Where are we? As 2010 begins, the relevant and deeply complex question to ask is probably: where are we? In the autumn of 2008, the abyss opened up and we went through a “near death” experience in the global economy. In addition to the collapse of the financial system – leading to inter-bank funding markets being totally non-existent for days – economic activity also collapsed – trade flows decreasing by no less than 90 per cent for a while. The fear of entering a period resembling the 1930s also spurred the most drastic and powerful coordinated global policy response ever seen.
The total fiscal stimulus within the G20 in 2009 was almost USD 700 billion, or 1.4 per cent of the combined GDP . Over time, the fiscal stimulus in the US will be even larger than the global amount for 2009 – and that is only the fiscal side. The monetary stimulus is the most aggressive in the 96-year history of the Federal Reserve. After six months, financial markets started rallying and economic activity slowly started to return. There is no doubt that the enormous fiscal and monetary response to the crisis succeeded in restoring functionality to financial markets and a certain level of economic activity. However, the structural problems that were made painfully apparent by the crisis of the financial system have not gone away. They have not begun to be addressed – in fact last year’s policies have exacerbated them.
The other real question right now is – when will stimulus be wound down and what will happen then? My fear is that the perceived recovery has been so rapid that we have missed some of the opportunities for fundamental change that come in times of crisis. It is too easy to return to business as usual; or as Bill Clinton recently put it: “It is hard to get people to agree with the truth when the lie is in fact financing their lifestyle”. A s I wrote in our annual report last year – the “Mythology of Crisis” – we at Proventus do not see this as a “financial crisis” or even a typical “recession”. We believe that what we saw in the autumn of 2008 and the spring of 2009 was not simply a blip in a positive long-term trend, but rather a symptom that something is fundamentally wrong. This was not just a financial crisis – it was the culmination of 20 years of living over our means, economically, socially and ecologically.
The real issue is the consumption bubble in the West and all the structural problems that come with it. Savings are still at too low a level, and an increase is bound to have an effect on consumption and corporate profits at some point. Also, the sovereign crisis in Europe shows that the overspending has existed on many levels. The required fiscal tightening will further hamper growth. In addition to the economic challenges, we also see increased inequality and weak social cohesion in the West. Larry Summers has put it aptly: “What we see is a statistical recovery and a human recession”. One of the biggest structural problems from a European perspective is the weak competitiveness of European industry. Even if the weak Euro helps in the short term, the fundamental competitiveness is weak. We see already how European automotive companies are forced to rationalize heavily or even go out of business, but competitiveness is a much broader issue.
European industry with its high cost levels has a hard time competing with China. Chinese companies, and companies from other newly industrialised countries, have very rapidly gone from exploiting short-term cost advantages to investing in innovation and competing through quality. Technology is far more omnipresent than at any time in history, but many mid-sized European companies have not had the resources to invest sufficiently in long-term strategic development. Also, there are a large number of smaller companies that need to go through generation shifts, and large companies that need restructuring. Not least, we are seeing a reversal in the strong trend of outsourcing and off-shoring that has been the rule for the last decade; more companies are taking back control over their supply chains and moving production closer to management and key markets. To sum up, there is a need for entrepreneurship, innovation and capital to replace and convert the old European industrial base into a new, competitive one. In our annual reports from 2003 until 2008, we have focused on these structural problems and our view on them. However, this year it is time to look ahead – what can we do to contribute towards development and create good returns?
Proventus Phase Three
Proventus has a long history of being innovative and contrarian in its investment approach. We have always looked for the “blind spots” in the capital market. In the early days of Proventus, even before the formal start of Proventus in its current form, back in the 1970s and early 1980s, the Swedish stock market was illiquid and underdeveloped. Valuations of Swedish companies were far lower than for their European counterparts. This was driven by the fact that the market was heavily regulated and exchange rate control meant that non-Swedish Investors could not invest in Swedish stocks. Proventus was very active on this market. As exchange rate controls were lifted and deregulation became the norm, the functioning of the stock market changed fundamentally, resulting in much greater transparency and liquidity. However, the Swedish, indeed the European, industrial structure was still inefficient in many aspects.
The engineering bias in corporate management and the lack of an efficient Corporate governance function had led to many large and unfocused conglomerates being built up. This created a void in which Proventus turned its focus to restructurings and actively working to bring focus and development to companies in need of change. Between the early 1980s and the early 1990s, Proventus carried out almost 70 restructurings with fundamentally positive results. Following upon the two experiences of investing in stocks in an underdeveloped stock market in the 1970s and being active in restructurings in the 1980s and early 1990s, we can refer to our current focus as the third phase of development. We have now turned our focus towards Corporate bonds and loans. This is the third time we act to address unmet needs by focusing on what we see as underdeveloped areas of the financial markets.
Demand For and Supply of Capital
This third phase is based on our analysis of macro-developments in general, and more specifically on what we are seeing in the capital markets. In 2009, both the demand and supply of capital were on hold. On the demand side, very little happened in terms of deals and other activities – the exception of course being refinancing of old debts as well as restructuring in cases where it could not be avoided. As regards refinancing, the use of the proceeds of bond issues changed from 90 per cent going towards acquisitions in 2008 to 75 per cent being used for refinancing in 2009. On the restructuring side, it seems that the many European restructurings that took place were focused on waiving bank covenants, extending maturities and postponing interest payments. Few restructurings involved injections of new cash and even fewer resulted in write-downs of senior debts. In essence, time has been bought, but there is bound to be a second wave of restructurings within the next 12-24 months where real changes in balance sheets need to happen and new capital will be key.
On the supply side, the banks withdrew from the market entirely and did not start to return – albeit slowly – until the end of the year. The primary equity markets were also closed for most of the year. The bond market however took care of most of the funding needed for refinancing – issuance of corporate bonds in Europe was more than double the average for the past ten years. In 2010, we already see the demand for capital returning. First of all, refinancing needs are enormous. In the market for high-yield bonds and loans, maturities are increasing from less than EUR 10 billion in 2008 to over EUR 50 billion in 2013. In addition, we see signs of mergers and acquisitions starting to take place.
Many companies are looking to resolve challenges to their competitiveness by increasing scale and efficiency through mergers. Some are healthy enough to be proactive in their merger activities, while others are reacting to pressure from banks or financial markets. Also, the demand for working capital in many industries is radically changing. Weakened customers and suppliers mean that a larger working capital needs to be funded externally. During the phase of lower economic activity, many companies have survived the decreases in demand by letting stock levels drop and cutting their wor king capital drastically. When demand starts to return, they will find themselves in a new situation with much higher needs for working capital.
Overall, we foresee that the needs of financing and restructuring in European industry will be considerable in the years to come. Things are also changing when it comes to the supply of capital. The banks are slowly returning to lending. Primarily, the banks are taking care of their existing customers, especially the bigger accounts which were in many cases treated as frugally as the smaller ones in 2009. However, we find it very unlikely that banks in general will return to the type of risk attitude and activity that prevailed before 2007. First of all, there are still a large amount of nonperforming credits that need to be taken care of. IMF predicts that we are only halfway through the necessary write-downs and loss provisions in US and European banks, with over USD 1,300 billion still to come. Also, we will still see the effects of deleveraging over time – the banks need to shrink their balance sheets. Many banks and financial institutions have also gone out of business or have refocused on their home markets, reducing the supply of international credit.
As always with this type of crisis, there is also a new attitude to risk that will be present for a number of years – the span of possible outcomes in any given situation has expanded, making banks increasingly cautious. Also, the competition for capital is increasing with the sovereign crisis in Europe which risks leading to severe crowding-out effects. And finally, we will see increasing regulation both as a result of among other things the Basel process that was already in progress before the crisis in the financial markets, and new regulations that are being drafted to prevent a similar collapse to that which we saw in 2008. The proposals that the Basel Committee on Banking Supervision has recently published – Basel III – include major changes, not least with regard to capital requirements and liquidity. This has the potential of increasing the cost of lending and restricting the supply of credit.
As for equity markets, liquidity is improving. We have seen some IPO activity in the spring of 2010 and private equity firms are well financed and are moving from dealing with old problems to making new investments. However, the public equity market remains very sensitive to shocks. The expectation in the S&P 500 is that profit levels in 2010 should be 90 per cent of what they were in 2006 – a year when Corporate profits hit a record 14.6 per cent of GDP in the US and when a large proportion of the profits came from banks and financial institutions. The risk of disappointments looms large. On a different level, we are also demographically challenged in that we are living with ageing populations in the West. This also means that a large part of the population will need to make use of savings – or de-save – in coming years, which means that the volatility of the stock market could be a problem. In many ways, the bond markets offer a better match for the large pension liabilities sheets of companies as well as nations. In fact, over the last 20 years in Sweden, the total yield of the bond market has been higher than the stock market.
The Need For a New Bond Market
So, while the need for capital and restructuring will be substantial in coming years, the supply of capital is likely to be less reliable. From this perspective, it is a problem and a major cost to society that the market for corporate bonds and subordinated capital is so underdeveloped in Europe. In relative terms, the market for Corporate bonds in Europe is just a fifth of the US market. There are several reasons for this, but I would claim that the main explanation is the reliance on relationship banking in Europe. Historically, the primary source of capital was the bank, which was also often an advisor to the company and even willing to step in as an owner if the situation so required. The US bond market was opened up in the early 1980s – largely through the activities of Michael Milken and his colleagues at Drexel, Burnham & Lambert. Even though this ended badly for Milken and some of his colleagues, the development of the bond market that they initiated helped fund a lot of small and mid-sized companies and also acted as a catalyst for the restructuring of many large and inefficient US corporations in the hands of able entrepreneurs.
Europe needs a similar development. In view of the banks’ changing risk appetite, there will be a need for capital ready to take on a greater risk than the banks. Equity is not suitable in all these situations. The European market for corporate bonds – especially the lower end of this market – is veritably archaic in its function. Trading is done over the phone with virtually no trading statistics and a low level of standardisation when it comes to corporate governance. At the moment, this market is trapped in a Catch 22 situation – the institutional investors do not invest since the lack of transparency and liquidity makes it a difficult market for them. Many companies and potential issuers do not see the bond market as an alternative because of the lack of institutional interest and the high costs of capital that result from the lack of liquidity and demand. Changes in the regulations have been discussed at European level, for example as regards the transparency of bond markets, but change will take time and self-regulation would be vastly preferable.
In addition to the issue of transparency and liquidity, corporate governance is a problem. In the past year a number of restructurings have been carried out in Europe where the senior lender and the equity owner have agreed on a restructuring plan that has squeezed out the mezzanine or junior lenders. This is partly a result of weak agreements that became standard in the heyday of LBO funding up until 2007 and which gave the junior capital virtually no rights in an insolvency situation, but partly also because there are very few guardians of junior lenders’ interests. We need more active players who protect the interests of all investors in the markets for corporate bonds and mezzanine financing. Also, if we are to increase transparency and liquidity and thus hopefully open this market up to individuals and smaller investors, we will need to standardise the terms of corporate bonds to a much larger extent – who can take the time to read a 400-page prospectus?
We will also need much more independent research and analysis as well as the type of structured and institutionalised self-regulation that is present in the stock market. As regards transparency, liquidity and governance of bond markets, we have taken an initiative together with Nasdaq OMX to gather investors, issuers, banks and regulators in a discussion of how this market could be developed. Our view is that Europe needs a much more transparent, liquid and effective market for corporate bonds, especially for mid-sized companies. This market will also need active investors who are willing to engage in the necessary restructurings.
Proventus Capital Partners
This is the reason for our strategy focusing entirely on investing in subordinated lending and corporate bonds for mid-sized companies in Europe. We feel that we have the experience and know-how to be an active investor in these markets and contribute to their growth and development. Proventus has a long history of being active in the capital markets and in funding mid-sized businesses for growth and restructuring. We have been active in the bond markets for at least a decade and our solid experience and track record in restructurings make us well positioned to take on an active role in the companies we finance should the need arise. In 2009, we took an additional step in this development through the formation of Proventus Capital Partners. To be successful in these markets we will need more capital in order to build a well-diversified portfolio and at the same time be large enough in each investment to have a seat at the table.
Proventus Capital Partners is a 220 million euro co-investment structure which is to be placed over the next two years. Our coinvestors are the Fourth National Pension Fund (AP4), the insurance companies Folksam and Länsförsäkringar and a further 20 investors both institutional and private. W e realise that it will take some time for this market to develop, especially since stimulus is currently making capital markets unnaturally liquid and risk premiums unnaturally low, but we are convinced that within five years the market for bonds and loans to European companies will be much more active and liquid than it is today. And we intend to be a major actor in that market.
Daniel Sachs, CEO Proventus, Stockholm, 25 May 2010