The CEO's view

May 2, 2007

During 2006, Proventus has continued contributing to the development of the companies that we are involved in. We have also made some new investments, but are reasonably cautious in what we see as a high-risk investment environment. Before I comment more on our activities, let me describe how I look upon the larger environment.

Risk premia at historic lows
When I look back at the developments around us in the last year, I realise that we are in an extreme situation. The financial markets are driven by the strongest liquidity we have seen for decades and at the same time are becoming increasingly complex. One sign of this is the amount of outstanding derivatives contracts, which has gone from a level equal to world economic output 10 years ago to seven times as much at present. I am reasonably young, but even when I turn to people in my vicinity who have been around for longer, no-one seems to recall a time when the risk premia were lower. We are conscious of a number of destabilising risks globally – geopolitical tensions, environmental concerns, demographic challenges, structural imbalances in the economy – yet none of this seems to be reflected in the capital markets. Securities are priced as if all these risks were merely theoretical.

Banks selling risks
The “overhang” of capital is present in many parts of the capital market and, on one hand, can cushion a negative development. On the other hand, when hedge funds and others fail to deliver the expected returns, it risks creating a crisis of confidence in financial markets – a run. The complexity of financial markets and the increased use of derivatives are
arguably also making risk less transparent. Banks have increasingly been selling risks to hedge funds, while also investing in and supplying leverage to these funds. Until now, this method of risk packaging seems to have reduced the effect of shocks in financial markets. But the interdependence of different parts of the financial system risks becoming very visible in the event of a major crisis.

Changing industrial dynamics
At the same time, the development of global markets is changing the industrial dynamics of the world. From a European perspective, industry is finding it increasingly difficult to compete. In many regions, this is leading to higher unemployment as industries are downsizing and entire cities are shrinking. The economic prospects for the European middle class are challenged. In these testing times, many take relief from the short-term benefits of the low price of risk providing a possibility for households to replace shrinking salaries with lending for consumption. Parallel to this, a competitive industry is rapidly being built in China and India, lifting the material living standard in underdeveloped regions. These countries are establishing the economic foundations for a growing middle class.

Oversimplification of globalisation
A central question is if these growing societies can be built with respect for human rights, democratic and liberal values and a sustainable development with responsible use of natural resources. Currently, there are many indications to the contrary. Yes, there are large potential industrial and societal benefits from trade and the global division of labour, but at present the debate is suffering from oversimplification. Globalisation is neither good nor bad. It is – like gravity – a given. It will continue and the only question is how we use the opportunities that it offers.

The most militant anti-globalisation campaigners are shutting their eyes to dynamic benefits in the interest of self-protection. But, paradoxically, it is the overenthusiastic proponents of globalisation who pose the greatest risk. The short-term attitude to globalisation has created a movement which pushes the short-term economic benefits of this development while largely ignoring the social, democratic, environmental and human costs. This in turn is leading to increasing protectionism and anti-globalisation protests. We must approach this new world order sensibly, not allow it to be buried in the populist grave of Doha criticism.

Yes, globalisation is building a middle class in China, but we are not carrying the full costs. We are not carrying the costs of reasonable social security and pensions to Chinese workers. Nor are we carrying the costs of environmental destruction in the Far East. As Western consumers, we keep reaping the profits of cheap goods and the existence of cheap credit. But we are leaving a huge bill behind us.

The illusion of outsourcing
At the same time, back home, we are exploiting the benefits of the combination of established Western innovations and brands and cheap production. The illusion of outsourcing tells us that we will be able to sustain a division where brand creation, strategic direction and innovation take place in the West and cheap production in the East. China is already training a huge number of engineers, designers and so on – do we really believe that they will stay happy with subcontracting? As a consequence of these global shifts and the short-term capital markets pushing for exploitation of existing innovations rather than the financing of new ones, we are not seeing enough innovation from European companies.

Record profits and increasing anti-democratic tendencies
Short-term profitability has been improving rapidly on the back of outsourcing – driving down the cost of production as well as putting downward pressure on salaries in the West. US corporate profits are up from 8 per cent of GDP to a record 14 per cent in 2006. As a result of the benign short-term environment, we also see short-term improvements in certain Western economies. In Germany for example, the unemployment rate has fallen and is now under 10 per cent. But this is largely due to pay cuts. Disposable income has decreased yearly since 2002. Up till now, consumption has been maintained with the help of cheap credit, but over time, the structural problems that European industry is facing are bound to have a more severe impact on European economic development and standard of living.

For a long time, we have been pointing out the risks of economic development and increasing pressure from demographic change having a negative impact on the democratic climate in Europe. During 2006 we have seen continued anti-democratic tendencies. For the first time, Europe’s extreme right wing parties have sufficient numbers of deputies to form their own political group in the European Parliament. The group is formed around an agenda of racism, anti-Semitism, xenophobia and homophobia.

Longer-term perspective needed
So, is there a better way? We believe so. It starts at home – Europe is in desperate need of a new industrial base. A European industry that can compete on a global scale based on strong proprietary products. This builds on the capital markets having a longer-term perspective. We need more active private capitalists and other investors with the capacity to take a longer-term perspective. Today, almost all of the capital is institutional and most of it is pension money. These are funds that in reality often have a 20- or 30- or 40-year perspective, but which – because of short-term incentive systems and striving for liquidity – almost always assume a shortterm and passive perspective. To create new strong industrial companies and recreate the suffering ones so that they regain competitiveness, a perspective of at least 10 years is necessary.

For those of us who do not retire in the next 10 years, would it not make sense to use our pension money in change processes to create a European industry with a sustainable competitive advantage? Rather than maximising the short-term return on our pension money through exploiting the benefits of old innovations and the accessibility of cheap labour, this will surely generate greater longer-term returns – even if liquidity will not be as great and if the short-term returns over a given period may be lower. Surely it must be the best long-term investment, helping to make Europe a more successful, humanistic and creative society in the process.

Outsource responsibly
Development is also needed in the Far East. The benefit of outsourcing is not simply cost reduction. There are many sectors where the quality of the product is improved through outsourcing production. But we must outsource responsibly. We must make sure that we retain enough knowledge to be a strong partner and to protect our interests and intellectual property. With BRIO, in which Proventus is majority owner, we have experienced the paradoxical development that outsourcing production actually means we have to hire more qualified production people than we have ever had. We have to be at the forefront of production technology, materials knowledge and design to be able to outsource sensibly. The other aspect of this is that we cannot apply different standards to the people we or our subcontractors employ in other parts of the world than we would at home. It is not enough to say that since everyone else is outsourcing, we have to. We should use our economic power to make sure that the work environment, social safety nets, pensions and environmental responsibility are developed over time. It will increase the prices of our products in the short term, but it is much more likely to create structures and conditions of trade that can be sustained for the long term.

Increasing quality awareness even in the toy market
BRIO exists in one of the industries where globalisation has progressed the furthest. On the one hand, the US is still by far the largest market with only 4 per cent of the children of the world but almost 45 per cent of the global toy market. On the other hand, China’s toy production accounts for around 80 per cent of the world’s total toy production. This, together with the mega-retailers taking over distribution and the decreasing toy lifecycles, makes the toy market become more and more of a wear-and-tear market. However, we are seeing increasing quality awareness even in the toy market and BRI O (which also makes nursery products and furniture) has gained a reputation for making highquality products. Of course, being competitive in these markets comes down to innovation. During 2006, BRIO launched its first early products under the new management in line with the new strategy and we look forward to many new launches in the years to come. Financially, 2006 was another difficult year with BRI O in the midst of a turnaround process. The management has communicated to the market that BRIO should deliver positive cash flow from 2007 and a positive net result from 2008.

Traditional broadcasting under pressure
The world of television will of course not be unaffected by the larger developments in society that I comment on above. At the same time, technological development, deregulation and a revolution in media consumption behaviour is reshaping the industry. The traditional broadcasting model of television is under pressure. Over time, this means that the traditional national broadcasters need to find new positions – go from distribution to an increasing emphasis on owned rights and ideas. News and debate and other unique programming will be of rising interest and profitability. Financially, 2006 was a very good year for our television companies TV4 in Sweden and MTV in Finland on the back of an excellent advertising market, but also thanks to successful change leading to both lower costs and increasing profitability in new channels, local transmissions and new media.

In March 2007 Proventus announced a change in the structure of our engagement in television. Our 50 per cent ownership of Nordic Broadcasting, which owns TV 4 and MTV , was terminated and Proventus extended a subordinated loan to Nordic Broadcasting instead. We will continue to play an active role in the future development of the two television companies.

There is a market for a more intelligent and flexible lender
We are also continuing to build on our investments in development capital. In Europe, there is a need for a more active mezzanine market for medium-sized companies. The flood of liquidity we described above gives larger corporations ample – perhaps too ample – access to external capital. However, for medium-sized companies, the available alternatives are relationship banks or private equity money. Due to the Basel II rules of capital adequacy and a regulatory weakening of the creditors’ position in cases of default, the banking world’s appetite for lending to these companies is falling. Many family-owned companies, reluctant to surrender control to the private equity world, are therefore abstaining from economically sound investments and other pportunities for growth. With the demographic and other challenges we face, this is something we cannot afford.

We also believe there is a market for a more intelligent and flexible lender, one who can provide not only money but also experience and support for the company. Our experience is that many of these companies, perhaps turning to new market niches or new regions, face the same problems, and make the same mistakes. Proventus aims to assist the companies we invest in to grow profitably, both because it is vital to our situation as a lender and because it will lead to more business opportunities for us in the future.

Investments in renewable energy
The investment team at Proventus spends a great amount of time and energy on proactive analysis. Apart from macro analysis on economic development, demography and changing democratic and social patterns, we follow closely the development of financial markets, as well as larger trends that affect the economy and indicate business opportunities. Two of the fields that we have spent time on in the last few years are functional food and renewable energy. Our efforts in functional food – based on a belief in the need for increasing preventive health awareness – are yet to result in an investment. In the field of renewable energy, we formed o2 Produktion in 2006. Proventus owns 70 per cent of o2 Produktion in partnership with the Swedish energy co-operative o2 Gruppen. The ambition is to build an electricity production company based solely on renewable sources, with wind power as the main focus. As fossil fuels approach peak levels, we will need to seek alternative sources of energy. Wind power is still in need of subsidies, but we believe that over time it will be an efficient technology that has the potential to replace some of the capacity of increasingly obsolete methods. o2 Produktion is currently building its first wind power plant in Dalarna, Sweden. The plant will be up and running by the end of 2007.

Engagements in culture and society
In addition to our investment activities, Proventus is engaged in research, experimenting, learning and debate, aiming at contributing to European societybuilding. This engagement is characterised by a long-term perspective and a focus on humanistic values and falls into three categories: contemporary culture, currently within Magasin 3 Stockholm Konsthall, the Jewish Theatre and the Batsheva Dance Company; environmental issues with special focus on our seas and oceans through our engagement in the Israeli environmental organisation EcoOcean; and research focusing on economic, demographic and democratic developments in Europe, carried out through the Jewish Cultural Heritage Foundation as well as through the research that is done in-house at Proventus.

Our engagements in the arts have continued to develop in experimental and exciting ways. The inspiration and learning we get through living close to these institutions is immense. 2006 saw a number of very strong exhibitions at Magasin 3 Stockholm Konsthall, including Paul Chan, Gunnel Wåhlstrand, Kimsooja and Fabrice Gygi. Magasin 3 was also rebuilt during the summer and now includes a library and a café. The first major exhibition of Pipilotti Rist in Scandinavia and another strong group exhibition, “Fleeing away from what bothers you most”, resulted in a record number of visitors during the first months of 2007.

At the Jewish Theatre, we were happy to see the successful result of the cooperation with Batsheva Dance Company in the truly innovative dance installation Furo. In February 2006, as part of the Stockholm New Music festival, the Jewish Theatre also staged Shadowtime, with music by Brian Ferneyhough and text by Charles Bernstein.

As part of Proventus’ interest in research on long-term European economic, demographic and political developments, and through our engagement in the Jewish Cultural Heritage Foundation, we were involved in arranging the international congress “The New European Cultural Landscape and the Jewish Experience”, which took place at the Museum of Modern Art in Stockholm in March. We were very happy to be part of the congress, which was a great success in terms of content as well as press coverage.

Proventus moving on
Our physical environment has also changed. In May, Proventus moved to the top floor of the so called ’Glass Building’ (Swedish: Glashuset) at Slussen right on the Stockholm waterfront. For a number of years, we have been looking for a modern, functional and inspiring office space – an office that suits our activities and reflects our values. This new space mirrors the breadth of our activities – from culture to commerce. At the same time, it has been important for us to create a good environment for committed and creative work, as well as an inspiring setting for conversations and meetings. We believe that an office with these qualities is an important element in continuing to develop Proventus.

If you have a deeper interest in Proventus, our projects and activities, there is always up-to-date information on www.proventus.se. Launched in June, the aim of this site is to show our wide range of engagements, convey our values, release news about our projects and function as a node for the Proventus group.

In all, even though our view of the world may be seen as pessimistic, we believe that through continuing to develop our model of product-centric change and our activities – in business, culture and research – we can be successful and also hopefully contribute to a more positive development in society.

Stockholm, 2 May 2007

Daniel Sachs