Fifty years ago, the first edition of Vernimmen was published, and we'll tell you more about it at the end of this article. It's an opportunity for us to look back at the major trends that have revolutionized the practice of corporate finance, and corporate finance itself.

With hindsight, what seems fundamental to us in explaining the last 50 years is the end of negative real interest rates (in France in 1976[1]), enabling the transition from a debt-based economy to a market-based economy. Coincidentally, this happened around the same time as the first French edition of Vernimmen (1974 and 1976) was published.

In a world of negative interest rates, companies have every interest in taking on debt, because as long as they are protected from inflation by being able to push through to their customers the price rises they incur upstream, the interest rate on debt, once inflation has been deducted, is negative. Admittedly, it is not negative at the time the debt is contracted, but as it was a fixed-rate interest loan, and as the inflation rate continues to rise (from 3.3% in 1961 to 13.3% in 1981), very quickly the real interest rate on a loan contracted 2 or 3 years ago becomes negative.

It is therefore in the interest of companies to finance themselves mainly through debt, and they do not hesitate to do so. The concept of the cost of capital is ignored, since it is limited to the cost of debt, or close to it, and this quickly turns negative in real terms.

So why try to raise equity capital on a moribund stock market, or from a non-existent private equity industry? The only significant sources of equity capital were the financial companies of Paribas and Suez, and outside France, Société Générale de Belgique, Mediobanca and Deutsche Bank, which were able to raise equity capital on the stock market to finance their equity investment activities (Club Med, RTL, Thomson, Thyssen, etc.).

Obviously, in this context, financial savings were not remunerated, and savings were invested primarily in real estate, for want of anything better. Between October 1944 and October 1974, an investment in the CAC 40, dividends reinvested, yielded 0.8% per annum[2] (sic), far less than inflation. How can the stock market be anything but moribund when savings are not remunerated in line with the risk taken?

In France, it was Raymond Barre, then Prime Minister and Minister of the Economy and Finance, who decided in 1976, as part of his policy to combat inflation (11.7% in 1975), to be consistent and not give in to the ease of borrowing at negative real interest rates, which made the State an accomplice of inflation, since the latter reduced its interest and repayment charges by the same amount. It's true that we were probably at the end of a system with the risk of uncontrollable inflation (24% in the UK in 1975), with investors gradually refusing to continue lending at fixed rates so as not to be robbed in real terms after fifteen years of uninterrupted inflation. It was decided that the State should set an example, and that its borrowings should be raised to a level where they offer a positive real interest rate. In our view, this was the cornerstone of a profound transformation in France's financial system, with the debt economy giving way to a financial market economy[3], which the political change of 1981 would not call into question, but rather accentuate after an initial phase of hesitation.

Companies gradually found greater freedom in their choice of financing, as real interest rates turned positive, making equity attractive once again, and depreciating debt, whose real cost after inflation became much higher than the rate of volume growth, and therefore unbearable (between 5 and 6% between 1981 and 1995). At the same time, savers were gradually returning to the stock market, initially helped by a tax break (Monory mutual funds, which had to contain at least 60% French equities and 30% bonds to mitigate risk).

In a context that has changed dramatically, and where savings are once again remunerative in real terms, it's hardly surprising that between October 1974 and October 2024, an investment in the CAC 40, dividends reinvested, returned an average of 10.2% a year, well above the average inflation rate for the period (3.9%).

Among the many changes brought about by this revolution, we should highlight the following:

• The emergence of floating-rate loans, to protect lenders against unexpected inflationary fluctuations, as in the 1960s-1980s, which rapidly became widespread, except among very small businesses and SMEs, and except on the bond market.
• The pivot of financial analysis, from an analysis centered on the company's solvency, a central concern of lenders in a debt-based economy, to an analysis that has become the inevitable prerequisite for anyone wishing to do a quality job of valuing a company in a financial market economy.
• Discounted Free Cash Flow valuation (DCF), which moved out of theoretical textbooks and into concrete practice (mid-1990s), as soon as every financier was equipped with a microcomputer, initially to enable him or her to write or reply to e-mails himself/herself, without dictating them to a secretary or assistant (early 1993). Try discounting free cash flow over 20 years by hand![4] So it was through e-mails that computers appeared on the desks of financiers, and no longer just their assistants; and computers meant spreadsheets (Lotus 1 2 3, then Excel). As a result, direct valuation methods are disappearing (except in the financial sector, P/E and PBR) in favor of indirect valuation methods (enterprise value before deducting the value of net debt), which are more precise and less restrictive in the choice of comparables, as they do not also require sharing a similar financial structure[5].
• The notion of the cost of capital, which goes from being theoretical to practical, can be calculated using the CAPM[6], enabling capital to be better allocated, now that spreadsheets make decentralized calculations possible. It raises awareness of the fact that capital does not exist in infinite amounts but has a cost that must at least be covered to avoid waste. And that if we can't find investments with a return at least equal to this cost of capital, that capital can be returned to investors, who will have to find new investment projects elsewhere that generate a proper return.
• As intermediation gave way to intermediaries, financial establishments changed their role, strongly developing the business of placing securities issued by companies with investors, and making less use of their balance sheets. This is how Suez sold its banking assets (to Crédit Agricole), and became an energy group (Engie) by merging with its holdings in the sector; how Paribas grouped its industrial and commercial holdings in PAI, which then became totally independent, and reinvested in the organic growth of its market activities; how Deutsche Bank sold all its industrial holdings, and acquired Bankers Trust to develop its market activities.
  
  In a capital market economy, most financing needs are met by companies issuing financial securities (shares, bonds, etc.), which are subscribed to directly by investors. A financial market economy is characterized by direct savings. A very large proportion of surplus agents' investments are made directly on the financial markets, through subscriptions or purchases of shares, bonds, CPs, mutual fund units. In this case, bank loans are mainly intended for households (consumer credit, mortgages, etc.) and businesses, often small and medium-sized, which have no access to financial markets.
• The development of financial markets necessarily leads to the internationalization of financial activities, which is both encouraged and induced by changes in regulations. Our young readers won't believe their eyes when they learn that in the 1970s, the very few major groups that issued bonds had to obtain prior authorization from the Treasury, which then managed the market access queue! It was Pierre Bérégovoy (French Minister of the Economy and Finance between 1984 and 1986) who put an end to this antinomian market regulation.
  
  As for internationalization, it came rather late. The first time an American bank advised a French group on a purely domestic M&A operation was in November 1996, when AXA, advised by Paribas and Goldman Sachs, acquired UAP. This was the last major deal that Pierre Vernimmen supervised before his untimely death a month later.
• The development of financial markets entails their own risks. In a debt-based economy, the risk is non-payment of interest or capital repayment, which results in a one-off provision. In a market economy, risk takes the form of a fluctuation in the value of the asset in question. Hence the considerable development of financial risk management tools for exchange rates and interest rates, which are no longer administered by the public authorities, and are thus becoming much more volatile[7], dragging commodities in their wake.
  
  The growth of these option- and futures-based tools was greatly facilitated by the development of the Black-Scholes formula in 1972, which made it easy to value options.[8]
• A market means customers, and sooner or later a finer segmentation of their needs in terms of risk and profitability. Hence the development, for example, of LBO funds from the 1980s onwards, for risk-loving investors and with a different mode of internal governance that has proved its effectiveness. This is the modern version of the carrot-and-stick approach, with the risk of bankruptcy affecting all personal reputations, and the management package that can make LBO managers rich for several generations. But LBO funds are just one example of funds that specialize in a particular risk/return trade-off; there are many others (venture capital funds, infrastructure funds, etc.).
• The greater freedom brought about by the development of markets has required not only the relaxation or abolition of certain regulations, as seen above, but also the development of new regulations to combat abuses. For example, since the Pinault group took control of Printemps in 1992[9] , it has no longer been possible to take control of a listed company without offering the same price to the other shareholders. Or, since the demonstration of banking regulators' inability to effectively control the risks taken by banks in the early 2000s, the considerable tightening of minimum capital requirements for a bank, whose amount in proportion to risk-weighted assets has roughly tripled.
• Finally, we'd like to remind you of the development of ESG issues that are well known to our readers, chronologically appearing in the order governance, environment and social, and which show that finance is not necessarily just the triumph of the purest egoism.

* * *

As for the Vernimmen you know today, it too is the product of its history. Created in 1974 by a 28-year-old professor at HEC Paris, Pierre Vernimmen, this was the first finance book to introduce elements of market finance into corporate finance, and to emphasize the importance of risk, profitability and the cost of capital in corporate financial management.

The book was published by Dalloz, a legal publisher looking to expand into the university and business school sector, where it had just launched Mercator, by Jacques Lendrevie and Denis Lindon, two marketing professors at HEC Paris. The former convinced Pierre Vernimmen, who had already started work on his book, that Dalloz would be a good publisher for his project. 50 years later, this is still true for the French edition.

The Vernimmen in English was first published in 2005 by Wiley and is now in its 6th edition. Together with the French edition, over 250,000 copies have been sold so far.

[9] Although the Bolloré group has shown real dexterity in this area (Havas, then Vivendi).

Jay Ritter updates this chart once a year in the area of research in which he has become a world specialist: IPOs.

Readers will note:

- That, for issuers, the French IPO market has become much more efficient than the US market, with a much lower average discount, but this may make it less attractive to investors.

- The two peaks reached in the United States, in 1999 and 2000, when all you had to do was add the suffix “.com” to the smallest laundry and its price would take off like a rocket; and the more recent post-covid peak, with the impact of SPACs.

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

The article we present this month[1] takes a very long-term perspective, uncommon in academic literature. It analyzes the gradual disappearance of collateral in debt contracts since the beginning of the twentieth century. The three authors of the article are indeed financiers, and their analysis is based on the usual tools of the discipline, but the approach is also partly historical, taking into account the structural evolution of capitalism over the period to explain the phenomenon. The entire analysis is based on American data, but the trend observed in Europe is similar.

The first part of the article notes the collapse of the principle of collateral in debt contracts. In 1900, even the largest companies were still young, with strong investment needs and little visibility on cash flow generation. Add to this underdeveloped accounting and auditing principles and rudimentary bankruptcy procedures, and lenders' need for collateral is easily explained. Even the principle of priority of debt over equity in the event of bankruptcy was not always respected. In those days, it was virtually impossible to borrow without collateral, and 98.5% of the debt issued was secured.

In the decades that followed, lender confidence grew as corporate governance made cash generation more secure and legislation ensured debt priority in the event of bankruptcy. By 1943, secured debt was still in the majority, but no longer accounted for more than two-thirds of issues. This trend continued unabated throughout the century and into the 2000s. Technically, in 1970, secured and unsecured debt each accounted for half of all issues.

By the early 2000s, secured debt accounted for just 5% of issues. Pledging has gone from being the norm to the exception in the space of a century. The authors observe a slight upturn in this practice since 2010, but the effect is too small and too recent on a historical scale to assert a reversal of the trend.

This trend is not simply due to the greater protection afforded to lenders, but also to the willingness of borrowers. Adding collateral to a debt issue increases transaction costs, so the more favorable rate obtained is partially offset by these additional costs. What's more, and this is probably the main argument, pledging reduces the borrower's financial and operational flexibility. Financial flexibility, because having pledged an asset greatly reduces the borrower's ability to re-borrow during the term of the pledge. Operational flexibility too, because the borrower cannot dispose of the collateral as he or she sees fit. Most often, these are tangible assets of fairly high value, such as buildings, which the company may wish to sell (even if it means becoming a lessor). The assets may also be assigned to a specific activity, in which case the possibility of disposing of this activity will be temporarily prevented by the pledge.

The second part of the article seeks to explain fine-grained trends (cyclical or borrower-specific) in the choice between secured and unsecured debt. To this end, the authors study variations in the pledge rate after eliminating the long-term trend. Over their entire period of analysis (between 1900 and 2017), they observed statistically significant countercyclicality in pledging. Guaranteed debt accounts for a larger share of issues when the borrower is in difficulty. The rate of collateralization increases by 5 percentage points when the credit spread is positive, once the long-term trend has been eliminated. What is true at the borrower-specific level is also true at the cyclical level. In a recession, the rate on guaranted debt issued increases by 3 percentage points.

These fine variations are fairly easy to explain. When borrowers have no particular difficulties, they seek to avoid pledging because of the additional transaction costs and loss of flexibility. The development of bankruptcy legislation and the greater protection afforded to creditors have made it easier to obtain unsecured credit.

The usual practice today is simply to add a so-called negative pledge clause to contracts: there is no pledge on the debt, but the borrower undertakes not to pledge any significant assets as collateral against future debt. In this way, the first lender ensures that the company's assets will be part of the creditor pool in the event of bankruptcy. The negative pledge is a further technical reason why pledging has become the exception.

Finally, the article shows that pledging is generally to be avoided in loan contracts, and that it has more disadvantages than advantages. When lenders' rights are sufficiently protected and bankruptcy procedures clearly established, secured debt is only justified in emergencies, when the economy is bad or the company is in difficulty. In such situations, the priority is to obtain the loan, and pledging may become necessary. Traditionally, real estate and other tangible assets have been the main collateral used. In recent years, however, intangible assets have gained in liquidity and are sometimes accepted as collateral. This may help to explain the end of the trend and the slight upturn in secured debt since the 2010s.

[1]   E. Benmelech, N. Kumar et R. Rajan (2024), « The decline of secured debt », Journal of Finance, vol.79(1), p. 35 à 93.

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.

Boeing: largest-ever capital increase in the United States

 (November, 2^nd)

$16.1bn, not including, as is often the case in such cases, $5bn in convertible bonds, and a possible extension (greenshoe) of $3.2bn, i.e. a total of $24.3bn.

But there was peril in the air. If in 2018 Boeing made $101bn in sales, delivering 806 aircraft and generating $14bn in free cash flow; in the first 9 months of 2024, its sales fell to $51bn, with 291 aircraft delivered and negative free cash flow of $10bn. Since 2019, the start of its industrial woes, Boeing has lost $24bn, including $8bn in the first 9 months of this year.

Since the same date, Boeing has had negative book equity (sic), -$24bn at September 30, because, while it has a lot of net debt ($55bn or 9.3 times its expected 2025 EBITDA (EBITDA 2024 is negative)), it has few fixed assets ($29bn) after years of outsourcing, and very low working capital thanks to customer advances ($2bn). But this source of financing could shrink, as with 5,400 aircraft still to be delivered, orders taken today may not be delivered until the next decade. And since 2025 is also expected to be a loss-making year, debt could only continue to rise.

To increase the number of its shares by 18%, Boeing had to concede a discount of only 5% to the syndicate of underwriting banks, compared with Monday evening's price. This shows the depth of the American financial market, in stark contrast to the European markets. Remember our post a month ago on the capital increase of ID Logistics, a star in its segment, which had to concede a 10% discount on the closing price to place a miserable 6% of new shares. A double discount to place 3 times fewer shares relative to the size of the company...

As we explain in the foreword to 2025 French edition of the Vernimmen, entitled Make equity great again, this is due to the funded pension system in the USA, which has created pension funds that buy equities over the long term; and in France to our preference for liquid, inflation-protected low risk investments, which are largely tax-exempt and tax-advantaged. It's high time, in these times of budget shortages, that the tax advantages of life insurance were reserved for risky equity investments, and not bonds (euro contracts), which account for 74% of assets under management of those contracts. This is exactly what the Swedes have done since 1980, with a financial market 2.6 times deeper than those of other European countries, 16% of Swedish companies with more than 250 employees listed (3% in France), and a number of IPOs since 2013 (501) that exceeds the combined IPO volumes of Paris, Frankfurt, Amsterdam and Madrid.

Tribute to John McQuown, passive investing pioneer

(0ctober, 29^th)

In 1971, John McQuown created the first investment fund to replicate the performance of an index, thus creating index investing (also known as passive investing), whose assets under management today exceed $20,000 billion. He passed away a few days ago at the age of 90. An engineer by training, he had been hired by the innovation center of Wells Fargo, then just a regional Californian bank. In 1970, an heir to the family that owned Samsonite was looking for a team that could manage $6 million, or around $47 million today, according to the principles he had learned in Chicago studying the work of Harry Markowitz, William Sharpe, Eugene Fama, Merton Miller, Myron Scholes and Fisher Black, all young finance professors who had just created the CAPM or Capital Asset Pricing Model, in other words, modern finance. They had also demonstrated that, over time, active managers underperformed the market. As The Vernimmen.com Newsletter reminds us in its October issue, only 17% of active equity managers have beaten their benchmark over the past 10 years.  It is therefore more efficient to hold the market portfolio represented by an index fund (ETF), and then adjust your level of risk by adding risk-free assets to run less risk than the market; or by taking on debt to invest in the market portfolio if you want to increase your risk relative to the market. More efficient, because management and transaction costs are lower, and because no random bets are made on this or that stock. In July 1971, John McQuown launched the first index fund on behalf of the Samsonite pension fund, and a new stage in collective asset management was launched. Like all trailblazers, John McQuown had to battle against prevailing skepticism and, above all, the criticism of asset managers who saw passive management as a far inferior source of income to active management. But he had on his side the research of the aforementioned scientists, all of whom went on to win Nobel Prizes in economics a few decades later. 53 years on, I've just sat on the selection committee for a new employee savings fund manager at an institution of higher education. Although the specifications explicitly called for at least one equity-index fund, only one of the six candidates proposed one in its response to the invitation to tender, and it won the contract.   While employee savings schemes have been pioneers in ESG investment, thanks to employees and their representatives, there is still much to be done in terms of investing efficiency, with passive equity investing virtually non-existent in this field, where the few players do not play up to the innovation that is so embarrassing for their margins, unless you insist on it. 

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