The first part of this article was published in the previous issue of the Vernimmen.com newsletter that you can read here.

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 $85 billion in 2019.

 Before the eruption of  covid-19, an investor in an unlisted fund could 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 governance[1] 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 all-in average rate of return of 11.2% per annum over the last 15 years, and 9.9% over 30 years (i.e. a 18.7-fold increase in value);
• They continue to be part of an average investment period of 5 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 is 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[2]. But that was before 2008, although they will most certainly be back. That's why Uber went public in the end. With a valuation of over $80bn, as an unlisted company, the private equity industry ran the risk of running out of steam fairly quickly, especially if Uber continued to push back its equilibrium over time. And since there was market appetite...

It will take some time before private equity funds have the financial means to buy control of one of the giants of the stock market, worth more than €50 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 to 15 bn, 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 €6.8 bn, 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, Latécoère, etc.

It seems clear to us that, again with some exceptions, the future of small and medium-sized listed companies will increasingly be in an unlisted environment, given the advantages and drawbacks of these two types of ownership. This would only be the continuation of a trend that has seen the average size of listed companies increase: doubling since 2010 in France (from €1.3bn to €2.7bn, $8bn in the United States), while the stock market index has risen by only half as much.

5/ 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 Tesla, 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 $7,400bn and the largest European (Amundi) €1,650bn, 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[3].

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 operating leases, 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 Europe). 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[4], where, in order to attract buyers, the regulatory environment is very light, although not very consistent with the rest!

6/ 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, in a surprising turn of events, can also have its funds listed on the stock market, and provided they are of a certain size, 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.

It is also to be expected that the height of the boundary between these two modes of shareholding and governance will gradually increase. It is unlikely that this will be a linear process. This has not been the case in the past. Players active in unlisted investment are not without their flaws. They have a definite tendency to mimic others (see "As long as the music is playing, you’ve got to get up and dance. We’re still dancing" said one of the main LBO players in July 2007), and some of them are driven by hubris and never satisfied, not even when sated.

Published by The Financial Times, this graph shows that:

·       more and more US firms were given access to the bond market with ratings lower than those of firms already raising money this way, which does not come as a surprise as new markets are opened by the most creditworthy issuers before enlarging the market to lower quality issuers;

·       the number of AAA rated companies has collapse in the USA mirroring the evolution on the world stage where they were sixty-five 40 years ago, and are now only 5, of which Microsoft and Johnson & Johnson for the USA.

Having a AAA rating is not in itself an objective for a CFO or a board. It is rather a relic and a subject of pride. To get it and keep it requires a level of shareholder equity and cash on the asset side of the balance sheet that might be better used elsewhere. We have not the feeling that Nestlé’s managers, who came to that conclusion in 2007 when they announced a share back-buy program for CHF 15bn, losing their supposedly coveted AAA rating the very same day, made a stupid mistake.

With the collaboration of Simon Gueguen, lecturer-researcher at CY Cergy Paris University

In 2006, the French Government passed a decree reforming the law covering collateral that had been enshrined in the French Civil Code since 1804. Expanding the contractual possibilities in terms of pledges and liens, the objective of the reform was to facilitate access to credit and to bring French collateral law more into line with that of most other developed countries. The article we present this month[1] offers a detailed empirical analysis of the effects of this reform. According to the results presented, the reform has made it possible to democratise access to credit and has led to better macroeconomic allocation of capital.

When the French Civil Code was drafted, the French economic system was centred around activities based on land ownership. The intention behind the wording of the law covering collateral in the Code was twofold: on the one hand, to protect borrowers from lenders abusing their position, and on the other hand, to protect lenders from borrowers that might be unable to hand over goods put up as collateral in the event of default. To achieve this balance, the Code specified that pledged property had to be transferred to the lender. The borrower could therefore not continue to control and use this property. Much of the 2006 reform consisted in removing this contractual limit, in particular to allow companies to pledge physical assets without losing control over them. In terms of corporate financing, it opened up new possibilities by significantly widening the scope of assets that could potentially be put up as collateral (in particular machinery and equipment). In addition, the reform made it possible to put goods up as collateral vis-à-vis several borrowers (in the case of syndicated loans).

For researchers, this reform has another advantage. While it broadens the possibilities of collateralisation for buildings and physical assets that are difficult to move, it does not change the conditions regarding liquid assets, nor does it alter the balance of power between debtor and creditor. It is therefore easier to identify the specific economic effects of the measure introduced.

The first result concerns changes in levels of indebtedness of companies affected by the reform. After the reform, the financial leverage of companies with a high rate of fixed assets increased by 7%, and that of other companies by only 1%. This variation is entirely accounted for by long-term debt (which benefits from the new opportunities). No change in short-term debt was observed over the same period. The reform therefore seems, in accordance with its objectives, to have facilitated access to credit for the companies concerned.

However, this result alone does not suffice to demonstrate the reform's positive effects. It is possible to imagine that better access to credit could create windfall effects and encourage excessive debt. Aretz et al are therefore also interested in the effects on the real economy. They find that companies that borrowed more increased investment and even created jobs. Above all, and contrary to the idea of excessive debt, the volatility of their results decreased and so did bankruptcy rates! So, it appears that borrowers have actually benefited from these increased opportunities.

Moreover, the authors show that the companies which have benefited the most from the reform are the smallest and the youngest. For example, companies with less than 35 employees (last quartile of the sample classified by workforce) saw their financial leverage increase by twice as much as those with more than 165 employees (first quartile), all other things being equal. The same effect is visible for start-ups with a high rate of fixed assets: their debt increased and their bankruptcy rate decreased (while no change is observed for other start-ups). Added to the fact that the positive effects are particularly pronounced for companies located outside large metropolitan areas, these results lead Aretz et al to claim that the reform has ushered in the democratisation of credit. Finally, at the macroeconomic level, they measure various indicators of the quality of the allocation of capital within the country, and conclude that the reform has had a positive effect on the French economy.

The benefits of the reform presented and studied in the article have therefore been manifold, without calling into question the very principle of civil law as this concept is defined in France, criticised in some academic literature for the links between law and finance. According to Aretz et al, this is an example of a useful reform, with a high impact, and which was less problematic to implement than a comprehensive reform of the legal system.

[1] K. Aretz, M. Campello and M. T. Marchica, "Access to collateral and the democratization of credit: France’s reform of the Napoleonic security code", Journal of Finance, vol. 75-1, p. 45 à 90.

We're all are entitled to a break, even from covenants… In 2020, the financial results of a large number of groups will be seriously impacted. Many of those that are subject to compliance with certain financial ratios (financial covenants) under their credit contracts will be unable to meet their commitments and therefore be in breach of covenant[1]. To avoid this situation and given these exceptional and (we hope) non-recurring events, these groups have or will ask their banks for a temporary exemption from compliance with their covenants. We call this a "covenant holiday". This exemption is generally given for 12 or 18 months (that is, for one observation if the ratios are observed annually, and for 2 or 3 if the ratios are observed semi-annually).

When it is anticipated that ratios will not be complied with over a longer period (this may be the case when the borrower has just completed a significant transaction (such as an acquisition) or following a change in accounting method), the company may ask its banks to permanently review the level of covenants; new thresholds are then set. This is called a "covenant reset". Banks will only agree to review these levels if the financial health of the company remains sound. The margin level may be reviewed at the same time.

Whether in the case of a covenant reset or a covenant holiday, the company sometimes offers a waiver fee, which is a commission paid to banks to accept this change to the contract. In the current environment, this is rarely the case, as the Covid-19 crisis has had a significant one-off impact irrespective of how responsible the company has been managed.

[1] For more on covenants, see chapter 39 of the Vernimmen.