During a conference we organized at HEC Paris, Nicolas Milesi, CEO of Batisanté, a company under LBO, spoke about the particularities of managing a company under LBO, compared with managing a family business or the subsidiary of a large group.

 

Just over twenty years ago, I was like you. I had spent three years on this campus and was attending my graduation ceremony. And among my fellow students at the ceremony were Rémi and Fabrice. Today, I run an LBO company, Batisanté; Rémi has become a managing partner in the private equity fund that is the majority investor in Batisanté; and Fabrice is in charge of the debt fund that lends money to Batisanté.

 

So, I'd advise you to be very careful about who you're standing next to today! There may be people among you who will form that infernal trio of private equity fund, operating company and debt fund. And in any case, I hope I can give you a few "tips" to help you decide whether or not you're interested in going into that world.

 

Forgive me, but I'm going to tell you about my experience for a few minutes, so that you can understand, and so that it illustrates in a very concrete way what it means to be the CEO of a company, depending on the nature of the shareholders.

 

I ran a company for eight years, which was a subsidiary of a large group; then I ran a company for five years, which was owned by an entrepreneur who had founded and developed it; and now I've been working for five years in a company which is under LBO.

 

For eight years, I managed a company called Châteaud'eau, which is the number 1 in water fountains, and which was a subsidiary of Danone at the time. For Danone, Châteaud'eau was the arm of its 360° strategy, offering an opportunity to drink spring water at every moment of the day: Volvic at home, Evian and Badoit in restaurants, Châteaud'eau in the workplace. When you run this kind of business, you're on the front line, looking after people, which means operations, customers and sales. And you're like in a relay race, you benefit from shared services, group services that take your mind off financing, accounting and information systems. This is provided to you so that you can be very focused on executing the company's strategy. As long as things are going well, it's comfortable.

 

When it's not, it's not so good. And the reason it's not so good is because you find yourself in a world where you're serving the strategy of a company, a large group, Danone, and you can't optimize everything that's going on in the world of the water cooler.

 

So, in 2005, when a fantastic innovation arrived on the water cooler market, a cooler that filters, refreshes and is connected directly to the water network, it was heresy for Danone, which only wants to sell spring and mineral water. They don't want to sell tap water, even filtered tap water.

 

But for customers, it's great because you see, a carboy weighs 20 kilos, you have to carry it to position it on the fountain, and sometimes the distributor won't deliver it to you when it's been 33 degrees for a fortnight because they're out of stock. So you're not in a position to fully optimize the market you're in by seizing this new growth opportunity.

 

For five years, I managed a company owned by its founder. This company is called MaxiCoffee, and it's the number 1 distributor of coffee in vending machines, and perhaps some of you have bought coffee machines from the MaxiCoffee.com site, which is the number 1 distributor of this type of bean-to-cup machine online. So, in this type of business, it's great: you've got your hands on the IT, you've got your hands on the accounting, you've got your hands on the financing.

 

But you don't have a hand in strategic vision, because that's the founder's domain. And here, perhaps, is where the introspection begins. You need to make sure that you are very much in line with the founder, that there is not the thickness of a line between the founder's strategic vision and the way you execute it. Because what you thought was strategy coming from a large group, strategy seen in the rationality of marketing, sales, HR, IT; in a company owned by its visionary founder, we're in a partial rationality of intuition. And so, we have to make sure that in this company, the visionary is visionary here, now and for the future. It's extremely important to be in harmony with this person.

 

Finally, five years ago, I joined a company that was under LBO, called Batisanté, which is number 1 in building protection against fire and pests, and which enables buildings to guarantee their regulatory compliance.

 

The company was founded in the 80s by a visionary entrepreneur, like MaxiCoffee, who took it from 0 to €30m in sales by 2008, and then decided to sell it to a first private equity fund, which paid a good price, twelve times EBITDA, and took on debt at seven times EBITDA, which was the norm at the time, and is becoming the norm again.

 

The following year, 2008-2009, the asbestos diagnostics market took a turn for the worse. Sales fell slightly, by 5%, as costs in this type of company are rock-solid. The company was making 10% net profit at the time. What does that mean, you financiers? 5% less sales, 50% of the margin gone.

 

So debt covenants were breached. The debt fund that lends the money demands immediate repayment. This doesn't work. The debt fund becomes the shareholder. Naturally, it says goodbye to the manager. Appoints a new manager. It gives him a new roadmap, which is to relaunch growth and improve margins. Classic. Unfortunately, it doesn't work. So he thanks the manager.

 

He appointed yours truly five years ago. Things are going a little better. We put the company back on a growth track, with a healthy 20% EBITDA margin. And we're in a position to take over our biggest competitor, doubling in size. And at that point, last year, we said to ourselves: "Let's bring in a real new private equity fund that doesn't come from debt, that has this private equity culture". And last year, I was lucky enough to have Rémi as a shareholder and Fabrice to lend me money.

 

Keep in mind that whatever your experience in a company, whether it's owned by a large group, a visionary founder or a fund, the job is the same. You do three things: you guarantee customer satisfaction, you accelerate growth, and you boost profitability. Whatever the nature of the shareholder.

 

It's easy to understand. A company is an organization that exists solely to satisfy a customer's need. Your job is to ensure that this organization is flexible and fluid, so that the customer experience with the product or service is as compatible as possible with customer satisfaction. The customer will reward you with growth, by giving you more business, and you'll win more customers.

 

I'm not going to explain why growth is good. I've experienced degrowth. So, try degrowth; you'll see, it's very nice. I don't know of any company where costs are variable. Costs are as fixed as a rock. You've got rising salaries, rising rents, all your teams working too hard and asking you for more resources, more people, more investment.

 

All it takes is a slight drop in sales, and you fall into the scissor effect: sales drop, costs rise, you're stuck in the middle, and it cuts, and it hurts. The good thing is that the opposite also works. As costs are more or less fixed, if you increase sales a little, it gives you more margin to invest in customer satisfaction and margin. And you've got this great virtuous circle on this three-pillar strategy, and do it right along these lines: 1) customer satisfaction, 2) growth, 3) profitability.

 

How do you do it? We always do it the same way. You have your team, the people around you. Pay attention to the balance in your teams. There are people who come from the field, who have risen through the ranks internally.

 

There have to be experts, people who have studied to be experts, in finance, HR, IT, you name it. Just because you come from the field doesn't mean that these positions are easy to fill.

 

Also, make sure you bring in new talents to open the windows, so that these people can question the habits of your organization.

 

The second way to carry out your strategy, your development, is to develop a strategic plan. And you have to make sure it's commensurate with the three challenges of customer satisfaction, growth and profitability.

 

Drawing up a strategic plan sets the course. Because in business, you don't just get there. You have to tack. And if we didn't say it was this way, sometimes we say, oh it's beautiful over here. Because the wind is pushing. Remember, it's that way. And that's what the strategic plan tells you. And you'll have to develop lots of plans. These are called commercial excellence plans for customer satisfaction and growth. They're called operational excellence plans for profitability. These are plans that will help you, on a day-to-day basis, to steer your business in the right direction, the direction you set yourself beforehand.

 

This brings us to the heart of the matter, but keep in mind that it's the same job. Managing a company means managing these three pillars.

 

 

Now to the LBO. There are two levers in LBOs. The first is always debt, which is easy. Obviously, the private equity fund buys the company by raising debt.

 

But there is the second lever, which is undoubtedly the most important, and that is that a private equity fund is made up of financial and strategic professionals. They didn't invest their own money; it's not their money. They went and got it from investors, banks, institutional investors and family offices, and raised a few hundred million euros. That was a few years ago; now they're raising billions. And they promise them an IRR in return, an IRR of over 20%. What does that mean? It means that in five years' time, they have to return more than twice what the investors put into the fund. The investor puts in 100; in five years, he has to earn 250.

 

It's a very simple equation. If you understand these two things, these two levers, you understand the specificity of LBO management. And in my experience, there are five major specificities of LBO management.

 

The first specificity is that there are many, many important indicators. This may come as a surprise, but it's absolutely necessary. Because your shareholder isn't a guy who knows your business. He knows nothing about fire protection. He knows nothing about asbestos diagnostics or energy performance. The only thing he knows are indicators. Therefore, we need to create a common language that enables us to talk about customer satisfaction, growth and profitability. It's very important to create this language, but it also means that it's very demanding in terms of time, precision and rigor for your finance team. It's exciting to work in an LBO in the finance team, because you're at the heart of performance. You're at the heart of plan execution. Because there's no plan that can't be managed using indicators.

 

The second specificity is that you use a lot of outside advice. I've never used so much outside advice in my life. I hardly ever used them before. Why didn't you? I was in a company owned by a group, by Danone. I had a question. I'd call the boss in Spain, the boss in Canada. There wasn't a guy in the Danone CEO fraternity who hadn't experienced my problem, who didn't have a solution to my problem. I didn't need an outsider. The Group provided it. I'm caricaturing, of course...

 

When you're in a company that's owned by its founder, the founder is brilliant, he or she has intuition, it's incredible. The science comes out. There's no need for outside advice. At least, that's what he or she thinks.

 

When you're under LBO, you have problems. Your team doesn't know how to answer them, and neither do you. Go and see strategy consulting firms, organizational consulting firms, cyber-security specialists, master path specialists to transform your business. It's all very useful.

 

The third specificity is the financing method. I've already tried to give you an idea of the financial equilibrium. When you make a 10% net margin, if you lose 5% of your sales, 50% of your margin disappears, and you lose your job. You're quite motivated to make sure that you don't drift from your strategic plan. In my experience, under an LBO, it's better not to take a step backwards in EBITDA.

 

And in business service companies, in companies that are fairly intensive in human resources, it's better not to fall back in sales either. This is the third very specific point. You have companies that can move, that can go up and down, the company can float. Under an LBO, that's not the way it should be. There are too many people who will be far too stressed because of the level of debt and the demand for a medium-term return on investment.

 

The fourth specificity is that we make a lot of acquisitions. You'll remember that the financial expert who is your shareholder went out and promised 20% to his shareholders. What's the easiest way to double value? Double the size of the company. It's stupid. That's just the way it is. That's because it's much harder to pay off debt. It's easier to make acquisitions. Often, a private equity fund - and this is particularly the case at Batisanté - chooses companies that can be acquisition platforms. They already have a strong organic growth engine. For Batisanté, we achieve between 7 and 10% embedded growth per year. This means that if I have sales of €100 million, in five years' time I'll have sales of €150 million. I haven't doubled in size. There's still €50 million to go. So, I have to find them through targeted acquisitions. And in the last year, I've made four acquisitions. That's the equivalent of the three previous years before the fund took a stake.

 

There's a real intensity on acquisitions. What does that mean in concrete terms? It means that you spend a lot of time identifying targets. You can't just buy anything. You have to negotiate, buy and integrate them. Integration is what takes up most of your HR, finance and IT teams' time. So, you have to be ready in advance to create a team to deal with all these integrations. If you don't, things won't go well.

 

The fifth specificity is that the private equity fund will be keen to align the interests of key people in the company. So they're going to ask you to invest alongside them, in what we call a management package. It could be €50,000, it could be €200,000, it could be €1 million, it doesn't matter, it's up to you.

 

What's meaningful to you, what keeps you motivated without keeping you up at night if you lose it. And in principle, if things go well, if the fund multiply its investment by three, you can do multiply your own investment by a minimum of 10 times. So that's something very specific, which you don't find in subsidiaries of a group, and which you don't necessarily see in companies owned by their founders.

 

I'm going to conclude by trying to give you a few keys. If any of you are Rémi, Fabrice or Nicolas, ask yourselves a few questions: the first is, do I have any disruptive ideas? If you do, great, found a startup. If you don't, maybe an LBO is for you.

 

If you have lots of money, great, don't work, or buy a company. If you don't, if your parents weren't lucky enough to be rich before you, maybe an LBO is for you.

 

Thirdly, if you're not afraid of losing your job, if you're good at dealing with stress in the form of driving stress rather than paralyzing stress, maybe an LBO is for you.

 

But the fourth condition is perhaps the most important. If you're better when you've got all the levers in your hand -operations, trading, accounting, financing and strategic vision - then definitely, an LBO is for you.

 

And I don't know if you're familiar with that Frank Sinatra song, whose melody was written by Claude François, but if it's worked out well for you, later on you'll be able to look back and say "I did it my way".

 

They fall into 2 categories: inverted rates, such as those on the euro, dollar, Swiss franc and pound sterling, which reflect an expectation that short rates will fall; and normal-format rates, with long rates higher than short rates, such as those on the yuan and yen, where investors do not have this expectation, but rather an expectation that short rates will rise.

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

 

SPACs (Special Purpose Acquisition Companies) have been around for a long time, but have experienced a sudden surge in popularity since the late 2010s, reaching a peak of 613 transactions in the USA in 2021 . These "blank check" companies are formed by raising funds for an empty shell listed on the stock exchange, with the mission of using the capital raised to acquire an unlisted target. In practical terms, this is an alternative IPO method to the traditional one, whose main advantage is the reduction of information asymmetries between the listed company and outside investors.

 

Proponents of SPACs point to the possibility of an easier IPO for young, growing companies, as well as the opportunity for investors to easily enter the capital of companies that would otherwise only have been accessible through private equity.

 

Critics of the method point to the fashion effect (often a bad sign in finance), the disappointing performance of SPAC exits, and the lack of transparency linked to regulations that have not yet taken the measure of the phenomenon.

 

This month's article presents an empirical study of SPACs on the US market between the beginning of 2010 and the end of 2021. The main finding is that this method of going public is extremely costly for the shareholders of the merged company. The authors acknowledge that this technique can, in some cases, facilitate IPOs by aligning the interests of the SPAC initiator (the sponsor) with those of investors, but for the most part their results show that the wave of SPACs from 2019 to 2022 was not financially justified.

 

The analysis of SPAC performance distinguishes between the three parties involved: the sponsor (the financial institution that creates the SPAC), the company merged into the SPAC (more precisely, its shareholders), and the external investors who subscribe to the SPAC.

 

For the sponsor, this is undoubtedly a good deal. The objective is to find a target to merge with so that the SPAC can be completed (otherwise, the cash invested in an interest-bearing fund is returned to the investors). When the SPAC is realized, the average observed return (annualized, between 2010 and 2020) is 23.9%. And the risk is very limited, if not non-existent: all 458 SPACs carried out over the period generated a positive return. For the authors, investing in a SPAC as a sponsor is akin to acquiring a convertible bond with no risk of default, and at a knock-down price. A great deal!

 

As far as external investors are concerned, performance is highly variable, but negative on average, at around -3%. The result would be even worse without the possibility for investors to exit at the time of the merger. Institutional investors, who are asked to complete the fundraising at the end of the SPAC (an operation known as PIPE, Private Investment in Public Equity) fare better, as they benefit from a discount, but performance remains disappointing.

 

Finally, and this is the main result, for the period between January 2015 and March 2021, the total cost of the IPO for the merged company is 15.1% of its post-IPO value, compared with 3.2% for a conventional IPO of equivalent characteristics. The difference is considerable: going public via a merger with a SPAC is extremely costly. For the most part, this cost comes from holding "free" shares, which remunerate the sponsor in the event of acquisition.

 

How then can we explain their considerable success between 2020 and 2022 (when the number of SPACs exceeded the number of traditional IPOs in the USA)? In the authors' view, the sponsors were particularly convincing, playing up the regulatory advantages of the method. The rules applicable to SPACs are those for mergers rather than IPOs, and the former are less demanding than the latter, particularly as regards transparency obligations.

 

This article was finalized at the beginning of 2023, at a time when the authors note that many SPACs are struggling to find a target. The rest of the story proves them right. By 2023, almost half of all SPACs had been liquidated without acquisition, and several companies floated in this way had gone bankrupt. Recently (January 2024), the SEC announced a tightening of its regulations, bringing SPACs into line with traditional IPOs to further protect investors. The year 2024 could see the end of the parenthesis opened ten years ago, with SPACs once again becoming a very exceptional operation.

 

It seems to us that they are twofold:

1/ Market liquidity is reduced, since some players who used to sell securities can no longer do so, resulting in lower trading volumes and a widening of the bid-ask spread, leading buyers to buy their securities at a higher price and sellers to sell them at a lower price.

 

 2/ The regulator demonstrates its poor opinion of investors' ability to find the equilibrium price of a stock on their own, since it prohibits a certain category of investors - short sellers - from doing so, thus depriving the market of information (these investors believe that the stock is overvalued, and are likely to have good reason to do so, since short selling is particularly risky, and if they engage in it, it's because they've thought twice rather than once about the stock's value).

 

Contrary to what a superficial reading might lead one to believe, the abolition of short selling, by eliminating a category of sellers, does not lead to a mechanical rise in prices, even though there are fewer sellers, because some buyers also withdraw from the market, telling themselves that the prices posted from now on are likely to be biased and not to reflect all the information that is available.

 

 

Regularly on the Vernimmen.com Facebook page^[1] we publish comments on financial news that we deem to be of interest, publish a question and its answer or quote of financial interest. Here are some of our recent comments.

 

 

Peugeot Invest or value-destroying reinvestment _{(May 8th)}

Peugeot Invest, which is 80% controlled by the eponymous family and listed on the stock exchange, has a 5.4% interest in Stellantis, which accounts for 54% of its net asset value. The balance of its assets is made up of minority stakes in listed (SPIE, LISI, etc) and unlisted companies, and in investment funds. For decades, Peugeot Invest has suffered from a discount to the value of its assets of around 50% (currently 55%). This is the price investors pay for agreeing to be shareholders in a structure that is useful for the Peugeot family, but whose relevance for investors and usefulness for the market are not obvious.

In the Netherlands, it is possible for a pure holding company to be listed on the stock exchange. Heineken Holding, for example, owns 54% of the Heineken group and no other assets. Its discount on net asset value (NAV) is only 17%, Heineken Holding is not forced to diversify. In France, it is unacceptable for a listed holding company, which over time has become a minority shareholder in a major group, to have this shareholding as its only asset.  To maintain this structure, the Peugeot family has had to invest in other assets. Sometimes brilliantly, like the investments in SEB and Zodiac-Safran; sometimes disastrously (Orpéa, Signa in the German property market). Not everyone can become Warren Buffett.

Over the last 5 years, while Stellantis' share price has doubled, the value of its other assets net of debt has fallen by 17%, while the Paris indices have risen by around 30%. Long-term minority shareholders have tabled resolutions at the forthcoming AGM calling for an increase in the dividend. This is not because they are as thirsty for cash as leeches, but quite simply because one euro paid in dividends is worth one euro in cash for all shareholders; whereas one euro of earnings not paid in dividends at Peugeot Invest only increases the value by 50 centimes, given the discount on the NAV. That's a quick calculation! As long as the structure and governance remain the same, the discount is unlikely to be reduced. To do this, Peugeot Invest would have to be given a real business by selling its financial assets, including its stake in Stellantis, like Eurazeo which is becoming an asset manager (a small Amundi). It is understandable that the Peugeots remain attached to their stake in Stellantis. But in this case, the new generation should consider that having its name synonymous with a 50% structural discount on the stock market is not the best way to honour the name of the founding entrepreneurs, and draw the necessary conclusion by delisting this vehicle that no longer has any place there. 

 

 

Will New York become TotalEnergies' main listing place? _{(April 27th)}

At this stage, it's just a thought, announced yesterday, as managers must have them, without them necessarily materialising. In this particular case, the difference in multiples between the American and European oil majors is impressive and may tempt managers to think that a main listing in New York could bring TotalEnergie's multiple into line with that of its American peers: Exxon is valued at 6.4x EBITDA 2024, Chevron 6.1x, compared with 4.3x for Total (Shell is at 4.1 and BP 3.2).

 

This gap is all the more striking given that TotalEnergies is one of the best managed majors, if not the best managed. It is therefore understandable that American shareholders, who hold more than 40% of the company's capital, should be pushing the wheel, especially as their percentage is increasing due to the withdrawal of European shareholders who are more sensitive to the challenges of the energy transition. This is not the least of the paradoxes, given that TotalEnergies is the most advanced of the majors in this field, and that it has not reduced its ambitions, unlike Shell and BP. But the level of multiples does not just depend on the listing market, it also depends on risk and growth characteristics. By this measure, a company listed in the United States, but with a smaller US share of its assets than its competitors, could be at a discount to them.  The transfer of the main listing cannot be decreed; it is observed on the basis of trading volumes. In order for New York to become its main listing, TotalEnergies would probably have to make a major share placement in the United States, where it is currently only listed in the form of ADRs. A full listing would probably be required. If such a move were to occur, and if TotalEnergies were thus better valued, its cost of capital would fall, since at constant free cash flows, the discount rate required to make these flows equal the value would be lower; and employees would see their profit-sharing and incentive schemes invested in their employer's shares increase in value. The usual critics of TotalEnergie will no doubt talk of betrayal, while others will regret this development if it comes to fruition.

 But you can't :

- Refuse to set up pension funds, the creation of which had been voted on at first reading in 1997 before the dissolution of the French parliament sent the text to oblivion, where it never came back despite the political changeover;

- Granting unlimited tax advantages to life insurance euro funds, i.e. debt securities; and limiting them for PEAs invested in equities;

 - And lamenting the shallowness of our equity market, resulting in lower valuations in a number of cases.

 

 

The strange accounting for capital gains on partial disposals of fully consolidated subsidiaries _{(April 13th)}

 

Last week, Wendel sold 9% of Bureau Veritas on the stock market for €1.1 billion, reducing its controlling stake from 51% to 42% of the voting rights. The capital gain was €800m, but did not appear in the profit and loss account, which goes against common sense. In doing so, Wendel is simply following the IFRS accounting principles that apply to it, which stipulate that as long as the controlling shareholder remains the controlling shareholder, the capital gains generated by block sales do not appear in the income statement. Indeed, in this logic of continuing full consolidation, all the assets and liabilities of Bureau Veritas remain consolidated within the Wendel group, and only the share of minority interests and that of the Wendel group in the result and in shareholders' equity are affected. The only change in Wendel's consolidated balance sheet is the appearance of €1,100 million in cash, the counterpart of which, in order to respect the balance sheet equilibrium, is an adjustment (increase) of €1,100 million in shareholders' equity, without the €800 million capital gain being taken to income or other comprehensive income (OCI). If the accounting rules considered that the €800m capital gain should appear, it would be sufficient to include it as such in the income statement and to adjust equity (excluding profit) by only €300m. When Wendel, by selling a new block, falls below a threshold of voting rights that no longer gives it control of Bureau Veritas, the capital gain on this block will then appear in the income statement, together with the entire unrealised capital gain on its residual stake. The latter will be recorded in Wendel's accounts on the basis of its market value at the time of the change from full consolidation to the equity method. Fluctuations in the value of this holding could then appear each year in the income statement (this is an option). We therefore have the unusual situation of a capital gain realised last week that does not appear in the profit and loss account, and another one to come that will appear in the profit and loss account because of the change in consolidation method, even though the holding will only have been partially sold. It is true that IFRS and US GAAP have freed themselves from the straitjacket of law and taxation to take a more economic view of situations, but in this particular case, it does not seem to us that this corresponds to real economic or financial life. Understand who can!  Fortunately, this situation is rare, because when industrial or financial groups sell a subsidiary, they usually sell 100% of their stake. Moreover, in the case of Wendel, an investment company, the profit and loss account is less important than an extra-accounting valuation of its net assets in assessing its performance.   

 

Kering and the Milanese real estate prices _{(April 6th)}

Should Kering have refrained from acquiring a magnificent building in Milan for €1.3 billion, on Via Montenapoleone, the Milanese Avenue Montaigne or New Bond Street? Admittedly, the price of these 11,800 m2 is €110,000 per m2 (sic), but the return apparently corresponds to a market yield of 3.85% in the second most expensive city in the world, at least for luxury retail properties.

This is the view of the Financial Times, which estimates that the return on this investment will be nowhere near the Group’s ROCE of 11.7% in 2023 (including goodwill).

Despite all our sympathy for the British daily, its reasoning does not hold water from a financial point of view. Indeed, to consider that an investment is bad whenever it yields less than the ROCE generated by the company is a fallacy. It is not appropriate to relate the prospective return of an investment to the accounting return currently generated by the company, but to the cost of capital of this investment. If you have a ROCE of 20% and a cost of capital of 8%, any investment yielding 12% will reduce the ROCE, which will then settle between 12% and 20%; but it will nevertheless create value if the forecasts made prove to be correct, because it will yield more (12%) than its cost of capital (8%). 

The second pitfall to avoid would be to compare the return on this property investment (just under 4%) with Kering's cost of capital (around 8.5%). This would only be relevant if the risk of this building were identical to that of the rest of Kering's activities. However, we all know that the cost of capital for a property company is much lower than 8.5% because the risk is much lower than for an industrial activity, even one in the luxury sector. With a yield in line with the market for this Milan acquisition, it is not obvious that this building was overpaid.

Secondly, it's true that property prices in Milan are particularly high, which explains why for years my Italian students at HEC Paris have been telling me that they don't want to go and work in the economic capital of their country, because salaries for young graduates are much lower there than in Paris. And as this has been going on for a long time, this is one of the reasons why Italy's top 20 market capitalisations today total just €431 billion, compared with 5 times as much for the top 20 French market capitalisations (€2,148 billion) for a roughly similar population.

When a country loses its best-trained and most agile young people, the economy can only suffer.

 

Could you join the IASB and become an accounting regulator? _{(March 4th)}

You'd stand a good chance if you can answer these 3 questions TRUE or FALSE, all relating to IAS 32, on which the IASB has published an exposure draft:

 

1/ A perpetual or hybrid debt must be recognised as equity even if, in the vast majority of cases, the issuer redeems it early after a few years to avoid having to bear a sharp rise in the interest rate, which is contractually provided for to prompt the issuer to redeem the perpetual bond early (which is bound to make you smile). 

 

 2/ Under IFRS, a bond redeemable in shares (mandatory convertible bond, MCB) is recognised under shareholders' equity, with the exception of the present value of the interest paid before being redeemed in shares, which is recognised under financial debt. However, if the redemption parity of the MCB (3 shares against one MCB, for example) is variable (against 3 shares, or 4 or 2 depending on a given criterion), then the MCB must be recognised as a debt. 

 

3/ More difficult now. You have granted minority shareholders in a subsidiary that you control a put option allowing them to sell you their shares. The amount you may have to pay out if the minority shareholders exercise their put option is a financial liability, the creation of which is offset (so that the balance sheet remains balanced) by a deduction from shareholders' equity (group share) of the same amount, and not by a deduction from shareholders' equity (minority share).

 

Well, if you answered TRUE 3 times, you have every chance of succeeding at the IASB, which holds these positions in the exposure draft mentioned above. But you are unlikely to be a good financier.

 

Equity capital is so important to a company - it is the cornerstone of its existence and development - that in this area you have to call a spade a spade and be particularly rigorous. A debt that is repaid, even if it is wrongly called perpetual, is a debt, not equity.

An MCB, with a fixed or variable parity, and which by definition does not involve any cash outlay, since it is redeemed in the issuer's shares, is an equity security, precisely because it is not redeemable in cash or debt securities.

 

As for the put on minority interests, the IASB is proposing a double penalty. Why not create a liability on the balance sheet in respect of minority interests. But where is the consistency in deducting the put amount from shareholders' equity, group share, and not from that of minority interests, who have just been assumed to be exercising their put by recording the put amount as a liability?

 

 When will the IASB finally realise that, by proposing provisions so far removed from common sense, it is discrediting the accounting standards of which it should be the intelligent and scrupulous guardian? 

 

 

Warren Buffett's 2024 annual letter to shareholders _{(February 27th)}

In this letter, Warren Buffett points out that what creates value is a company's ability to reinvest its profits at a rate of return higher than its cost of capital. Conversely, a company that reinvests its profits at a rate of return lower than its cost of capital destroys value. This explains why the share price of these companies jumps when their managers promise significantly higher returns. 

Barclays, for example, has just promised to return £10bn to its shareholders over the next 3 years (on a market capitalisation of £23bn). The share price has jumped by 10%. Not that shareholders are dividend-hungry leeches. It's just that they know how to count. To understand this, you need to remember that Barclays' equity of £71bn is only worth £23bn on the stock market, the result of Barclays' return on equity (7.3% in 2023) being lower than its cost of capital for years. This represents a 68% discount and a £48bn loss in value. 

10bn of dividends paid means £10bn of cash reaching shareholders' accounts and being worth £10bn. It also means a £10bn reduction in book equity, which at a constant 62% discount means a reduction in equity value of only £3.8bn. In net terms, +10 - 3.2 = +6.8.  On the other hand, £10bn of reinvested earnings means a £10bn increase in the book value of shareholders' equity and a £3.2bn increase in its value at a constant 32% discount.  + £6.8bn if Barclays returns £10bn to shareholders, versus +£3.2bn if Barclays reinvests the £10bn in its business, whose marginal profitability is lower than the cost of capital, leading to a loss of value. No wonder shareholders are applauding with both hands. Especially as there could be a second-round effect, as at least 60% of the returns will take the form of share buy-backs, leading ipso facto to an increase in shareholders' equity per share, and at a constant discount, a corresponding increase in the share price.

On the other side of the Atlantic, once again this year, Berkshire Hathaway shareholders will overwhelmingly vote for no dividend, preferring reinvestment, confident in their leader's ability to generate returns in excess of the cost of capital. 

Having said that, Warren Buffett warns that Berkshire Hathaway's size ($900bn) means that its future performance will no longer be as exceptional as in the past.  The day when Berkshire Hathaway will pay dividends is not far off; probably after the death of its founder, just as Apple waited until the death of Steve Jobs to do so, such is the power of these exceptional men.   

 

 

Uber and share buybacks _{(February 15th)}

On the occasion of the publication of its 2023 results, the first to show positive net income ($1.9 billion), Uber announced the launch of a $7 billion share buyback plan. Why initiate share buybacks when the group still has a net debt of $5.8 bn, i.e. 3 times EBITDA (or 1.5 times if we consider share-based compensation expensed as a non-cash expense)? Admittedly, Uber is announcing growth rates for the next 3 years of between 15/20% and cash flow growth twice as strong, which makes doubts about its ability to meet its debts irrelevant. So, it's not a case of idle, surplus capital, as with Apple or Google. Nor is it that the stock is grossly undervalued - that's not immediately obvious at 50 times operating cash flow minus tangible investments. These are the two most common reasons for share buybacks.

The issue is rather the growth in the number of shares. Indeed, like virtually all technology groups, Uber compensates its employees through the granting of free shares, averaging $58k in 2022, but probably much, much more for employees in the key R&D and Technology department, which accounts for $1,215m of the $1,935m in share-based compensation booked in 2023. Since the share-based compensation of these employees accounts for 38% of the department's costs, their share of compensation is likely to exceed half of their total compensation, and therefore exceed the amount of their salaries paid in cash. A share price that has doubled since the 2019 IPO is a blessing for everyone (sorry, short sellers), but the day a bearish phase sets in, some in the R&D and technology department will look sadly for greener pastures, as soon as the downward price movement is not general, but specific to Uber.

Since the IPO, the number of Uber shares has grown by an average of 5% a year, due to this effect and to the payment of external growth operations in shares. Buying back shares limits the growth in the number of shares, which would otherwise reduce the growth rates of operating parameters and threaten a good valuation. This shows a discipline that appeals to investors, and is the strength of this convention to which Uber has just adhered (in its own best interests).

PS: for those who believe that share buybacks boost share prices. The $7 billion announced by Uber, assuming it is fully realized in 2024, would represent only 2.4% of the average daily volume of transactions on the share. Not enough, in itself, to boost the share price mechanically and significantly. And academic research shows that the idea that share buybacks will boost share prices is false.