The New “Normal” Implications of Sovereign Debt and the Competition for Capital A survey and report created with Printed June 2010 Table of Contents About the survey Introduction + Key survey findings CPP – The IPO markets re-open Sovereign debt: crisis and change + Investor appetite for sovereign debt + Longer-term prospects + Changing perceptions of risk Postponing the inevitable: An interview with Carmen Reinhart The reserve currency of choice Sophos exploits the thawing of the private equity market The outlook for corporates + Cash and other alternatives + Regulation and credit availability Nord Stream: From three banks to 26 Conclusion 8 9 11 12 13 14 16 17 19 20 About RBC Capital Markets RBC Capital Markets is A Premier Investment Bank Our strengths in providing focused expertise, superior execution and ­insightful thinking have consistently ranked us among the top 20 global investment banks With over 3,000 employees, we provide our capital markets products and services from 75 offices in 15 countries and work with clients through operations in Asia and Australasia, the U.K and Europe and in every major North American city We are part of a global financial institution, Royal Bank of Canada (RBC) RBC has been providing financial services for over 140 years We are a top 10 global bank by market capitalization and have one of the highest credit ratings of any financial institution: Moody’s Aaa and Standard & Poor’s AA- About The Economist Intelligence Unit The Economist Intelligence Unit is the business information and research arm of The Economist Group, publisher of The Economist Through its global network of 650 analysts, it continuously assesses and forecasts political, economic and business conditions in more than 200 countries As the world’s leading provider of country intelligence, it helps executives make better business decisions by providing timely, reliable and impartial analysis on worldwide market trends and business strategies Foreword Our clients are operating in unprecedented times – what many are calling “the new normal” This environment of high frequency change and evolution is challenging institutional investors and corporate executives to understand, as never before, the derivative implications of complex global economic issues when making important capital allocation decisions for their organizations At RBC Capital Markets, we strive to provide our clients with relevant information and a unique perspective to help them make the best decisions possible With this goal in mind, we partnered with the Economist Intelligence Unit to embark on our second poll of over 400 capital markets participants to specifically address sovereign risk and the outlook for global investors and corporates We launched our survey on April 28, 2010 – concurrent with the beginning of the most volatile month of the European debt crisis – and received responses through the end of May This white paper is the result of the survey work conducted in the midst of this crisis It reveals interesting insights regarding the impact of recent financial, economic and fiscal events on future financing and investing decisions of corporate and institutional leaders Some of the themes addressed in the report include: • Guarded optimism about industrialised North American and Asian economies over the next 12 months • Decoupling of European prospects for currency, fiscal solidarity and economic growth from global peers • Long-term capital availability concerns for sovereigns and a cautionary approach from corporates in light of risk reorientation Paul Abberley, Chief Executive, Aviva Investors Paul Corcoran, Financial Director, Nord Stream James Douglas, Head of Debt Advisory, Deloitte Teddy Moynihan, Partner, Oliver Wyman Steve Munford, Chief Executive Officer, Sophos Shaun Parker, Chief Financial Officer, CPP Carmen Reinhart, Co-Author of This Time Is Different Robin Stalker, Chief Financial Officer, Adidas Ian Winham, Chief Financial Officer, Ricoh Europe Theo Zemek, Global Head of Fixed Income, AXA Investment Managers We hope you will find the report insightful Marc Harris Co-Head of Global Research RBC Capital Markets Richard Talbot Co-Head of Global Research RBC Capital Markets About the survey • Respondents were almost evenly split between financial institutions (229 or 52%) and non-financial corporations (211 or 48%) • Among the financial institutions, 27% were commercial banks, 20% investment banks, 19% asset managers, 16% private equity firms, 10% hedge funds and 8% pension funds, sovereign wealth funds or other institutional investors About one-third had over $150bn in assets, while 60% had over $10bn.1 • The corporates came from a wide range of industries, with six sectors accounting for 61%: healthcare and pharma, professional services, manufacturing, technology, energy and natural resources, and retail Threequarters had over $500m in annual revenues and about a third had over $5bn As part of this research program, RBC Capital Markets commissioned the Economist Intelligence Unit to survey 440 capital markets participants on the effects of the recent financial, economic and fiscal events on borrowers and investors The online survey was done over a period of four weeks, from April 28 to May 25, 2010, a time of massive market volatility and constant headlines on a potential Greek default (see below) Headlines over the time period Greece readies austerity measures, markets steady April 30 • The largest group of respondents, ECB dashes rescue hopes EU, IMF stitch together €750bn emergency fund; IMF to disburse €5.5bn now Greece gets €14.5bn loan from EU IMF chief economist says Greek aid package doubts remain May May 10 May 18 May 25 41%, was from Europe, followed by North America (34%) and Asia-Pacific (16%) The remaining 9% were from Latin America, the Middle East or Africa a senior group, with 38% at the C-level and 61% at or above the VP or director level The rest were heads of business lines, departmental heads or managers Cumulative Responses • The executives polled were All $ figures are USD$ unless otherwise noted The New “Normal” Market activity during the survey window The timing of the survey coincided with a period of extreme volatility visible in most market indicators $ per Euro VIX Index 1.5 50 40 1.4 30 1.3 20 1.2 10 Jun Aug Oct Dec Feb Apr Jun Jun Aug S&P500 FTSE-100 1,250 6,000 Oct Dec Feb Apr Jun 1,200 5,500 1,150 1,100 5,000 1,050 1,000 4,500 950 900 850 Jun 4,000 Aug Oct Dec Feb Apr Jun Jun Aug Greek sovereign CDS spreads WTI crude oil 1000 90 Oct Dec Feb Apr Jun 900 85 800 700 80 600 500 75 400 70 300 200 65 100 Jun 60 Aug Oct Dec Feb Apr Jun Jun Aug Oct Dec Feb Apr Jun Source: Bloomberg The New “Normal” Introduction “The lesson of history, then, is that even as institutions and policy-makers improve, there will always be a temptation to stretch the limits Just as an individual can go bankrupt no matter how rich she starts out, a financial system can collapse under the pressure of greed, politics and profits no matter how well regulated it seems to be.” This Time Is Different, Carmen Reinhart and Kenneth Rogoff As one crisis leads to another – first financial, then economic, now fiscal – market participants struggle to discern the shape of the next big wave Investment-grade capital providers and borrowers have plenty of cash and the ability to get more But in terms of perceptions and performance, the gap between high-quality borrowers and others – companies, sovereigns or even entire industries – has seldom been wider And capital providers need to remain vigilant in light of continuing writedowns and regulatory challenges that could reduce their financial flexibility Demand for funding is low today, but competition may well grow more acute The scale of debt issuance required by governments and financial institutions over the next few years will be almost without precedent As demand grows, any institution seeking to raise capital will face more selective and critical investors The euro is not likely to recover soon; sovereigns in developed nations will need years to repair the fiscal damage To succeed in this environment, borrowers will require strong, long-term relationships and the ability to construct a convincing argument for their prospects in a volatile environment At the end of 2009, the global economy was showing strong signs of recovery Major economies had emerged from recession, equity markets had enjoyed a sustained boom, trade was flowing again, and corporate profitability had returned after companies had slashed costs Even the major investment banks at the epicentre of the crisis enjoyed a strong rebound and posted significant increases in revenues and profitability But despite a growing sense that the worst is over, serious problems continue to bubble up The economic recovery is uneven, with emerging markets leading the way and industrialised countries constrained by damage to the financial sector Banks are in better shape than at the start of 2009 but continue to be severely impaired, particularly in Europe And unemployment remains stubbornly high in many OECD countries, constraining consumption and prompting further fears of defaults on loans But perhaps the most severe challenge is the indebtedness of many industrialised countries The massive transfer of debt from the private sector to the public sector, along with an unprecedented fiscal and monetary stimulus from the world’s major industrialised economies, has led to a dramatic deterioration in public finances As the OECD notes: “Many countries are facing very unfavorable government debt dynamics, as rising indebtedness raises risk premia, which adds to the debt burden while holding back growth, which has further adverse consequences on debt sustainability.” 2 OECD Economic Outlook No 87, May 2010 The New “Normal” Key survey findings TOPIC FINDINGS Financial institutions and corporates are guardedly optimistic about the prospects for economic growth > Respondents expect growth-friendly monetary (if not fiscal) policies over the next three years > Despite strength in the emerging markets, growth in the developed nations will remain below historic norms > Respondents expect the prospects for industrialised Asia and North America to improve over the next 12 months The economic prospects for Europe appear to have decoupled from those of other industrialised regions > A strong consensus exists that Europe’s prospects are negative > There is little confidence in the euro; most respondents expect it to continue its slide in value > Almost half of respondents think there is a greater than a 50/50 chance of one or more countries leaving the eurozone in the next three years > One-third see at least a 25% chance of a complete break-up of the eurozone over the same period > Problems facing the euro have reinforced the position of the dollar as the international reserve currency of choice The European sovereign debt crisis has caused a reorientation of risk > There are concerns that governments of developed countries will not have sufficient credit capacity for the massive intervention required to kick-start their economies in the event of another financial crisis > Sovereign debt is not alone in being perceived as more risky: respondents think all asset classes have become riskier as a result of the financial crisis > A small majority of respondents expect yields on bonds from the most creditworthy corporates to fall below those of sovereign benchmarks over the next three years – corporates, suggest these respondents, are the new sovereigns Economic uncertainty is deterring corporates from raising capital > Just one-third of corporates say that they plan to raise capital over the next 12 months > For companies that plan to raise capital, investment-grade debt and private equity are the most popular categories > There is a mismatch between expectations of financial services and corporate respondents; the former are more optimistic about the outlook for transaction volumes than the latter > More than half of companies have restructured their business operations to improve access to capital The New “Normal” Although the actions of policy-makers around the world have been effective in dealing with the short-term problems of the financial crisis, many commentators continue to worry that the underlying problems remain unresolved “Policy-makers essentially took a private sector debt overhang and nationalised it,” says Paul Abberley, Chief Executive of Aviva Investors “The response to the financial crisis has delayed a reckoning rather than solving the problem and getting us back to normal.” While corporates and investors expect a return to growth, the adverse economic headwinds continue to weigh heavily on their minds Among the survey respondents, 87% think that economic growth will be positive over the next two years, but only 5% expect it to exceed levels seen in 2003 to 2007 There is a strong consensus that growth will be driven by policy intervention rather than an improvement in the economic fundamentals The number of respondents who agree that central banks will continue to prop up the economy and financial sector rather than fight inflation exceeds the number who disagree by 44% (see Chart 1) Respondents also foresee a divergence between developed and undeveloped markets Many more respondents agree than disagree with the assertion that economic growth and consumer demand in developed countries will remain well below the post-war norm (see Chart 1) We find similar levels of agreement with the statement that faster-growing nations such as China and India will replace the U.S as a source of import demand driving global growth.3 To use a phrase borrowed from Mohamed El-Erian, CEO of PIMCO, this is the “new normal” of “muted growth overall, a protracted need for balance sheet rehabilitation, accelerated migration of growth and wealth dynamics to systemically important emerging economies and relatively weak global governance”.4 Chart 1: Positive albeit modest growth prospects Demand and growth over next years (agree minus disagree) Central banks will continue to prop up the economy and financial sector rather than fight inflation Even after income, credit and confidence return, U.S consumers will not spend at historic peak levels Economic growth and consumer demand in developed economies will remain well below the post-war norm For instance, China’s spending on imports rose 48% year-on-year in May and India’s imports 43% in April PIMCO Secular Outlook, May 2010 Faster-growing nations will replace the U.S as a source of import demand driving global growth 0% 10% 20% 30% 40% 50% Respondents were given choices of agree, disagree, neutral or don't know/no opinion The chart shows the percentage choosing "agree" less those choosing "disagree." It does not show those choosing "neutral" or "don't know/no opinion." The New “Normal” But although growth prospects are polarised between industrialised and emerging economies, there are important nuances While respondents undoubtedly see Asia as having the best economic prospects over the next 12 months, North America is close behind in terms of levels of optimism The outlier is Europe, which many more respondents think has a negative outlook than a positive one (see Chart 2) Essentially, survey participants’ perceptions of Europe’s economic outlook appear to have decoupled from their perceptions of the rest of the industralised world Chart 2: E  urope’s lack of expected growth contrasts with the rest of the world Economic prospects over next 12 months by region (better minus worse) India Other developed Asia (Hong Kong, Singapore, South Korea) China North America Russia Middle East Africa Japan Europe -40% -20% 0% 20% 40% 60% 80% Respondents were given choices of better economic prospects, worse economic prospects, no change or don’t know/no opinion The chart shows the percentage choosing “better prospects” less those choosing “worse prospects.” It does not show those choosing “neutral” or “don’t know/no opinion.” CPP – The IPO markets re-open In the first quarter of 2010, there were 100 IPO deals globally, making it the best quarter for issuance since the end of 2007 CPP, an insurance company providing protection against credit card and identity theft, was one beneficiary of this trend In March 2010, it raised £150m (US$220m) on the London Stock Exchange through an IPO that valued the company at £396m (US$581m) Although the shares were priced at the lower end of the expected range, the IPO is a sign of growing investor appetite to participate in new offerings The IPO took place before the eruption of sovereign debt problems, but there was still considerable volatility “As we went into the process there were good weeks and bad weeks in the financial markets,” says Shaun Parker, Chief Financial The New “Normal” Officer of CPP “At some points things looked bad and then all of a sudden the market would firm up again So it was a period of considerable volatility but still within a reasonable boundary that led us to feel comfortable about the timing.” A number of other companies cancelled offerings due to market volatility or lack of demand The key to success, according to Mr Parker, is to ensure that the company has strong financial fundamentals before going to market “We’re a business with a growth story and we’ve proven that over a relatively long period of time,” he explains “We also generate cash, which means we can pay out a pretty strong dividend I believe that if the fundamentals are there and investors have money to invest, then they will be willing to get involved.” Sovereign debt: crisis and change Although few industrialised countries can boast a positive fiscal outlook, the problems have become most acute on the periphery of the eurozone In December 2009, Greece’s credit rating was downgraded to the lowest in the eurozone as a result of concerns over its ballooning debt Despite promises of “austerity measures” comprising public spending cuts and tax increases, Greek bond yields jumped to unprecedented levels Fears grew that other indebted members of the eurozone – Portugal, Spain, Italy, Ireland, even France – faced problems on a similar scale Despite a €750bn rescue package announced in late May by eurozone finance ministers, concerns about a potential Greek default, and indeed for the future of the entire eurozone, persist “The bail-out failed to reassure the markets, but I think it would have been impossible at an institutional level to move any faster than the governments actually did,” says Mr Abberley The problems facing the eurozone have raised questions as to whether the euro can survive the crisis Almost half of survey respondents think there is a greater than 50/50 chance of one or more countries leaving the eurozone in the next three years (see Chart 3) More worryingly, about one-third see at least a 25% chance of a complete break-up of the eurozone over the same period (see Chart 4) Part of the problem has been that peripheral countries have built up fiscal deficits that massively breach the eurozone’s targets of 3% of GDP But a deeper problem has been a monetary union achieved without fiscal or political union “I genuinely cannot see how in the longer term the euro can last in the form that it is in, unless there is greater fiscal and political centralisation in Brussels,” says Theo Zemek, Global Head of Fixed Income at AXA “And the implications of that are so onerous that I not believe it will ever happen.” Investor appetite for sovereign debt In 2009, sovereign debt issuance surged to record levels in the U.S., U.K and eurozone as crisis-related interventions led to a dramatic increase in borrowing requirements This huge transfer of debt from the private to public sector raises the question of whether institutional investors will have the capacity or willingness to absorb the supply of new sovereign debt issuance Among the survey respondents, significantly more agree than disagree with the assertion that the credit capacity of developed countries will diminish significantly compared with capacity today (see Chart 5) Respondents agree even more strongly that developed countries will not stop Chart 3: Survey respondents estimate the odds of one or more countries leaving the eurozone in the next three years 14% 46% of respondents say the probability is 50% or more 12% % of respondents 10% 8% 6% 4% 2% 0% Probability of at least one country leaving Eurozone in next years The New “Normal” Chart 4: Survey respondents estimate the odds of the eurozone breaking up in the next three years 75–100% Probability 36% of respondents believe there is at least a 25% probability 50–74% Probability 7% 11% 25–49% Probability 18% increasing their levels of indebtedness until investors force them to scale back on debt purchases (see Chart 5) In short, even supposedly “safe” sovereigns could experience a shock if they not restore fiscal discipline and bring down deficits For now there is sufficient appetite for sovereign debt issuance, even if the conditions may not be to everyone’s liking “Everything can be digested under certain scenarios – it is just that some are more pleasant than others,” says Professor Reinhart “There will be costs You cannot take current interest rates as a given in this kind of scenario because the issuance by the major parties is so huge.” 64% of respondents 0–24% Probability A persistent risk aversion among investors also suggests higher allocations to bonds despite a reassessment of sovereign debt “In one form or another, pension funds and other large investors are increasing their exposure to bonds at the expense of equities,” says Ms Zemek “But given the choice, we are buying shorter-dated bonds and we are buying ones with inflation protection.” Changing demographics, particularly in the developed world, also benefit bonds “The demographics of the wealthy world suggest that there will be more aging and this will require a greater shift towards age-related products, of which bonds are certainly one,” says Ms Zemek Longer-term prospects Despite price volatility, sovereign assets have a good deal going for them over the long term Banks are likely to hold more sovereign debt to meet new rules on capital adequacy and liquidity Basel III will heavily weight government bonds on the asset side, leading to higher demand for sovereigns Moreover, banks have learned the importance of holding assets that can be sold quickly and easily As the most liquid asset class by far, government bonds will always hold strong appeal The New “Normal” Changing perceptions of risk But while banks and other investors will continue to place great emphasis on sovereign debt as an asset class, they will increasingly take the view that not all government bonds are created equal Before the crisis, there was an assumption that all sovereign debt had similar risk and that spreads between countries were minimal Investors are now more discriminating – and this discrimination is reflected in bond prices Chart 5: Financial executives say that the sovereign crisis is far from over Opinions of sovereign credit over next years (agree minus disagree) Developed countries will not stop increasing their levels of indebtedness until investors force them to by scaling back on debt purchases In the aftermath of another financial crisis, governments will not have sufficient credit capacity for the massive intervention required to re-start the economy The credit capacity of developed economies will diminish significantly compared to capacity today Corporate bonds from the most creditworthy companies will yield less than their sovereign benchmarks Respondents were given choices of agree, disagree, neutral or don't know/no opinion The chart shows the percentage choosing "agree" less those choosing "disagree." It does not show those choosing "neutral" or "don't know/no opinion." This reassessment of risk raises questions about how fixed income products should be priced in the future “If the government bond you own is no longer a risk-free rate, then you have a re-orientation of the corporate bond market,” continues Mr Abberley “Rather than saying a bond is 112 basis points over you have to go back to the days when you say: the yield is 7% But is that the right number?” Of course, sovereign debt is not the only asset class that is perceived as riskier as a result of the financial crisis Asked how their risk perceptions had changed over the past year, more respondents said that risks were higher than lower for every single asset class (see Chart 6) Indeed, currencies and equities were perceived to have become even more risky than sovereign debt At the same time, a significant minority of respondents said that certain asset classes had become less risky The top three were classic inflation hedges: real estate (both residential and commercial) and commodities And indeed, a majority of both corporate and financial services executives said that they had begun to fear the impact of inflation more than deflation This stands in contrast to the survey that preceded this one – done in August of 2009 – in which executives split close to 50-50 on expectations for the impact of inflation versus deflation Chart 6: Financial services respondents perceive all asset classes as becoming more risky over the past year Less risky More risky Currencies Commercial real estate in my country Equities Corporate debt in my market Sovereign debt of my country, if not U.S Residential real estate in my country U.S Treasuries Private equity Hedge funds Commodities % of respondents 10 The New “Normal” Postponing the inevitable: An interview with Carmen Reinhart In May, the European Central Bank and IMF announced a €750bn aid package to stem the panic over Greek sovereign debt After a brief rally, the euro plunged to a new low and investors fled to U.S Treasury bills there’s going to be a restructuring, which is a partial default so it’s a matter of semantics at that stage,” she says “We don’t have many tools available to deal with this crisis so one can’t rule out restructuring.” For Carmen Reinhart, professor of economics at the University of Maryland and co-author with Kenneth Rogoff of This Time Is Different, the reaction was typical In her book, she traces the history of financial crises across 800 years and finds patterns in how they unfold Financial crises are often followed by sovereign debt crises as governments face falling tax revenues and the cost of bailouts This, in turn, often leads to defaults on sovereign debt But delay is good: it provides time to reduce positions in an orderly fashion and reduces the risk of contagion The element of surprise is one of three factors that Professor Reinhart calls “the unholy trinity of financial contagion,” along with an abrupt reversal in capital inflows and a leveraged common creditor “Episodes that turn out to have fast and furious contagion tend to be characterised by surprise and high leverage,” she says “And an immediate default by Greece would have had both of those elements So postponement plays a useful role in giving Europe time to adjust to this.” Professor Reinhart foresees a similar cycle in the sovereign debt problems of the eurozone “Although the situation in many of the more troubled European countries is different, the collective exposure has led to a fundamental risk reassessment of those countries,” she explains “And that, coupled with worrisome growth prospects, makes for more non-performing loans In turn, that leads to more banking problems and further fiscal strain.” The troubles on Europe’s periphery have echoes of sovereign debt crises such as Mexico in 1994-1995 or Turkey in 2000 But the problems facing Greece are particularly severe “Both Mexico and Turkey had far stronger fundamentals and were able to devalue their currency, which is not an option for Greece,” she says Professor Reinhart believes that the ECB and IMF bailout will only delay Greece’s default “I think The New “Normal” Holdings by European banks of troubled sovereign bonds raise the spectre of banking crisis “Even if the ripple effects are not on the gloom-and-doom panic mode for European banks, they are on the downside and that means that growth prospects are further dampened,” says Professor Reinhart “The combination of higher risk in lending and lower growth prospects tends to end badly for banks When they end badly for banks, they end badly for governments, too.” Many survey respondents predict that countries will drop out of the eurozone “I think the efforts will be enormous to try to avoid that,” says Professor Reinhart “I’m not saying that particular scenario will not play out, just that this will be something that countries will work very hard to avoid.” 11 The reserve currency of choice The cloud hanging over the euro has reduced the likelihood of a shift away from the dollar “The fact that the whole coalition surrounding the euro has seemed rather weaker than one would have hoped has undermined its position as a solid and tested reserve currency,” says Ms Zemek “It’s just not clear how a politically and fiscally diverse entity such as the E.U would perform over the long term according to a number of different scenarios.” But this says less about the dollar than it does about a lack of real alternatives “If you are an investor looking for a reserve currency, that is a pretty unpalatable choice,” says Mr Abberley “None of [the currencies] have anything to commend them at the moment Almost by default, the dollar remains the reserve currency at the present time But I don’t think people will talk about dollar reserves with any great relish because they’ll also be aware that, to a degree, the dollar story can only be maintained as long as everyone else believes it.” The vast majority of respondents (80%) expect the dollar to remain the reserve currency of choice in three years’ time, while 57% expect it to retain its role in five years’ time (see Chart 7) Over the five-year horizon, respondents are more likely to expect the Chinese renminbi to take over than the euro – despite the low likelihood of this occurring Ultimately, this finding says more about the poor perception of the euro than it does about the potential of the renminbi While the weakness of the euro may postpone its chances of becoming a more widely used reserve currency, its decline is good news from an economic perspective because it may help the region export its way out of the crisis Although a credible currency is important, so is an exchange rate that stimulates growth Chart 7: There is no substitute for the dollar in the intermediate term What will be the world’s dominant reserve currency in three years? In five years? Dollar Euro years Special drawing rights years Renminbi Don’t know % of respondents 12 The New “Normal” Sophos exploits the thawing of the private equity market The financial crisis devastated the private equity industry According to Ernst & Young, the number of acquisitions fell by 38% in 2009 while total deal values fell by 56% to US$95.5bn But this drop conceals a more nuanced picture While highly leveraged transactions may still be difficult to conduct, there continues to be a market for equity in fast-growing companies with strong balance sheets One such company is Sophos, an IT security and data protection firm with headquarters in the U.S and U.K In May 2010, Sophos announced that it had reached an agreement to sell a majority interest to Apax Partners, a global private equity house The transaction would value Sophos at US$830m Unlike many private equity deals prior to the crisis, the transaction between Sophos and Apax relies on low levels of leverage In return for a US$400m equity investment, Apax will take ownership of 70% of the company The remaining 30% will be financed with debt “We were not keen to enter into a highly leveraged deal,” says Steve Munford, Chief Executive Officer of Sophos “The goal was to support the company through its next stage of growth You can’t that in a technology company if you’re highly leveraged We need to retain a degree of agility to take advantage of acquisitions or investment opportunities as they arise.” The agreement occurred during a period of rising concern about sovereign debt from Greece and other peripheral eurozone countries But The New “Normal” according to Mr Munford, this had no material impact on the economics or willingness of either party to complete the deal “We wanted a partner that would take a longer-term view, beyond what’s happening in the markets in this quarter and the next,” he explains “And when you have a four- to five-year investment horizon, a short-term change in the markets may cause some discomfort, but it certainly doesn’t change the long-term merits of the investment.” Mr Munford felt that the longer-term perspective could not be achieved through a public listing In 2007, Sophos embarked on the early stages of an IPO but cancelled its plans because of concerns about the emerging financial crisis At that time “it was tough to get the right demand at the right valuation,” says Mr Munford The financial markets may have since stabilised, but a public listing would still not have been appropriate “Although the public markets were open, they were certainly going to be choppy and what we didn’t want to is have the conditions of the public markets affecting our ability to provide liquidity and raise capital,” says Mr Munford This does not preclude a public offering in the future Mr Munford views the current deal with Apax as a stepping-stone to a public listing once the company has grown “We see private equity as a viable alternative to delaying an IPO and giving our company the benefits of raising capital but allowing us to continue to invest in the future,” says Mr Munford “Our goal is to continue our growth trajectory and enable us to have more skill and staying power in the market.” 13 The outlook for corporates A gradual recovery in the global economy encourages corporates to shift their focus to strategies for growth, rather than cost-cutting and strengthening their balance sheets Although volumes remain small by pre-crisis standards, there is a gradual return of M&A activity, private equity deals, project financings and IPOs But despite the return of strategic activity, the number of companies that expect to raise capital remains surprisingly low Just 38% of respondents say that they expect to issue new debt or equity capital in the next two years (see Chart 8) This suggests that many companies harbour doubts about the strength of the economic recovery and are shelving major strategic growth projects for the foreseeable future Chart 8: Corporates have scaled back funding plans Does your firm expect to raise new capital in the next two years? Yes, significant amounts of capital Yes, moderate amounts of capital No, we will finance the current level of operations from cash flow and retained earnings No, we will finance a scaled-down level of operations from cash flow and retained earnings May 2010 Aug 2009 No, we are unable to access the capital markets Don’t know % of respondents Further evidence of this pervasive caution can be seen in the mismatch between the expectations of financial services respondents and those from the corporate world When asked about the outlook for transaction volumes in their country or region over the next 12 months, respondents from financial institutions are, without exception, more optimistic than corporate executives (see Chart 9) Overall, respondents see M&A activity as the area where an increase in transaction volumes is most likely, with 61% of financial services respondents expecting an increase, compared with 52% of corporates Although higher equity prices in 2009 stimulated optimism on a return to M&A activity, this seems to have faded “It’s going to be quite a while before there’s sufficient liquidity in the market to support a return to an M&A boom,” says Teddy Moynihan, a Partner in the Corporate and Institutional Banking practice at Oliver Wyman in EMEA “When deals happen, there will be a focus on transactions that are not highly leveraged, that have very good cash flows and can service debt easily without a lot of risk.” Which group’s forecast of transaction volume has more credibility? Ultimately it is the corporations that are closest to their own capital-raising decisions The most creditworthy may have already filled up on funding, while the less creditworthy have fewer funding opportunities and lower expectations The respondents from the financial institutions are specialists in their markets But the scope for originating assets backed by financial portfolios is limited, and it will be difficult to create transactions when corporations have little interest in them 14 The New “Normal” Chart 9: Corporates have scaled back funding plans Outlook for transaction volumes over next 12 months vs last 12 months M&A activity Secondary equity offerings Initial public offerings Investment-grade debt Private equity High-yield debt Convertible debt Syndicated loans Financial institutions Corporates Commercial paper Preferred equity 0% 10% 20% 30% 40% 50% 60% 70% % predicting an increase in transaction volume over next 12 months Uncertainty about future growth is leading corporates to postpone major fundraising plans According to the Bank for International Settlements, borrowers from developed economies reduced their issuance by 38% in the final quarter of 2009, although those from emerging markets raised 19% more funds in the international market than in the third quarter.5 The crisis in the eurozone, combined with the unexpected unilateral decision by the German government to ban naked short-selling, has unsettled the markets “People are postponing bond issuance while the environment is so uncertain,” says James Douglas, Head of Debt Advisory at Deloitte “It was unexpected but it is having a pretty significant knock-on effect on companies who have had to shelve capital raising plans as a result of the sovereign turmoil.” But not all corporates think that the sovereign debt problems will affect their capital raising activities “What is happening at the moment is of concern in terms of the value of the currencies but not in terms of raising capital,” says Robin Stalker, Chief Financial Officer of Adidas “It is a worry but won’t in the short-term or long-term affect our ability to raise capital.” The New “Normal” BIS Quarterly Review, March 2010 15 This sudden drop in bond issuance follows a period in which unprecedented numbers of corporates came to the capital markets By August 2009, global corporate bond issuance had broken through the US$1tr threshold for the first time in a single year The inability to borrow from banks encouraged smaller and medium-sized companies, who would previously have relied on bank lending, to tap capital markets for the first time “The severe shortage of credit supply in the banking sector means that the capital markets will have to step in and pick up the slack in terms of supplying leverage into the economy to support growth,” says Mr Moynihan This has been particularly true in Europe, a region that has traditionally been more closely associated with bank finance In the U.K., for example, the average size of bond issues has halved from the market peak in 2007, according to Dealogic Institutional investors such as AXA regard this trend as a positive one overall “It has been a good thing that the capital markets have been open and ready for business because this has kept a significant number of businesses afloat in some fairly difficult times,” says Ms Zemek “This has also been a positive development for us because we can get access to assets of a good quality and this enables us to diversify more than we have been able to for a while.” With credit constraints diverting companies from bank lenders to the capital markets directly, investor relations teams have been growing accustomed to a new type of stakeholder: the bondholder Prior to the crisis, few CFOs held investor roadshows for bondholders, but this is becoming increasingly commonplace “CFOs have to get a lot 16 Chart 10: Market participants expect more regulation To what extent you agree with these predictions about the next three years? (agree minus disagree) Global capital movements will be regulated to a greater extent than they are today as countries seek to protect themselves from disruptive inflows and outflows As derivatives and other transactions become more tightly regulated, activity will increasingly be pushed into less regulated offshore venues 0% 20 % 40 % 60 % Respondents were given choices of agree, disagree, neutral or don't know/no opinion The chart shows the percentage choosing "agree" less those choosing "disagree." It does not show those choosing "neutral" or "don't know/no opinion." more match fit in terms of how they present information to lenders,” says Mr Douglas of Deloitte “There’s a lot more emphasis on the numerical data and CFOs are finding that they must make a real effort to make their companies look more attractive to the lending community.” Cash and other alternatives It used to be that investors frowned on companies hoarding cash Now they recognise the benefits of a war chest “I’ve certainly put a message into the business that while I’m looking to invest and take advantage of opportunities, I need everyone to focus on building up the cash reserves,” says Ian Winham, Chief Financial Officer of Ricoh Europe “In my discussions with funders, the fact that we are able to bring an element of self-funding and equity to the table is a real positive.” Ricoh also recognises that its smalland medium-sized customers may have trouble getting financing To this end, the company has worked with providers of lease financing to ensure that its customers get access to funds they need to make investments “The willingness of lease finance companies to support our customer base is absolutely essential,” says Mr Winham “We have been taking great care to understand their decisionmaking process Just by being very engaged with these providers of finance, you can start to get a real sense of how they arrive at decisions.” Taking advantage of its strong position in terms of raising capital, Ricoh has The New “Normal” even started to disintermediate the external providers of capital and disburse funds directly to its customers “The lease finance companies haven’t necessarily got the history with the customers,” says Mr Winham “Whereas from our perspective we’re close to them, we can see their history and, as a manufacturer, we have greater flexibility on how the product works with them as well This means that we’re moving into a different funding requirement where it’s internally driven and I’ve got to raise the funds to support that capital requirement.” Regulation and credit availability The regulatory agenda focuses on reducing systemic risk Although harmonisation of regulatory oversight across countries is seen as the most effective way of reducing systemic risk, respondents not consider this particularly likely They also doubt that regulators will be able to agree on an approach to central clearing of over-the-counter derivatives More likely, according to respondents, is closer supervision of banks by the same regulators – in most jurisdictions this is already happening – and the upcoming Basel III rules on capital and liquidity Stricter capital and liquidity buffers, a potential global tax on transactions and attempts to reduce leverage in the system will all help to improve the stability of the financial sector, but they could also have a profound impact on the profitability of the banking sector According to a recent report from Oliver Wyman, a punitive response from regulators could reduce the return on equity in the investment banking sector by as much as 8%.6 The survey results and interviews confirm that market participants are very concerned about the impact of new regulations Mr Abberley worries that the regulatory agenda will reduce not just bank profitability, but economic growth as well Regulators keen to clamp down on capital markets and the banking sector will constrain the ability of financial institutions to lend and leave corporates with limited options for raising capital “If you restrict both the banking system and the capital markets from a regulatory perspective, then logically you have to accept that GDP will potentially be lower than it would otherwise have been – albeit less volatile Corporates have got to be able to borrow from somewhere.” The uncertain regulatory outlook is affecting corporate borrowers “Uncertainty about what regulators will allow you to in capital markets is creating risk aversion and potentially raising the cost for borrowers,” says Mr Abberley “It might also impact the maturities over which they can borrow because committing to longer-term investments could be dangerous in the context of a changing regulatory environment.” Unilateral regulatory decisions taken by some governments have the potential to muddy the waters even further Take the decision by the German government to ban naked short-selling, which exacerbated fears about liquidity in the bond markets “The actions in Germany are the thin end of the wedge which, if you follow it along its shape, gets to the point where it may be that you are simply not allowed as an investor to sell a government bond,” says Mr Abberley “So liquidity risk suddenly goes through the roof.” The New “Normal” O utlook for Global Wholesale and Investment Banking, March 2010 17 Chart 11: Investors, and to a lesser extent issuers, see regulation as a threat ISSUERS INVESTORS What is the single biggest threat to your ability to finance your business? What is the single biggest threat to the value of your portfolio? Rank Issue Regulation/government actions Weak demand Defaults Inflation Higher risk Risky debt Sovereign credits Pricing of risk Issue Weak demand Tight credit High cost of finance Crisis/Volatility High operating costs Debt availability Risk appetite of lenders Regulation/government actions Frequency 15% 13% 9% 7% 6% 5% 5% 4% Frequency 13% 9% 8% 7% 5% 4% 3% 3% Chart 11 categorises the answers to write-in questions posed to issuers and investors In the comments section, some investors were merciless in their condemnation of impending regulatory changes Typical write-ins included: > Regulatory overshoot > Government interference > Ill-conceived legislation > Intrusive and burdensome regulation > Top-heavy governments in developed countries > Abrupt asset price changes driven by inconsistent/indecisive governments > Liquidity rules forcing poor capital allocation 18 The New “Normal” Nord Stream: From three banks to 26 When it comes to large financings, persistence and flexibility can win the game even in difficult market conditions In March 2010, Nord Stream successfully raised €3.9bn of project finance to fund the first phase of a 1,200-km underwater gas pipeline linking Russia and the European Union With Europe expected to import 70% of its energy supplies by 2030, the pipeline is vital to the continent’s energy security and a sign of stronger relations between Europe and Russia Nord Stream is a joint venture between the Russian energy giant Gazprom, which owns a controlling stake, BASF Wintershall, E.ON Ruhrgas and Gasunie of the Netherlands For the Phase financing, the consortium partners provided 30% of the funds in line with their shareholding, while the remaining 70% was raised from a syndicate of participating banks Although the funding was ultimately oversubscribed, it was difficult to secure When the project first launched in 2005, offers from banks were such that only three or four would have been required In the end, 26 participated “The whole environment had changed,” says Paul Corcoran, Financial Director of Nord Stream “Many of those banks who were key relationship banks with our shareholders and who were keen on the project were just not in a position to be able to go ahead They just didn’t have the liquidity.” To finance the project, Nord Stream had to increase the coverage ratio to give investors more protection “We worked very hard with the partners in the financing to improve the covered to uncovered ratio, and indeed we improved it to The New “Normal” 80/20 This opened up the liquidity that we needed to cover the commercial tranche and ultimately led to successful financing.” Mr Corcoran says that project financings have been affected less by credit constraints than other areas of debt finance “With project finance, the underlying credit is the project itself so as long as it is solid, then investors are less influenced by macroeconomic factors,” he says “In terms of our project, I think all the fundamentals mean a low-risk offering to banks.” But with credit committees scrutinising every investment, clear documentation and planning are essential “You don’t give them any excuses to block the deal,” says Mr Corcoran “You need as much interest in the project as you can generate in order to end up with a good clearing price.” It may seem surprising that Nord Stream did not tap the capital markets directly “We did consider whether we’d go to the bond market, but at the time that we were looking to make our decision, it was in a very poor state,” says Mr Corcoran “When you decide to go for bond markets, you need to know that they’re going to be there when you want them.” With the first phase of financing now over, Nord Stream has begun construction and expects it to be complete by 2012 A second fundraising phase is expected to close by the end of 2010 “We have a solid package, a project that everyone is familiar with and thorough documentation established in Phase One,” says Mr Corcoran “Just by the nature of this process, that puts us in a very strong position for the next stage.” 19 Conclusion Six months can be a long time in the financial markets In the first half of 2010, each week brought the shock of the new, with old verities crumbling and fresh ones taking shape The survey and interviews conducted for this research confirmed the outline of certain aspects of this new world First, there is a new dichotomy between developed and emerging markets Countries such as China, India and Brazil have little debt and huge capacity The U.S., Europe and Japan have a great deal of debt and capacity approaching its limits The old notion of safety in the center and danger on the frontier is eroding Or perhaps the center is simply shifting: the developed world is seen as a legacy economy while the former periphery becomes a vibrant center of growth and opportunity As this shift occurs, survey participants see every asset class as riskier This is especially true for currencies – and not just the euro There are no good choices among currencies A significant minority of executives sees the euro shrinking at the very least and potentially disappearing The dollar is king by default, but few believe in its long-term viability The renminbi is too controlled; the SDR, too abstract In a world of high volatility and no-win choices, every holding will be scrutinized and every investor will re-evaluate the trade-off between liquidity and risk This new level of scrutiny will bring about a new era of competition for capital It’s true that corporate demand for debt and equity financing is down It’s also true that investment-grade borrowers, both corporate and sovereign, can choose their investors and almost name their prices Nevertheless, over the next few years there will be stiff competition for increasingly scarce capital The financial, economic and fiscal crises all carry high price tags as governments seek to simultaneously rescue their financial institutions, stimulate their economies and address tax shortfalls Beyond the cyclical expenditures lie structural outlays related to the aging population, the deteriorating infrastructure and impending energy and climate crises All will compete for funds in increasingly crowded capital markets With banks looking to rebuild balance sheets in a more stringent regulatory environment, sovereigns seeking to restore public finances to health and corporates looking to finance – at the very least – day-to-day needs, this competition presents a highly challenging overall environment for raising capital Capacity may not be the problem Instead, it could be willingness on the part of investors to commit funds in an uncertain and problematic environment The key, for any entity seeking to raise capital, is to ensure that strong fundamentals are in place For sovereigns, this means taking the necessary steps towards fiscal discipline For corporates, it means building strong, long-term relationships with both equity investors and lenders, and ensuring that the company’s prospects are clearly articulated and understood Regardless of how the next wave plays out, the keys to navigating the crowded capital markets of the future will be a strong balance sheet, a flexible approach and a recognition that borrowers will have to work harder for their capital than ever before 20 The New “Normal” RBC Capital Markets is the business name used by certain subsidiaries of Royal Bank of Canada, including RBC Dominion Securities Inc., RBC Capital Markets Corporation, Royal Bank of Canada Europe Limited and Royal Bank of Canada - Sydney Branch The information contained in this report has been compiled by RBC Capital Markets from sources believed to be reliable, but no representation or warranty, express or implied, is made by Royal Bank of Canada, RBC Capital Markets, its affiliates or any other person as to its accuracy, completeness or correctness All opinions and estimates contained in this report constitute RBC Capital Markets’ judgement 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Conclusion Six months can be a long time in the financial markets In the first half of 2010, each week brought the shock of the new, with old verities crumbling and fresh ones taking shape The survey and interviews conducted for this research confirmed the outline of certain aspects of this new world First, there... restructuring.” For Carmen Reinhart, professor of economics at the University of Maryland and co-author with Kenneth Rogoff of This Time Is Different, the reaction was typical In her book, she traces the history of financial crises across 800 years and finds patterns in how they unfold Financial crises are often followed by sovereign debt crises as governments face falling tax revenues and the cost of bailouts... fundamentals and were able to devalue their currency, which is not an option for Greece,” she says Professor Reinhart believes that the ECB and IMF bailout will only delay Greece’s default “I think The New Normal Holdings by European banks of troubled sovereign bonds raise the spectre of banking crisis “Even if the ripple effects are not on the gloom -and- doom panic mode for European banks, they are on the. .. a new dichotomy between developed and emerging markets Countries such as China, India and Brazil have little debt and huge capacity The U.S., Europe and Japan have a great deal of debt and capacity approaching its limits The old notion of safety in the center and danger on the frontier is eroding Or perhaps the center is simply shifting: the developed world is seen as a legacy economy while the former... controlled; the SDR, too abstract In a world of high volatility and no-win choices, every holding will be scrutinized and every investor will re-evaluate the trade-off between liquidity and risk This new level of scrutiny will bring about a new era of competition for capital It’s true that corporate demand for debt and equity financing is down It’s also true that investment-grade borrowers, both corporate and. .. supervision of banks by the same regulators – in most jurisdictions this is already happening – and the upcoming Basel III rules on capital and liquidity Stricter capital and liquidity buffers, a potential global tax on transactions and attempts to reduce leverage in the system will all help to improve the stability of the financial sector, but they could also have a profound impact on the profitability of the. .. cost-cutting and strengthening their balance sheets Although volumes remain small by pre-crisis standards, there is a gradual return of M&A activity, private equity deals, project financings and IPOs But despite the return of strategic activity, the number of companies that expect to raise capital remains surprisingly low Just 38% of respondents say that they expect to issue new debt or equity capital in the. .. harbour doubts about the strength of the economic recovery and are shelving major strategic growth projects for the foreseeable future Chart 8: Corporates have scaled back funding plans Does your firm expect to raise new capital in the next two years? Yes, significant amounts of capital Yes, moderate amounts of capital No, we will finance the current level of operations from cash flow and retained earnings... of concern in terms of the value of the currencies but not in terms of raising capital, ” says Robin Stalker, Chief Financial Officer of Adidas “It is a worry but won’t in the short-term or long-term affect our ability to raise capital. ” The New Normal 5 BIS Quarterly Review, March 2010 15 This sudden drop in bond issuance follows a period in which unprecedented numbers of corporates came to the capital ... the beginning of the most volatile month of the European debt crisis – and received responses through the end of May This white paper is the result of the survey work conducted in the midst of. .. Although the shares were priced at the lower end of the expected range, the IPO is a sign of growing investor appetite to participate in new offerings The IPO took place before the eruption of sovereign. .. India and Brazil have little debt and huge capacity The U.S., Europe and Japan have a great deal of debt and capacity approaching its limits The old notion of safety in the center and danger on the