank for small future acquisitions;
or a capex facility to finance capital expenditures.

At the peak of the cycle, where the most complex and inventive structures flourish such as a tranche of bank debt that falls in between senior debt and mezzanine debt – second lien debt, which is first-ranking but long-term debt, and interim facility agreements, which enable the LBO to go ahead even before the legal paperwork (often running to hundreds of pages) has been finalised and fully negotiated. Interim facility agreements are very short-term debts that are refinanced using LBO loans. “First-loss-second loss” bank loans can complement operations financed by a unitranche debt.

(e) The larger context

The prices of the target companies acquired under LBOs changes in tandem with the evolution of stock market multiples, interest rates, and banks’ appetite to lend.

As an example, Wessanen was acquired for 16 times its EBITDA, financed by debt equivalent to 7.7 times its EBITDA.
Source: Data from Standard & Poor’s

Since the 2008 crisis, lenders’ assessment of the risk of LBOs has been revised upwards considerably, thereby inducing an increase in their required remuneration. Mid-2020 the LBO market has closed over a short period of time but resumed rapidly with a record second half of the year.

5/ THE EMPLOYEES AND MANAGERS OF A COMPANY UNDER AN LBO

The managers of a company under an LBO may be the historical managers of the company or new managers appointed by the LBO fund. Regardless of their background, they are responsible for implementing a clearly defined business plan that was drawn up with the LBO fund when it took over the target. The business plan makes provision for operational improvements, investment plans and/or disposals, with a focus on cash generation because, as the reader is no doubt aware, cash is what is needed for paying back debts!

LBO funds tend to ask managers to invest large amounts of their own cash in the company (often 1 to 2 years of earnings), and even to take out loans to be able to do so, in order to ensure that management’s interests are closely aligned with those of the fund. Investments could be in the form of warrants, convertible bonds or shares, providing managers with a second leverage effect, which, if the business plan bears fruit, will result in a five- to ten-fold or even greater increase in their investment. On the other hand, if the business plan fails, they will lose everything. So, only in the event of success will the management team get a partial share of the capital gains and a higher IRR on its investment than that of the LBO funds. This arrangement is known as the management incentive package.

In some cases, following several successful LBOs, the management team can, as a result of this highly motivating remuneration scheme, take control of the company,⁸ having seen its initial stake multiplied several times.

More and more often, management teams are advised by a specialised consultancy firm and lawyers for the implementation of these management packages.

Employees are also key to the success of an LBO, which is why some LBO funds have made it a practice to give a small part of their capital gain (usually 2–5%) to employees.

Section 47.3 LBOS AND FINANCIAL THEORY

Experience has shown that LBOs are often done at the same price or at an even higher price than what a trade buyer would be willing to pay. Yet the trade buyer, assuming they plan to unlock industrial and commercial synergies, should be able to pay more. How can we explain the widespread success of LBOs? Do they create value? How can we explain the difference between the pre-LBO value and the LBO purchase price?

At first, we might be tempted to think that there is value created because increased leverage reduces tax payments. But the efficient markets hypothesis casts serious doubts on this explanation, even though financial markets are not, in reality, always perfect. To begin with, the present value of the tax savings generated by the new debt service must be reduced by the present value of bankruptcy costs. Secondly, the arguments in Chapter 33 have led us to believe that the savings might not be so great after all. Hence, the attractions of leverage are not enough to explain the success of the LBO.

We might also think that a new, more dynamic management team will not hesitate to restructure the company to achieve productivity gains and that this would justify the premium. But this would not be consistent with the fact that the LBOs that keep the existing management team create as much value as the others.

Agency theory provides a relevant explanation. The high debt level prompts shareholders to keep a close eye on management. Shareholders will closely monitor operating performance and require in-depth monthly reporting. Management is put under pressure by the threat of bankruptcy if the company does not generate enough cash flow to rapidly pay down debt. At the same time, managers systematically become – either directly or potentially – shareholders themselves via their management package, so they have a strong incentive to manage the company to the best of their abilities.

Kaplan has demonstrated through the study of many LBOs that their operating performance, compared with that of peer companies, is much better (cash flow generation, return on capital employed) and that they are able to outgrow the average company and create jobs. This is one example where there is a clear interference of financial structure with operating performance.

LBO transactions greatly reduce agency problems and in so doing create value. Their corporate governance policies are different from those of listed groups and family companies, and in many cases are more efficient.

LBOs give fluidity to markets, helping industrial groups to restructure their portfolio of assets. They play a bigger role than IPOs, which are not always possible (equity markets are regularly shut down) or realistic (small and medium-sized companies in some countries are, in fact, practically banned from the stock exchange).

Section 47.4 THE LBO MARKET: A WELL-ESTABLISHED MARKET

While LBOs have grown considerably in Europe since the 1980s, this growth has been highly cyclical. It is highly dependent on lenders’ appetite for risky debt, without which LBOs cannot take place, and on economic conditions that suggest that the debt contracted will be repaid by the cash flows generated and/or the resale of the company under LBO. There is therefore an alternation, with the regularity of a metronome, between phases of expansion (late 1990s, 2003–2007, 2014–2019) and contraction (early 1990s, 2000–2003, 2008–2013, 2020).

*Source*: Data from CMBOR / Equistone Partners Europe, Mergermarket

The debt to EBITDA ratios are reduced and inflated, covenants are more or less strict, A tranches (repaid on a straight-line basis and not at the end) provide a more or less significant part of the debt repayment, making LBO financing more like asset financing (when the vast majority of the repayment comes from the resale of the company under LBO), or rather cash flow financing, which is what they were supposed to be when LBOs were invented.

In 2020, as in 2008–2013, companies under LBO suffered the consequences of a decline in activity coupled with high debt levels. Nevertheless, the rapid recovery of activity in 2021 gives reason to hope that, in most sectors, equity will be sufficient to absorb the business losses of 2020.

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

A leveraged buyout is a transaction whereby the purchase of a company is financed primarily with borrowed funds. A holding company contracts the debt and purchases the target company. The company’s cash flow is regularly funnelled upstream to the holding company via dividends to enable the latter to pay interest and reimburse the loans.

Although initially, an LBO was often a solution in a family succession situation or when a large group wanted to sell off a division, it is increasingly a form of ownership in itself; a company being bought and sold by different LBO funds. It can also be a way for a company to delist itself when it is undervalued in the market.

The target company in an LBO may keep the current management in place or hire a new management team. Equity capital is provided by specialised funds, the LBO funds. The structure depends on several layers of debt – senior, junior or subordinate or mezzanine – with different repayment priorities. As priority declines, risk and expected returns increase.

Increased gearing and the deductibility of interest expense do not satisfactorily explain why value is created in an LBO. Instead, it appears that the heavier debt burden motivates management to do a better job managing the company, of which they are often destined to become shareholders themselves. This is agency theory in action. LBO funds bring different and, most of the time, more efficient corporate governance policies than those of family companies or listed groups: they focus management teams on cash flow generation and value creation. This is why a company can remain under an LBO for years, with one LBO fund selling it to another.

QUESTIONS

1/Explain why an LBO is a type of capital reduction.
2/What risks are involved in an LBO?
3/Can mezzanine financing in the context of an LBO be compared with equity or debt?
4/In the context of an LBO, does the holder of senior debt take more or less risk than the holder of junior debt?
5/Can an LBO be carried out on a start-up company?
6/In a secondary LBO, can an LBO fund accept that the management team does not reinvest a significant part of the capital gains achieved on the first LBO in the new LBO? Why?
7/What are the different possible exit routes after an LBO?
8/How does corporate governance of an LBO differ from that of a listed company with no major shareholder?
9/How does corporate governance of an LBO differ from that of most unlisted family companies?
10/What are the pros and cons of being a shareholder of a listed LBO fund compared to being a shareholder of a private one?
11/What are the three types of risks that the shareholder of an LBO fund runs?
12/Can an LBO work without debt?
13/Can someone remain an LBO manager for more than 10 years?
You’ll find more questions at www.vernimmen.com.

ANSWERS

Questions

1/Because shareholders’ equity is mostly replaced by debt.
2/The risk that debts will outweigh cash flows generated.
3/With debt, because sooner or later it has to be repaid.
4/Less risk, because the holder of senior debt is repaid before the holder of junior debt.
5/No, because a start-up company’s cash flows are much too volatile to allow it to carry debt.
6/No, an LBO fund requires around 50% of the capital gains to be reinvested to keep management’s motivation high.
7/IPO, sale to a trade buyer, a secondary buyout, bankruptcy, a recapitalisation.
8/Strong financial incentives for managers, constraint of the debt to be paid down, regular business discussions with shareholders (LBO fund representatives).
9/Meritocracy is the rule of the game, not being a member of the founding family.
10/The share of the LBO fund can be sold on the market, but it trades at a significant discount to the net asset value.
11/Business risk, financial risk linked to the highly geared structure, risk linked to the lack of liquidity of the investment.
12/No, as there is neither the pressure linked to the debt burden nor the hope for very high returns thanks to the leverage.
13/No, as it would mean very high pressure for a very long time, and lack of motivation as the managers would normally have already become very rich.

BIBLIOGRAPHY

To go into more detail:

Bain, Global Private Equity Report 2020, 2020.
B. Burrough, J. Helyar, Barbarians at the Gate, Harper Business Essentials, 2003.
M. Jensen, Eclipse of the public corporation, Harvard Business Review, 67, 61–74, September 1989.
S. Kaplan, The staying power of leveraged buyouts, Journal of Financial Economics, 29(2), 287–313, October 1991.
Y. Le Fur, P. Quiry, What’s a first loss-second loss loan? The Vernimmen.com Newsletter, 119, 7, February 2019.
P. Povel, R. Singh, Stapled finance, Journal of Finance, 65(3), 927–953, June 2010.
P. Santini, Managing a company under LBO, The Vernimmen.com Newsletter, 25, 1–4, June 2007.
www.equistonepe.com/cmbor, The Centre for Management Buy-out Research’s website.
www.investeurope.eu, site of the European Private Equity and Venture Capital Association.

To study the value creation of LBOs:

V. Acharya, O. Gottschalg, M. Hahn, C. Kehoe, Corporate governance and value creation: Evidence from private equity, Review of Financial Studies, 26(2), 368–402, February 2013.
A.K. Achleitner, Value Creation in Private Equity, Centre for Entrepreneurial and Financial Studies – Capital Dynamics, 2009.
U. Axelson, T. Jenkinson, P. Strömberg, M. Weisbach, Borrow cheap, buy high? The determinants of leverage and pricing in buyouts, Journal of Finance, 68(6), 2223–2267, December 2013.
N. Bloom, R. Sadun, J. Van Reenen, Do private equity owned firms have better management practices?, American Economic Review, 105(5), 442–446, May 2015.
Q. Boucly, D. Sraer, D. Thesmar, Growth LBOs, Journal of Financial Economics, 102(2), 432–453, November 2011.
F. Evers, Value Creation and Drivers of Secondary Buyouts in France, Research thesis, HEC, 2012.
P. Gompers, S. Kaplan, V. Mukharlyamov, What do private equity firms say they do?, Journal of Financial Economics, 121(3), 449–476, 2016.
O. Gottschalg, L. Phalippou, The performance of private equity funds, Review of Financial Studies, 22(4), 1747–1776, March 2009.
S. Kaplan, The effects of management buy-outs on operating performance and value, Journal of Financial Economics, 24(2), 217–254, October 1989.
Y. Le Fur, P. Quiry, Creating and sharing values in LBOs, The Vernimmen.com Newsletter, 51, 1–4, June 2010.
M. Sorensen, N. Wang, J. Yang, Valuing private equity, Review of Financial Studies, 27(7), 1977–2021, March 2014.
T. Tykvová, M. Borell, Do private equity owners increase risk of financial distress and bankruptcy?, Journal of Corporate Finance, 18(1), 138–150, February 2012.

NOTES

1 We have based this example on publicly available information, and for some of the figures have either simplified the reality or made some estimates. It should be considered as illustrative and does not reflect the reality or the exact state of the company.
2 Assuming 100% payout.
3 Assuming tax consolidation treatment.
4 Pension funds, insurance companies, banks, sovereign wealth funds.
5 Just before the LBO market ground to a sudden halt.
6 Earnings before interest, taxes, depreciation and amortisation. For more, see Chapter 3.
7 Section 20.1.
8 Of small or medium size; Fives is an example.

Chapter 48. BANKRUPTCY AND RESTRUCTURING

Chapter 48
BANKRUPTCY AND RESTRUCTURING

Women and children first!

Every economic system needs mechanisms to ensure the optimal use of resources. Bankruptcy is the primary instrument for reallocating means of production from inefficient to efficient firms.

A bankruptcy process can allow a company to reorganise, often requiring asset sales, a change in ownership and partial debt forgiveness on the part of creditors. In other cases, bankruptcy leads to liquidation – the death of the company.

Generally speaking, bankruptcy is triggered when a company can no longer meet its short-term commitments and thus faces a liquidity crisis. This does not necessarily lead to bankruptcy. Nevertheless, the exact definition of the financial distress leading the company to file for bankruptcy may differ from one jurisdiction to another.

Bankruptcy is a critical juncture in the life of the firm. Not only does the bankruptcy require that each of the company’s stakeholders make specific choices, but the very possibility of bankruptcy has an impact on the investment and financing strategies of healthy companies.

Section 48.1 CAUSES OF BANKRUPTCY

The problems generally stem from an ill-conceived strategy, or because that strategy is not implemented properly for its sector (costs are too high, for example). As a result, profitability falls short of creditor expectations. If the company does not have a heavy debt burden, it can limp along for a certain period of time. Otherwise, financial difficulties rapidly start appearing.

Generally speaking, financial difficulties result either from a market problem, a cost problem or a combination of the two. The company may have been caught unawares by market changes and its products might not suit market demands (e.g. Virgin Megastore, a book and disk retailer, Silicon Graphics). Alternatively, the market may be too small for the number of companies competing in it (e.g. crowdlending platforms in various countries). Ballooning costs compared with those of rivals can also lead to bankruptcy. General Motors, for example, was uncompetitive against other carmakers. Eurotunnel, meanwhile, spent twice the budgeted amount on digging the tunnel between France and the UK.

Nevertheless, a profitable company can encounter financial difficulties, too. For example, if a company’s debt is primarily short term, it may have trouble rolling it over if liquidity is lacking on the financial markets. In this case, the most rational solution is to restructure the company’s debt.

One of the fundamental goals of financial analysis as it is practised in commercial banks, whose main business is making loans to companies, is to identify the companies most likely to go belly up in the near or medium term and not lend to them. Numerous standardised tools have been developed to help banks identify bankruptcy risks as early as possible. This is the goal of credit scoring, which we analysed in Section 8.7.

Rating agencies also estimate the probability that a company will go bankrupt in the short or long term (bankruptcies as a function of rating were presented in Section 20.6).

Section 48.2 THE DIFFERENT BANKRUPTCY PROCEDURES

The bankruptcy process is one of the legal mechanisms that is the least standardised and homogenised around the world. Virtually all countries have different systems. In addition, legislation is generally recent and evolves rapidly.

Nevertheless, among the different procedures, some patterns can be found. In a nutshell, there are two different types of bankruptcy procedure. The process will be either “creditor (lender) friendly” or “debtor (company) friendly”. But all processes have the same ultimate goals, although they may rank differently:

paying down the liabilities of the firm;
minimising the disruptive impact on the industry;
minimising the social impact.

A creditor-oriented process clearly sets the reimbursement of creditors as the main target of the bankruptcy process. In addition, the seniority of debt is of high importance and is therefore recognised in the procedure. In this type of procedure, creditors gain control, or at least retain substantial powers in the process. This type of process generally results in the liquidation of the firm. The bankruptcy procedure in the UK clearly falls into this category.

Such a regulation may seem unfair and too tough, but it aims to prevent financial distress rather than solving it in the least disruptive way for the whole economy. In such countries, firms exercise a kind of self-discipline and tend to keep their level of debt reasonable in order to avoid financial distress. As a counterpart, creditors are more confident when granting loans, and money is more readily available to companies. For those supporting this type of process, the smaller number of bankruptcies in countries with stringent regulations (and an efficient judicial system) is evidence that this self-regulation works.

At the other end of the spectrum, some jurisdictions will give the maximum chance to the company to restructure. These procedures will generally allow management to stay in place and give sufficient time to come up with a restructuring plan. Countries with this approach include the USA (Chapter 11) and France.

The difference between the two approaches is reflected in the shorter duration of proceedings in creditor-friendly systems (1 year in the UK, 1.2 years in Germany) than in countries favouring business continuity (1.9 years in France).

The transposition of the European directive on bankruptcy prevention should partially converge the approaches to bankruptcy. Inspired by French prevention law, it should nevertheless give more power to creditors in the most debtor friendly countries (e.g. France).

To summarise, the following criteria help define a bankruptcy procedure:

Does the procedure allow restructuring or does it systematically lead to liquidation (most jurisdictions design two distinct procedures)?
Does management stay in place or not?
Does the procedure include secured debts? In some countries, secured debts (i.e. debts that are guaranteed by specific assets) and related assets are excluded from the process and treated separately, allowing greater certainty in the repayment. In such countries, securing a debt by a pledge on an asset gives strong guarantees.
Do creditors take the lead, or at least have a say in the outcome of the process? In most jurisdictions, creditors vote on the plan that is proposed to them as the outcome of the bankruptcy process. They sometimes have even greater power and are allowed to name a trustee who will liquidate the assets to pay down debt. But in some countries (e.g. France) they are generally not even consulted.

	France	Germany	India	Italy	UK	USA
Type	Debtor (borrower) friendly	Creditor (lender) friendly	Creditor (lender) friendly	Debtor (borrower) friendly	Creditor (lender) friendly	Debtor (borrower) friendly
Possible restructuring	Yes	Yes (rare)	Yes	Yes	Rare after opening of a proceeding	Yes
Management can stay in place	Yes*	Yes*	No	***	No	Yes
Lenders vote on restructuring/liquidation plan	No	Yes	Yes	Yes**	Yes	Yes
Priority rule	Salaries; tax, other social liabilities; part of secured debts; proceeding charges; other secured debts; other debts	Proceeding charges; secured debts; other debts	Secured debts and employee proceeding charges; tax and social liabilities; unsecured debts	Proceeding charges; preferential creditors (inc. tax and social) and secured creditors; unsecured creditors	Proceeding charges; secured debts on specific assets; tax and social security; other secured debts; other debts	Secured debts granted after filing; employee benefit and tax claims; unsecured debts

* Assisted by court-designated trustee.

** Yes in the case of restructuring (pre-emptive arrangement) but only consultative committee in case of liquidation.

*** No in the case of liquidation.

Recasens (2001) has demonstrated that a creditor-orientated process is the most efficient. He reaches this conclusion after having compared the US system (debtor friendly) and the Canadian one (creditor friendly) on the basis of:

the length and cost of the liquidation;
the recovery rate according to seniority ranking;
the risk of allowing a non-viable company to restructure and the risk of liquidating an efficient company.

He has noticed that creditor-orientated processes increase the debt offer. As a matter of fact, it is logical that the offering of debt will be less abundant in countries where lenders are badly treated in case of difficulties experienced by their borrowers. Davydenko and Franks (2008) have demonstrated that British lenders recover 20% more on their claims than their French counterparts.

Claessens and Klapper (2002) have shown that the number of bankruptcies is greater in countries with mature financial markets. The proposed explanation is that, in those countries, companies are more likely to have public or syndicated debt and therefore a large number of creditors. In addition, with sophisticated markets, firms are more likely to have several types of debt: secured loans, senior debt, convertibles, subordinated, etc. In this context it may appear to be very difficult to restructure the firm privately (i.e. to find an agreement with a large number of parties with often conflicting interests such as hedge funds, vulture funds, trade suppliers, commercial banks, etc.), hence a bankruptcy process is the favoured route.

This is especially true when a lender has already hedged itself though a credit default swap¹ and will earn more from bankruptcy (recover 100% of its claims thanks to the CDS) than in a reorganisation (will get less than 100%).

In bank-financing-based countries, firms have strong relationships with banks. In the case of financial distress, banks are likely to organise the restructuring privately. This is often the case in Germany or in France, where bilateral relationships between banks and corporates are stronger than in the anglosphere.

Section 48.3 BANKRUPTCY AND FINANCIAL THEORY

1/ THE EFFICIENT MARKETS HYPOTHESIS

In the efficient markets hypothesis, bankruptcy is nothing more than a reallocation of assets and liabilities to more efficient companies. It should not have an impact on investor wealth, because investors all hold perfectly diversified portfolios. Bankruptcy, therefore, is simply a reallocation of the portfolio.

The reality of bankruptcy is, however, much more complicated than a simple redistribution. Bankruptcy costs amount to a significant percentage of the total value of the company. By bankruptcy costs, we mean not only the direct costs, such as the cost of court proceedings, but also the indirect costs. These include loss of credibility vis-à-vis customers and suppliers, loss of certain business opportunities, etc. Almeida and Philippon have estimated that bankruptcy costs range at 4.5% of the enterprise value of the company (see Section 33.1).

2/ SIGNAL THEORY AND AGENCY THEORY

The possibility of bankruptcy is a key element of signalling theory. An aggressive borrowing strategy sends a positive signal to the market, because company managers are showing their belief that future cash flows will be sufficient to meet the company’s commitments. But this signal is credible only because there is also the threat of sanctions: if managers are wrong, the company goes bankrupt and incurs the related costs.

Moreover, conflicts between shareholders and creditors, as predicted by agency theory, appear only when the company is close to the financial precipice. When the company is in good health, creditors are indifferent to shareholder decisions. But any decision that makes bankruptcy more likely, even if this decision is highly likely to create value overall for the company, will be perceived negatively by the creditors.

Let’s look at an example. Rainbow Ltd manufactures umbrellas and is expected to generate just one cash flow. To avoid having to calculate present values, we assume the company will receive the cash flow tomorrow. Tomorrow’s cash flow will be one of two values, depending on the weather. Rainbow has borrowings and will have to pay 50 to its creditors tomorrow (principal and interest).

Weather	Rain	Shine
Cash flow	100	50
Payment of principal and interest	−50	−50
Shareholders’ portion of cash flow (equity)	50	0

Rainbow now has an investment opportunity requiring an outlay of 40 and returning cash flow of 100 in case of rainy weather and −10 in case of sunny weather. The investment project appears to have a positive net present value. Let’s see what happens if the investment is financed with additional borrowings.

Weather	Rain	Shine
Cash flow	200	40
Payment of principal and interest	−90	−40 (whereas 90 was due)
Shareholders’ portion of cash flow (equity)	110	0

Even though the investment project has a positive net present value, Rainbow’s creditors will oppose the project because it endangers the repayment of part of their loans. Shareholders will, of course, try to undertake risky projects as it will more than double the value of the equity.

It can be demonstrated that when a company is close to bankruptcy, all financial decisions constitute a potential transfer of value between shareholders and creditors. Any decision that increases the company’s overall risk profile (risky investment project, increase in debt coupled with a share buy-back) will transfer value from creditors to shareholders. Decisions that lower the risk of the company (e.g. capital increase) will transfer value from shareholders to creditors. As we showed in Chapter 34, these value transfers can be modelled using options theory.

Conflicts between shareholders and creditors and between senior and junior creditors also influence the decisions taken when the company is already in bankruptcy. On the one hand, creditors want to accelerate the procedure and liquidate assets quickly, because the value of assets rapidly decreases when the company is “in the tank”. On the other hand, shareholders and managers want to avoid liquidation for as long as possible because it signifies the end of all hope of turning the company around, without any financial reward. For managers, it means they will lose their jobs and their reputations will suffer. At the same time, managers, shareholders and creditors would all like to avoid the inefficiencies linked with liquidation. This common objective can make their disparate interests converge.

The table below shows the average hope for repayment in the case of bankruptcy, depending on the ranking of the debt.

Whereas US senior creditors get, on average, 60% of their money back, most junior creditors will receive around 40% of their initial lending.
*Source*: Data from Moody’s Global Credit Policy, January 2021

Lastly, a company in financial difficulties gives rise to the free-rider problem (see Section 26.3). For example, a small bank participating in a large syndicated loan may prefer to see the other banks renegotiate their loans, while keeping the terms of its loan unchanged.

3/ THE LIMITS OF LIMITED LIABILITY

Modern economies are based largely on the concept of limited liability, under which a shareholder’s commitment can never exceed the amount invested in the company. It is this rule that gives rise to the conflicts between creditors and shareholders and all other theoretical ramifications on this theme (agency theory).

In bankruptcy, managers can be required to cover liabilities in the event of gross negligence. In such cases, they can be forced to pay back creditors out of their own pockets, once the value of the company’s assets is exhausted. So, when majority shareholders are also the managers of the company, their responsibility is no longer limited to their investment. Such cases are outside the framework of the pure financial decision situations we have studied here.

Section 48.4 RESTRUCTURING PLANS

Restructurings concern companies that are considered to be viable, subject to certain conditions, often requiring operational changes in management, strategy, scope, production or marketing methods, etc.

Additionally, their capital structure must be adapted to a new environment because these companies, although they may be viable, do not and will not generate sufficient cash flows over a foreseeable period in order to cope with their current debts. Accordingly, these debts must be reduced one way or another, leading to sacrifices for lenders, who in turn will only agree to do so if shareholders also make an effort.

When a company is simply in breach of a covenant (see Section 39.2), it will negotiate a waiver with its banks, most of the time in exchange for a commission of 0.1% to 1% of the total debt (waiver fee) and a rise in the margins on the loans, the risk of which has increased.

If the company realises that it is not going to be able to meet the next repayment on its loan, it is strongly advised, with the help of an advisor, to commence private negotiations, known as private workouts, with its creditors. The more numerous the company’s sources of funding – common shareholders, preferred shareholders, convertible bondholders, creditors, etc. – the more complex the negotiations.

The business plan submitted by the company in financial distress is a key element in estimating its ability to generate the cash flows needed to pay off creditors, partly or totally according to the seniority of their claims. It is usually validated through an independent business review (IBR), carried out by a specialist firm.

A restructuring plan requires sacrifices from all of the company’s stakeholders. It generally includes a recapitalisation, often funded primarily by the company’s existing shareholders or by new shareholders who can thus take control over the company, and a renegotiation of the company’s debt. Creditors are often asked to give up some of their claims, accept a moratorium on interest payments and/or reschedule principal payments or accept a swap of part of their debts into equity of the borrower.

The parties naturally have diverging interests, with each one seeking to minimise the reductions in value that it will have to agree to in order to enable the company to achieve a capital structure in line with economic conditions that have deteriorated.

The shareholders, who have already lost a lot of money, only want to put in a minimum amount of new equity, as long as an overall agreement can be reached and as long as they are confident in the company’s ability to turn itself around. Sometimes they are unable to put in any money as they have no resources (for example, LBO funds at the end of their lives).

Lenders are, in theory, in a strong position thanks to the guarantees that they may have insisted on or their ability to take control of the company by converting part of their debts into shares in the case of an insolvency plan or court-ordered administration. In practice, they are not always keen or able to become shareholders, since this often involves providing new funds to finance the operational restructuring, which is a particularly risky investment. But under a debtor-friendly system, it is not always clear who has the upper hand, since the aim of the lawmakers is first and foremost the preservation of the company and its jobs, not the preservation of the creditors.

Creditors and shareholders are naturally at odds with each other in a restructuring. To bring them all on board, the renegotiated debt agreements sometimes include clawback provisions, whereby the principal initially foregone will be repaid if the company’s future profits exceed a certain level. Alternatively, creditors might be granted share warrants. If the restructuring is successful, warrants enable the creditors to reap part of the benefits.

This whole context explains that most restructuring negotiations finish in the early morning, after several all-night negotiating sessions, break-offs and unexpected dramatic turns in events. They end because there is a deadline which forces the parties to reach an agreement! To succeed, financial restructuring must be accompanied by operational restructuring allowing the return to a normal level of return on capital employed. Needless to say, it is the most important one! Working capital will have to be reduced as well as headcount, certain businesses might be sold or discontinued. Note that restructuring a company in difficulty can sometimes be a vicious circle. Faced with a liquidity crisis, the company must sell off its most profitable operations. But as it must do so quickly, it sells them for less than their fair value. The profitability of the remaining assets is therefore impaired, paving the way to new financial difficulties.

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

Bankruptcy is triggered when a company can no longer meet its short-term commitments and thus faces a liquidity crisis. This situation does not arise because the company has too much debt, but because it is not profitable enough. A heavy debt burden does no more than hasten the onset of financial difficulties.

The bankruptcy process is one of the legal mechanisms that is the least standardised and homogenised around the world. Virtually all countries have a different system. Depending on the country, the process will be either “creditor (lender) friendly” (United Kingdom, Germany, Spain) or “debtor (company) friendly” (France, Italy, United States). But all processes have the same goals, although they might rank differently:

paying down the liabilities of the firm;
minimising the disruptive impact on the industry;
minimising the social impact.

The bankruptcy process can generate two types of inefficiencies:

allowing restructuring of an inefficient firm that destroys value;
initiating the liquidation of efficient companies.

Prior to court proceedings, a company experiencing financial difficulties can try to implement a restructuring plan. The plan generally includes a recapitalisation and renegotiation of the company’s debt.

Bankruptcy generates both direct costs (court proceedings, lawyers, fees, etc.) and indirect costs (loss of credibility vis-à-vis customers and suppliers, loss of certain business opportunities, etc.). These costs have an impact on a company’s choice of financial structure.

Financial distress will generate conflict between shareholders and creditors (agency theory) and conflict among creditors (free-rider issues).

QUESTIONS

1/Why do companies go bankrupt?
2/What risks do you take if you buy a subsidiary of a group that you know is in financial distress?
3/Do the same types of conflict arise in the event of the bankruptcy of a partnership and that of a limited company? Why?
4/How, in some countries, can bankruptcy play a role in the survival of the company?
5/How do bankruptcy costs impact on the tax breaks available on debt?
6/Why are companies that are emerging from bankruptcy proceedings often strong competitors?
7/Why are companies in France that are emerging from bankruptcy proceedings rarely strong competitors?
8/Can a company with no debts go bankrupt? Can it destroy value?
9/Why is a company able to get back on its feet financially during the bankruptcy period?
10/Why do creditors agree to grant loans to companies during the bankruptcy period?
11/What are the pros of a creditor-friendly bankruptcy procedure for shareholders?
12/Name countries which have debtor-friendly bankruptcy procedures.
You’ll find more questions at www.vernimmen.com.

EXERCISES

1/The Landmark car park will be shutting down tomorrow after having generated a final cash flow. It has debts of 500 used to finance its activities. Depending on whether the economic situation is good or bad (there is an equal probability of either), the flows are as follows:
Economic situation − +
Operating cash flow 500 1,000
Payment of debt −500 −500
Shareholders’ portion of cash flow 0 500
The company is offered an investment yielding 0 if things go badly (−) and 300 if things go well (+).
1. What is the initial value of the debt? And of shareholders’ equity?
2. What is the present value of the investment project? At what price would shareholders agree the company to acquire it? Does your answer depend on the way this investment is financed?
3. What conditions would new creditors set for financing this new investment?
4. Are conflicts that arise between shareholders and creditors a result of the way in which the company finances investments?

2/Alok Malpani and Sons is a high-tech group in financial distress. Its key financials are as follows:

(€m)	2018	2019	2020
Sales	8,026	5,208	3,018
Operating income	130	(168)	(100)
Financial expense	(330)	(144)	(62)
Restructuring costs	(1,020)	(314)	(0)
Net income	(1,220)	(626)	(162)
Fixed assets		122	72
Working capital		614	330
Shareholders’ equity		(620)	(784)
Subordinated debt		616	616
Senior debt		740	570

Alok Malpani and Sons shares are trading at €24. The company’s share capital is divided into 8,910,000 shares. The value of the senior debt can be estimated at half of its face value and the value of the subordinated debt at 21% of its face value.

The following rescue plan has been submitted to all of the investors in the company:

Shareholder subscription to a capital increase of 15,500,000 new shares at a price of €20 per share, totalling €310m.
Partial repayment and conversion of the subordinated debt into capital: issue of 3,850,000 new shares and repayment of €36.96m.
Waiver of €160m of debts by senior creditors. In exchange, 1,250,000 warrants entitling holders to subscribe after three years to 1 share per warrant at a price of €25 per share. The value of these warrants is estimated at €4 per warrant. The proceeds of the capital increase that are left over after partial repayment of the subordinated debt will be used to repay the senior creditors.

What is your view of the financial health of this company?
Calculate the value of the different securities used to finance the capital employed.
Calculate how much the various lenders will have before and after the rescue plan. Assume the negotiated amount of the face value of the senior debt will be 80% after the plan.
Who are the key beneficiaries of this plan?

ANSWERS

Questions

1/Because their return on capital employed is too low and they do not generate enough free cash flow.
2/The risk that the sale may be declared invalid, as it took place during the period immediately preceding the bankruptcy.
3/No, because in partnerships, partners’ liability is not limited to their contributions.
4/It puts the counter back to zero for all contracts.
5/The present value of the cost of bankruptcy is deducted from the enterprise value. The more debts a company has, the higher the tax shield but also the higher bankruptcy costs.
6/Because a portion of their charges may have been renegotiated and revised downwards (rent, personnel expenses, miscellaneous charges).
7/Because in France, public policy is weighted heavily in favour of job preservation, and the recovery plan that saves the largest number of jobs is likely to be the one selected by the bankruptcy courts, even if, in the long term, it leads to the demise of the company.
8/No, since it doesn’t owe anything (or practically nothing). Yes, if it invests at a rate of return below that required by shareholders.
9/Because in most jurisdictions, repayments on old debts are frozen and customers continue to pay their debts.
10/Because their new debts will be paid off before the old debts if the company is liquidated (so-called new money privilege).
11/Managers will try to postpone bankruptcy for as long as possible.
12/USA, France.

Exercises

A detailed Excel version of the solutions is available at www.vernimmen.com.

1/
1. V_D = 500, V_E = 250.
2. 150; up to 300 if it is debt financed as no value will be destroyed (in the + case: +300 of operating cash flow and 300 debt to repay, unchanged free cash flows to equity in the – case); 150 if it is equity financed.
3. They would want to be certain that they will be reimbursed first (i.e. their credit is ranked higher than that of existing creditors).
4. Yes, but only because the company was close to bankruptcy at the outset.
2/
1. The group is in very poor shape financially, and its returns are far too low. The disposal of the most attractive assets that became necessary to meet cash needs merely served to accelerate the group’s plunge into bankruptcy. The business is shrinking away.
2. Value of shareholders’ equity = €213.84m.
  Value of subordinated debt = €129.36m.
  Value of senior debt = €285m.
  Value of capital employed = €628.2m.
3. Value of senior creditors’ assets = (310 − 36.94) + (570 − 160 − 310 + 36.94) × 80% + 1.25 × 4 = €387.61m.
  Value of shareholders’ equity = 628.2 − (570 − 160 − 310 + 36.94) × 80% − 1.25 × 4 = 513.65.
  Value of a share = 513.65 / (8.91 + 15.5 + 3.85) = €18.2.
  Shareholders’ wealth without capital increase = €162.2m (compared with €213.83m before plan).
  Subordinated creditors’ assets = 36.94 + 3.85 × 18.2 = €107m (compared with €129.36m before).
  Wealth of shareholders who subscribed to the capital increase = 15.5 × 18.2 = €282.1m (for €310m invested).
4. The creditors.

BIBLIOGRAPHY

E. Altman, E. Hotchkiss, Corporate Financial Distress, Restructuring and Bankruptcy: Analyze Leveraged Finance, Distressed Debt and Bankruptcy, 4th edn, Wiley, 2019.
E. Berkovitch, R. Israel, Optimal bankruptcy laws across different economic systems, Review of Financial Studies, 12(2), 347–377, Summer 1999.
B. Branch, H. Ray, R. Russel, Last Rights: Liquidating a Company, Oxford University Press, 2007.
A. Bris, I. Welch, N. Zhu, The costs of bankruptcy: Chapter 7 liquidation versus Chapter 11 reorganization, Journal of Finance, 61(3), 1253–1306, June 2006.
J. Campbell, J. Hilscher, J. Szilagyi, In search of distress risk, Journal of Finance, 63(6), 2899–2939, December 2008.
S. Claessens, L. Klapper, Bankruptcy around the World – Explanation of its Relative Use, World Bank Development Research Group, July 2002.
S. Davydenko, J. Franks, Do bankruptcy codes matter? A study of defaults in France, Germany, and the UK, Journal of Finance, 63(2), 565–608, April 2008.
S. Gilson, E. Altman, Creating Value through Corporate Restructuring, 2nd edn, John Wiley & Sons, Inc., 2010.
C. López, M. García, B. Torre, Economic valuation of the efficiency of bankruptcy systems, Spanish Journal of Finance and Accounting, 40(150), 221–250, 2011.
D. Markwardt, C. López, R. DeVol, The economic impact of Chapter 11 bankruptcy versus out-of-court restructuring, Journal of Applied Corporate Finance, 28(4), 124–128, Autumn 2016.
C. Molina, L. Preve, Trade receivables policy of distressed firms and its effect on the costs of financial distress, Financial Management, 38(3), 663–686, Autumn 2009.
G. Recasens, Aléa moral, financement par dette bancaire et clémence de la loi sur les défaillances d’entreprises, Revue Finance, 22(1), 65–86, June 2001.
M. White, The corporate bankruptcy decision, Journal of Economic Perspective, 3(2), 129–151, October 1989.
G. Zhang, Emerging from Chapter 11 bankruptcy: Is it good news or bad news for industry competitors?, Financial Management, 39(4), 1719–1742, Winter 2010.

NOTE

1 For more, see Section 51.3.

****PART TWO. MANAGING WORKING CAPITAL, CASH FLOWS, FINANCIAL RISKS AND REAL ESTATE

In this section, readers will understand that what may at first glance appear to be of little interest is in fact crucial for the sound financial management of a firm. The management of flows is one of the elements that optimise working capital and the reduction of capital employed by the firm. It makes it possible to “track cash”, which is an advance indicator of results and of potential operational problems. Management of financial risks is essential in a complex and volatile world in order to prevent such risks impacting on the firm, or threatening its development or even its survival. Finally, managing real estate, especially operating real estate, can be a strategic matter for some firms.

Chapter 49 MANAGING WORKING CAPITAL

Chapter 49
MANAGING WORKING CAPITAL

Is it supply chain management or is it strategy? It’s finance, General!

On aggregate in Continental Europe, working capital represents large amounts (c. 15% on capital employed). Customer credits (and symmetrically, supplier credits), which are commercial loans between companies, amount to nearly three times the amount of short-term loans granted to corporates.

The similarity between the amount of working capital and that of net debt is not completely coincidental, as often these two items behave in concert. An increase in working capital means an increase in net debt, as a large number of companies can testify following their experiences in late 2020. A drop in working capital often means a drop in net debt, as a large number of companies can testify following their experiences in mid-2020.

Finally, the problems and the amounts of working capital are not identical for all sectors. There is a world of difference between industry (management of work-in-progress, credit limits for major customers, etc.) and the services sector.

Section 49.1 A BIT OF COMMON SENSE

Working capital is an investment, like any other, even if on occasion there is less choice involved (for example, when a customer “forgets” to pay by the due date and turns the supplier into its unwilling banker). As an investment, it should be managed lucidly and properly. Reducing it in order to reduce the company’s need for funds and to improve its earnings is a possibility, but it is not the only possibility.

1/ THE NUMEROUS ASPECTS OF WORKING CAPITAL

From the company’s point of view, what is working capital?

First and foremost, it’s part of commercial conquest. We all know that payment periods form part of the terms of a commercial contract. Try to set up a business in Greece, where contractual payment periods are 53 days with average periods often stretching to 69 days, by asking to be paid at 25 days like in the Netherlands! Similarly, keeping stock levels high reduces the risk of losing an order because supplies are not available. Consumers will remember the sense of annoyance and frustration felt in March of 2020 at the empty toilet paper shelves of a number of retailers.¹
Next, it’s a source of financing when it reduces and a source of financing requirement when it increases. One might be tempted to assume that the stakes are not the same when the very short-term interest rates stand at 0% or even negative, as they did in 2016–2021, or at 10% per year, as they did between 1990 and 1993.² This is a false assumption. The problem is not so much the cost of money as it is making money available by reducing working capital in order to invest, to repay debt or to constitute a war chest. The problem is also not having money when the company needs it. In other words, managing working capital is a timeless problem, even if some situations are better than others for highlighting the issue.
Finally, it is a source of risk: the risk that customers will pay late or will only pay partially or not at all because they have gone bankrupt, which could in turn create problems for the company and create a series of domino-like bankruptcies. It is to alleviate this risk that the European authorities have introduced statutory provisions to reduce payment periods to 60 days (or by way of exception 45 days end of month) after the invoice is issued. There is also the risk of the loss of value for obsolescence of certain goods (news journals, cut flowers, yoghurt, etc.).

From a more economic point of view, working capital can be:

A tool for helping customers or suppliers who are already experiencing problems as a result of a liquidity crisis. For example, in March–April 2020, some large groups as L’Oréal, with ample cash resources, in turn helped their main subcontractors, who were experiencing a liquidity crisis, by reducing their payment periods. This was not only a question of altruism, it was also in their best interest, in order to avoid the bankruptcy of their suppliers, which would have threatened the continuity of their supplies.
A source of value creation in periods of negative real interest rates and significant inflation, for sectors with high levels of inventories, through inflation gains.³ In other words, good management of working capital in this case means not managing it!
A source of speculation (and hence of risk) when the company overstocks raw materials, the price of which it is expecting will rise substantially over the coming months (electronic components end 2020–beginning 2021).

Working capital results from the company’s strategy. For example, when a company decides to get involved upstream in order to secure its supplies (ArcelorMittal owns iron-ore mines that provide it with 65% of its consumption), or downstream in order to fill the gaps in a retail network that is patchy or not yet established (SEB runs close to 1,300 shops in 45 emerging countries such as China, Turkey), then working capital is necessarily increased. Similarly, when the company decides, like Indesit did, to outsource part of its production to Eastern Europe, South East Asia or China, then margins rise (or don’t fall), but working capital increases, since these subcontractors just don’t have the financial structure necessary to grant Greek-style payment periods!⁴

The level of working capital is also the result of a financial arbitrage between margins and costs. We know of a magazine group that pays cash for its paper supplies. It is able to purchase its paper at a knock-down price, as it is in a very good position to negotiate discounts at a higher rate than that at which it could invest its cash, from suppliers whose need for cash is constant given the extent of their investments. Our magazine publisher’s working capital is mediocre (practically no supplier credit), but its margins are outstanding!

Another example is the public works sector, which is structured around customer advances that more or less cover the cost of the works, and more, for the best of them. Working capital is low, but then so are margins. You can’t expect your customer to give you everything!

The company grants discounts so that customers will pay quickly, which means that working capital level is low and that cash is quite plentiful but also that margins will decline. This is why in the USA it is standard to offer customers the option of paying at 30 days or of paying at 10 days and getting a 2% discount. As the yield to maturity of this commercial offer is 44.6%, very few buyers are able to resist the temptation! (And those who do send out a signal of a pitiful financial situation which may alarm suppliers.) Sales, when they are exceptional, are also a way of buying cash.

2/ MANAGING WORKING CAPITAL

There are four ways of approaching working capital management:

tighten control over waste: stop the payments department from paying suppliers early, sell off stocks with low turnover rates and consider phasing out the production of such items. These measures are relatively easy to put in place and will not require a major overhaul of the company;
take a close look at more structural elements that will require a change in behaviour or organisation. This could mean indexing the variable compensation of sales reps, not to orders taken but to actual payments or margins made, reorganising production chains in order to reduce buffer stocks, shifting from a mass procedure to a process procedure,⁵ introducing made-to-order production for slow-moving products, but also to optimise administrative procedures (paperless invoices, automated reminders) etc. Such changes are complex to put in place, and will require the active cooperation of a number of departments, which more often than not will mean the involvement of general management;
carry out an arbitrage between margins and working capital in order to buy or sell cash;
create a false appearance, by reducing working capital on the balance sheet using factoring, securitisation, discounting, reverse factoring etc. But let’s not fool ourselves, working capital has not really been reduced, it has only been partly financed, and this part disappears from view in the same way that poverty is invisible in Potemkin villages. These are financing techniques that are discussed in Section 21.3.

Only the first two of the above ways of approaching working capital management will lead to the generation of cash without weighing heavily on the cost structure.

Working capital management is also a cultural issue. We saw in Section 11.3 that payment periods in Europe differ widely from one country to the next.

Some companies have a more developed cash culture than others, either because of the financial difficulties they have had to face in the past (carmakers in the 1980s), the influence of their shareholders (LBO funds make cash an essential lever of their culture⁶) or the approach of a manager (former financial director), which have made them sensitive to cash from a very early stage. Other firms have less of a cash culture because financial conditions make cash less of a pressing problem or because their culture is far removed from such preoccupations (engineering firms, firms involved primarily in research and development, etc.).

In other words, if a cash culture is to take hold within a company, as an add-on to other cultures rather than a replacement, it will require a long learning period, patience, diplomacy and, above all, the support of general management, as it often leads to a root-and-branch overhaul of established practices with which staff are familiar and comfortable.

Finally, even though all employees can be expected to try to enhance their performance and improve their weak points, we can’t help being a bit sceptical. Division managers are rarely superhuman. If we set division managers multiple targets of growing the market shares of their products, increasing margins, ensuring good relationships between labour and management and seeing to it that their divisions comply with corporate culture, not forgetting to innovate along the way, and then we also ask them to reduce their working capital over and above the obvious waste that needs to be avoided, we are perhaps asking too much of them. These multiple objectives could hamper managers in the performance of their tasks, with the risk that they are unable to perform properly and fail to achieve any of their goals.

We know of a multinational firm that has become a leader in its field as a result of innovation and highly effective marketing. Its margins are enviable and its after-tax return on capital employed is just under 20%, yet its working capital can hardly be described as good. Is it possible to be good at everything all of the time?

This rather existential question has, unfortunately, to give way to the more mundane. The following sections look at the operational and more concrete ways of reducing working capital. This may seem a bit dull, but it is the nuts and bolts of the field. Stay with us and be patient.

Section 49.2 MANAGING RECEIVABLES

Managing receivables involves:

negotiating better payment terms (general terms and conditions);
securing the actual payment of receivables as closely as possible to the original contractual terms and conditions;
securing the payment of receivables in order to avoid bad debts.

The last two points are intertwined, as the risk of default increases in direct proportion to the length of the payment period. Payment periods for Spanish, Italian, Portuguese and Greek groups are twice as long as in Scandinavia, and, here, the default rate is twice as high.

1/ SPEEDING UP THE PAYMENT OF TRADE RECEIVABLES

Altares estimates that 45% of invoices remain unpaid on their due date and that 3.2% of them are still unpaid 90 days later.

Payment periods are often described as the result of four factors:

The general terms and conditions of sale make provision for payment periods that are set by the company and are in line with its strategy, standard industry practice and local customs.

When sales reps offer exceptional terms and conditions of payment, this means that the financial manager has made sure that they come with a commercial gain (higher price, larger volumes). If this is not the case, then sales reps will have to go back on their word, which is never easy with a customer who has been allowed to slide into bad habits! This is why it is best not to let sales reps make decisions on exceptional terms and conditions.

When customers fail to meet payment in full and on time, they are bending the rules and stretching the terms and conditions of sale which they signed up to. The EU Directive on the reduction of payment periods makes provisions for penalties for such infringements: late payment interest calculated at the Central European Bank rate plus 10 points (10% in mid-2020). In certain countries, the law also makes provision for civil and criminal penalties (fines). Even though suppliers are under an obligation to apply them, they may think twice before doing so, given the potential negative consequences of such action.

In order to avoid ending up in this situation, it is in the company’s best interests to:

contact customers 15 to 30 days before invoices are due in order to remind them that payment is due and to check that there are no problems with the invoice. If there are any problems, corrective measures should be taken immediately (for example, a new invoice with the correct purchase order number should be issued). Such reminders should preferably be made by telephone if they are to be more effective. They must be adapted to the type of customer (large companies vs. small businesses) and should target the largest outstanding amounts. Payment reminders also provide an opportunity to check that all invoices sent to a particular client are up to date;
identify customers that are systematically late payers or that regularly come up with stalling tactics in order to delay payment;
identify customers who have long and complicated internal invoice payment approval systems, for example a customer with multiple delivery sites for payments that are centralised and paid by batch (invoices approved for payment received after the 20th of the month are paid on the 10th of the following month, etc.);
set up a procedure for identifying swift and efficient dispute settlement. Customers that dispute invoices don’t pay them. It is estimated that it takes, on average, 30 minutes to settle a dispute and that two-thirds of disputes are settled as soon as the first action is taken. Dispute settlement is all the more necessary since an unpaid invoice will often be an obstacle to new orders from the same customer, even if nothing is being done to understand and resolve the cause of the dispute;
send out written reminders at the latest 15 days after the invoice is due, followed by a second reminder 15 days after that, and a final reminder 15 days after the second reminder, before taking legal action or handing over the debt to a debt collection agency.

Delays resulting from the internal malfunctioning of the company are, in theory, the easiest to remedy, even though this often involves overhauling the company’s administrative processes, while always keeping in mind the playoff between costs and efficiency. It’s also a good idea to look at the time it takes for invoices to be issued because the payment period starts as of the date of the invoice, even if the product or service has already been provided. Checks should be carried out to ensure that the invoice bears the correct address and that the quantity invoiced is identical to the quantity ordered.

2/ SECURING THE PAYMENT OF TRADE RECEIVABLES

As a defaulting customer can cause a company to go bankrupt, it is in the company’s best interests to protect its receivables from any risk in this regard.

There are several simple measures that can be put in place:

setting of a maximum credit limit for each major customer. In practice, two credit limits are often put in place, with the lower one triggering an alarm when it is breached, leading to an investigation into the customer’s solvency. If the second credit limit is breached, then orders will no longer be taken from this customer, unless it agrees to pay on delivery or agrees to reservation of ownership clauses⁷ for as long as it has not paid its commercial debt;
spot checks on the solvency of customers because a customer that is solvent today may not be solvent tomorrow. Such checks can be carried out by analysing the customer’s accounts and checking its rating with professionals involved in commercial information (Ellisphere, Altares, Dun & Bradstreet, Creditsafe, etc.);
preparation of sales reps’ prospecting campaigns by carrying out advance checks on the solvency of targets. This is good practice in order to avoid payment problems in the short term, but also from a long-term point of view as the most solvent companies often turn out to be the best customers with the best payment practices;
use of the most secure payment methods such as confirmed export letters of credit⁸ or requirement of a down payment on ordering.

This is the province of the credit manager, generally attached to the finance department, who is responsible for trade receivables, customer risks and collection and is also required to optimise performance, working alongside the sales departments.

At a later stage, the credit manager may have to make use of the services of collection firms (Intrum, Ellisphere, Pouey, etc.), which handle the recovery of unpaid debts on behalf of companies, either amicably or through the courts.

In order to avoid such situations, the company can take out credit insurance. This is an insurance policy which guarantees the reimbursement of the unpaid debt by the credit insurer (Coface, Atradius, Euler Hermes, Zurich, SACE) in exchange for an insurance premium of between 0.10% and 2% of sales covered.⁹ It is rare that full compensation is paid out as the company will still have to pay the insurance excess, which will be between 10% and 30% of the amount of the debt. The insurance payout is made either when the purchaser of the company’s goods is declared insolvent or at the end of the waiting period before payment. In order to avoid carrying only the risks that the company knows are bad risks (adverse selection), insurance companies often insist on covering the whole of the company’s customer portfolio.

Credit insurers provide three services:

the prevention of receivables risk through solvency analyses and the provision of centralised commercial information which they update on an ongoing basis;
recovery of unpaid invoices;
compensation on guaranteed debts it has not been possible to recover.

Credit managers also have other tools at their disposal to protect the company against defaulting customers:

bank guarantees: the banks of certain problem customers are sometimes prepared to provide a bank guarantee that they will meet their payments;
techniques used in trade finance such as the irrevocable and confirmed documentary credit (very popular in high-risk countries);
non-recourse factoring,¹⁰ allowing a company to sell trade receivables.

Section 49.3 MANAGING TRADE PAYABLES

This item is often neglected as company buyers are often more keen to negotiate good prices than to negotiate advantageous payment periods.

But this is a pressing need with the development of credit insurance. If a company’s supplier has taken out credit insurance to cover its receivables, and if the company pays after the contractual payment period and the supplier declares a default on payment to the insurance company, the company will be identified as a bad payer by the insurance company and this news will spread very quickly on the market.

Management of trade payables will mainly involve:

a review of payment periods negotiated with each supplier. The company will often discover that it has a wide range of payment periods as a result of decentralisation. Even at companies where purchasing negotiations are centralised, payment periods are not dealt with as the focus is often only on prices fixed for the whole of the group. In such cases, the company should negotiate with its biggest suppliers and try to align all payment periods with the longest periods that are already in place. The company can try and force smaller suppliers to accept such longer payment periods;
a comparison of theory (contractual payment periods) and practice (the actual period after which the company pays) will highlight situations in which the company pays earlier than it should. Often, if lack of discipline and incompetence are eliminated as causes, the reason for this is that different dates appear in the terms of payment in the contract, on the order and even on the invoice. Sometimes companies pay on the 15th of the month amounts that are due between the 15th and the 30th, and on the 30th of the month amounts that are due between the 1st and the 15th of the following month. There are other times when the supplier delivers the goods or service earlier than planned, and sends off the invoice immediately;
a review of the procedure for validating the receipt of deliveries will help to prevent late validation of deliveries which, in the best of cases, generates delays in invoice accounting and hence payment delays, which could result in heavy penalties. In the worst of cases, new orders will be triggered as the stocks in the system could appear to be abnormally low!;
finally, disputes should be dealt with quickly as they will not result in any extension of the contractual payment period.

Section 49.4 INVENTORY MANAGEMENT

The ability of a company to manage its inventories well is dependent on several parameters and on how well the company manages these:

its ability to correctly forecast the level of activity in advance, which is highly dependent on the sector;
its ability to carry out cross-analyses between product families and customer families in order to be able to work out suitable supplies and storage policies;
its ability to reduce its supply periods;
its ability to transform its stocks rapidly from raw materials into finished products, and then to sell them (called optimisation of the production process);
its ability to monitor stock levels;
its ability to obtain a service rate¹¹ high enough to avoid stockouts.

Experience has shown that when a company takes a serious look at its inventory levels, it can achieve impressive results. We know of a company that has been able to reduce its inventories by 23%, cutting them from 70 to 54 days of sales. Progress in logistics and IT management have played a large role in these improvements. However, it would be fallacious to believe that it is always best to keep inventories low. Inventories remain an investment which results from a playoff of financial cost versus the flexibility gained.

As for the management of receivables, managing inventories involves action to combat waste and more structural action.

Action to combat waste includes:

selling off dormant inventories for which orders have not been placed for more than a year;
systematically using the Wilson formula for determining the optimal quantity to order. The Wilson formula¹² consists in playing off the cost of placing the order (administrative cost, discount in line with size of order) against the cost of storage (financial cost of tying up capital, storage and risk);
reducing uncertainty over supplies by analysing delivery periods and the reliability of the various suppliers or even setting up partnerships with some suppliers (as is the case in the automotive industry);
integrating sales forecasts into the stock management tool;
determining the inventories policy on the basis of service rates to be provided to customers.

Structural measures include:

shifting from a mass production mode to a process mode,¹³ which is not without cost as the firm will lose flexibility and run the risk of breaks in production; or shifting from a workshop production mode to a mass production mode;
shifting from a mass production mode to made-to-order unit production. This will mean sacrificing economies of scale but with technological development (e.g. 3D printing), production costs may still be reasonable and a build-up of unsold stock or lost sales can be avoided;
including performance-based targets in the calculation of the variable remuneration of stock managers (only 20% of groups have such systems in place);
optimising the location of stock and of picking processes at factories, in order to reduce in-transit inventory;
working on sales forecasts so as to reduce buffer stocks and anticipation inventories, which may involve working more closely with the firm’s main customers or working out precise statistics in order to be in a better position to determine the seasonality or the cyclical nature of sales;
simplifying the range of products offered by reducing varieties which increase the number of unit stocks.

Section 49.5 CONCLUSION

Financial managers will not be able to put in place measures for managing working capital without the close collaboration of operational managers responsible for purchasing, stocks, logistics, production, sales and human resources, over whom financial managers have no authority. Over and above the fight against waste, managing working capital often quickly leads to strategic decisions involving the firm’s commercial, production and logistics policies.

Financial managers will, this time internally, have an opportunity to demonstrate their teaching skills and negotiating talents.

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

Working capital is an investment, like any other, and accordingly it has to be managed. Management of working capital does not necessarily mean reducing it at all costs. Working capital is the result of a playoff between liquidity and margins.

Over and above waste, which is relatively simple to eliminate but which requires determination and an ongoing effort, working capital can only be reduced at the expense of EBIT or at the cost of investing in modifying the firm’s economic model.

In crisis periods, the firm will focus on reducing working capital in order to generate cash, which is useful for paying down debt or self-financing projects. The impact on margins is less of an issue. During economically good times, the firm will focus more on sales and margins than on working capital.

All of the techniques and tools for managing working capital are described in this chapter.

Financial managers will, this time internally, have an opportunity to demonstrate their teaching skills and negotiating talents.

QUESTIONS

1/For how long can factories be shut down while surplus stocks are absorbed?
2/Why does managing working capital involve both supply management and strategy?
3/Why do LBO funds set so much store on the management of working capital?
4/In what conditions is excessive working capital not the sign of poor management?
5/A customer suddenly increases their orders from you. What is your reaction?
6/You are late in paying an invoice. You have not received a reminder. What do you conclude?
7/What are the three documents that prove the existence of a debt and which are indispensable for sending out an effective reminder?
8/Is the securitisation of trade receivables or inventories a way of managing working capital?
9/What are the services provided by credit insurance?
10/Why would a company, knowing that its suppliers had taken out credit insurance for part of the trade payables it owes, be well advised to pay by the due date?
11/A client has the choice of paying at 10 days with a 2% discount or at 60 days, and it chooses the latter option. What does this signal?
12/Why is there a correlation between payment period and rate of customer default?
13/Is managing working capital only the business of the financial manager? Why?
14/What could a group be tempted to do if it fears that at the close of its financial year it will be unable to meet its debt covenants, resulting in the restructuring or possibly even the calling-in of this debt?
You’ll find more questions at www.vernimmen.com.

EXERCISES

1/Provide a simple example to illustrate that upstream integration increases working capital.
2/Provide a simple example to illustrate that downstream integration increases working capital.
3/Show how the figure 44.6% (mentioned on page 893) is calculated.
4/A company makes annual sales of €10m (excl. VAT) and is subject to VAT at a rate of 20%. Its actual collection time is 75 days. What is the average outstanding amount receivable? The payment period has to be reduced to 60 days for legal reasons. How much extra cash will this mean for the company? What is the impact on the income statement if the company is currently borrowing at 4%?
5/A company posts monthly sales of €100,000 with a customer for which its gross margin is 25%. How long after the start of the relationship with this customer can the customer go bankrupt without the company making any net losses, given the gross margin made and the total loss of trade payables that remain unpaid? The payment period is two months.

ANSWERS

Questions

1/Some factories take a long time to shut down or start up again. It takes a lot longer to start up a blast furnace than it does to start up a sewing machine!
2/It involves strategy, because it depends on the commercial, production and financial strategy of the firm – arbitrage, margin and volume vs. cash. It involves supply management, as this is the continuation of small actions and decisions to be implemented.
3/Because by tightening up its working capital, the firm generates cash which will enable it to reimburse part of its debt and improve the IRR of the LBO fund.
4/If this situation is desired and the result of a conscious decision, and not something the company has to reluctantly bear. If, in exchange, the company receives more orders and records higher margins.
5/Has this customer failed to pay a competitor, which is now refusing to make more deliveries? This may be why the customer has increased orders from you.
6/Your supplier is badly organised and/or rich!
7/The order slip and the delivery slip signed by the customer, the invoice.
8/No, merely a way of financing working capital.
9/The analysis of the solvency of customers/prospects, the recovery of bad debts, compensation for receivables that are not recovered.
10/Because the market will find out very quickly if the firm is a bad payer via the credit insurer, which will pass on this information to its other clients.
11/Either that it has no cash or that its marginal cost of debt is higher than 15.6%, which is not a good sign of its future prospects! 15.6% = (1 + 2%)^365/50 − 1.
12/Because a customer who pays late does not necessarily do so on purpose, but also does so because of liquidity problems, which indicates a high risk of bankruptcy.
13/No, because it also involves the commercial, marketing, production/logistics managers, and even the general manager, who have to make choices and decisions, playing various factors off against others.
14/It can buy cash by temporarily reducing its working capital in order to reduce its net debt.

Exercises

A detailed Excel version of the solutions is available at www.vernimmen.com.

1/A factory pays all of its suppliers 900 on day 1, and receives 980 from its retailer customer on day 60. The retailer pays its supplier (the factory) 980 and 100 to other suppliers on day 60, and receives 1,100 from its customers on day 90.
For 60 days, the factory has a cash deficit of 900, which is its working capital, and makes a margin of 80. For 30 days, the retailer has a cash deficit of 1080, which is its working capital, and makes a margin of 1,100 − 980 − 100 = 20.
If the factory buys the retailer, it carries working capital of 900 over 90 days and of 100 over 30 days, or an average of 933 over 90 days compared with 900 over 60 days.
Its working capital has thus increased.
2/Let’s take the above example again. This time, let’s say that the retailer buys the factory. It carries 1,080 over 30 days. Now it has to carry 900 over 90 days and 100 over 30 days, or an average of 933 over 90 days. Its working capital has thus increased.
3/98 = 100/(1 + r)^20/365 so r = 44.6%.
4/€10 × 1.2 × 75 / 365 = €2.5m. Cash gain: 2.5 − €10 × 1.2 × 60 / 365 = €0.5m. Savings in terms of financial expense: €0.5m × 4% = €20,000.
5/Monthly margin: 100,000 × 25% = €25,000. Company’s financial risk: 100,000 × (1 − 25%) × 3 months = €225,000. 225 / 25 = 9 months of margins collected. Period of 9 + 3 months of margins not collected = 1 year. A 2-month payment period means 3 months of invoices, as customers generally go bankrupt just before a payment is due and not just after they have paid.

BIBLIOGRAPHY

For numerical data on cash flow requirements:

Cribis Dun & Bradstreet, Payment Study 2020, 2020.
Hackett Group, Hackett 1000: 2020 Working Capital Study, 2020.
Intrum, European Payment Report 2021, June 2021.

For more on management techniques of cash flow requirements:

AFDCC, Credit Management Survey 2017, 2018.
M. Birshan, M. Park, M. Stone, Transforming the culture of managing working capital, McKinsey, January 2018.
Hackett Group, The Working Capitalist, Autumn 2018.
R. Smid, Unlocking value from your sheet through working capital management, Journal of Payment Strategy & Systems, 2(2), 127–137, January 2008.
J. Tennent, Working capital management, in Guide to Financial Management, 3rd edn, Economist Intelligence Unit, 2013.

To discover the work of researchers of cash flow requirements:

J.-N. Barrot, Trade credit and industry dynamics: evidence from trucking firms, Journal of Finance, 71(5), 1975–2016, October 2016.
J. Enqvist, M. Graham, J. Nikkinen, The impact of working capital management on firm profitability, in different business cycles: Evidence from Finland, Research in International Business and Finance, 32, 36–49, August 2014.
M. Hill, G. Kelly, M. Highfield, Net operating working capital behavior: A first look, Financial Management, 39(2), 783–805, Summer 2010.
C. Molina, L. Preve, Trade receivables policy of distressed firms and its effect on the costs of financial distress, Financial Management, 68(3), 663–686, Autumn 2009.
J. Murfin, K. Njoroge, The implicit costs of trade credit borrowing by large firms, Review of Financial Studies, 28(1), 112–145, January 2015.

NOTES

1 And ours when we see that the Vernimmen is only available for delivery in 10 days on Amazon!
2 See Section 35.1, 3/.
3 See Section 35.1, 3/.
4 Without taking into account the fact that purchases are made by whole container or that more is bought in order to avoid stock outs (more than one month’s delay).
5 Which often means rebalancing part of the company’s stocks, like the carmakers did in the 1980s. See Section 8.2, 2/.
6 See Chapter 47.
7 Enabling the company that has not yet been paid to automatically recover its asset if the customer goes bankrupt, without having to join the queue of creditors.
8 See Section 21.3.
9 Excluding very risky export regions and excluding very long periods for major export works.
10 See Section 21.3.
11 Calculated as the number of error-free orders delivered on time/number of orders.
12 Which you can download from www.vernimmen.com.
13 See Section 8.2.

Chapter 50. CASH MANAGEMENT

Chapter 50
CASH MANAGEMENT

A balancing act …

Cash management is the traditional role of the treasury function. It handles cash inflows and outflows, as well as intra-group fund transfers. With the development of information systems, this function is usually largely automated. As a result, the treasurer merely designs or chooses a model, and then supervises the day-to-day operations. Nonetheless, we need to take a closer look at the basic mechanics of the treasury function to understand the relevance and impact of the different options.

Section 50.1 THE BASICS

1/ VALUE DATING

From the treasurer’s standpoint, the balance of cash flows is not the same as that recorded in the company’s accounts or that shown on a bank statement. An example can illustrate these differences.

Example: A, a company headquartered in Amsterdam, issues a cheque for €1,000 on 15 April to its supplier R in Rotterdam. Three different people will record the same amount, but not necessarily on the same date:

A’s accountant, for whom the issue of the cheque theoretically makes the sum of €1,000 unavailable as soon as the cheque has been issued;
A’s banker, who records the €1,000 cheque when it is presented for payment by R’s bank. He then debits the amount from company A’s account based on this date;
A’s treasurer, for whom the €1,000 remains available until the cheque has been debited from the relevant bank account. The date of debit depends on when the cheque is cashed in by the supplier and how long the payment process takes.

There may be a difference of a few days between these three dates, which determines movements in the three separate balances.

Cash management based on value dates, in countries where this system is used,¹ is built on an analysis from the treasurer’s standpoint. The company is interested only in the periods during which funds are actually available. Positive balances can then be invested or used, while negative balances generate real interest expense.

The date from which a bank makes incoming funds available to its customers does not always correspond exactly to the payment date. As a result, a value date can be defined as follows:

for an interest-bearing account, it represents the date from which an amount credited to the account bears interest following a collection of funds; and the date from which an amount debited from the account stops bearing interest following a disbursement of funds;
for a demand deposit account,² it represents the date from which an amount credited to the account may be withdrawn without the account holder having to pay overdraft interest charges (in the event that the withdrawal would make the account show a debit balance) following a collection; and the date from which an amount debited from the account becomes unavailable following a disbursement.

Under this system, it is therefore obvious that:

a credit amount is given a value date after the credit date for accounting purposes;
a debit amount is given a value date prior to the debit date for accounting purposes.

Let us consider, for example, the deposit of the €1,000 cheque received by R when the sum is paid into an account. We will assume that the cash in process is assigned a value date one banking day later, and that on the same day R makes a withdrawal of €300 in cash, with a similar value date.

Although the initial account balance is zero, R’s account is in debit on a value date basis and in credit from an accounting standpoint.

Although the account balance always remains in credit from an accounting standpoint, the balance from a value date standpoint shows a debit of €300 until D + 1. The company will therefore incur interest expense, even though its financial statements show a credit balance.

In the European Economic Area, the value date is a maximum of one working day after the transaction has been processed. Companies generally negotiate for transactions to be credited or debited on the day on which they are executed. The transaction may, however, be executed the following day if it is transmitted too late in the afternoon (after the cut-off time set by the bank).

The increasingly limited use of cheques and the widespread use of systems that allow for immediate accounting of cashflows (SEPA, real-time payment, etc.) are making value dates increasingly obsolete. Moreover, negative interest rates do not encourage banks to anticipate the arrival of funds in their books as they would have to transfer the funds to the central bank with a negative return.

2/ ACCOUNT BALANCING

Company bank current accounts are intended simply to cover day-to-day cash management. They offer borrowing and investment conditions that are far from satisfactory:

the cost of an overdraft where the conditions have not been pre-negotiated is much higher than that of any other type of borrowing;
the interest rate paid on credit balances is low or zero. But today it is not so bad when money market funds offer a negative return and banks charge negative interest rates on too large balances.

It is therefore easy to understand why it makes little sense for the company to run a permanent credit or debit balance on a bank account. A company generally has several accounts with various different banks. An international group may have several hundred accounts in numerous different currencies, although the current trend is towards a reduction in the number of accounts operated by businesses (notably to reduce operational risks).

One of the treasurer’s primary tasks is to avoid financial expense (or reduced financial income) deriving from the fact that some accounts are in credit while others show a debit balance. The practice of account balancing is based on the following two principles:

avoiding the simultaneous existence of debit and credit balances by transferring funds from accounts in credit to those in debit;
channelling cash outflows and cash inflows so as to arrive at a balanced overall cash position.

Banks offer account balancing services, whereby they automatically make the requisite transfers to optimise the balance of company accounts.

3/ BANK CHARGES

The return on equity³ generated by a bank from a customer needs to be analysed by considering all the services, loans and other products the bank offers, including some:

not charged for and thus representing unprofitable activities for the bank (e.g. cheques deposited by retail customers in some countries);
charged for over and above their actual cost, notably using charging systems that do not reflect the nature of the transaction processed.

Banks now tend to invoice companies the actual price of the financial flow management services provided, through ad hoc charges. This activity is no longer seen as one of the ways of compensating for an undervalued price of loans as part of an overall relationship (the side business in Section 39.1). Banks currently see managing the financial flows of companies as a strategic activity, enabling them to better understand their clients’ risks on the basis of their financial flows and to improve their own liquidity (Basel III ratios). It should be noted that fees charged by banks are not always transparent, and companies are lobbying for the standardisation of fees through electronic reporting, similar to the Bank Service Billing system in the USA.

Section 50.2 CASH MANAGEMENT

1/ CASH BUDGETING

The cash budget shows not only the cash flows that have already taken place, but also all the receipts and disbursements that the company plans to make. These cash inflows and outflows may be related to the company’s investment, operating or financing cycles.

The cash budget, showing the amount and duration of expected cash surpluses and deficits, serves two purposes:

to ensure that the credit lines in place are sufficient to cover any funding requirements;
to define the likely uses of loans by major categories (e.g. the need to discount based on the company’s trade debts).

Planning cash requirements and resources is a way of adapting borrowing and investment facilities to actual needs and, first and foremost, of managing a company’s interest expense. It is easy to see that a better loan rate can be negotiated if the need is forecast several months before the need arises. Likewise, a treasury investment will be more profitable over a predetermined period, during which the company can commit not to use the funds.

The cash budget is a forward-looking management chart showing supply and demand for liquidity within the company. It allows the treasurer to manage interest expense as efficiently as possible by harnessing competition not only among different banks, but also with investors on the financial markets.

2/ FORECASTING HORIZONS

Different budgets cover different forecasting horizons for the company. Budgets can be used to distinguish between the degree of accuracy users are entitled to expect from the treasurer’s projections.

Companies forecast cash flows by major categories over long-term periods and refine their projections as cash flows draw closer in time. Thanks to the various services offered by banks, budgets do not need to be 100% accurate, but can focus on achieving the relevant degree of precision for the period they cover.

An annual cash budget is generally drawn up at the start of the year based on the expected profit and loss account, which has to be translated into cash flows. The top priority at this point is for cash flow figures to be consistent and material in relation to the company’s business activities. At this stage, cash flows are classified by category rather than by type of payment.

These projections are then refined over periods ranging from one to six months to yield rolling cash budgets, usually for monthly periods. These documents are used to update the annual budgets based on the real level of cash inflows and outflows, rather than using expected profit and loss accounts.

Day-to-day forecasting represents the final stage in the process. This is the basic task of all treasurers and the basis on which their effectiveness is assessed. Because of the precision required, day-to-day forecasting gives rise to complex problems:

it covers all the movements affecting the company’s cash position;
each bank account needs to be analysed;
it is carried out on a value date basis;
it exploits the differences between the payment methods used;
as far as possible, it distinguishes between cash flows on a category-by-category basis.

The following table summarises these various aspects:

	BANK No. 1 Account value dates
	Monday	Tuesday	Wednesday	Thursday	Friday
Bills presented for payment Cheques issued Transfers issued Standing orders paid Cash withdrawals Overdraft interest charges paid Sundry transactions (1) TOTAL DISBURSEMENTS
Customer bills presented for collection Cheques paid in Standing orders received Transfers received Interest on treasury placements Sundry transactions (2) TOTAL RECEIPTS (2) – (1) = DAILY BALANCE ON A VALUE DATE BASIS

Day-to-day forecasting has been made much easier by IT systems. Thanks to the ERP⁴ and other IT systems used by most companies, the information received by the various parts of the business is processed directly and can be used to forecast future disbursements instantaneously. As a result, cash budgeting is linked to the availability of information and thus of the characteristics of the payment methods used.

3/ THE IMPACT OF PAYMENT METHODS

The various payment methods available raise complex problems and may give rise to uncertainties that are inherent in day-to-day cash forecasting. There are two main types of uncertainty:

Is the forecast timing of receipts correct? A cheque may have been collected by a sales agent without having immediately been paid into the relevant account. It may not be possible to forecast exactly when a client will pay down its debt by bank transfer.
When will expenditure give rise to actual cash disbursements? It is impossible to say exactly when the creditor will collect the payment that has been handed over (e.g. cheque, or even a bill of exchange or promissory note when they are still used, as they have become quite rare).

From a cash budgeting standpoint, payment methods are more attractive where one of the two participants in the transaction possesses the initiative both in terms of setting up the payment and triggering the transfer of funds. Where a company has this initiative, it has much greater certainty regarding the value dates for the transfer.

The following table shows an analysis of the various payment methods used by companies from this standpoint. It does not take into account the risk of non-payment by a debtor (e.g. not enough funds in the account, insufficient account details, refusal to pay). This risk is self-evident and applies to all payment methods.

	Initiative for setting up transfer	Initiative for completing fund transfer	Utility for cash budgeting
Transfer⁵	Debtor	Debtor	Debtor
Debit⁶	Creditor	Creditor	Creditor
Cheque	Debtor	Creditor	None
Electronic promissory note⁷	Debtor	Creditor

From this standpoint, establishing the actual date on which cheques will be paid represents the major problem facing treasurers.

Although their due date is generally known, domiciled bills⁸ and notes can also cause problems. If the creditor is slow to collect the relevant amounts, the debtor, which sets aside sufficient funds in its account to cover payment on the relevant date, is obliged to freeze the funds in an account that does not pay any interest. It is in the interests of the debtor company to work out a statistical rule for the collection of domiciled bills and notes and to get to know the collection habits of its main suppliers.

Aside from the problems caused by forecasting uncertainties, payment methods do not all have the same flexibility in terms of domiciliation, i.e. the choice of account to credit or debit. The customer cheques received by a company may be paid into an account chosen by the treasurer. The same does not apply to standing orders and transfers, where the account details must usually be agreed in advance and for a certain period of time. This lack of flexibility makes it harder to balance accounts. Lastly, the various payment methods have different value dates. The treasurer needs to take the different value dates into account very carefully in order to manage the account balances on a value date basis.

Each country has its own history and payment habits in Europe; these are far from being unified.
Source: Data from European Central Bank, 2020

Harmonisation of payment methods in the eurozone (Single Euro Payment Area, or SEPA) has allowed companies or individuals to transfer money and debits as easily and as quickly and at the same cost as if the transfer were between two towns in the same country.

New payment methods that take advantage of the SEPA standard have been developed, such as SEPAmail, the main service of which is an email transfer for paying invoices at radically reduced processing costs, much faster processing periods and reduced risks of fraud. This is what Blockchain will be able to do on a very large scale, once it is developed beyond the experimental phase it is in today.

4/ OPTIMISING CASH MANAGEMENT

Our survey of account balancing naturally leads us to the concept of zero cash, the nirvana of corporate treasurers, which keeps interest expense down to a minimum (even though in the current climate of very low, even negative, short-term interest rates, this is becoming a worry of the past).

Even so, this aim can never be completely achieved. A treasurer always has to deal with some unpredictable movements, be they disbursements or collections. The greater the number or volume of unpredictable movements, the more imprecise cash budgeting will be and the harder it is to optimise. That said, several techniques may be used to improve cash management significantly.

(a) Behavioural analysis

The same type of analysis as performed for payment methods can also yield direct benefits for cash management. The company establishes collection times based on the habits of its suppliers. A statistical average for collection times is then calculated. Any deviations from the normal pattern are usually offset where an account sees a large number of transactions. This enables the company to manage the cash balance on each account to “cover” payments forecast with a certain delay of up to four or five days for value date purposes.

In any case, payments will always be covered by the overdraft facilities agreed with the bank, the only risk for the company being that it will run an overdraft for some limited period and thus pay interest expense.

(b) Intercompany agreements

Since efficient treasury management can unlock tangible savings, it is normal for companies that have commercial relationships to get together to maximise these gains. Various types of contract have been developed to facilitate and increase the reliability of payments between companies. Some companies have attempted to demonstrate to their customers the mutual benefits of harmonisation of their cash management procedures and negotiated special agreements. In a bid to minimise interest expense attributable to the use of short-term borrowings, others offer discounts to their customers for swift payment. Nonetheless, this approach has drawbacks because, for obvious commercial reasons, it is hard to apply the stipulated penalties when contracts are not respected.

(c) Lockbox systems

Under the lockbox system, the creditor asks its debtors to send their payments directly to a PO box that is emptied regularly by its creditor bank. The funds are immediately paid into the banking system, without first being processed by the creditor’s accounting department.

When the creditor’s and debtor’s banks are located in the same place, cheques can easily be cleared on the spot. Such clearing represents another substantial time saving. This system, which is still widely used, particularly in the United States, will certainly disappear with the rapid decline in payments by cheque.

(d) Checking bank terms

The complexity of bank charges and the various different items on which they are based makes them hard to check. This task is thus an integral part of a treasurer’s job.

Companies implement systematic procedures to verify all the aspects of bank charges. The conditions used to calculate interest payments and transaction charges may be verified by reconciling the documents issued by the bank (particularly interest-rate scales and overdraft interest charges) with internal cash monitoring systems. Flat-rate charges may be checked on a test basis, which is more than necessary as banks’ back office teams are generally far from perfect.

Section 50.3 CASH MANAGEMENT WITHIN A GROUP

Managing the cash position of a group adds an additional layer of data-processing and decision-making based on principles that are exactly the same as those explained in Sections 50.1 and 50.2 for individual companies (i.e. group subsidiaries or SMEs⁹).

1/ CENTRALISED CASH MANAGEMENT

The methods explained in the previous sections show the scale of the task facing a treasury department. It therefore seems natural to centralise cash management on a group-wide basis, a technique known as cash pooling, since it allows a group to take responsibility for all the liquidity requirements of its subsidiaries.

The cash positions of the subsidiaries (lenders or borrowers) can thus be pooled in the same way as the various accounts of a single company, thereby creating a genuine internal money market. The group will thus save on all the additional costs deriving from the inefficiencies of the financial markets (bank charges, brokerage fees, differences between lending and borrowing rates, etc.). In particular, cash pooling enables a group to hold on to the borrowing/lending margin that banks are normally able to charge.

This is not the only benefit of pooling. It gives a relatively big group comprising a large number of small companies the option of tapping financial markets. Information-related costs and brokerage fees on an organised market may prevent a large number of subsidiaries from receiving the same financing or investment conditions as the group as a whole. With the introduction of cash pooling, the corporate treasurer can address the financing needs of the entire group by going to market. The treasurer then organises an internal refinancing of each subsidiary on the same financing terms that the group receives.

Cash pooling has numerous advantages. The manager’s workload is not proportional to the number of transactions or the size of the funds under management. Consequently, there is no need to double the size of a department handling the cash needs of twice the number of companies. The skills of existing teams will nevertheless need to be enhanced. Likewise, investment in systems (hardware, software, communication systems, etc.) can be reduced when they are pooled within a single central department. Information-gathering costs can yield the same type of saving. Consequently, cash pooling offers scope for genuine “industrial” economies of scale.

Although the creation of a cash pooling unit may be justified for very good reasons, it may also lead to an unwise financial strategy and possibly even management errors. Notably, cash pooling will give rise to an internal debt market totally disconnected from the assets being financed. Certain corporate financiers may still be heard to claim that they have secured better financing or investment terms by leveraging the group’s size or the size of the funds under management.

Let’s not confuse two situations which are different. On the one hand, we have integration within a much larger set of smaller companies in the same sector, which immediately enjoy better financial terms that the group has access to thanks to its size and strong negotiating position. On the other hand, the integration of higher-risk entities, which, if they are able to get better financial terms, owe this either to the short-sightedness of lenders and rating agencies (which won’t last) or to the detriment of the cost of financing of the whole (which will rise). We should not forget that in a market economy, only the level of risk of each investment determines its cost of financing. Any other line of reasoning is not tenable over the long term.

A prerequisite for cash pooling is the existence of an efficient system transmitting information between the parent company and its subsidiaries. The system requires the subsidiaries to send their forecasts to the head office in real time. The rapidity of fund movements – i.e. the unit’s efficiency – depends on the quality of these forecasts, as well as on that of the corporate information system.

Lastly, a high degree of centralisation can reduce the risks of fraud but also reduces the subsidiaries’ ability to take initiatives. The limited responsibilities granted to local cash managers may encourage them not to optimise their own management when it comes to either conducting behavioural analysis of payments or controlling internal parameters. Local borrowing opportunities at competitive rates may therefore go begging. To avoid demotivating the subsidiaries’ treasurers, they may be given greater responsibility for local cash management.

2/ THE DIFFERENT TYPES AND DEGREES OF CENTRALISATION

There are many different ways of pooling a group’s cash resources in practice, ranging from the outright elimination of the subsidiaries’ cash management departments to highly decentralised management. There are two major types of organisation, which reflect two opposite approaches:

Most common is the centralisation of balances and liquidity, which involves the group-wide pooling of cash from the subsidiaries’ bank accounts. The group balances the accounts of its subsidiaries just as the subsidiaries balance their bank accounts. There are a number of different variations on this system.
The centralisation of cash balances can be dictated from above or carried out upon request of the subsidiary. In the latter case, each subsidiary decides to use the group’s cash or external resources in line with the rates charged, thereby creating competition between the banks, the market and internal funds. This flexibility can help alleviate any demotivation caused by the centralisation of cash management.
Significantly rarer is the centralisation of cash flows, under which the group’s cash management department not only receives all incoming payments, but may also even make all the disbursements. The department deals with issues such as due dates for customer payments and customer payment risks, reducing the role of any subsidiary to providing information and forecasting. This type of organisation may be described as hypercentralised.

Coherent cash management requires the definition of uniform banking terms and conditions within a group.

Notional pooling provides a relatively flexible way of exploiting the benefits of cash pooling. With notional pooling, subsidiaries’ account balances are never actually balanced, but the group’s bank recalculates credit or debit interest based on the fictitious balance of the overall entity. This method yields exactly the same result as if the accounts had been perfectly balanced, but the fund transfers are never carried out in practice. As a result, this method leaves subsidiaries some room for manoeuvre and does not impact on their independence.

A high-risk subsidiary thus receives financing on exactly the same terms as the group as a whole, while the group can benefit from limited liability from a legal standpoint by declaring its subsidiary bankrupt. Banks thus introduce additional restrictions and request reciprocal guarantees between each of the companies participating in the pooling arrangements. This often takes the form of a formal guarantee given by the parent company (parent company guarantee, PCG).

Consequently, cash balances are more commonly pooled by means of the daily balancing of the subsidiaries’ positions. The zero balance account (ZBA) concept requires subsidiaries to balance their position (i.e. the balance of their bank accounts) each day by using the concentration accounts managed at group or subgroup level. The banks offer automated balancing systems and can perform all these tasks on behalf of companies. The use of ZBA requires a set of legal agreements between the parent company and each subsidiary (cash management agreements), which must be negotiated at arm’s length so as not to raise any legal or tax issues.

In summary, the degree of centralisation of cash management and the method used by a group do not depend on financial criteria only. The three key factors are as follows:

the group’s managerial culture, e.g. notional pooling, is more suited to highly decentralised organisations than daily position balancing;
regulations and tax systems in the relevant countries;
the cost of banking services. While position balancing is carried out by the group, notional pooling is the task of the bank.

It should be stressed that the first step, certainly the most important (and least costly) of cash pooling, is the centralisation of information on the cash position within the group. Sometimes centralisation can stop there!

3/ INTERNATIONAL CASH MANAGEMENT

The problems arising with cash pooling are particularly acute in an international environment. That said, international cash management techniques are exactly the same as those used at national level, i.e. pooling on demand, notional pooling, account balancing.

Regulatory differences make the direct pooling of account balances of foreign subsidiaries a tricky task. Indeed, many groups find that they cannot do without the services of local banks, which are able to collect payments throughout a given zone. Consequently, multinational groups tend to apply a two-tier pooling system. A local concentration bank performs the initial pooling process within each country, and an international banking group, called an overlay bank, then handles the international pooling process.

The international bank sends the funds across the border,¹⁰ as shown in the chart above, which helps to dispense with a large number of regulatory problems.

At the local level, centralisation can be tailored to the specific regulatory requirements in each country, while at a higher level the international bank can carry out both notional pooling and daily account balancing. Lastly, it can manage the subsidiaries’ interest and exchange rate risks (see Chapter 51) by offering exchange-rate and interest-rate guarantees. The structure set up can be used to manage all the group’s financial issues rather than just the cash management aspects.

Within a fairly large area including the countries of the European Union, but also the United Kingdom, Switzerland, Norway, Iceland, the interconnection of payment systems under the aegis of the European Central Bank has made it possible to carry out fund transfers in real time, more cheaply and without having to face the issue of value dating. In the eurozone, cash pooling may thus be carried out with the assistance of a single concentration bank in each country with cross-border transfers not presenting any problems.

More and more groups have created a payment factory which pays off all the group’s suppliers on behalf of all the subsidiaries, which reduces the number of transfers when subsidiaries have common suppliers.

4/ CASH MANAGEMENT OF A GROUP EXPERIENCING FINANCIAL DIFFICULTIES

We ought to mention that all of the techniques and products discussed in this chapter work best for a group in good financial health and which accordingly has easy access to the debt market.

The treasurer of a group whose finances are stretched also has to manage its cash with as much, if not more, care and attention, although the goals of such a treasurer will obviously be a lot different from those of the treasurer of a more financially sound group. Instead of seeking to optimise financial expenses, the treasurer will want to secure the group’s financing.

Accordingly, the treasurer will maximise the amount of loans granted, even if this means taking out more short-term debt than is actually needed to meet short-term requirements.

When the going gets tough, the group is able to draw on all of its credit lines, as long as it is still meeting its financial covenants,¹¹ and place the funds in short-term investments. So, if the situation gets worse, the group will not run the risk of having its credit lines cut off by the banks. The banks will be forced to work with the company in order to turn it around financially.

Looking after a company’s cash turns out to be more of an operational monitoring job than an optimisation one. In fact, and paradoxically, the treasurer succeeds in managing the company’s cash only thanks to its short-term investments.

This situation could raise the cost of debt for the company, but this additional cost is no more than a form of insurance against a liquidity risk!

The treasurer will, of course, at the same time work actively on the management of working capital, as we saw in Chapter 49.

Section 50.4 INVESTING CASH BALANCES

Financial novices may wonder why debt-burdened companies do not use their cash to reduce debt. There are two good reasons for this:

Paying back debt in advance can be costly because of early repayment penalties, or unwise if the debt was contracted at a rate that is lower than the rates prevailing today.
Keeping cash on hand enables the company to seize investment opportunities quickly and without constraints or to withstand changes in the economic environment. Some research papers¹² have demonstrated that companies with strong growth or volatile cash flows tend to have more available cash than average. Conversely, companies that have access to financial markets or excellent credit ratings have less cash than average.

Obviously, all financing products used by companies have a mirror image as investment products, since the two operations are symmetrical. The corporate treasurer’s role in investing the company’s cash is nevertheless somewhat specific, because the purpose of the company is not to make profits by engaging in risky financial investments. This is why specific products have been created to meet this criterion.

Remember that all investment policies are based on anticipated developments in the bank balances of each account managed by the company or, if it is a group, on consolidated, multicurrency forecasts. The treasurer cannot decide to make an investment without first estimating its amount and the duration. Any mistake, and the treasurer is forced to choose between two alternatives:

either resort to new loans to meet the financial shortage created if too much cash was invested, thus generating a loss (negative margin) on the difference between lending and borrowing rates (i.e. the interest rate spread); or
retrieve the amounts invested and incur the attendant penalties, lost interest or (in certain cases such as bond investments) risk of a capital loss.

Since corporate treasurers rarely know exactly how much cash they will have available for a given period, their main concern when choosing an investment is its liquidity – that is, how fast it can be converted back into cash. For an investment to be cashed in immediately, it must have an active secondary market or a redemption clause that can be activated at any time.

Of course, if an investment can be terminated at any time, its rate of return can be uncertain since the exit price can be uncertain. However, if the rate of return is set in advance, it is virtually impossible to exit the investment before its maturity, since there is no secondary market or redemption clause, or if there is, only at a prohibitive cost.

Within the context of this liquidity-security, the treasurer should not forget that:

accounting standards strictly define investments that can be classified as cash equivalents: they must be short term (in general less than three months), very liquid, easily convertible into a known amount of cash and subject to a negligible risk of any change in value. This classification has consequences on the calculation of net debt (which can have an impact on the banking covenants and the company’s credit rating);
the risk of a bank collapsing is not just a theoretical risk. A bank that offers substantially higher interest on deposits than its competitors may do so because it is having trouble finding cash, which is not a good sign. Counterparty risk also means that companies should choose carefully and diversify the banks they place their cash with and not put all of their eggs into one basket;
readily available products may fall under a different tax regime.

Note that the treasurer now faces negative short-term rates in Europe (as banks have started to charge for deposits). This encourages them to look at riskier or longer investments so that they do not have to take a loss on their investment. But beware! In 2020, in Europe, investing a significant amount at 0% is certainly synonymous with taking risks.

1/ INVESTMENT PRODUCTS WITH NO SECONDARY MARKET

Interest-bearing current accounts (or simple current accounts) are offered by banks in order to be able to capture liquidity so as to improve their regulatory solvency ratios. Interest may be fixed or rise over time (extending the life of these deposits).

Time deposits are fixed-term deposits on an interest-bearing bank account that are governed by a letter signed by the account holder. The interest on deposits with maturity of at least one month is negotiated between the bank and the client. It can be at a fixed rate or indexed to the money market. No interest is paid if the client withdraws the funds before the agreed maturity date.

Cash certificates are time deposits that take the physical form of a bearer or registered certificate.

Repos (repurchase agreements) are agreements whereby institutional investors or companies can exchange cash for securities for a fixed period of time (a securities for cash agreement is called a “reverse repo”). At the end of the contract, which can take various legal forms, the securities are returned to their original owner. All title and rights to the securities are transferred to the buyer of the securities for the duration of the contract. The only risk is that the borrower of the cash (the repo seller) will default.

Repo sellers hold equity or bond portfolios, while repo buyers are looking for cash revenues. From the buyer’s point of view, a repo is basically an alternative solution when a time deposit is not feasible, for example for periods of less than one month. A repo allows the seller to obtain cash immediately by pledging securities with the assurance that it can buy them back.

Since the procedure is fairly unwieldy, it is only used for large amounts, well above €2m. This means that it competes with negotiable debt securities, such as commercial paper. However, the development of money market mutual funds investing in repos has lowered the €2m threshold and opened up the market to a larger number of companies.

2/ INVESTMENT PRODUCTS WITH A SECONDARY MARKET

Commercial papers are securities issued for periods ranging from one day to one year with fixed maturity dates and mainly issued by large companies and financial institutions.

Negotiable European medium-term notes have the same characteristics as commercial papers with the only difference that the duration is necessarily longer than one year (generally between one and two years).

We described the main characteristics of commercial paper and medium-term negotiable notes in Section 21.1.

Treasury bills and notes are issued by governments at monthly or weekly auctions for periods ranging from two weeks to five years. Depending upon the creditworthiness of the issuer (governments) they are the safest of all investments, but their other features make them less flexible and competitive. However, the substantial amount of outstanding negotiable Treasury bills and notes ensures sufficient liquidity, even for large volumes. These instruments can be a fairly good vehicle for short-term investments.

Money-market or cash mutual funds are funds that issue or buy back their shares at the request of investors at prices that must be published daily. The return on a money-market capitalisation mutual fund arises from the daily appreciation (or depreciation if interest rates are negative!) in net asset value (NAV). This return is similar to that of the money market. Depending on the mutual fund’s stated objective, the increase in NAV is more or less steady. A very regular progression can only be obtained at the cost of profitability.

In order to meet its objectives, each cash mutual fund invests in a selection of Treasury bills, commercial papers, repos and variable or fixed-rate bonds with a short residual maturity. Its investment policy is backed by quite sophisticated interest-rate risk management.

The subprime crisis was a healthy (but costly!) reminder for some treasurers that an increase in return cannot be obtained without an increase in risk. Some money-market funds, nicknamed “turbo” or “dynamic”, had invested part of their portfolio in subprime securities to boost their returns. During the summer of 2007 and thereafter, their performances suffered severely and the majority of them lost most of their customers.

Securitisation vehicles are special-purpose vehicles created to take over the claims sold by a credit institution or company engaging in a securitisation transaction (see Section 21.3). In exchange, these vehicles issue units that the institution sells to investors.

In theory, bond investments should yield higher returns than money-market or money-market-indexed investments. However, interest-rate fluctuations generate capital risks on bond portfolios that must be hedged, unless the treasurer has opted for short-maturity bonds or floating-rate bonds. Investing in bonds therefore calls for a certain degree of technical know-how and constant monitoring of the market. Only a limited number of treasurers have the resources to invest directly in bonds for which default risk is far from being negligible.

The high returns arising from investing surplus cash in the equity market over long periods become far more uncertain on shorter horizons, when the capital risk exposure is very high. Equity investments are theoretically only used very marginally and only for surplus cash over the long term. However, treasurers may be charged with monitoring portfolios of equity interests.

The current context of very low or even negative interest rates is forcing treasurers to think about the maximum level of acceptable risk. Some banks will even decline deposits (beyond a certain amount justified by day-to-day business) so that they don’t have to impose negative rates, others have taken the plunge and are applying negative interest rates to deposits when they go above a certain threshold!

Section 50.5 THE CHANGING ROLE OF THE TREASURER

Technological developments have resulted in greater integration and automation in the management of a company’s cash, and have also facilitated the centralisation of the process.

Large groups appear to be centralising cash management as much as they possibly can (which has no impact outside the group). However, this was just a start, and many groups have now also started centralising trade payables. In Europe, thanks to SEPA, we are seeing the centralisation of both payables and receivables. This would be rather more difficult to set up as it requires the cooperation of customers who will have to send their payment, not to the company that has supplied it with the goods or services it has ordered, but to another company.

Some groups view cash management as a complex administrative function that generates additional risks. Some large groups have, quite simply, outsourced the cash management function, either to banks or to consulting firms offering off-the-shelf solutions for outsourced cash management. But most groups consider this function as strategic. The Covid-19 crisis has reinforced this position.

Since the early 2000s, however, there has also been a democratisation of cash centralisation. With the development and greater security of the Internet, SMEs that do a lot of business on the international market have been able to set up efficient systems at a lower cost.

In addition to optimising cash flow, it is the treasurer’s responsibility to put in place procedures to prevent fraud and to identify compliance issues. Since 2019, there has been an increase in fraud (ransomwares, CEO fraud, etc.), which has brought this subject to the forefront.

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

A treasurer’s job is to perform the following tasks:

forecast trends in the credit and debit balances of the company’s accounts;
keep dormant funds to a minimum;
invest excess cash as efficiently as possible;
finance borrowing requirements as cheaply as possible.

Cash balances for treasury purposes are not the same as the balances shown in a company’s accounts or the accounting balance of its assets held by the bank. In particular, treasurers must take account of value dating. The value date is the date from which a credited amount accrues interest when paid into an interest-bearing account or becomes available when paid into a demand account.

The aim of the cash budget is to determine the amount and duration of cash requirements and surpluses. The cash budget shows all the receipts and all the disbursements that the business expects to collect or make. Day-to-day forecasting, which takes into account value dating, requires paying considerable attention to the payment methods used. Forecasts are more reliable when the treasurer has the initiative both for setting up a payment and carrying out the fund transfer.

Account balancing is the final stage in the liquidity management process. It eliminates the additional costs derived from differences between borrowing and investment rates. Lastly, optimised cash management entails the acceleration of the collection process and the extension of suppliers’ payment deadlines.

Cash pooling – the centralisation of subsidiaries’ account balances within a group – is comparable to the process of balancing all of a subsidiary’s accounts. Pooling is generally backed up by an integrated information system and a group-wide agreement concerning banking terms and conditions. At the international level, regulatory difficulties concerning some cross-border transfers prevent the direct balancing of subsidiaries’ accounts. Instead, the initial pooling process is carried out by a local bank in each country, and then the resulting balances are pooled by an international banking group.

The corporate treasurer’s first concern when investing cash is liquidity. The treasurer’s second concern – security – is thus closely linked to the first. Security is measured in terms of the risk on the interest and principal. Products that can be used can be split between products with a secondary market (interest-bearing current accounts, Treasury bills, money-market funds, commercial papers, etc.) or without (time deposit, repos, etc.).

QUESTIONS

1/What are the three key objectives of a corporate treasurer?
2/What are the three cash positions for a company?
3/What is a value date?
4/What is a concentration account?
5/What is the main difference between national group pooling and international group pooling?
6/Does perfect daily balancing of accounts cost more or less than perfect notional pooling?
7/Is the risk of bankruptcy of a subsidiary an obstacle to cash pooling for a group which balances its accounts daily?
8/What is the main argument against full cash pooling for a group?
9/What sort of cash organisation is generally in place for highly decentralised groups?
10/What common practice is the principal of value dates based on?
11/Is an investment that can be quickly sold on a vast market without risk?
12/Can an investment yield more than a debt? What is then the consequence?
13/Why do treasurers avoid investing their cash in shares?
14/In 2006, ABN AMRO created a new financial product, the “constant proportion debt obligation”, rated AAA by Standard & Poor’s and yielding 1% to 2% more than a AAA-rated bond. What do you think?
15/As treasurer of the city of Manheim in North Rhine-Westphalia (42,000 inhabitants), you have €38m in cash. All German banks charge 0.5% per annum for deposits; all except Greensill Bank. What do you do?
16/In an environment with very low interest rates, what might the treasurer be tempted to do?
You’ll find more questions at www.vernimmen.com.

ANSWERS

Questions

1/To reduce dormant funds to a minimum, to optimise the cost of financing and investing cash balances, to optimise the cost of risk management.
2/Value dating accounts, accounting records, company’s bank accounts.
3/The date from which a credit amount starts to bear interest and a debit amount ceases to bear interest.
4/An account used for balancing cash positions.
5/The level of pooling.
6/In both cases: no financial expenses since accounts are balanced.
7/No, as reciprocal guarantees between each of the companies participating in the pooling arrangements can be set up.
8/Disempowering of subsidiaries in the management of their liquidity leading to lower local efficiency in generating cash.
9/Cash pools that can be used upon request.
10/Clearing cheques.
11/No, as the liquidity risk does not erase all the other risks that may result in a change in value.
12/Yes if the risk of the investment is higher than that of the borrower.
13/High short- and medium-term risk.
14/It was either a fabulous arbitrage opportunity or an investment with a higher risk than apparent. In early 2008, CPDOs were valued at 40–75% of face value. Their risk, counterparty of their return, had been severely underestimated.
15/Such a gap is suspicious and is probably due to a lower creditworthiness and notoriety of Greensill Bank. As a treasurer has difficulty in doing a financial analysis of a bank, it is better to be cautious and not to take this risk despite a higher remuneration! Greensill Bank went bankrupt in March 2021 and the treasurer in Manheim lost all the funds he had invested there.
16/To take more risks in investing in securities with longer maturity, which may then be reclassified as financial fixed assets or towards counterparts of lesser quality. Both should be avoided.

BIBLIOGRAPHY

NOTES

1 European Union, Switzerland, Norway, Ireland, Monaco and Liechtenstein.
2 Also called transactional account, current account, checking account.
3 When a bank lends some money, it uses part of the bank equity because it has to constitute a minimum solvency ratio (equity/weighted assets).
4 Enterprise resource planning.
5 Order given by the customer to its bank to debit a sum from its account and to credit another account.
6 Payment method whereby a debtor asks its creditor to issue standing orders and its bank to pay the standing orders.
7 Promissory note on a magnetic strip.
8 An invoice that must be paid at a particular place.
9 Small and medium-sized enterprises.
10 For currencies that are freely convertible.
11 See Section 39.2.
12 Opler et al. (1999).

Chapter 51. MANAGING FINANCIAL RISKS

The worst is never certain

The graph below illustrates the high volatility of some parameters of importance for the profit and loss account of companies: exchange rate (dollar/euro), interest rate (Eonia), raw materials (copper) and services (freight rates).

*Source:* Data from Factset – copper spot price in $ per MT: London Metal Exchange – Fret price: Baltic Dry Index

Investors, supervisory authorities and managers pay more and more attention to risk management. This has led to:

management teams’ awareness of the importance of risk monitoring that leads to the setting up or the reinforcement of departments dedicated to risk management (internal audit, risk managers);
strong pressure from capital markets to show transparency. Good governance advice for reinforced supervision of directors in the management of risks through the implementation of risk audit committees;
a regulatory framework imposing communication on procedures to identify and assess risks for the firm and on strategy for management of those risks and its efficiency. The “risk factors” section of universal registration documents, and of share or bond issue prospectuses has thus become a vital section.

The evolution of risk management in recent years has consisted in increasingly segmenting risks and developing products that offer more accurate and flexible hedging for risk that in the past had not always been well assessed.

Section 51.1 INTRODUCTION TO RISK MANAGEMENT

1/ DEFINITION OF RISK

The key features of risk are:

intensity of the possible loss on the amount of the exposure;
frequency, which is the likelihood of this loss occurring (insurers talk about loss probability).

Risk can be classified into four major categories:

Risk fundamentally linked to market changes (interest and exchange rates, raw material prices). The likelihood of occurrence of fundamental risk, i.e. the probability that the market will move against the interests of the company, is mechanically close to 50%. The intensity of the loss will depend on the volatility of the market in question.
Loss probability refers to the likelihood of the loss occurring on a recurrent basis (such as losses on bad debts, the unknown losses suffered by mass market retailers on marked-down products, damage caused to vehicles by car rental companies, etc.). This is more of a statistical cost than a risk. The real risk is the possibility that a probable loss will occur more suddenly than usual, hence its name.
Volatility risk is a risk that materialises during an exceptional year (unusual late frost). This sort of risk should always be covered.
A disaster risk materialises once a century (for example, a pandemic) but it can have a very high level of intensity. It is difficult to cover¹ and it is not unusual for the risk of a disaster occurring to be only partially covered, or not covered at all, given the fact that it is very unlikely to occur.

2/ RISK MANAGEMENT STEPS

The different steps involved in risk management are as follows:

Identification: the map-making work involved in risks. Once the intensity and probability of the risk has been identified and determined, it can be classified.
Determination of existing internal controls and procedures which will help to mitigate the risk. This step involves assessing and testing existing internal controls (adequacy and efficiency). Controls should, in fact, lead to the substantial reduction (and generally at a low cost) of most risks, acting as a sort of filter. So it would be counterproductive for a company to insure its losses on receivables if it hadn’t put in place basic controls to ensure their recovery (monitoring of outstanding payables, sending out reminders, etc.).

Prevention is often the best form of internal control. There is the very telling example of the manager of a transport firm who sent all of his drivers off for driving lessons in order to reduce the firm’s accident rate. In finance departments, teams receive regular training on the types of fraud that are possible (in particular “fake CEO” scams whereby a fraudster poses as a company executive and asks an employee to transfer money in strict confidence).

Determination of a residual risk and assessment: internal control generally manages and eliminates a large part of the risk that is easy to master. This leaves the company in a position where it can determine the residual risk. It then only has to assess the potential impact, which will be a determining factor in the final phase.
Definition of a management strategy: this involves finding the answers to two questions:
- Am I in a position to manage this risk internally? If so, what is the cost?
- Are there any tools that can be used to hedge against this risk? If so, what is the cost?

Managers will rely on an assessment of the relationship between the level of hedging and the cost of each strategy to help them come to a decision. However, the choice of whether to cover a risk or not is not a simple yes or no decision, as it may first appear. Often, the best solution turns out to be an intelligent combination of a number of options.

However, issues relating to corporate image and communication may interfere with this purely economic reasoning. For example, a company may have to opt for more expensive hedging if this ties in with its image as a good corporate citizen. There are also some financial directors who may question whether the company should take out insurance against certain risks that will need to be booked at fair value (as required under IFRS 9) and which would be likely to introduce high levels of volatility on the income statement!

Insuring against risks helps to limit the volatility of earnings and/or cash flows. Nevertheless, the reader, who will by now have developed the reasoning of a skilled theoretician, could quite rightly point out that, as the risks covered are by nature diversified risks, eliminating them through insurance is not remunerated by the investor in the form of a lower required rate of return.² In other words, the coverage does not create value. This is true from a purely logical point of view of efficient markets, in particular when the investor has perfect information on the risks borne by the company.

Looking at the issue in terms of agency theory, it is clear that managers should reduce the volatility of cash flows. Even if the hedging decision does not create value, a company that is less exposed to the ups and downs of the market is, from a manager’s point of view, in a more comfortable position. Comprehensive insurance will enable management to implement a long-term strategy by reducing the likelihood of bankruptcy and reducing the personal risk of managers.

Campello et al. (2011) have demonstrated that a company that hedges its financial risks benefits from a lower cost of debt and from less restrictive covenants. Lenders do not like specific risks.

Finally, Rountree et al. (2008) have shown that an increase by 1% of the volatility of cash flows results in a decrease of enterprise value by 0.15%. Shareholders do not like the lack of hedging either, and it is rare that a company does not hedge, at least partially, the financial risks that it can hedge. This is often simply a sign that management is managing the company closely.

3/ THE DIFFERENT TYPES OF RISK

Risks run by companies can be split into five categories:

Market risk is exposure to unfavourable trends in product prices, interest rates, exchange rates, raw material prices or stock prices. Market risk occurs at various levels:
- a position (a debt, for example, or an expected receipt of revenue in foreign currencies, etc.);
- a business activity (e.g. purchases paid in a currency other than that in which the products are sold); or
- a portfolio (short- and long-term financial holdings).
Counterparty or credit risk. This is the risk of loss on an outstanding receivable or, more generally, on a debt that is not paid on time. It naturally depends on three parameters: the amount of the debt, the likelihood of default and the portion of the debt that will be collected in the event of a default.
Liquidity risk is the impossibility at a given moment of meeting a debt payment, because:
- the company no longer has assets that can rapidly be turned into cash;
- a financial crisis (a market crash, for example) has made it very difficult to liquidate assets, except at a very great loss in value; or
- it is impossible to find investors willing to offer new funding. Markets are then closed, as in Autumn 2008 (this was largely avoided mid-2020 thanks to States’ reactivity).
Operating risks: these are risks of losses caused by errors on the part of employees, systems and processes, or by external events. They include:
- risk of deterioration of industrial facilities (accident, fire, explosion, etc.) or other assets (ransomware) that may also cover the risk of a temporary halt in business;
- technological risk: am I in a position to identify/anticipate the arrival of new technology which will make my own technology redundant?
- climate risks that may be of vital importance in some sectors, such as agriculture or the leisure sector (what sort of insurance should ski resorts take out?);
- environmental risks: how can I ensure that I’m in a position to protect the environment from the potentially harmful impact of my activity? Am I in a position to certify that I comply with all environmental statutes and regulations in force?
Country risk (and in particular political risk), regulatory and legal risks): these are risks that impact on the immediate environment of the company and that could substantially modify its competitive situation and even the business model itself.

Section 51.2 MEASURING FINANCIAL RISKS

We will now focus on financial risks.

Different financial risks are measured in very different ways. Measurement is quite sophisticated for market risks, for example, with the notion of position and value at risk (VaR), and for liquidity risks, less sophisticated for counterparty risks and quite unsatisfactory for other risks. Most risk measurement tools were initially developed by banks – whose activities make them highly exposed to financial risks – before being gradually adopted by other companies.

1/ POSITION AND MEASUREMENT OF MARKET RISKS

Market risk is exposure to fluctuations in the value of an asset called the underlying asset. An operator’s position is the residual market exposure on the balance sheet at any given moment.

When an operator has bought more in an underlying asset than they have sold, they are long (for interest or exchange rate a long position is when the underlying asset is worth more than the corresponding liability). It is possible, for example, to be long in euros, long in bonds or long three months out (i.e. having lent more than borrowed three months out). The market risk on a long position is the risk of a fall in market value of the underlying asset (or an increase in interest rates).

On the other hand, when an operator has sold more in the underlying asset than they have bought, they are said to be short. The market risk on a short position is the risk of an increase in market value of the underlying asset (or a fall in interest rates).

The notion of position is very important for banks operating on the fixed-income and currency markets. Generally speaking, traders are allowed to keep a given amount in an open position, depending on their expectations. However, clients buy and sell products constantly, each time modifying traders’ positions. At a given moment, a trader could even have a position that runs counter to their expectations. Whenever this is the case, they can close out their position (by realising a transaction that cancels out their position) in the interbank market.

2/ COMPANIES’ MARKET POSITIONS

Like banks, at any given moment an industrial company can have positions vis-à-vis the various categories of risk (the most common being currency and interest-rate risk). These positions are a natural consequence of its business activities, financing and the geographical location of its subsidiaries. A company’s aggregate position results from the following three items:

its commercial position;
its financial position;
its accounting position.

Let us first consider currency risk. Exposure to currency risk arises first of all from the purchases and sales that a company makes in foreign currencies in the course of carrying out its business activities. Let us say, for example, that a eurozone company is due to receive $10m in six months, and has no dollar payables at the same date. That company is said to be long in six-month dollars. Depending on the company’s business cycle, the actual timeframe can range from a few days to several years (if the order backlog is equivalent to several years of revenues). The company must therefore quantify its total currency risk exposure by setting receipts against expenditure, currency by currency, at the level of existing billings and forecast billings. By doing so, it obtains its commercial currency position.

However, the company’s commercial exchange position goes well beyond the one-off transaction described above. Take, for example, a company such as Airbus, which gets its revenues in dollars but pays its costs in euros. Even if it hedges against foreign exchange losses on its orders, it will still be exposed over the long term to fluctuating exchange rates. Its commercial position is thus structural and it is obvious that this position is even more precarious when the company’s competitors are not in the same position. Boeing, for example, has the majority of its revenues and costs in dollars.

Under IFRS, the use of hedge accounting relating to hedges of transactions not yet entered into requires a realistic budget. In practice, this requirement is a disincentive as it is difficult to establish a realistic budget beyond one year.

There is also a risk in holding financial assets and liabilities denominated in foreign currencies. If our eurozone company has raised funds in dollars, it is now short in dollars, as some of its liabilities are denominated in dollars with nothing to offset them on the asset side. The main sources of this risk are: (1) loans, borrowings and current accounts denominated in foreign currencies, with their related interest charges; and (2) investments in foreign currencies. Taken as a whole, these risks express companies’ financial currency position.

The third component of currency risk is accounting currency risk, which arises from the consolidation of foreign subsidiaries. Equity denominated in foreign currencies, dividend flows, financial investments denominated in foreign currencies and currency translation differences³ give rise to accounting currency risk. Note, however, that this is reflected in the currency translation differential in the consolidated accounts and therefore has no impact on net income.

The same thing can apply to the interest rate risk. The commercial interest rate risk depends on the level of inflation of the currencies in which the goods are bought and sold, while the financial interest rate is obviously tied directly to the terms a company has obtained for its borrowings and investments. Floating-rate borrowings, for example, expose companies to an increase in the benchmark rate, while fixed-rate borrowings expose them to opportunity cost if they cannot take advantage of a possible cut in rates.

In addition to currencies and interest rates, other market-related risks require companies to take positions. In many sectors, for example, raw material prices are a key factor. A company can have a strategically important position in oil, coffee, semiconductors or electricity markets, for example.

3/ VALUE AT RISK (VAR) AND CORPORATE VALUE AT RISK

VaR is a finer measure of market risk. It represents an investor’s maximum potential loss on the value of an asset or a portfolio of financial assets and liabilities, based on the investment timeframe and a confidence interval. This potential loss is calculated on the basis of historical data or deduced from normal statistical laws.

Hence, a portfolio worth €100m with a VaR of €2.5m at 95% (calculated on a monthly basis) has just a 5% chance of shrinking more than €2.5m in one month.

VaR is often used by financial establishments as a tool in managing risk. VaR is beginning to be used by major industrial groups. Engie, for example, includes it in its annual reports. However, VaR has two drawbacks:

it assumes that the markets follow normal distribution laws, an assumption that underestimates the frequency of extreme values (see Section 23.5, 2/);
it tells us absolutely nothing about the potential loss that could occur when stepping outside the confidence interval.

Based on the above example, how much can be lost in those 5% of cases: €3m, €10m or €100m? VaR tells us nothing on this point, but stress scenarios can then be implemented. Stress test computations (sensitivity, worst-case scenarios) can complete the information from the VaR. The average loss beyond the confidence interval (expected shortfall) measures the average loss over a certain period in x% of worst cases. The expected shortfall of €10m over one month and 5% means that over one month, the portfolio has a probability of 5% of suffering an average loss of €10m.

In the same way, some firms compute earnings at risk, cash flows at risk and corporate value at risk to measure the impact of adverse effects on earnings, cash flows and value over a longer period than for banks: from several months up to a year.

4/ MEASURING OTHER FINANCIAL RISKS

Liquidity risk is measured by comparing contractual debt maturities with estimated future cash flow, via either a cash flow statement or curves such as those presented in Section 12.2. Contracts carrying financial or rating covenants must not be included under debt maturing in more than one year because a worsening in the company’s ratios or a downgrade could trigger early repayment of outstanding loans.

In addition to conventional financial analysis techniques and credit scoring, credit and counterparty risk is measured mainly via tests that break down risks. Such tests include the proportion of the company’s top 10 clients in total receivables, the number of clients with credit lines above a certain level, etc.

Country risk is generally measured by a rating (most of the time provided by a third party) taking into account, among other things, the stability of governments, the recurrence of wars and other crises.

The measure of legal and regulatory risk is still in its infancy.

Section 51.3 PRINCIPLES OF FINANCIAL RISK MANAGEMENT

Financial risk management comes in four forms:

avoidance: do not expose yourself (when possible!) to the risk concerned. This strategy generally consists of refraining from developing a business in certain countries or with certain customers, or disposing of the risky asset or liability. For example, some banks have been able to sell entire portfolios of loans in order to remove counterparty risks from their balance sheet;
self-hedging, a seemingly passive stance that is taken only by a few, very large, companies and only on some of their risks;
locking in prices or rates for a future transaction, which has the drawback of preventing the company from benefiting from a favourable shift in prices or rates;
insurance, which consists in paying a premium in some form to a third party, which will then assume the risk, if it materialises; this approach allows the company to benefit from a favourable shift in prices or rates;

1/ AVOIDANCE

An expedient solution if ever there was one, but disposal will not disconnect the holding of the asset (or the liability) from the management of its risk. It overlaps with securitisation without recourse, discounting without recourse and factoring without recourse (see Section 21.3).

Avoidance also involves fixing a minimum rating for granting a customer loan (or at the very least to set a credit limit per customer), or imposing the currency for settlement so as not to incur foreign exchange risks.

2/ SELF-HEDGING

Self-hedging is only a strategy for hedging against risk when it is deliberately chosen by the company or when there is no other alternative (uninsurable risks). It can be structured to a greater or lesser extent. At one extreme, we get risk taking (no hedging after the risk has been analysed) and at the other, the setting up of a captive insurance scheme.

Self-hedging consists, in fact, in not hedging a risk. This is a reasonable strategy but only for very large groups. Such groups assume that the law of averages applies to them and that they are therefore certain to experience some negative events on a regular basis, such as devaluations, customer bankruptcy, etc. Risk thus becomes a certainty and, hence, a cost. Rather than paying what amounts to an insurance premium, the company provisions a sum each year to meet claims that will inevitably occur, thus becoming its own insurer.

The risk can be diminished, but not eliminated, by natural hedges. A European company, for example, that sells in the US will also produce there, so that its costs can be in dollars rather than euros. It will take on debt in the US rather than in Europe, to set dollar-denominated liabilities against dollar-denominated assets.

One sophisticated procedure consists in setting up a captive insurance (or reinsurance) company, which will invest the premiums thus saved to build up reserves in order to meet future claims. In the meantime, some of the risk can be sold on the reinsurance market.⁴

A captive insurance company is an insurance or reinsurance company that belongs to an industrial or commercial company whose core business is not insurance. The purpose of the company’s existence is to insure the risks of the group to which it belongs. This sort of setup sometimes becomes necessary because of the shortcomings of traditional insurance:

some groups may be tempted to reduce risk prevention measures when they know that the insurance company will pay out if anything goes wrong;
coverage capacities are limited and some risks are no longer insurable, for example gradual pollution or pandemics;
good risks end up making up for bad risks.

The scheme works as follows: the captive insurance company collects premiums from the industrial or commercial company and its subsidiaries, and covers their insurance losses. Like all insurance companies, it reinsures part of its risks with international reinsurance companies. A captive insurance setup has the following advantages:

much greater efficiency (involvement in its own loss profile, exclusion of credit risk, reduction of overinsurance, tailor-made policies);
access to the reinsurance market;
greater independence from insurance companies (having them compete against each other);
reduction in vulnerability to cycles on the insurance market;
possibility of tax optimisation;
spreading the impact of losses over several financial years.

Walt Disney, or Volkswagen and over 350 European groups use this type of vehicle to manage risks limited to a few million euros. But captive insurances are also used by smaller groups offering their customers insurance as a side product (car rental, sale of household appliances, etc.).

3/ LOCKING IN FUTURE PRICES OR RATES THROUGH FORWARD TRANSACTIONS

Forward transactions can fully eliminate risk by locking in now the price or rate at which a transaction will be made in the future. This costs the company nothing but does prevent it from benefiting from a favourable shift in price or rates.

Forward transactions sometimes defy conventional logic, as they allow one to “sell” what one does not yet possess or to “buy” a product before it is available. As we will show, forward transactions can be broken down into the simple, familiar operations of spot purchasing or selling, borrowing and lending.

(a) Forward currency transactions

Let us take the example of a US company that is to receive €100m in three months. Let’s say the euro is currently trading at $1.0198. Unless the company treasurer is speculating on a rise in the euro, they want to lock in today the exchange rate at which they will be able to sell these euros. So they offer to sell euros now that they will not receive for another three months. This is the essence of the forward transaction. Although forward transactions are common practice, it is worth looking at how they are calculated.

Assume A is the amount in euros received by the company, N the number of days between today and the date of receipt, R_€ the euro borrowing rate and R_$ the dollar interest rate.

The amount borrowed today in euros is simply the value A, discounted at rate R_€:

This amount is then exchanged at the R_S spot rate and invested in dollars at rate R_$. Future value is thus expressed as:

Thus:

The forward rate (F_R) is that which equalises the future value in euros and the amount A:

Thus: If R_S = $1.0198, N = 90 days, R_$ = 2.03% and R_€ = 0.38%, we obtain a forward selling price of $1.0240.

A forward purchase of euros, in which the company treasurer pledges to buy euros in the future, is tantamount to the treasurer buying the euros today while borrowing their corresponding value in dollars for the same period. The euros that have been bought are also invested during this time at the euro interest rate.

In our example, as interest rates are higher in dollars than in euros, the forward euro-into-dollar exchange rate is higher than the spot rate. The difference is called swap points. In our example, swap points come to 42 (0198 − 0240). Swap points can be seen as the compensation demanded by the treasurer in the forward transaction for borrowing in a high-yielding currency (the euro in our example) and investing in a low-yielding currency (the dollar in our example) up to the moment when the transaction is unwound. More generally, if the benchmark currency offers a lower interest rate than the foreign currency, the forward rate will be below the spot rate. Currency A is said to be at discount vis-à-vis currency B if A offers higher interest rates than B during the period concerned.

Similarly, currency A is said to be at premium vis-à-vis currency B if interest rates on A are below interest rates on B during the period concerned.

As in any forward transaction, treasurers know at what price they will be able to buy or sell their currencies, but will be unable to take advantage of any later opportunities. For example, if a treasurer sold €100m forward at $1.0240, and the euro is trading at $1.0460 at maturity, they will have to keep their word (unless they want to break the futures contract, in which case they will have to pay a penalty) and bear an opportunity cost equal to $0.0220 per euro sold.

(b) Forward-forward rate and FRAs

Let us say that our company treasurer learns their company plans to install a new IT system, which will require a considerable outlay in equipment and software in three months. The cash flow projections show that, in three months, they will have to borrow €20m for six months.

On the euro money market, spot interest rates are as follows:

3 months	1.35%–1.55%
6 months	1.63%–1.83%
9 months	1.81%–2.05%

How can the treasurer hedge against a rise in short-term rates over the next three months? Armed with knowledge of the yield curve, they can use the procedures discussed below to lock in the six-month rate as it will be in three months.

The treasurer decides to borrow €20m today for nine months and to reinvest it for the first three months. Assuming that they work directly at money-market conditions, in nine months they will have to pay back:

But their three-month investment turns €20m into:

The implied rate obtained is called the forward-forward rate and is expressed as follows:

Our treasurer was thus able to hedge the exchange-rate risk but has borrowed €20m from the bank, €20m that they will not be using for three months. Hence, they must bear the corresponding intermediation costs. The company’s balance sheet and income statement will be affected by this transaction.

Now let us imagine that the bank finds out about our treasurer’s concerns and offers the following product:

in three months’ time, if the six-month (floating benchmark) rate is above 2.39% (the guaranteed rate), the bank pledges to pay the difference between the market rate and 2.39% on a predetermined principal;
in three months’ time, if the six-month (floating benchmark) rate is below 2.39% (the guaranteed rate), the company will have to pay the bank the difference between 2.39% and the market rate on the same predetermined principal.

This is called a forward rate agreement (FRA). An FRA allows the treasurer to hedge against fluctuations in rates, without the amount of the transaction being actually borrowed or lent.

If, in three months’ time, the six-month rate is 2.5%, our treasurer will borrow €20m at this high rate but will receive, on the same amount, the pro-rated difference between 2.5% and 2.39%. The actual cost of the loan will therefore be 2.39%. Similarly, if the six-month rate is 1.5%, the treasurer will have borrowed on favourable terms, but will have to pay the pro-rated difference between 2.39% and 1.5%.

The same reasoning applies if the treasurer wishes to invest any surplus funds. Such a transaction would involve FRA lending, as opposed to the FRA borrowing described above.

The notional amount is the theoretical amount to which the difference between the guaranteed rate and the floating rate is applied. The notional amount is never exchanged between the buyer and seller of an FRA. The interest-rate differential is not paid at the maturity of the underlying loan but is discounted and paid at the maturity of the FRA.

An FRA is free of charge at set up but, of course, the “purchase” of an FRA and the “sale” of an FRA are not made at the same interest rate. As in all financial products, a margin separates the rate charged on a six-month loan in three months’ time and the rate at which that money can be invested over the same period of time.

Banks are key operators on the FRA market and offer companies the opportunity to buy or sell FRAs with maturities generally shorter than one year.

(c) Swaps

In its broadest sense, a swap is an exchange of financial assets or flows between two entities during a certain period of time. Both operators must, of course, believe the transaction to be to their advantage.

“Swap” in everyday parlance means an exchange of financial flows (calculated on the basis of a theoretical benchmark called a notional) between two entities during a given period of time. Such financial flows can be:

currency swaps without principal;
interest rate swaps (IRS);
currency swaps with principal.

Interest rate swaps are a long-term portfolio of FRAs (from one to 15 years).

As with FRAs, the principle is to compare a floating rate and a guaranteed rate and to make up the difference without an exchange of principal. Interest rate swaps are especially suited for managing a company’s long-term currency exposure.

For a company with long-term debt (at X% fixed rate) and wishing to benefit from the fall in interest rates that it expects, the simplest solution is to receive the fixed rate (X%) on a notional amount and to pay the floating rate on the same amount.

That is:

which is tantamount to our company borrowing the notional at a floating rate for the duration of the swap without its lenders seeing any change in their debts. After the first year, if the variable benchmark rate (SOFR, Euribor, etc.)⁶ is (X – 1)%, the company will have paid its creditors an interest rate of X%, but will receive 1% of the swap’s notional amount. Its effective rate will be (X – 1)%.

The transaction described is a swap of fixed for floating rates, and all sorts of combinations are possible:

swapping a fixed rate for a fixed rate (in the same currency);
swapping floating rate 1 for floating rate 2 (called benchmark switching);
swapping a fixed rate in currency 1 for a fixed rate in currency 2;
swapping a fixed rate in currency 1 for a floating rate in currency 2;
swapping a floating rate in currency 1 for a floating rate in currency 2.

These last three swaps come with an exchange of principal, as the two parties use different currencies. This exchange is generally done at the beginning and at the maturity of the swap at the same exchange rate. More sophisticated swaps make it possible to separate the benchmark rates from the currencies concerned.

The swaps market is very large and banks are key players. Company treasurers appreciate the flexibility of swaps, which allow them to choose the duration, the floating benchmark rate and the notional amount. Note, finally, that a swap between a bank and a company can be liquidated at any moment by calculating the present value of future cash flows at the market rate and comparing it to the initial notional amount. Swaps are also frequently used to manage interest rate risk on floating or fixed-rate assets.

The concept of the swap has been enlarged with total return swaps. Two players swap the revenues and change in value of two different assets they own during a certain period of time. One of the assets is generally a short-term loan, the other one can be a share price index, a block of shares, a portfolio of bonds, etc. Equity swaps thus make it possible to gain exposure to a share without having to acquire it.

Contingent futures contracts make it possible to hedge situations where the company is not certain it will carry out a transaction (e.g. acquisition via auction, call for tenders). The futures contract is entered into but lapses if the transaction does not take place.

4/ INSURANCE

Insurance allows companies to pay a premium to a third party, which assumes the risk if that risk materialises. If it doesn’t, companies will lose the premium but can benefit from a favourable trend in the parameter hedged (exchange rate, interest rates, solvency of a debtor, etc.).

As we saw in Chapter 23, an option gives its holder the right to buy or sell an underlying asset at a specified price on a specified date, or to forego this right if the market offers better opportunities. See Chapter 23 for background, valuation and conditions in which options are used.

Options may look like an ideal management tool for company treasurers, as they help guarantee a price while still leaving some leeway. But, as our reader has learned, there are no miracles in finance and the option premium is the price of this freedom. Its cost can be prohibitive, particularly in the case of companies operating businesses with low sales margins.

In addition, the premium must appear on the income statement, whereas a forward contract may, under certain conditions, be mirrored to its underlying asset in the books (hedge accounting).

Major international banks are market makers on all sorts of markets. Below we present the most commonly used options.

(a) Currency options

Currency options allow their holders to lock in an exchange rate in a particular currency while retaining the choice of realising a transaction at the spot market rate if it is more favourable. Of course, the strike price has to be compared with the forward rate and not the spot rate. Banks can theoretically list all types of options, although European-style options are the main ones traded.

While standardised contracts are listed, treasurers generally prefer the over-the-counter variety, as they are more flexible for choosing an amount (which can correspond exactly to the amount of the flow for companies), dates and strike prices. Options can be used in many ways. Some companies buy only options that are far out of the money and thus carry low premiums; in doing so, they seek to hedge against extreme events such as devaluations. Other companies set the strike price in line with their commercial needs or perhaps their expectations.

Given the often high cost of the premium, several imaginative (and risky) products have been developed, including average strike options, lookback options, options on options and barrier options.

Average strike options⁷ can be used to buy or sell currencies on the basis of the average exchange rate during the life of the option. The premium is thus lower, as less risk is taken by the seller and the buyer has a lower return potential.

Lookback options are options where the strike price is fixed at the lowest price reached by the underlying asset during the life of the call option, and at its highest price for a put option. This kind of option cancels all opportunity cost, consequently its premium is high.

Options on options are quite useful for companies bidding on a foreign project. The bid is made on the basis of a certain exchange rate, but let’s say the rate has moved the wrong way by the time the company wins the contract. Options on options allow the company to hedge its currency exposure as soon as it submits its bid, by giving it the right to buy a currency option with a strike price close to the benchmark rate. If the company is not chosen for the bid, it simply gives up its option on the option. As the value of an option is below the value of the underlying asset, the value of an option on an option will be low.

Barrier options are surely the most frequently traded exotic products on the market. A barrier is a limit price which, when exceeded, knocks in or knocks out the option (i.e. creates or cancels the option). This reduces the premium.

It’s easy to imagine various combinations of barrier options (e.g. knock-out barrier above the current price or knock-in barrier below; options at various strike prices, one activated at the level where the other is deactivated, etc.). When a bank offers a new currency product with a strange earnings profile (accumulators⁸), it is generally the combination of one (or several) barrier option(s) with other standard market products.

Barrier options are attractive but require careful management as treasurers must constantly keep up with exchange rates in order to maintain their hedging situation (and to rehedge, if the option is knocked out). Moreover, their own risk-management tools would not necessarily tell them the exact consequences of these products or their implied specifications.

(b) Interest rate options

The rules that apply to options in general obviously apply to interest rate options. For the financial market, the exact nature of the underlying asset is irrelevant to either the design or valuation of the option. As a result, many products are built around identical concepts and their degree of popularity is often a simple matter of fashion.

A cap allows borrowers to set a ceiling interest rate above which they no longer wish to borrow and they will receive the difference between the market rate and the cap rate.

A floor allows lenders to set a minimum interest rate below which they do not wish to lend and they will receive the difference between the floor rate and the market rate.

A collar or rate tunnel involves both the purchase of a cap and the sale of a floor. This sets a zone of fluctuation in interest rates below which operators must pay the difference in rates between the floor rate and market rate and above which the counterparty pays the differential between the market rate and the cap rate. This combination reduces the cost of hedging, as the premium of the cap is paid partly or totally by the sale of the floor.

Do not be intimidated by these products, as the cap is none other than a call option on an FRA borrower. Similarly, the floor is just a call option on an FRA lender. As we have seen, these products allow operators to set a borrowing or lending rate vis-à-vis the counterparty. These options are frequently used by operators to take positions on the long part of the yield curve.

Swaptions are options on swaps, and can be used to buy or sell the right to conclude a swap over a certain duration. The underlying swap is stated at the outset and is defined by its notional amount, maturity and the fixed and floating rates that are used as benchmarks.

Some banks have combined swaps with swaptions to produce what they call swaps that can be cancelled at no cost. Do not be too impressed by the lack of cost. This product is none other than a swap combined with an option to sell a swap. The premium of the option is not paid in cash but factored into the calculation of the swap rate.

Barrier interest rate options are similar to barrier currency options:

either the option exists only if the benchmark rate reaches the barrier rate; or
the option is knocked in only if the benchmark rate exceeds a set limit.

The presence of barriers reduces the option’s premium. Company treasurers can combine these options with other products into a custom-made hedge. Like barrier currency options, barrier interest rate options often require careful management.

(c) Confirmed credit lines

In exchange for a commitment fee, a company can obtain short- and medium-term confirmed credit lines from banks, on which it can draw at any time for its cash needs. A confirmed credit line is like an option to take out a loan.

(d) Credit insurance

Insurance companies specialising in appraising default risk (Euler Hermes, Atradius, Coface, etc.) guarantee companies’ payment of a debt in exchange for a premium equivalent between 0.1% and 2% of the nominal.

(e) Credit derivatives

Credit derivatives are used to unlink the management of a credit risk on an asset or liability from the ownership of that asset or liability.

Developed and used first of all by financial institutions, credit derivatives are sometimes used by major industrial and commercial groups (less than 10% of volume) mainly to reduce the credit risk on some clients.

The most conventional form of credit derivative is the credit default swap (or CDS). In these agreements, one side buys protection against the default of its counterparty by paying a third party regularly and receiving from it the predetermined amount in the event of default. The credit risk is thus transferred from the buyer of protection (a company, an investor, a bank) to a third party (an investor, a bank, an insurance company, etc.) in exchange for some compensation.

Some regulators question the possibility of issuing this type of product if it does not effectively hedge a risk and is then pure speculation on the issuer’s repayment capacity.

Exponential development for better hedging of an old risk…, or for better speculating as in the case of the leading US insurance company AIG, which almost resulted in its collapse in late 2008 and a crisis in the credit derivatives market which is below its 2005 level in 2020.
*Source:* Data from Bank for International Settlements (BIS)

(f) Political risk insurance

Political risk insurance is offered by specialised companies, such as Unistrat-Coface and SACE, which can cover 90–95% of the value of an investment for as long as 15 years in most parts of the world. Risks normally covered include expropriation, nationalisation, confiscation and changes in legislation covering foreign investments. Initially the domain of public or quasi-public organisations, political risk insurance is increasingly being offered by the private sector.

Section 51.4 ORGANISED MARKETS – OTC⁹ MARKETS

1/ STANDARDISATION OF CONTRACTS

In the forward transactions we looked at in Section 51.3, two operators concluded a contract, each exposing themself to counterparty risk if the other was in default at the delivery of the currency, for example, or before the maturity of the swap. Finally, the product’s liquidity was unreliable. Liquidity is closely tied to the product’s specificity, and usually dependent on the willingness of the counterparty to unwind the transaction.

It is because of these drawbacks that investors turn to standardised products that can be bought and sold on an organised market, like a stock on the stock exchange. The futures and options markets have responded to this demand by offering a liquid and listed product, with a clearing house, and specialised traders who act as intermediaries and ensure that the market functions properly.

Let’s take the example of a three-month Euribor traded on ICE Future Europe, which has a €1m notional value. The contract matures on the twentieth day of March, June, September and December. It is listed in the form of 100 minus three-month Euribor and can thus be compared immediately with bond prices. The initial deposit is €500 per contract and the minimum fluctuation is 0.005.

The high degree of standardisation in futures ensures fungibility of contracts and market liquidity. Liquidity is often greater on futures than on the underlying asset, as, unlike the underlying assets, futures volumes are not limited by the amount actually in issue.

Eurex, ICE Futures Europe and Chicago future markets are the main marketplaces offering contracts for managing interest rates and commodity prices.

As listed contracts have become more liquid, standardised options have emerged on these contracts, which allow financial institutions and companies to take positions on the volatility of contract prices. Organised currency risk management markets are still in their infancy, as the dominance of banks in forward currency transactions constitutes an obstacle to the development of contracts of this type.

2/ UNWINDING OF CONTRACTS

In theory, when a contract matures, the buyer buys the agreed quantity of the underlying asset and pays the agreed price. Meanwhile, the seller of the contract receives the agreed price and delivers the agreed quantity of the underlying asset. This is the mechanism of delivery. For futures markets to be viable and to function properly, there must be at least the theoretical possibility of delivery. Possibility of physical delivery prevents the contract prices from being fully disconnected from price trends in the underlying asset. In other words, the value of the contract at maturity is equal to the value of the underlying asset at that time.

If it were otherwise, arbitrations using the physical delivery option would occur. This is quite rare because markets self-regulate. At maturity, buyers of contracts sell them to the sellers at a price that is equivalent to the price of the underlying asset at the time. The purchase of a futures contract is normally unwound by selling it. The sale of a futures contract is normally unwound by buying it back.

While upon maturity, the spot price and the future price will coincide; prior to maturity on the other hand, the difference between the spot price and the future price, known as the “base”, varies and is only rarely reduced to zero.

3/ ELIMINATING COUNTERPARTY RISKS

Derivatives markets offer considerable possibilities to investors, as long as everyone meets their commitments. The possibility of them not doing so is called counterparty risk. And such a risk, while small, does exist. For example, a contract could be so unfavourable for an operator that they might decide not to deliver the securities or funds promised, preferring to expose themself to a long legal process rather than suffer immediate losses. And even when everyone is operating in good faith, could not the bankruptcy of one operator create a domino effect, jeopardising several other commitments and considerable sums?

Unless specific measures are in place, counterparty risk should certainly be considered the main market risk. But, in fact, markets are organised to address this concern.

Derivatives market authorities may, at any time, demand that all buyers and sellers prove they are financially able to assume the risks they have taken on (i.e. they can bear the losses already incurred and even those that are possible the next day). They do so through the mechanism of theclearing, deposits and margin calls. The clearing house is, in fact, the sole counterparty of all market operators since the first one appeared in Le Havre in 1882.

The buyer is not buying from the seller, but from the clearing house. The seller is not selling to the buyer, but to the clearing house. All operators are dealing with an organisation whose financial weight, reputation and functioning rules guarantee that all contracts will be honoured.

Clearing authorities demand a deposit on the day that a contract is concluded. This deposit normally covers two days of maximum loss.

Daily price movements create potential losses and gains relative to the transaction price. Each day, the clearing house credits or debits the account of each operator for this potential gain or loss.

When it is a loss, the clearing house makes a margin call – i.e. it demands an additional payment from the operator. Hence, the operator’s account is always in the black at least by the amount of the initial deposit. If the operator does not meet a margin call, the clearing house closes out its position and uses the deposit to cover the loss.

For potential gains, the clearing house pays out a margin.

When the contract has exceeded the clearing house’s maximum regulatory amount, price quotation is stopped and the clearing house makes further margin calls before quotation resumes.

It should be noted that OTC hedging contracts generally fit into a relatively standardised framework agreement (similar to models proposed by ISDA¹⁰). These framework agreements often provide for margin calls as in organised markets.

4/ IMPORTANT LEVERAGE EFFECT

Margin calls are an integral component of derivatives markets. By limiting the amount of the initial deposit, margins provide considerable leverage to investors. Let’s take the example of cocoa futures contracts and let’s assume a guarantee deposit of £75. On 21 March, we buy a July cocoa contract for £1,887/tonne. In July, cocoa is quoted at maturity at £2,000/tonne on the spot market. We used futures contracts to procure July cocoa for £1,887/tonne, hence a £113 gain for a very limited outlay (just the deposit of £75). The return is considerable: 113 / 75 = 151%, whereas cocoa has gone up just (2,000 – 1,887) / 1,887 = 6%. Here is an example of the steep leverage of futures, but leverage can also work in reverse.

Such steep leverage explains why counterparty risk is never totally eliminated, despite precautions that are normally quite effective. Margin calls limit the extent of potential defaults to the losses that are incurred in one day, while the initial deposit is meant to cover unexpected events.

This leverage effect is not typical of organised derivative markets, it is typical of derivative products. The mechanics of a clearing house do not make it possible to eliminate this leverage but they ensure that at any point in time, each market player can meet the consequence of its positions. This theoretically avoids a chain reaction in case of bankruptcy.

OTC markets are much larger than organised markets due to interest swaps, as a consequence of the 2008 financial crisis.
*Source:* Data from Bank for International Settlements (BIS)

Companies are required to file declarations for hedging transactions using over-the-counter or market instruments (European Market Infrastructure Regulation – EMIR).

5/ A ZERO-SUM GAME

Futures are a zero-sum game, as what one operator earns, another loses. The aggregate of market operators gets neither richer nor poorer (when excluding intermediation fees).

Let’s take the above example of a tonne of cocoa quoted at £2,000 at the end of July. We saw that the person who bought contracts on 21 March has earned £113 per tonne. On the other side, the operator who sold those contracts on 21 March must deliver cocoa at the end of July for £1,887, even though it is priced at £2,000. They will thus lose £113, the exact amount that their counterparty has earned.

This is not only a zero-sum game but also a worthwhile game. Derivatives markets are there not to create wealth, but to spread risk and to improve the liquidity of the financial markets. On the whole, there is no wealth creation.

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

Managing risk inside a company has become a hot issue: regulations are much stricter, and there is strong pressure from investors for more transparency and greater awareness by top management.

Risk management requires identification of risks, setting up controls, measuring the residual risk and lastly choosing a hedging strategy.

Risk is characterised by frequency and intensity.

We can identify five major risks:

market risk – i.e. exposure of the company to unfavourable changes in interest and exchange rates or prices of raw materials or shares;
counterparty risk – i.e. the loss of repayments of a debt in the event of default of the creditor;
liquidity risk – i.e. the inability of a company to make its payments by their due date;
operating risk – i.e. the losses caused by errors on the part of employees, systems and processes;
political risk – i.e. the impacts on importers, exporters and companies that invest abroad.

Market risks are measured with the notion of position and value at risk (VaR). Liquidity is measured by comparing debt repayment and expected cash receipts. Techniques for measuring other risks are still in their infancy.

When confronted with risk, a company can:

decide to do nothing and take its own hedging measures. This will only apply to small risks or some very large corporates;
lock in prices or rates for a future transaction by means of forwardation;
insure against the risk by paying a premium to a third party, which will then assume the risk if it materialises. This can take the form of an option;
immediately dispose of the risky asset or liability (securitisation, defeasance, factoring, etc.).

The same types of product (forward buying, put options, swaps, etc.) have been developed to cover the five different risks and are traded either on the over-the-counter (OTC) markets or on stock exchanges. On the OTC market, the company can find products that are perfectly suited to its needs, but there is the counterparty risk of the third party that provides the hedging. This problem is eliminated on the futures and options markets, although the price paid is reduced flexibility in tailoring products to companies’ needs.

QUESTIONS

1/What are the five financial risks that companies are exposed to?
2/Describe five ways for a company to deal with risk.
3/You plan to use arbitrage to calculate forward selling of yen against euros at three months. What information do you need to do the calculation?
4/What is an FRA?
5/What is a future?
6/A Portuguese company imports maize from Mexico, which it in turn exports to Canada. The company pays and is paid at three months (the maize is, in fact, shipped direct from Mexico to Canada). Should it buy or sell a peso call option or a put option against the Canadian dollar?
7/What are the differences between OTC forward transactions and futures?
8/What role does a clearing house play?
9/Can credit derivatives be based on options?
10/Does a derivative product have to be sufficiently liquid to be attractive?
11/Can you provide examples of hedging products used by individuals?
12/What category of derivative products would personal injury insurance fit into?
13/Should corporate treasurers take advantage of any arbitrages that they detect on the markets?
14/Should traders take advantage of any arbitrages that they detect on the markets?
15/Excluding any costs, can a company hedge against all of its risks, taking the risk of opportunity into account? And the trader?
16/A company is hedging more than its actual position. In doing so what is it actually doing?
You’ll find more questions at www.vernimmen.com.

EXERCISES

1/Calculate the future buy and sell price at three months (dollar against euro) using the following information:
- the three-month euro rate is equal to –⅞%;
- the three-month dollar rate is equal to 3⅞ – 4%;
- the euro is currently trading at $1.0210 / 20.
2/Calculate the six-month interest rate of the dollar on the basis of the following information:
- the six-month euro rate is equal to – ⅝%;
- the euro is currently trading at $1.0210 / 20;
- the euro is trading at six months at $1.0150 / 60.
3/A market trader is offering a $500m loan agreement in three months, for a period of three months, on the following terms: 3¾ – 3⅞%. Using the information provided in Exercises 1 and 2, can you identify an arbitrage opportunity? What is the potential gain for the arbitrageur?
4/Is an arbitrage of this sort really without risk?
5/If a corporate treasurer finds themself in the situation described above, should they execute the arbitrage?

ANSWERS

Questions

1/Market, liquidity, political, operational and counterparty risk.
2/Avoidance, self-hedging, locking in prices or interest rates now, taking out insurance, disposing of the risky asset or liability.
3/See Section 51.3, 3/(a). Three-month yen borrowing rate. Three-month euro investment rate. Yen/euro spot price.
4/See Section 51.3, 3/(b).
5/A forward purchase or sale contract traded on an exchange where the counterparty risk is eliminated by the clearing house but the contracts are not tailor-made.
6/Purchase of a call option on pesos because its risk is that of a rise in the peso.
7/Futures are traded on an organised market that eliminates counterparty risk and offers standardised contracts that are more or less adapted to the needs of the company. OTC contracts have opposite advantages and disadvantages.
8/Eliminating counterparty risk thanks to deposits and margin calls.
9/Yes there is no limit to imagination.
10/No – it may be an OTC product, like most of them.
11/All insurance policies.
12/A floor, which guarantees you a minimum price just as insurance restores the value of a property that would have been lost due to an accident.
13/No, there is no such thing as a perfect arbitrage, and there is often an element of speculation. Accordingly, it does not fall within the remit of a corporate treasurer.
14/Yes, of course – that’s what traders do.
15/No, because it cannot wind up its business. Yes, because they can wind up their commitments.
16/It is speculating.

Exercises

A detailed Excel version of the solutions is available at www.vernimmen.com.

1/Three-month forward euro exchange rate: $1.0185 – $1.0201.
2/Six-month dollar interest rate: 3.099% – 3.623%.
3/You should borrow $495.2m at six months at 3.623%, invest it at 3⅞% in dollars for three months (you will then have $500m in three months) and buy the traders’ contract. The value of the arbitrage gain is $514,380 to be cashed in with no risk at maturity of the contract.
4/No, there is always the counterparty risk of the trader offering the contract.
5/No, because there is no way of measuring counterparty risk or any of the other market inefficiencies. For the corporate treasurer, this transaction would amount to financial speculation and, accordingly, would not form part of the ordinary course of the company’s business.

BIBLIOGRAPHY

M. Albouy, P. Dupuy, Selective hedging of foreign exchange risk: New evidence from French non-financial firms, International Management, 21(4), 76–88, Summer 2017.
J. Graham, C. Harvey, The theory and practice of corporate finance: Evidence from the field, Journal of Financial Economics, 60(2–3), 187–243, May 2001.

On the theory behind the purpose and practice of hedging:

T. Adam, C. Fernando, Hedging, speculation and shareholder value, Journal of Financial Economics, 81(2), 283–309, August 2006.
K. Ben Khediri, D. Folus, Hedging and financing decisions, Bankers, Markets & Investors, 98, 28–38, January–February 2009.
B. Biais, F. Heider, M. Hoerova, Risk-sharing or risk-taking? Counterparty-risk, incentives and margins, Journal of Finance, 71(4), 1669–1698, August 2016.
G. Brown, Managing foreign exchange risk with derivatives, Journal of Financial Economics, 60(2&3), 401–448, May 2001.
G. Brown, K. Bjerre Toft, How firms should hedge, Review of Financial Studies, 15(4), 1283–1324, Autumn 2002.
M. Campello, Ch. Lui, Y. Ma, H. Zou, The real and financial implications of corporate hedging, Journal of Finance, 66(5), 1615–1647, October 2011.
M. Faulkender, Hedging or market timing? Selecting the interest rate exposure of corporate debt. Journal of Finance, 60(2), 187–243, May 2001.
G. Gay, C.-M. Lin, S. Smith, Corporate derivatives use and the cost of equity, Journal of Banking and Finance, 35(2011), 1491–1506, 2011.
Y. Le Fur, P. Quiry, Should one borrow at a fixed or floating rate?, The Vernimmen.com Newsletter, 48, 1–5, February 2010.
M. Lievenbrück, Th. Schmid, Why do firms (not) hedge? Novel evidence on cultural influence. Journal of Corporate Finance, 25, 92–106, April 2014.
P. Mackay, S. Moeller, The value of corporate risk management, Journal of Finance, 62(3), 1379–1419, June 2007.
F. Pérez-González, H. Yun, Risk management and firm value: Evidence from weather derivatives, Journal of Finance, 68(5), 2143–2176, October 2013.
B. Rountree, J. Weston, G. Allayannis, Do investors value smooth performance?, Journal of Financial Economics, 90(3), 237–251, December 2008.
G. Vuillemey, The value of central clearing, Journal of Finance, 75(4), 2021–2053, August 2020.

And for more about credit derivatives:

G. Chacko, A. Sjöman, H. Motohashi, V. Dessain, Credit Derivatives: A Primer on Credit Risk, Modeling and Instruments, 2nd edn, FT Press, 2015.
A. Lipton, A. Rennie, The Oxford Handbook of Credit Derivatives, Oxford University Press, 2013.

On the transfer of alternative risks:

K. Froot, The market for catastrophe risk: A clinical examination, Journal of Financial Economics, 60(2&3), 529–571, May 2001.

On political risks:

M. Bouchet, C. Fishkin, A. Goguel, Managing Country Risk in an Age of Globalisation, Palgrave Macmillan, 2018.
D. Wagner, Managing Country Risk: A Practitioner’s Guide to Effective Cross-border Risk Analysis, Productivity Press, 2012.

On value at risk:

M. Auer, Hands-on Value-at-Risk and Expected Shortfalls: A Practical Primer, Springer, 2018.
M. Choudhry, An Introduction to Value-at-Risk, 5th edn, John Wiley & Sons, Inc., 2013.
M.Leippold, Don’t rely on VaR, Euromoney, 36–49, November 2004.

On pension obligations:

G. Kimyagarov, A. Shivdasani, Managing pension risks: A corporate finance perspective, Journal of Applied Corporate Finance, 25(4), 41–49, Autumn 2013.
Y. Le Fur, P. Quiry, Whether or not to finance pension obligations, The Vernimmen.com Newsletter, 94, 1–4, May 2016.

For a global view on risk:

G. Bénéplanc, J.-Ch. Rochet, Risk Management in Turbulent Times, Oxford University Press, 2012.
Deloitte, Risk Management Survey, 12th edn, 2021.
S. Myint, F. Famery, The Handbook of Corporate Financial Risk Management, 2nd edn, Risk Books, 2019.
N.N. Taleb, The Black Swan: The Impact of the Highly Improbable, Penguin, 2008.

NOTES

1 Excluding market products such as cat bonds, where the coupon or redemption price is drastically cut in the event of an occurrence of a disaster suffered by the issuer.
2 See Chapter 18.
3 That is, the use of an average exchange rate for the P&L and the closing rate for the balance sheet.
4 The reinsurance market allows insurers to transfer part of their risks to other insurance companies, called reinsurance companies, which act as insurers for insurers.
5 If the swap exists as a hedge for an existing debt (or asset).
6 Secured Overnight Financing Rate that will soon replace the USD Libor; Euro Interbank Offered Rate.
7 Also called Asian options.
8 Products allowing the buildup over a period of time of a hedge at attractive rates… if market conditions are favourable.
9 Over the counter.
10 International Swap and Derivatives Association.

Chapter 52. MANAGING OPERATIONAL REAL ESTATE

Fifty shades of rent

Methods for managing operational real estate differ from group to group. Some prefer to remain the king of the castle and own their operational real estate, while others consider these blocked assets as frozen cash that could be better used in developing the group’s core business more rapidly. Even within a given sector, strategies differ from one player to another, over time, or within the same group.

There are, however, three facts that are clear: managing operational real estate is a real issue, which has become increasingly sophisticated under the influence of private equity firms and real-estate professionals. Often within the company, the different departments all have their own opinion on real estate – the finance department of course, but also legal, human resources and operations. An internal real-estate department or an external advisor is often necessary for consolidating all of the views of all of these departments and providing general management with rational proposals that are solely in the interest of the company.

The problem of managing real estate is certainly more acute in sectors where real estate plays a key role (the hotel, retail, restaurant, health and leisure sectors) than in others, but it impacts on all companies, even if only in terms of their headquarters.

Finally, this chapter does not concern real-estate assets which have a very specific purpose, such as a nuclear power plant or a petrochemical factory, the redeployment of which would be prohibitively expensive to carry out.

Section 52.1 METHODS FOR FINANCING REAL ESTATE

1/ REAL ESTATE FINANCED USING EQUITY CAPITAL

Real-estate assets have the advantage, as a general rule, of maintaining a high value that is unrelated to the operational process and that is relatively not very volatile. Accordingly, they are, in theory, attractive and can be used to back financing through borrowing. Even if real estate is financed using equity capital without it explicitly constituting a guarantee for lenders in one way or another, it is still a source of comfort for the group’s bankers. It is also important to bear in mind that raising debt backed by real estate may seem like the easy option, but it could handicap the company at a later stage when it is seeking to raise ordinary debts, since the lenders will know that the real estate has already been pledged to third parties.

Financing real estate using equity capital means keeping room for manoeuvre in the future (with the possibility in the future of selling it, renting it, or by offering it as collateral) and providing comfort to shareholders and lenders, but also suppliers, customers and staff vis-à-vis the solvency and thus the long-term success of the company.

2/ REAL ESTATE AS BACKING FOR STANDARD LOANS

A mortgage, i.e. a pledge of a real-estate asset to a lender, is the most direct way of backing a debt with a real-estate asset. What happens in such cases is that the proceeds of the sale of the asset are used to reimburse the creditor directly. Nevertheless, in countries where it is a cumbersome and expensive process, this type of financing is generally only used by very small and small to medium-sized companies, which do not necessarily have access to other forms of financing. With a mortgage loan it is possible to easily raise up to 50% of the value of the asset (the loan to value ratio is called “loan to value”, LTV). In Anglo-American countries, mortgage loans on commercial assets are more common and the loan to value ratio can be up to 70%.

In some countries, a trust is a more secure way for the lender to finance real estate. The real estate assets are placed in a trust of which the bank is the trustee. This does not result in a transfer of ownership (i.e. no capital gain and hence no tax cost).

But there are other less formal ways of securing a loan with real estate. These assets may be covered, under a loan agreement (or a bond), by a so-called negative pledge which prevents the company from using its real estate as a guarantee to other lenders, or selling it. Additionally, banking covenants (see Section 39.2) may oblige the company to keep a minimum amount of real estate on its balance sheet. Such covenants are significantly more flexible than taking out a direct guarantee on a property, as they enable the company to carry out arbitrage on its real-estate assets.

Finally, securitisation of real-estate assets (see Section 21.3) is only an option for real-estate groups or for very large industrial groups which own a lot of real estate. Label’Vie, a Carrefour franchisee in Morocco, securitised some of its shops in 2020 for €40m, after an initial operation in 2013 for €45m.

3/ FINANCE LEASE

A finance lease is a common tool used for financing real-estate assets over a long period (up to 15–20 years). For a company, this means having a real-estate asset acquired by a specialised financial institution (which must either be a bank or a financial firm) and then leasing it (see Section 21.3). At the end of the finance leasing agreement, the company can either acquire the asset for a small or symbolic amount, or leave it to the financial lessor or possibly continue to lease it (at a reduced rent as it no longer covers the amortisation of the asset). The financial lessor remains the owner of the asset for the duration of the agreement, which ensures its liquidity in the event of the company defaulting, since it can re-let it to a third party if there is no secondary market for the real-estate asset, which would be too specific.

Property leasing generally covers 80% of the value of an asset, which is more than for a standard loan and at a lower interest rate. Additionally, financial lessors are often prepared to finance more than 90% of the value of necessary renovations.

In most countries, property finance leasing presents a marginal tax advantage as the rent reflects an accelerated amortisation of the property. Even if this surplus amortisation must be taken up when the option is lifted, the company would have benefited from postponement of the tax paid.

4/ OPERATING LEASE

For ordinary rental, the company only makes a commitment for the duration of the operating lease. This may vary widely depending on the aims of the company and the lessor, but also in line with the type of property and the country.

Rents can be indexed according to activity either to a commercial rents index or consumer prices, new construction price changes in retail sales or the change in GDP, or any other index the parties agree upon. Indexing rents to an independent index of the company’s economic activity results in the risk of a negative scissors effect over which the company has no control. So some groups have opted for rents that are totally or partially indexed to the activity of the site exploited (e.g. rent indexed to turnover). Some groups have even succeeded in forcing the property owner to agree to a rent cap in line with earnings of the activity exploited.

We refer to the capitalisation rate to designate rent divided by the value of the asset.

5/ SALE AND LEASEBACK

Sale and leaseback is an implementation method and not a type of financing as such. This operation enables a company to change from an equity capital financing to a rental. Some use the term leaseback to refer to the sale of a real-estate asset and its subsequent rental with an option to buy (usually though a finance lease), others do not draw a distinction and refer to a sale and leaseback whether there is an option to buy (finance lease) or not (operating lease).

The sale and leaseback system enables the company to free up cash and also to unlock the market value of the real estate with the pros (strengthen equity capital in the event of capital gains) and cons (possible tax to be paid on capital gains) that this brings.

Section 52.2 CRITERIA FOR CHOOSING REAL-ESTATE FINANCING

1/ MATURITY OF THE COMPANY

A young company, in its high-growth phase, will need large amounts of cash to develop its activity. Additionally, as its perimeter (and sometimes even its economic model) is not yet fixed, its real-estate requirements will vary sharply over time. In such cases, an operating lease seems to be the most suitable choice in order to provide maximum flexibility while not depleting supplies of cash, a resource that is very precious at this stage. There’s no point in buying premises only to find that they’re too small in a few quarters’ time. When choosing a lease, don’t be swayed by the immediate advantages that may go with a longer lease (no rent for several months, reduced charges) instead of a shorter lease, and then a few years later find yourself stuck with a building but not enough business to justify it.

On the other hand, a company that has reached maturity could seriously consider investing in its real estate. In particular, it could secure its strategic operating assets by owning them outright. This is how Chanel acquired in 2020 (for £310m) the building on Bond Street which houses its London shop on 12,600 square feet, paying £70m more than the price initially required as there were many buyers. Owning a large chunk of real estate could also be a form of saving for a rainy day in the case of a major investment opportunity or financial difficulty linked to an economic downturn.

Midway between these two cases is the company that has reached maturity on its market and which externalises its operating real estate in order to finance growth on new markets. Once the commercial concept has taken hold on these new markets, the company then again has the option of externalising the financing of its operating real estate.

2/ SHAREHOLDERS

The role of shareholders is especially important in terms of a company’s real-estate policy when such companies are family owned, for both psychological and asset-related reasons.

Very often, a family will be attached to a building or a geographical area where the company took off or which marks a very important step in the company’s life. There may be reasons that are not at all rational why it may be reluctant to sell its property. For example, take the Publicis building at the top of the Champs-Elysées, which was destroyed by fire in 1972 and rebuilt.

It is, moreover, frequent to see a family-owned holding company or a family-owned real-estate investment firm holding all or part of the operating real estate that it rents to the company and that it finances using debt that is repaid with the rent received. This arrangement enables an entrepreneur who is approaching retirement age, and who wishes to secure their revenues, to be more exposed to real estate than to the operating activity. They just need to increase the size of their stake in the real-estate company and gradually dilute their stake in the operating company. In time, real estate that is personally owned can then be sold to the company, thus constituting a larger retirement capital, all the more so when capital gains tax on real estate is regressive and falls to zero after a certain number of years of ownership.

In the same vein, the head of a family-owned company who has several children could leave the operational activity to the child who is best suited to carrying on the business and leave the real estate (and any other non-strategic assets) to the other children. This sort of arrangement will prevent the company from getting bogged down in fratricidal wars or incompetent siblings being left in top management positions.

Real estate can also be considered as a reserve of value and liquidity in the event of a major issue, and as a stabiliser of the company’s value, following the example of the CMA CGM tower in Marseille for the eponymous group.

3/ OPERATIONAL CONSTRAINTS AND OPPORTUNITIES

A company’s real-estate assets do not all serve the same purpose and they can be classified into several categories:

very specific assets, the location of which is key, e.g. the Harrods building on Knightsbridge or the Saks Building on 5th Avenue;
ordinary real-estate assets which, if the company moved location, would not result in a significant impact. Office blocks fall into this category;
non-strategic operating assets or assets of which the long-term usefulness is not apparent.

The first category of real-estate assets has a value for the company over and above the turnover generated, which is the brand value, the value of its image. Additionally, the company often wishes to retain the freedom to restructure the building, to choose its neighbours (co-operators), etc. Only full ownership and possibly capital leasing (which is deferred full ownership) allows it to guarantee this flexibility. Moreover, a decision by the landlord not to renew an operating lease cannot be excluded, which is why ownership is often preferred for this kind of asset.

Some real-estate groups that have acquired ownership of buildings are now seeking to take back the business and/or the operation. The reason for this is simple. In many sectors, a building only has value as a result of the rent that the tenant can pay. If the tenant improves its income statement substantially as a result of its commercial actions, management and renovation work, it will be able to pay higher variable rent to the owner.

For ordinary buildings, operational flexibility is of little interest and the group can generally neglect operational issues in the choice of a holding system. In this case, the choice between ownership and a rental method is purely a financial arbitrage.

For non-strategic assets or assets that the group does not intend to hold long term, maximum flexibility is achieved by renting. This enables the group to decide more easily between locations and increases the number of potential buyers if the activity is sold (because the selling price is reduced). A game then sets in between the seller, who remains in the building as a tenant, and the buyer, which revolves around the length of the lease and the probability that the tenant will renew the lease or not. The new owner of the property will lose out if the tenant ends up staying for a shorter term than expected, because it will then incur costs for finding a new tenant, for upgrading the building and in lost rent.

For example, Peugeot sold its Paris headquarters in 2012 to help it cope with a serious crisis and opted for a location in Rueil-Malmaison. This gave it the flexibility in June 2020 to leave it and spread its employees over existing industrial sites… and work from home 80% of the time to reduce its office space by 30%. This move would undoubtedly have been much more difficult with a head office that was still in full ownership, quite old, and unsaleable in the middle of a lockdown!

4/ TAXATION

Of course, taxation has to be factored in – capital gains tax in the case of a sale and leaseback, during the exploitation of the asset (deductibility or real-estate charges) and the eventual sale of the asset (capital gains tax).

The revaluation of a relatively old building when it is sold generally results in capital gains taxable at the normal corporation tax rate for the company selling the asset, but makes it possible to create (for the acquirer) a tax base linked to the future amortisation of the asset. Taxation will generally be negligible for a newly constructed building that is sold.

Capital gains tax is a major issue in a sale to a third party and could create an obstacle for an internal restructuring without generating any cash with which to pay this tax. However, for a company that has tax losses carried forward, capital tax can then be reduced (or sometimes eliminated altogether) and will balance out with the present value of the future tax saving due to the tax base created by the revaluation of the carrying price of the real-estate asset.

It is worth noting that many countries have a special type of real-estate company that provides tax transparency. So we get REITs (real estate investment trusts) in the US and the UK, SIIQs in Italy and sociétés d’investissements immobiliers cotées (SIIC) in France. The benefits of this regime are subject (most of the time) to certain constraints in terms of payouts (most rents received and most capital gains made must be paid out as dividends) and in terms of shareholding (a single shareholder may not hold more than a certain percentage of the share capital).

5/ FINANCIAL CONSTRAINTS

When a company’s financial situation is strained, the sale (temporary or permanent) of its real estate may be a solution that can be implemented quickly. It’s a bit like having a nest egg. An example is the supermarket Casino, which in 2018–2019 sold €1.5bn of commercial real estate. If the assets are very specific operational real-estate assets, with no secondary market, the investor will require a long-term commitment from the company to stay on as a long-term tenant.

This operation is the “liquefying” of one of the company’s assets, i.e. the exchange of a promise of future flows (rent) for an amount of cash (the sale price of the property). Here, the real estate becomes a simple financial product. In such cases, the owner is generally a financial investor taking on the possible non-exploitation of the underlying site as its main risk. If the site is a sufficiently key element of the company’s industrial set-up, then this risk is limited. Often, the management of the building will remain mostly the responsibility of the operating tenant, which will also cover the cost of maintaining the site (triple net rent).

6/ FINANCIAL CRITERIA

For a purely financial manager, owning real estate (or another asset) means considering that unless one is the owner thereof, it’s a good idea to buy it. This implies thinking that buying this asset will create value for the company, either because it was bought at a lower price than its market value or because it enables the company to reduce its risk.

The assumption that an acquisition price is lower than the market price (or that a sale price is higher than the market price) implies that the real-estate market is inefficient at a given time. Deciding to sell a property when real-estate prices are high, or to take advantage of a buoyant market to sell real-estate assets, is, if one believes in the theory of efficient markets, simply speculating on the evolution of real-estate prices, which means taking a risk.

Although the acquisition of real estate usually enables the company to reduce its risk, this is not a good enough reason in itself to acquire property. This reduction in risk is only followed by an increase in value if returns decline at a slower pace than the risk. But let’s not deceive ourselves, if real estate is less risky than the company’s capital employed, it will also be less profitable. Here, this ends up being just a type of diversification for the company. And we saw in Section 26.2 that diversification only reduces the specific risk, which is a non-remunerated risk, and that financial synergies do not exist. So most often, it’s naïve to believe that value can be created in this way.

A first step in deciding whether a company should own its real estate or not could be to compare the cash flows of the different options. At the end of this chapter there is an exercise involving such a simulation.

This comparison will require you to determine a discount rate which must differ in line with the methods for owning the property. Since it is often difficult to put an exact figure on the impact of difference in risk on the required rates of return in each situation, we often see people using the same discount rate. Do not be deceived – this is financial heresy.

The problem is often turned the other way round by looking at the difference in yield to maturity between renting and a loan or between a bank loan and real-estate leasing, in order to make a choice.

In the 2000s, capitalisation rates were lower than the interest rates on loans of some groups, encouraging them to sell their real estate. Today, the situation is generally the other way round in Western Europe: we see capitalisation rates of 2.7% to 5.5% compared with interest rates of 1% to 2%.

Accordingly, it is better now to buy real estate (and borrow at 1–2%) rather than to externalise real estate (and pay rent at 3–6%), which explains why today, externalisation operations have become increasingly rare. Unless, of course, you believe that there will be a substantial drop in the value of real estate in the future or you bear very high interest rates due to your financial situation.

Section 52.3 VALUE CREATION AND INVESTOR PERCEPTION

The impact of sale and leasebacks on enterprise value has been considered thoroughly in the academic literature. Grönlund et al. (2008) found that sale and leaseback operations carried out between 1998 and 2003 created value. The results of this study converge with other similar studies, carried out in the UK and the US.

Other more recent studies seem to mitigate these results. The perception of value creation may change over time and, over the long term, rental-related constraints may destroy value, something that would not initially have been obvious, either to the company or to its shareholders.

A financial director considering the impact of externalising their real estate assets will compare the value of the shareholders’ equity with its real estate on the one hand, to the value of the externalised real estate plus the value of the shareholders’ equity without the operating real estate on the other hand. The latter can be rigorously assessed either by the multiples method, with a few precautions, or by a variant of the discounted free cash flow method (Opco/Propco method).

Via the multiples method, three approaches are possible:

use an EBITDA multiple (now that the application of IFRS 16 requires the restatement of operating rents¹);
restrict the sample of comparable companies to those with a similar real estate policy, i.e. those that rent out their operating property;
or, in the multiple of companies that own their own real estate, to reverse the impact of this situation on the multiple by using the following formula:

But if markets are not efficient and do not integrate this way of reasoning, the externalisation of real estate could mechanically create value. In fact, the property is valued on the basis of high multiples that reflect a very low risk (and currently very low interest rates).

AVERAGE EBITDA MULTIPLES OF LISTED REAL-ESTATE COMPANIES IN EUROPE

	2011	2012	2013	2014	2015	2016	2017	2018	2019	2020	2021e	2022e
EBITDA multiple	19.5	20.3	22.2	23.8	28.0	25.5	25.5	25.4	27.4	29.5	27.6	25.3

Source: Exane BNP Paribas

The creation of value linked to the externalisation of real estate should be visible if groups owning their own real estate are valued on the basis of the same EBITDA multiples as those which are renting theirs.

The Opco/Propco method is a discounted free cash flow method adapted to take into account the significant real estate component of a group. The group is then valued as the sum of an operating company (Opco) and a company owning the operating property (Propco) that it leases to the operating branch. The former is valued by discounting its free cash flows, from which the rents (net of corporate income tax) paid to the Propco have been deducted. The latter is valued on the basis of the market value of the operating property (capitalisation of the rent or price per square metre).

From a practical point of view, the appraiser will be sure to discount the free cash flows, after deducting property, rent at a higher discount rate than that observed for a company that owns its operating property. This is because rents are a fixed cash cost (they must be paid whether in real life or as a hypothesis for a calculation!) and therefore raise the breakeven point.

The generalisation of valuations as Opco/Propco² for companies with a large amount of real estate shows that investors are not usually village idiots and that they do take the real-estate part into account in the overall multiple that they attribute to a group!

Section 52.4 AN IDEAL WAY OF ORGANISING REAL ESTATE?

A large number of groups that own operating real estate have understood that this situation could lead to a major drawback, i.e. the fact that operational managers consider real estate as being cost-free or virtually cost-free, because, since depreciation and amortisation is a non-cash cost, it is often considered to be conventional and insignificant.

In order to get around this problem, the group could set up an internal structure with a property subsidiary (Propco, which owns the real-estate assets) and an operational subsidiary (Opco, which rents and operates this real estate). This structure means that operational units are required to pay a rent, which is a way of making operational managers aware of the cost of capital and puts an end to the incorrect perception that real estate that is owned is cost-free.

As an illustration, a few years ago, Galeries Lafayette in the centre of Metz, France, owned and occupied the whole of a building, on the principle that, when real estate is “free”, the store should occupy the whole building. Then, a market-rate rent started to be invoiced to this store, which resulted in operating losses. After some protests, the store managers had to admit that this method of invoicing rent, although new, was not unreasonable because the other group stores, in other regional towns, had third-party landlords. As the loss-making situation could not continue in the long run, the store managers gave serious thought to the nature of the product offering that they provided to their customers, given customer requirements and the competitive situation. They came to the conclusion that they could return to the group one-quarter of the floor space they occupied and still have a relevant offer, while being better placed to respond to competitors on the outskirts of the town. This extra floor space was let by the group to a third-party retailer with a complementary product offer which, combined with the renovation work financed from the rent received, enabled the high-street store to inject new energy into their commercial offer and make it profitable again.

More generally, the setting up of a subsidiary dedicated to real estate means that the group could get professionals in the field to manage the group’s real estate synergistically, because real-estate management is a separate job in itself (asset arbitrage, monitoring of works, real-estate taxation, service providers, etc.).

Using real estate to extend the maturity of debt is made much easier if all of the assets are held within a single vehicle. Finally, if in time the group wishes to sell all or part of its property, internal property can be sold or its capital opened up to third parties.

There are some constraints that limit the setting up of a Propco within a group (mainly, a high latent tax on capital gains could discourage sales between the group’s companies). In a large group, with an elaborate management control system, different reporting units can be structured within the same company to allow analytical accounting to show the presence of an Opco and a Propco virtually, even if such entities do not exist legally.

For a group that owns its real estate and does not publish its financial statements according to this breakdown, external analysts can try to recreate these two components virtually in order to better compare performances with sector peers or to value them in a homogeneous manner.

SUMMARY

The summary of this chapter can be downloaded from www.vernimmen.com.

A company’s real-estate assets can be owned outright and financed using equity capital (i.e. without using them explicitly as backing for a financing), used as backing for a specific financing (mortgage, sale and leaseback) or rented using an ordinary lease. Raising financing backed by real estate can handicap a company in the future if it wished to raise ordinary debt, as the lenders will know that the real estate is already pledged to third parties. Financing real estate using equity capital means keeping room for manoeuvre in the future (with the possibility of selling it or renting it) and providing comfort to shareholders, lenders, suppliers, customers and staff. A sale and leaseback can be used to move from ownership to lease (operating or finance).

The optimal financing method will depend on the nature of the asset (strategic, ordinary or not long term for the group), on the maturity of the group (more rental for a young group and more ownership for a group that has reached maturity), on the desires and constraints of shareholders (in particular when shareholders are family members), on taxation (capital gains) and on the financial constraints with which the group is confronted.

Groups in the same sector with different methods of holding their property will present different growth and risk profiles, which justify valuation multiples that are also different. Investors will take this aspect into account, either by reasoning in terms of EBITDA multiple (i.e. before rent under IFRS standards) or by valuing the operational activity separately from the real-estate activity (Opco/Propco).

The distinction within the company of flows relating to real estate (rent) and flows relating to the operating activity means that the managers of the different sites can be forced to comply with a healthy constraint and thus optimise management. This distinction can be concretised by setting up a real-estate subsidiary that is managed separately or a virtual subsidiary using analytical accounting.

All in all, when it comes to real estate, the financial director must first and foremost be pragmatic.

QUESTIONS

EXERCISE

1/The Multiplax group, the European leader in cinema theatres, is considering an investment in a 15-theatre complex in Dover. The investment would amount to £3.7m for the land and £15m for the building and equipment, to be amortised over 15 years. Multiplax is considering either buying or renting the real estate. The group expects its business to expand as follows:

In thousands of euros	N	N + 1	N + 2	N + 3	N + 4	N +5	N + 6
Sales	—	3,429	5,988	6,800	7,088	7,390	7,635
Cost of goods sold	—	(1,484)	(2,551)	(2,912)	(3,047)	(3,190)	(3,301)
Personnel expense	—	(667)	(887)	(913)	(941)	(969)	(988)
Other operating charges (excl. rent and depreciation and amortisation)	—	(212)	(51)	(169)	(176)	(181)	(197)

Theoretically, for this type of activity, working capital is negative (customers pay cash and the company has practically no inventories), but the careful management has made its projections on the assumption of zero working capital over the whole of the business-plan period.

Given the uncertainties hanging over this project, the group has also taken a terminal value of zero after 20 years (excluding the book value of the land if the group is the owner thereof). On the other hand, the group has not planned to invest in maintenance of the building.

If the group buys the real estate, it intends to finance it through a 10-year bullet loan at 2.5%.

Alternatively, Multiplax could rent the same building from a third party at an annual rent of €1,350m.

Simulate the income statement, balance sheet and cash flow statement for Multiplex according to both methods for holding the real estate (assume a corporation tax rate of 25% and interest on cash at 0%).
Do you think the amount of debt that Multiplax wishes to take out is tenable?
Calculate the NPV on both investments with a cost of capital of 7%.
Is using the same cost of capital justified? At what cost of capital is the NPV of the project with rental equal to the NPV of the project with a purchase of the real estate?

ANSWERS

Questions

1/There is no ideal method for holding real estate and it depends on the company’s parameters (investment opportunities, financial situation) and on those of the target property (strategic for the company or not, in need of renovation, etc.).
2/In general this is false, because even if the interest rate obtained on the real-estate financing looks attractive, it would be to the detriment of other financings for which the cost would be consequently higher, as the lenders would then not benefit from the security provided by the real estate.
3/It is possible that the Houses for the Retired Inc. rents its real-estate assets and that Kentucky Retired Homes owns its real-estate assets. Accordingly, even if the operating risk may be identical, the risk after factoring in the real estate would be lower for the second group. Obviously, there are other explanations that are also possible (fewer growth opportunities for the first group, etc.).
4/Generally, family groups own more real estate. The group is used by the family to diversify its portfolio. Nevertheless, if the group is in a growth phase, this may not be the case as access to equity capital is more limited for a family-owned group, which has to use all of its resources in order to generate alternative financings.
5/Because every time a deal involves selling real estate, there will potentially be taxes to be paid (on the capital gains) – stamp duty, land tax – and because there are tax regimes that are specific to real estate (REIT, SIIC, etc.).

Exercise

A detailed Excel version of the solutions is available at www.vernimmen.com.

1/
1. See on the vernimmen.com website.
2. Yes, but the financial situation of the project would be strained. In fact, the cash flows generated by the project are only just sufficient to reimburse the debt when it matures.
3. On the basis of free cash flows (excluding financing), NPV if real estate owned: €9.2m; NPV if real estate rented: €13.6m. When the financing of the debt is taken into account, the NPV if the real estate is owned would be €17.9m but it would be absurd to keep the same discount rate when the risk has increased as a result of the leverage effect (see Section 28.2, 4/).
4. No, the risk taken is not the same. Without taking the financing into account, the rental project is substantially riskier than the ownership project. The opposite would probably be true if we took the financing using debt into account. Effectively, if the project is a failure, the debt will still be payable, whereas in the case of a rental, the operator would seek to terminate the lease as soon as possible (all would then depend on the terms for ending the lease). 3.7%.

BIBLIOGRAPHY

NOTES

1 See Section 7.12.
2 See Le Fur and Quiry (2010).

	Old (for Gamma)	New (P/E = 50)	New (P/E = 15)	New (P/E = 6)
EPS	0.01	0.0227	0.0145	0.0082
Equity per share	0.03	0.136	0.087	0.049
% of control held by Gamma shareholders	100% of Gamma	75.8%	48.4%	27.3%