Private Equity – Snapshot & Outlook

– In 2017, Private Equity markets continued to reach new record highs with regard to capital commitment, deal valuations and number of active investors. Competition for private investments increased dramatically, largely caused by traditional asset managers shifting significant proportions of their capital into private markets. With easy access to capital and increased competition for deals, Private Equity investors increasingly experience problems to effectively deploy their capital. However, the valuation rally is expected to continue in 2018, introducing new forms of investors, so-called megafunds. –

STATUS QUO – Private Equity markets are booming: Private asset managers raised a record sum of nearly $750 billion globally, extending a cycle that began eight years ago. In addition, less traditional investors such as pension funds or sovereign wealth funds increasingly engage in direct investments in private markets due to a lack of profitable investment opportunities in more traditional asset classes. With more capital available, the total deal volume rose by 14 percent to $1.3 trillion compared to the previous year, reaching almost its record high of $1.4 trillion from 2007. In contrast, deal count dropped for the second year in a row by 8 percent. As a result, the average deal size increased from $126 million in 2016 to $157 million in 2017, a 25 percent increase, mirroring the increased competition among investors.

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Furthermore, the Median EBITDA multiple for investments in 2017 exceeded 10x, displaying a significant increase from its previous all-time high of 9.2x in 2016. Despite record valuations, the number of exits fell for the third consecutive year, suggesting that investors believe in further value appreciation of their investments.

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High investment performance and superior yields for limited partners attracted new types of investors, ultimately resulting in greater capital commitments and fund size: The latter can be attributed to a large part to the rise of US buyout megafunds, private blind-pool capital vehicles with assets under management (AUM) above $5 billion. The prevailing wisdom has long been that the “law of large numbers” might put a cap on megafund returns, however average returns have outperformed returns of other fund sizes consistently during the last decade. The latter was not only a US phenomenon: The rise of US megafunds was nearly matched in Europe, where several firms successfully closed big new funds totaling $40 billion, and in Asia, where megafunds—previously close to nonexistent— contributed more than $20 billion of the $60 billion raised in 2017.

Besides buyout funds, it appears that other private asset classes constitute increasingly attractive investment opportunities for investors. First, private debt markets are more and more seen as a good alternative to banks and public debt, fueled by all-time low interest rates and investor demand for portfolio diversification. Second, real-estate gained popularity following collective rent rises in major cities. While investors have historically viewed Real Estate as a source of alpha, more and more are coming to see it rather as a source of income. In a world of compressing yields, relatively low-risk assets that produce annual returns of 5 to 7 percent, appeal to many investors. Finally, infrastructure investments remain an attractive alternative for investors. Since 2016, some of the largest general partners have raised record-breaking funds for traditional, brownfield infrastructure strategies.

CHALLENGES – Due to the continuous popularity of Private Equity as an investment vehicle, new challenges have emerged, pressuring the superior profitability of the industry. Higher number of sophisticated investors, ranging from pensions and endowments to family offices, decrease the likelihood for exclusive bidding. Hence, valuations continue to approach artificial highs, which makes it considerably more difficult to reach desired return multiples. This can be mainly attributed to thriving public markets, corporate strategic investors as well as the low-cost debt environment.

The public markets are hot despite some recent wobbles, which has been driving comparables’ valuations to new heights. Furthermore, the low-cost debt environment of the past decade encouraged strategic buyers to open their pocketbooks and quickly expand through acquisitions. In so doing, they are competing directly with Private Equity for deals and pushing multiples even higher. Another factor is the ongoing availability of cheap debt, which is driving up leverage levels for company acquisition, thereby increasing the risk for lenders in case of default. The mere unlimited rise in valuation manifests in fewer investments from general partners, zeroing in on targets where they can still earn an attractive IRR. However, what constitutes ‘attractive’ is undergoing revision, as many firms lower their hurdle rates in response to higher prices. Thus, investors sit on a whopping $1.8 trillion of dry powder in 2017. A continuation of this trend over the coming years would result in a vicious circle for general partners, forcing them to further reduce hurdle rates as well as to deploy capital in situations they otherwise would not.

 

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OUTLOOK – The next years will undoubtedly mark a decisive period for Private Equity as a mainstream asset class. Following the rise of megafunds, we expect to see assets to consolidate at the top of the league table, i.e. private market funds are beginning to concentrate into fewer hands. This trend will be supported by a growing number of co-investments between traditional Private Equity investors and new direct investors such as pension funds.

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In addition, funds will aim at bringing more structure and scale into their processes to cope with the changing market environment, innovation and unconventional investment horizons. For example, we currently experience first attempts of next-generation sourcing, which aims at improving sourcing with sophisticated analytics. Funds may be able to automatically match their sourcing activities with investment criteria and their respective perception of industry attractiveness. Besides, we expect to see investors increasingly engage in active management, as digital transformation processes open up new opportunities for value creation, which cannot be realized (at least in the holding period) without major involvement of the investor.

Due to uncertainty about future interest rates and valuation multiples, Private Equity investors will increasingly deviate from average exit periods: On one end, exit cycles for investments purchased at high multiples may decrease to as little as two years, as firms cash in on multiple growth early when they anticipate that multiples will decline. On the other end, Private Equity investors allocate theirs funds to private asset classes generally associated with longer holding periods (e.g. infrastructure, natural resources, and Real Estate) due to their high value creating potential.

In summary, Private Equity will remain one of the most sought-after assets classes experiencing further growth in both number of investors and average deal sizes. However, the future will show whether today’s high valuation levels are reasonable and enable superior exit returns.

 

Authors

Paul Theilig

Felix Schafer

 

Sources

  • McKinsey Global Private Markets Review (2018). The rise and rise of private markets.
  • Pitchbook (2017). European Private Equity Breakdown
  • Bain & Company (2017). Global Private Equity Report

Breakfast with: Federico Tenga, Bitcoin Entrepreneur and Co-Founder at Chainside

Breakfast with: Federico Tenga (alumnus MiM ESCP), Bitcoin Entrepreneur and Co-Founder at Chainside.

Federico is an early bitcoin adopter, co-founder at Chainside and consultant for blockchain implementations. In December 2014, he founded the Italian branch of the BEN (Blockchain Education Network) with the aim of spreading the network in the Italian Universities.

Q: First of all, I would like to thank you for taking part in this episode of the ESCP Finance Society’s “Breakfast with” agenda. How did it come to your mind to deepen your knowledge about Bitcoin in 2015? What did your classmates think about it at the time?

Actually the first time I learned about Bitcoin was in 2011, when I was still in high school, but even if I found the concept very interesting at the time I didn’t get passionate about it. Later, in 2013, I finally started studying it, trying to trade it and start with my first projects around Bitcoin. While at university I had many classmates that showed some interest in the topic, but just few decided to try to learn more about it or buy some coins.

Q: What is Chainside and what is your long-term plan?

Chainside’s goal is to make easier the interaction with the blockchain for enterprises, reducing technical barriers with a simple interface that abstracts the complexities of Bitcoin. Right now we are focused on bitcoin payment solutions for merchants, but since differently from some other competitors we built our own technology from scratch, we are able to enable new blockchain use cases according the customers demand. In the long-term, we aim to establish ourself as a leading company in the industry and facilitate the transition to a crypto-based economy.

 

Q: Why should a firm choose Bitcoin over fiat money? What are the advantages of the former over the latter?

Bitcoin presents multiple advantages, both for people using it as a medium of exchange and for those using it as store of value. A firm accepting Bitcoin payments can benefits from the absence of charge-back related frauds as the settlements of a Bitcoin transaction is some order of magnitude faster than any traditional payment system (just about 10 minutes). Moreover, thanks to its permission-less nature, Bitcoin makes possible financial interaction also with people who do not have access to traditional financial infrastructure, or people who care about their financial privacy and prefer to use a tool not controlled by any centralised entity, increasing the potential customers of a company. Bitcoin has also the advantage to be programmable money, making innovation and automation more effective.

On the other hand, enterprises looking for a superior store of value for them or for their customers will find in Bitcoin an asset with limited and deterministic supply backed by frozen energy, somewhat similar to gold but technically more advanced.

 

Q: Do you actually believe that Bitcoin is an expression of financial world’s democratization (given that 97% of Bitcoins is held by 4% of the addresses)?

I don’t think that the distribution of wealth is really related to financial democratization. Bitcoin is an expression of permission-less finance, meaning that anybody in the world can have access to advance financial tools without having to deal with the limitations imposed by local regulation. This means that under a financial perspective, people in developed countries won’t be as advantaged as they are today over people in developing countries with poor banking infrastructure.

 

Q: As of 4 February 2018, the number of existing cryptocurrencies is over 1,512 and still growing. Who will thrive in such a market in the long term and what is the competitive advantage of Bitcoin over the other cryptocurrencies?

Most of those cryptocurrencies out there are already to be considered dead, only few of them actually have a decent transaction volume. In general, I am expecting a consolidation in the coming years, if you think about that the purpose of money is to be the single intermediate good that everybody uses for trading, so with the exception of transition phases when better money substitutes inferior money, people will always converge on using a single currency. This means that there is no space for multiple cryptocurrency in the long term, and the market will converge on the best one, which at the moment seems to be Bitcoin as it has the more stable and battle tested technology and a stronger network effect. Some cryptos claim that their purpose is not to be a currency but something else (e.g. a world computer), so they are not in competition with Bitcoin, but the truth is that they still need a native currency to secure their blockchain, so they will suffer competition anyway.

 

Q: Do you think it is possible to apply financial theoretical concepts to Bitcoin and cryptocurrencies in general? For example, is it possible to identify the fundamentals of a crypto? If yes, please explain how.

There are fundamentals in crypto, as there is an utility that people consume while using cryptos. When you want to evaluate a cryptocurrency you have to ask yourself “do people have any benefit in using it” and “is it long term sustainable”, which also implies how scalability concerns are being addressed. Bitcoin has already proved to be a good store of value and a useful medium of exchange for a least some niches, and current protocol upgrade proposals create optimism about the future, while most other cryptos are in a phase where they still have to prove themselves to provide some kind of real value to the users and have long term sustainability.

 

Q: Different investors use different methods to analyse an asset before investing in it. Which method should an investor in Bitcoin use? And if you have ever invested in it, which one did you use?

I studied the technology and tried to see the potential and the limitations. I know it can be hard for people without a technical background to really understand how the technology works, but if you don’t make some effort to study it as much as you can, it becomes very easy to make very expensive mistakes when it comes to investment. Understanding the tech helps you to see what the long term trend can be, while for the short term I consider any kind of trading mostly gambling, so it can be fun but there is no much you can do to systematically outperform the market.

 

Q: Warren Buffett in an interview to CNBC said: ”I can say almost with certainty that cryptocurrencies will come to a bad end.” In your opinion, are we witnessing the burst of the bubble or a healthy correction?

I believe that corrections are a natural part of a price discovery process, so as an asset gains popularity it is to be expected to have both bull market and bear market phases. The fundamental value of the technology is growing with new protocol upgrades being proposed every week, so I consider the daily price fluctuation just a distraction.

 

Q: Last question, what is the most important piece of advice you can give to the ESCP students that would like to pursue a career in Fintech industry? What are the most important qualities to succeed?

You need to be willing to go out of your comfort zone and start studying stuff you know nothing about on your own, you can’t be successful in Fintech if you don’t know how the technology works under the woods. You also have to deal with the fact that the university cannot help you in any relevant way to be prepared for the industry, it is a fast changing environment and few people are knowledgeable about these topics, and they usually don’t teach in universities. The good news is that nowadays there is so much information freely available on the Internet, so  you can easily learn a lot alone, but it requires commitment and genuine interest. 

 

It has been a pleasure to host you at our “Coffee Break”. Thanks again for your time and patience, Mr. Tenga!

 

Author:
Andrea Simoni

Private Equity – The best asset-class of the last 25 years

Private Equity – What is it?

Private equity (PE) has gained a great amount of influence in today’s financial marketplace, but only few people actually understand the ins and outs of the industry.

This quick article (less than “360” seconds long!) breaks down the topic, discussing in brief (i) the different types of PE strategies; (ii) the main PE firms out there and (iii) the current momentum of the industry.

First things first. What is a PE firm?

To make an (extremely) long story short, PE Firms are essentially asset-management companies (AMC) advising, managing and investing investor’s money through registered investment vehicles called “funds”, each having a different investment scope. AMCs need to comprise skilled and trustworthy Investment Professionals able to raise capital and attract investors promising in exchange solid and constant returns.

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PE investments range from listed and non-listed companies to physical assets (i.e. real estate), offering returns much less correlated to indexes than the returns available in classic public market investment opportunities. However, the tradeoff is that these investments are illiquid (i.e. 3-7 years to generate attractive returns) and thus require longer investment periods.

PE Firms can invest in a wide mix of private investment strategies, with the mix varying greatly from firm to firm depending on the firm’s size, stated strategy, geographical scope, industry and transaction expertise. There are many different types and sizes of PE firms / Funds specialised in either a specific industry or a specific geography.

 

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7 PE strategies – The key elements

Here are the main PE strategies everyone should be aware of:Venture capital (VC) – startups and young companies / little to no track record of VC investments are made with the goal of generating outsized returns by identifying and investing in the most promising companies and profiting from a successful exit (the most desired being an IPO)

  • Growth capital – mature companies / proven business models / looking for capital to restructure their operations, enter new markets or finance an acquisition. Typically, these are minority investments in more mature companies than for a VC scope
  • Buyouts – mature companies / generating significant and steady cash flows. PE firms make buyout investments when they believe that they can extract value by holding and managing a company for a period of time and exiting the company after significant value has been created. This strategy typically involves debt (i.e. usually above 50% of the total acquisition value) to finance the acquisition, enabling the PE Firm to generate high returns while only risking a small amount of capital
  • Fund of Funds (FoF) – investments are made in PE funds rather than directly in the equity of companies. By investing in a fund of funds, investors are granted diversification and the ability to hedge their risk by investing in various fund strategies
  • Debt/Mezzanine – consists of both debt and equity financing to support a company’s Companies that take on mezzanine financing must have an established product and reputation in the industry, a history of profitability, and a viable expansion plan. A key reason of why a company may prefer mezzanine financing, is that it allows it to receive the capital injection needed for business without having to give up a lot of equity ownership
  • PE Real Estate – investing in ownership of real estate properties. The 3 common strategies are: (i) investments in low-risk / low-return assets with predictable cash flows requiring some form of value added element; (ii) medium-risk / medium-return investments involving the purchasing of properties to improve and sell at a gain; (iii) high-risk / high-return investments in properties requiring massive amounts of enhancements (i.e. investments in development, raw land, and mortgage notes)
  • Special situations & Distressed funds – target companies that need restructuring, turnaround, or are in any other unusual circumstances. Investments typically profit from a change in the company’s valuation as a result of the special situation. (i.e. company spin-off, tender offers, bankruptcy proceedings…). Besides PE Firms, Hedge Funds also implement this type of investment

 

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The main players – American legends vs. European firms

Henry Kravis (KKR), Steve Schwarzman (Blackstone), David Rubenstein (Carlyle) and Leon Black (Apollo). These four men run the world’s largest private-equity firms.

Billionaires all, they are at or well past the age when CEOs of public companies move on, either by choice or force. Apple, founded the same year as KKR (1976), has had seven bosses; Microsoft, founded the year before, has had three. On average, public companies replace their leaders once or twice a decade. In finance executives begin bowing out in their 40s, flush with wealth and drained by stress.

 

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One thing is clear, the fame of the big names in the industry resides in the US!                    But Private Equity is not just an American thing. The “Old Continent” defends itself well. The UK leads the table when it comes to PE, placing 7 Firms in the European Top 10.

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The current momentum – why does everyone want PE?

Last year was a massive year for private-equity fundraising, and there is little indication that the flow of money into the asset-class will wane any time soon. A staggering 48% of European investors plan to put more money into private equity this year, compared with 2% who plan to trim their allocation, according to a survey published in December by Coller Capital.

“As long as the demand from investors is there, we will see firms looking to raise bigger funds,” she said. “Some private-equity managers will try to raise as much as possible; others will try to remain more disciplined. Some managers, such as Vitruvian Partners and Partners Group, more than doubled their fund size last year.” – Britta Lindhorst, MD at HQ Capital

As of December 2017, there were 1,038 new private-equity funds (less in number but way bigger in size) in the market filled with $415bn of fresh capital (+6.5% vs 2016), compared to 1,324 funds seeking $390 billion a year earlier, according to Preqin. In brief, 2017 was another record-year for PE (i.e 7th year of consecutive growth), the tough times post 2009 financial crisis are long gone.

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Reasoning on why PE gained so much attention in the last decades, one thing pops up quite immediately bringing us back to the title of the article: Private Equity is simply the most profitable asset-class of the past 25 years!

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Authors

Massimiliano Marchisio

Nikita Kuzmich

Paul Theilig

Felix Schafer

 

Glossary

AMC = Also called General Partner “GP”, is a financial institution approved and supervised by the local authority, whose task it is to manage the fund.

Fund = a fund is a “bucket” filled with investors’ money and managed by the AMC. The amount of money collected can be used to invest into any type of asset

Investors = Also called Limited Partners “LP”, are banks, insurance companies, pension funds, family offices, corporations, governments, HNWI…

 

Suggested readings

Barbarians at the Gate: The Fall of RJR Nabisco – Bryan Burrough and John Helyar (1989)

 

Sources

  • The Economist
  • Cambridge Associates Private Equity Benchmark
  • Street of Walls
  • Private Equity News
  • Private Equity International
  • Financial Times
  • Preqin – Research Center
  • Macabacus – Finance

Bidding War fires up the largest European deal of 2017

On May 15th, 2017 Atlantia has announced its intention to acquire its Spanish competitor, Abertis.

Atlantia, Italian toll operator whose main asset is Autostrade per l’Italia, the largest concessionaire on the Italian highway network, is a holding company belonging to the Benetton family. Under the management of its CEO, Giovanni Castellucci, former partner at the Boston Consulting Group and manager at Barilla, the company has produced revenues for more than €4 billion and generated a net income of €1.12 billion in 2016. Its assets are strongly exposed to country risk, and an acquisition would be a way to enter new markets and diversify this exposure.

Abertis, headquartered in Barcelona and listed in Madrid, is a leading toll operator as well. Present in 13 countries, with a net profit of €897 million in 2017, a 13% increase from 2016, has appeared as an attractive target for Atlantia’s needs: the new conglomerate, in fact, would be in charge of the management of more than 14,000 km of highways and present in 19 countries.

The Italian company, advised by Mediobanca, Santander and Credit Suisse, has proposed a cash-offer, financed by Bnl-Bnp Paribas, Credit Suisse, Intesa San Paolo and Unicredit[1] valuing the Abertis at €16.50 per share and making up a €16.3 billion deal.

Alternatively, Atlantia has also offered stocks with the aim of making the offer attractive Criteria,  unlisted investment bank holding of the Caixa foundation and majority shareholder in Abertis with a 22.3 percent stake, with important investments in the Industrial and the Real Estate sector.
The Italian company would offer unquoted, locked-in stocks, at a fixed conversion rate of 0.697 Atlantia’s share per Abertis share[2], for up to the 23.2 percent of the total offer. This would value the Spanish operator at €17.34 per share; considering the latest trading price at €16.38[3], it represents a generous upside for the shareholders with a premium of around 6%.

This share-swap offer is not appealing for all of Abertis’ stakeholders. Instead, it is a strategic move to win the favor of Criteria, a strategic investor with long-term objectives: in facts, not only the holding keeps its current claims on dividends, projected to increase, but also acquires the right to appoint up to three directors in the Atlantia’s Board, whose size therefore increases from 15 to 18 members[4].

Should this scenario concretize, Edizione, the investment vehicle of the Benetton Family, would suffer a 5 percent dilution in Atlantia, with its stake diminishing from 30 to 25 percent, while Criteria would earn a 15 percent stake. Castellucci has stressed that the combined groups’ strongly performing Latin American assets would be transferred to Abertis, which would maintain its headquarters in Barcelona and would keep trading in Madrid[5].

According to the Spanish Financial Authority, the CNMV, on October 19th Abertis should have formally responded to Atlantia’s offer. Therefore, the bid carried forward by Hochtief, a German leading construction company operating worldwide, with important assets in the US and Australia and, controlled by the Spanish ACS[6], has been a surprise. Hochtief is offering €18.76 per share in cash, attributing to the target a value of €18,6 billion. Alternatively, Abertis investors may opt for a stock-swap option, the conversion rate being 0.1281 per newly issued Hochtief share. Should the Spanish constructor accept this offer, it would add more than 8000 km to the construction business of the German company and ACS, opening up the possibility to extend their operations in Brazil. Advised by J.P. Morgan, Lazard and Key Capital Partners, ACS and Hochtief are now tempting the investors with the promise of high dividends – the combined entity, whose stocks are intended to be traded in Frankfurt, is expected to generate revenues for €24.8 billion and has announced a retention ratio of 10 percent, meaning that roughly 90 percent of its profits would be paid out. Instead, some of the Abertis’ assets would be sold, among which shares in Cellnex Telecom SA and Hispasat SA.

The results of the takeover would be a decrease of ACS’s share in Hochtief, from 72 to less than 50 percent. This would cancel the leverage of the €12 billion net debt, contracted by its investment vehicle, to fund the cash payment, and would leave the company with a stronger position in the resulting entity8.

While Catellucci is considering raising its offer, that could be raised up to €19 per share according to some analysts5, and entering a bidding war, it also has to face a strong opposition by the Spanish government, which is concerned about the loss of the strategic assets owned by Abertis, and wants to prevent the company from falling under foreign ownership. In addition, in case of approval of the second offer by the CNMV, the Spanish Financial Authority, the government may still appeal to the administrative tribunal and cause severe delays in the execution process. The Hochtief offer, that would bring Abertis under the ownership and control of the ACS’ president, Florentino Perez, has encountered a much lower opposition, as the strategic assets owned by Abertis would remain under Spanish ownership. These governmental activities are not unusual: for example, in July 2017 the Macron government had decided to block the offer of Fincantieri and nationalize the building sites in Saint-Nazaire, considered of strategic importance for France, given the unique know-how of the employees, as reported by the French government’s spokesman Castaner[7]. Nevertheless, it is worth noting that such practices seriously harm free market competition and should be limited. Indeed, the issue of governmental interference in public utility companies has been long debated: a recurrent, and sometimes a bit abused, practice is the so-called Golden Share, which allows governments to acquire shares of capital and to appoint members in the Board of Directors of strategic companies and consequently to have a high influence on the decisions taken. This privilege has been, in some cases, sanctioned by the European Court of Justice as dangerous for the markets’ competitive functioning.

Financial markets have responded to the bids’ announcements. While Atlantia lost 1.2 percent, Abertis has been traded at a premium on the bid of the Italian company. The bullish trend has been followed also by ACS and Hochtief, which have gained 5.6 and 1 percent, respectively.[8]

In the end, Abertis seems to be the company benefiting the least from the deal: in fact, it is already well-diversified in terms of EBITDA sources. Additionally, the deal with ACS may be dangerous for Abertis’ creditors in terms of the exposure to the cash-flow volatility of the bidder.
Instead, Atlantia, whose main assets are located in the home market, could diversify its country risk away penetrating in Latin America. Furthermore, despite the poor synergies, it could benefit from an appealingly low acquisition premium embedded in its first offer and, in addition, may increase its cash-flows by building up scale. However, despite the higher acquisition premium of the eventual second offer these benefits would decrease, the Italian group would still enjoy substantial advantages.

With the recent approval of the second offer by the Spanish government, declared at the end of January, the two bidders are now free to compete. In the next 15 days the two companies will have to improve their bids, according to the Cnmv regulation, and then will submit their final offers.

What it is going to happen is still uncertain, but it is possible to see some general drivers in the wave of recent European deals. Low cost of financing, need of consolidation, low opportunities for organic growth are all factors that make M&A extremely attractive for European top players willing to compete in a global field. Just think about the deals between Johnson&Johnson and Actelion, Essilor and Luxottica, Mead Johnson Nutrition and Reckitt Benckiser, Toshiba and Consortium and Vodafone and Idea cellular. These are all examples of the cross-border trend of M&A in Europe, where external growth tends to be preferred more and more to internal expansion[9].

 

Author: Giacomo-Luigi Rossi

Notes:

[1] Source: Reuters

[2] The conversion rate indicates the number of Atlantia shares that can be exchanged with 1 Abertis share

[3] Abertis’ share price on May 15th, 2017. Source: Yahoo Finance

[4] Source: Il Fatto Quotidiano

[5] Source: Financial Times

[6] Actividades de Construccion y Servicios SA – Spanish company whose President is Florentino Perez. ACS is headquartered in Madrid

[7] Source: Il Sole 24 Ore

[8] Source: Bloomberg

[9] Source: Factset

ICO is the new IPO?

The beginning of 2018 saw another example of the psychological impact of the Bitcoin, Cryptocurrencies, ICO’s and Blockchain on human beings in this period.

In fact, Kodak company, the pioneer in the photography sector announced the Initial Coin Offering (ICO) of KODAKCOIN, to enable photographer to get more protection for the image rights. As a result, the stock soared by more than 400% just after the news.

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Kodak was not a darling of Wall Street nor a Company on the headlines of newspapers for innovative initiative, so how can the offering of a digital coin make everyone change idea?

What is a Coin, how is it traded and what are the risks involved? The following addresses those questions and provides an objective framework on the topic, analysing and confronting IPOs with ICOs.

IPO: Initial Public Offering

An IPO, or Initial Public Offering, is the first sale of stock issued by a company to the public. Before it, the public is unable to invest in it, so the company is considered private and involves a relative small number of shareholders in the business. IPOs are the main way to go to widen the range of potential investors from founders, friends and venture capitalists to any individual or institutional investor.

Large firms use this process to raise a great deal of money, allowing the company to grow, expanding their market share and revenues. Private companies have many options to raise capital, such as borrowing, finding additional private investors, or being acquired by another company. But, by far, the IPO option raises the largest sums of money for the company and its early investors.

Obviously, this process has some pros such as the lower cost of capital, the increase in company’s public image, and it finally allows the attraction and retention of the best management. But, as everything, it has also negative aspects as the company is then required to disclose financial, accounting, tax, and other business information so making public and possibly disseminate that information, which can eventually lead to an increase in the risk of legal or regulatory issues and finally requires more time for reporting.

In this process, the prospectus is essential. It is a formal legal document that is required by and filed with the Securities and Exchange Commission that provides details about an IPO. It is issued in order to inform investors about the risks involved with investing in this stock. The information also guards the issuing company against claims that pertinent information was not fully detailed before the investor put money into a security.

In an IPO, we can have two types of investors, the institutional and the retail; the qualified one acting on behalf of an institution such as pension funds, endowment funds, insurance companies, commercial banks, mutual funds and hedge funds. Alternatively, it can be a retail investor and so also individuals. The main difference between those two categories is that, differently from the institutions which can buy shares on the primary market, the retail cannot participate the IPO and can buy the new shares once they are on the secondary market. As a result, some investors are kind of discriminated.

Once the IPO is completed, investors who bought the shares become shareholders, so they are then interested in the risks incurred by the company and the return they can achieve with their investment. Here after you can see the IPOs occurred in 2017 worldwide, but pay attention that this year this market soared compared to the average trend observed in the past years, not in the number but in the average funds raised, passing from 100 million $ in 2014, 94 in 2015 and 95 in 2016 compared to 120 million $ average in 2017, similar to pre crisis level.

total funds

When looking at the returns, investors need to consider both the capital gains, that is an increase in the value of a capital asset that gives it a higher worth than the purchase price and it is not realized until the asset is sold, and the dividend, a distribution of a portion of company’s earnings under the forms of cash, shares or other possible decided by the board of directors.

ICO: Initial Coin Offering

Looking now at the ICOs we can notice a completely different process from the IPOs. In fact, the ICO, the abbreviation of Initial Coin Offering, means that someone offers investors units of a new cryptocurrency or crypto-token in exchange of already existing cryptos like Bitcoin or Ethereum. The underlying technology called Blockchain is about solving problems of traditional money (corruptible, politically biased and opaque). It works with a distributed, cryptographically secured and transparent database. The pros it offers are no central authority in charge of trust, lower transaction costs, an ecosystem simplification, faster transactions, durable and reliable data with process integrity.

The token itself offers the holder access to any platform or service that the developers create in the future with the token. However, as the majority of projects are in development stage, the main scope for holding the token is to speculate on the adoption and the eventual real-world usage of those systems. The benefits of such speculation are the creation of liquidity which enables developers to fund their project and bring it to fruition. The duration of an ICO can be quantified in days or weeks, as opposed to the long time needed in IPOs. Coins and tokens can then be traded on unregulated crypto-exchanges like Poloniex, GDAX or Kraken.

In 2017, there have been 92 ICOs which collectively have raised $3 billion. The following chart is about the ICO market from January to October 2017, showing the amount in million Dollars raised in each month by this process.

ICO market

Just to give you an idea of the situation of last year, here are some of the most successful and so probably followed ICOs of 2017.

top 10

The equivalent for the IPO’s prospectus is the white paper in the ICO, a document explaining in detail the pitch of the future company and platform, describing the technology behind the proposal itself.

It details the commercial, technological and financial figures of a new coin offering and puts it into digestible chunks that the reader can understand.

The majority of ICOs are projects in a very early stage of development and are more similar to ideas or prototypes rather than real businesses.

There is no universally accepted mechanism for the ICO and every company may sell anything they want. Usually, they sell the following: the right of ownership to a certain part of the company’s intellectual property, the right to a percentage of the company’s revenue (dividends), the right of ownership to an internal resource (ex. Virtual values) or something else.

Finally, it is specified which electronic platforms/exchanges/systems are actually ready to exchange company tokens for electronic money. The reputation of each exchange can be used to assume the reliability of each ICO.

The value of coins or tokens lays in potential market and network effect, a phenomenon whereby a good or service becomes more valuable when more people use it. The number of users required for significant network effects is often referred to as critical mass. After the critical mass is attained, the good or service should be able to obtain many new users since its network offers utility. The expected returns can be extremely higher than those in the stock market. As users are also investors, they are more willing to spread the word and encourage the use of the service.

As recognized by the Financial Conduct Authority regulators, ICO participants face abnormal risks as a consequence of being an unregulated space such as the inexistent investor protection from fraud or misleading information and the price volatility of the token.

To sum up, this little table can help better understand the similarities and differences of those two processes.

  IPO ICO
Stage Later stage Very early stage
Regulation – Prospectus essential

– Heavily regulated

– White Paper needed

– Not regulated

Listing Requirements Yes No
Duration of Offerings 4-6 months on average Depends on length decided

from 30 seconds to 1 month

Access to Offerings Institutional investors only Everyone
Beneficiaries Many Few
Allocation Sophisticated various methods One method
Investor Type Known and “qualified” Not known, anonymous
Utility – Piece of ownership

– Stake for future earnings

– No ownership

– Some stakes for project      revenues others for usage in system

 

Authors: Lorenzo Bracco and Mario Stopponi

 

SOURCES:

https://masterthecrypto.com/crypto-ico-vs-stock-ipo/

https://www.bloomberg.com/news/articles/2017-09-18/what-s-an-ico-like-an-ipo-but-with-digital-coins-quicktake-q-a

https://baseberry.com/what-is-the-difference-between-ico-and-ipo/

https://themerkle.com/ipo-vs-ico/

https://www.bitcoinmarketjournal.com/ico-vs-ipo/

https://www.investopedia.com/university/ipo/ipo.asp

https://www.investopedia.com/terms/i/initial-coin-offering-ico.asp

 

 

Bitcoin: Is this time different?

Bitcoin: Is this time different?

Spoiler: NO.

Bitcoin is the buzzword of our decade, even grandmas talk about it in their tea sessions with friends. Is Bitcoin the future? Will it substitute fiat money? Has it really a value? The aim of this article is to address these questions with tested frameworks and examples from the past to provide simple and practical answers.

What is the value of Bitcoin? Is it a Bubble?

Well, let’s start from a very basic concept: there is no existing way to calculate Bitcoin’s value because there are no fundamentals or anchors to analyze and derive the cryptocurrency’s value. Furthermore, the average Joe has not fully understood Bitcoin, and no one knows who is actually behind the creation of the cryptocurrency. This environment of disinformation is fueling the irrationality of market participants, which are governed by the Fear of Missing Out on the next big thing. The extreme shifts in sentiment can explain why the cryptocurrency is the most volatile instrument at the moment, jumping from $19,000 to $13,000 in 6 days (16th Dec – 22nd Dec). Bitcoin has returned a stunning 1400% in 2017 and this raises concerns about the possibility of a bubble. However, the disruptive nature of Blockchain, which aims at eliminating intermediary costs and creating efficiency, does not mean that Bitcoin will be the future universal currency and does not justify such returns. Indeed, the price is held up only by the belief that someone else will bid a higher price in the future, no cash flows distribution or asset appreciation. Finally, by looking at some objective facts, Bitcoin matches all 5 criteria for a speculative bubble that Richard Bernstein, former Merrill Lynch Chief Investment Strategist, has expressed as follows:

1- High liquidity encouraging speculation – current monetary policies implemented by central banks;

2- Leverage increase – introduction of “Bitcoin future” which allow to buy more instruments with smaller amount of money;

3- Market “democratization” – everyone talks about Bitcoin;

4- Supply increase pushed by demand increase – more than 1,000 cryptocurrencies and dozens of ICOs (Initial Coin Offerings);

5- Trading volume increase – number of trades per day continue to raise.

These 5 factors give an objective definition of a bubble and Bitcoin seems to match all of them. Does that mean it is a bubble? No. It means that the cryptocurrency has all the prerequisites to be a bubble but that depending on how things will evolve, this market might crash or flourish. By still looking at facts, it is clear that investment banks’ behavior is fueling some of the causes of bubbles’ creation. For instance, Goldman Sachs has announced the implementation of a cryptocurrency dedicated desk within the commodity division in order to act as clearing house and charge fat fees on brokers (e.g. 100% margin). This happens because investment banks found in Bitcoin a way to profit from volatility during a low-volatility period of time. Commissions from trading have slumped in recent years, as testified by recent earnings releases of JP Morgan and Goldman Sachs, Bitcoin and Cryptocurrencies represent a valid alternative. This volatility appetite pushes banks to enter the market creating more supply to satisfy the raising demand and then increasing liquidity and trading volume, hence the probability of a bubble. However, not only banks are contributing to this risky game but Institutions seem to feed this bubble’s risk too. For instance, the choice of creating “Bitcoin future” from CME (Chicago Mercantile Exchange) has allowed more investors to enter the cryptocurrency market by investing a significant amount of money in products whose value derives from Bitcoin’s one. Exotic products like leveraged ETFs are waiting for approval from SEC administration, ready to attract more capitals in this modern gold rush.

 

Dotcom Bubble Case

Looking backward it is easy to spot bubbles and have a perfect accuracy in doing so, everything makes perfect sense after it has happened. The most similar example to what is happening today is represented by the Technology bubble, which lasted for more than five years from 1995 to 2000. The late 1990s were characterized by the Internet revolution, a period of rapid technological advancements and unlimited possibilities, at least on paper. The Internet promised to change everyday life in unimaginable ways, enhancing the potential growth of companies which would have dominated their markets in few years. Just add “.com” to the company’s name, fill a paper with stunning future prospects and unrealistic business plan and the game was on. During the formation of the bubble investors were thinking of the opportunity to be too huge to be missed, and that conventional metrics of evaluation were not applicable as that time was different. The availability of cheap money and easy capital thanks to low interest rates fueled the confidence of investors who consequently underestimated risks or totally neglected them. The froth pervaded all levels of investment environment from venture capitals to public markets; profits and revenues were not considered, only rising prices mattered. From 1995 to the peak of 2000, the Nasdaq Composite the major technology index, returned more than 1200% reaching a size of 3-5$ Trillion.

As the Federal Reserve increased interest rates reducing the liquidity available, investors started pulling money out of the market and panic selling was the ending of the bubble, until the bottom was found in late 2002.

Even if professional investors and eminent professors like Warren Buffett, Robert Schiller and Alan Greenspan warned of the “Irrational Exuberance” of market participants, the feedback loop of rising prices was enough to attract and finally destroy wealth.

If someone had invested at the peak in 2000, he would have got back his money only seventeen years later in 2017, when the Nasdaq Index made new highs. Internet has really changed the world, but negative returns for two decades are not attractive for any kind of investor.

Invest in Bitcoin… Or Speculate?

Investing and speculating are two very different things. Investing means strategically buying something which, according to qualitative and quantitative analyses, will have high probability to generate additional income or profit with a low downturn risk. This is the only essence of any wealth building over time. On the other hand, speculating has a significant risk of losing all the initial capital in change of an expectation of big gains which in other words means: betting. Pay attention, anyone decides to invest his own money as wished since different people have different risk profiles which means that they might prefer betting over investing or vice versa. Therefore, there is not right or wrong answer, it just depends on whether being and investor or a speculator. Furthermore, statistically speaking it is preferable to keep control of finances by reducing as much as possible the effect of random variables on investments, but probably someone else likes more the hazard of venturing. Bitcoin does not represent an investment opportunity but a speculative one, therefore the real question at the end of the day, should be: Are you investing or betting?

 

Authors: Alessandro Sicilia and Mario Stopponi

China 2017: Snapshot

China is facing some structural problems in 2017, Said Medley Global Advisor (MGA), a research institute of Financial Times.

The first one is whether China’s economy can achieve its re-balance of reducing reliance on investment and increasing consumption in 2017. As the average increasing rate of 6.7% in 2016 is exactly the same as its target (at least according to official propaganda), MGA estimated, household consumption accounts for 1 point percentage more than last year, achieving 39% of the domestic nominal GDP. Even though the percentage is far less than advanced economy, it demonstrates China’s stable development since 2008’s financial crisis.

China Gdp growth

Unfortunately, China is not likely to sustain its increase of household consumption in 2017, as the household income’s increasing rate slows down from 16% in 2011 to 8%, while the dramatically climbing price of house suppresses people’s expenses.

As for the next year, The International Monetary Fund upgraded its growth forecast for China’s economy in 2017 to 6.5 percent, 0.3 percentage points higher than their October forecast, on the back of expectations for continued government stimulus.

Meanwhile, the debt market in china should be highlighted, MGA emphasized, as the ratio of outstanding obligation to GDP is approaching 265%, China’s debt market is always expanding, making the asset riskier, but it’s still quite possible to issue a large scale of debt in 2017. Chinese government set the target to issue from 11 trillion to 12 trillion RMB debt for local government (1.6 trillion to 1.7 trillion dollars)—much higher than 6 trillion in 2016—as to finish the plan of exchange local government’s debt that started in 2014.

In 2017, default of enterprises and bankruptcy are more likely to happen, especially considering Beijing is now leading reform of cutting overcapacity in some industry.

 forex

China’s foreign exchange reserves fell from $4tn to $3tn in the past three years despite a persistent trade surplus. The first month of 2017 found China’s foreign exchange reserves fall below $3tn for the first time in the past five years despite Chinese government’s tighter controls on capital outflows. In February, China’s central bank managed to raise the reserves to $3.01tn. This first raise after an 8-month declines in a row indicates Chinese government’s resolution in setting a safety line for its foreign reserves, although there is no consensus on the bottom line number yet among experts familiar with the topic.

Trading Economics forecasts China’s foreign reserves to continue falling below $3tn for the next quarters of 2017. The publication expects the country’s foreign reserves to remain around $2.84tn by 2020.  In the meanwhile, the country’s central bank chief said in a press conference that such decline is a normal phenomenon because the nation does not want that much forex reserves. Despite the decline, China still holds the largest forex reserves in the world, much higher than the runner-up, the chief commented.

State Administration of Foreign Exchange(SAFE) said that China’s foreign reserves will gradually stabilize despite the uncertainties in the international financial market. With China’s growing economic momentum, there will eventually be less control on capital outflow.

Authors: Yiping Zhang and Zhengyi Hu

Spain Overview: Economic Analysis and M&A Market Trends

Overview of the Spanish Market
Spain has the fourteenth-largest economy by nominal GDP in the world, and it is also among the largest in the world by purchasing power parity. The Spanish economy is the fourth-largest in the European Union, and the fourth-largest in the Eurozone, based on nominal GDP statistics (GDP 2016: $1252 trillion). Following the financial crisis of 2007–08, the Spanish economy’s plunged into recession, entering a cycle of negative macroeconomic performance. Compared to the EU’s and US. average, the Spanish economy entered recession later (the economy was still growing by 2008), but stayed there for longer. The economic boom of the 2000s was reversed, leaving over a quarter of Spain’s workforce unemployed by 2012. In aggregate terms, the Spanish GDP contracted by almost 9% during the 2009-2013 period. The economic situation started improving by 2013-2014. The country managed to reverse the record trade deficit which had built up during the boom years attaining a trade surplus in 2013 after three decades of running a trade deficit. The surplus kept strengthening during 2014 and 2015. In 2015, the Spanish GDP grew by 3.2% (one of the highest among the EU economies in 2015). In 2014-2015 Spain was able to recover 85% of the GDP that went lost during recession (2009-2013). In all the quarters of 2016 was registered a strong GDP, with the country growing twice as fast as the eurozone average. According to the IMF forecast, Spain will recover in 2017 all the GDP growth lost during the economic crisis, exceeding for the first time in 2017 the output level that had been reached in 2008.

Economic Forecast: Steady GDP growth for the 4 next years.
Fiscal stimulus and the ease of monetary policy from the ECB has contributed significantly to the growth of Spanish economy in 2016. With a growth of 5.5% over 2015 Spain’s GDP is expected to keep growing at a slower but steady pace for the next 4 years with domestic demand leading the recovery.

Spain GDP

Labour market: An improving but still challenging environment
The recent reshaping of the labour market through a series of reforms actuated by the new government has contributed to improve Spain labour market conditions and to put it in a strong position to capture future growth. Anyway, with an unemployment rate still at about 19% Spain is the second worst economy of the Eurozone in terms of unemployment, with youth unemployment posing a particularly acute challenge for the future of the economy.

Spain Unemployment

Fiscal policy: “little room for future fiscal stimulus”
With a public debt around 100% of the GDP and a deficit slightly below 5% of the GDP Spanish authorities have little room for fiscal expansion. After two years of significant easing of fiscal policy Spain has to find out a way to stimulate growth by shifting the structure of taxations towards growth enhancing initiatives such as education and R&D that are still below levels of peer countries after having been reduced significantly during the crisis.

Political situation: “achieving stability following 1 year without a real government”
After a year without a government Spain has finally achieved a stable political situation. The measures adopted to tackle budgetary austerity and labour market performance appear to have paid off as the economy is expected to grow by 3%. With a government in place, Spain is well prepared for further growth in a European environment where access to cheap financing is available. Furthermore, M&A activity has increased significantly following legislative changes in 2015, which aimed at facilitating the capitalisation of debt and the acquisition of business units from insolvent companies.

Sources:  OECD outlook on Spain economy, Grant Thornton European M&A activity report

 Deals Volume in 2016
The Spanish economy has continued growing during 2016. In 2016, Spanish M&A transactions totalled a range between €88bn[1] and €111bn[2]. The total deal value in Europe reached an amount of €1.502 bn: the Spanish market represented 5,9% of the total deal value in Europe. The increase shown in 2016 was encouraged by factors like those presented in 2015: continued economic growth; low interest rates and increased market liquidity; negative inflation; foreign trade balance; and stable risk premium for the Spanish sovereign debt. According to the M&A Attractiveness Index drawn up by the M&A Research Centre at Cass Business School, Spain has climbed several positions in the ranking of the most attractive countries for M&A purposes.  Spain fell to 26th position in 2012, but is now ranked 16th. If we break in details the total amount of transactions made in 2016 per size and per Inbound and Outbound, we obtain these numbers[3]:

Mid-market transactions showed a 43.5% increase compared to 2015.  Large-sized and small-sized transactions showed a slight increase in value of 4.5% and 1.1% respectively. Inbound investments increased in number during 2016.  The number of foreign acquirers of Spanish companies increased by a remarkable 9.3% compared to 2015 and outbound investments increased by 25.4%.  The most active sector in terms of M&A deals was real estate which increased to 11.6% compared to 2015.  In general terms, the real estate market continues growing as big banks keep unloading assets and tax structures such as Spanish Reits (SOCIMIS) and collective investment vehicles remain appealing to domestic and foreign investors.

Spain Sector

The main M&A transaction that took place in 2016 in Spain was the merger of the Coca-Cola bottling companies for an amount of €20bn.  Coca-Cola Enterprises CCE.N combined with Coca-Cola Iberian Partners (CCIP) and the German bottling business of Coca-Cola to create a new company that is the world’s largest independent bottler of Coke drinks by net revenue. The transaction gave new company, Coca-Cola European Partners (CCEP)[4].

According to the data collected by Thomson Reuters, the top actors per value and numbers are[5]:

Spain M&A Actor

The two Spanish banks Santander and BBVA do not owe their position to any concrete operation. On the contrary: their situation has been created thanks to the sum of many transactions of medium size. “This year has been one marked by the lack of big transactions, but characterised by mid-sized deals”, indicates an executive of a financial institution. “Banks which have the capacity to reach this segment have been very active”, he adds[6].

This lack of big transactions is reflected also on the deal volume of big American banks as JP Morgan and Goldman Sachs. In 2015, the last one was first in this ranking made by Reuters and now it is eight losing 6% of market share. Others American banks have kept their position and in particular Citi is gaining position in this ranking.

Outlook – Trends
One of the biggest player KPMG expects the M&A market in Spain to perk up based on the favourable development of the Spanish economy[7]. According to them investors regained their faith in Spain and see it as a reliable market with an abundant amount of liquidity. In particular, the interest of investors is driven by market growth expectations, legal security, the global importance of Spanish companies and the new reforms that make the Spanish economy more competitive[8]. A study conducted by KPMG shows that investors are 7% more confident to realize M&A activity in 2017 compared to year before[9]. Furthermore, the M&A market capacity is expected to be growing by 14% compared to 2016. Concerning the importance of the sectors, KPMG foresees that most M&A activity will be in consumer goods, health and finance. Consequently, they also expect the number of IPOs to increase. A partner of Magnum Capital, a leading private equity enterprise in Spain, the Spanish M&A market didn’t use its full potential due to uncertainty of the effects of the Brexit and the political instability in Spain[10]. Therefore, his forecast for 2017 is very positive mainly based on the fact that many operations were stopped in 2016 and are expected to be closed in 2017. Baker McKenzie, the second biggest law firm worldwide and specialized in commercial law, predicts the M&A activity to grow by 41% until 2018[11]. This is mainly explained by the competitive advantage resulting out of the labour reform in 2016 that is resulting in growing employment[12]. Also, they expect the IPO activity to grow significantly during the next three years based on the difficulties in 2016[13].

Main challenge of 2017:

1. The first is the normalization of the labour market. The unemployment rate is finally below 20%, and the Spanish economy has been outperforming the rest of the eurozone since 2015. But the good labour market performance cannot hide an hysteresis effect that is changing the quality of the labour market. A real long-term unemployment problem is emerging, together with the loss of human capital that this entails. This means that employability is decreasing, and that much higher growth rates in the future may be needed to keep unemployment on a decreasing trend. The problem of long term unemployment is compounded by youth unemployment, that remains extraordinarily high at more than 40%, and NEET young people can be found especially among the low-skilled, with a serious risk of poverty. Dualism of the labour market is a source of fragility and of insufficient investment and innovation.

2. The second challenge is the fiscal stance, and it is of course related to the debate in Europe. The Spanish government has strongly reduced its net lending (including the structural deficit) that nevertheless remains at around 5% of GDP.  Yet, the Spanish situation clearly needs a more expansionary environment, that could only come from the rest of the Eurozone. Continued austerity will not help with Spain’s most pressing problem, hysteresis and long term unemployment.

3. The effects of the Brexit referendum remain unpredictable.[14] How it will impact the M&A activity in Spain and Europe depends on how Britain will foster the exit and how the process will develop.

 References:

Agencia EFE (2017)

Las fusiones y adquisiciones aumentarán un 41 % en España hasta 2018, http://www.efe.com/efe/
espana/economia/las-fusiones-y-adquisiciones-aumentaran-un-41-en-espana-hasta-2018/10003-3156469.

Argali Abogados (2017)

Spanish M&A surges again despite obstacles, http://www.mandaspain.com/spanish-ma-surges-again
-despite-obstacles/.

Baker McKenzie (2017)

Baker McKenzie prevé para España un aumento del 41 % en M&A hasta 2018, http://www.bakermckenzie.com/es/insight/publications/2017/01/global-transactions-forecast/.

Europa Press (2015)

El mercado de fusiones y adquisiciones resurge en España, según KPMG, http://www.europapress.es/economia/finanzas-00340/noticia-mercado-fusiones-adquisiciones-resurge-espana-kpmg-20150316183707.html

Expansion (2017)

Las fusiones y adquisiciones crecieron un 20% en España en 2016, http://www.expansion.com/
empresas/2017/01/01/58692ab4468aeb670d8b45e1.html

[1] Expansion
[2] Mergers Market
[3] Global Legal Insight
[4] Thomson Reuters
[5] Thomson Reuters
[6] Expansion
[7] This and the following Europa Press
[8] Expansion
[9] This and the following Europa Press
[10] This and the following Argali Abogados
[11] Agencia EFE
[12] Baker McKenzie
[13] Agencia EFE
[14] Here and the following Argali Abogados

Authors:

Virginia Bassano, Luca Pancari, Andrea Terzi, Felix Oliver Napp

Free Trade: New Challenges Ahead

On the 23rd of June 2016, the British people decided to leave the EU, the only geographical area that almost completely fits the textbook definition of free trade, i.e. “the economic policy of not discriminating against imports from and exports to foreign jurisdictions.”. They made this decision official on the 27th of March, and lots of interrogations remain about the new agreements between the EU and Great Britain. In fact, a NatCen study shows that 88% of Britons back free trade, but 69% of them also support customs check and a harder immigration policy. This, associated with a lot of privileges like passporting no longer being available to British based companies, would push talents away, and ultimately entail less growth and innovation in Great Britain. But this is only one of the many possible scenarios. As said before, the EU is the only really integrated area. In the rest of the world, there exist many obstacles to free trade such as quotas, restrictions, subsidies or prohibitions. Barriers like the ones named here do not seem to negatively impact economic growth or innovation: China has practiced protectionism since 1978 when it decided to become a market economy, and yet its GDP is still growing at a rate of about 7%!

China GDP

Even developed economies have used protectionism and strong barriers to free trade to develop: during the 18th and 19th centuries (and even until WWII for the US), protectionism was seen as the only way to increase wealth and protect your interests against the ones of other countries. International trade was not seen as a win-win game but more as a zero-sum game, where for someone to win, someone must lose.

tariff rates

Anyway, already in the 19th century economists such as David Ricardo or Adam Smith declared and proved that free trade is the best possible solution for economies to thrive and grow. In response to their research, and because economies started to open up as a result of industrialisation and the facilitation of commerce and transportation, free trade became the norm and regulation became lighter and lighter. For instance, tariffs shifted from an average of 50% of the total imports in the US in 1830 (sometimes even more depending of the product) to an average of 3.8% in developed countries. After the Uruguay round of 1995, the proportion of imports into developed countries from all sources facing tariffs rates of more than 15% declined from 7% to 5% and the WTO set up piles of regulation on tariffs. (The WTO tariff agreement report is 22,500 pages long!)

The creation of the WTO in 1995 combined with globalisation really helped reduce the obstacles to free trade, but some still exist. In this article, we will therefore analyse the still existing obstacles to free trade and more importantly their impact on the global economy. Free trade is first and foremost a political choice, and consequently the largest part of the obstacles to free trade are political too and can take the form of quotas, tariffs, or other restrictions.

According to Robert Feenstra in Advanced International Trade, they are three main reasons why a country would impose tariffs: to protect fledging domestic industries from foreign competition, to protect aging and inefficient domestic industries or to protect domestic producers from dumping by foreign companies or governments. These three justifications of some level of protectionism can seem inoffensive, but as reported by the World Bank, if all barriers to trade were eliminated, the global economy would expand by about 830 billion dollars.

When looking at such number, it seems evident that it comes from the extra costs induced by the countries which are imposed with tariffs, but countries imposing tariffs also generate extra costs that usually outweigh the benefits. Indeed, when imposing a tariff, countries usually expect a rise in production and prices (due to lower competition), and this should induce producers to hire more workers which will automatically cause consumer spending to rise. But in the vast majority of cases, the rise in price will mean a decrease in purchasing power for the consumer. As a response, he will either buy less of the good which price has increased or less of another good. In any case, the increase in price will affect negatively global demand, and logically, it will also impact growth. Let’s think of the UK for instance: Brexit has become official of the 27th of March, but it should not be completed before 2019, and yet prices already started to rise[1], and growth expectations are rather negative[2].

Furthermore, tariffs and other restrictions can be used as a very powerful weapon in an economic battle. Such battle started for instance between the EU and the US in 1989, when the EU decided for sanitary reasons to impose heavy restrictions on American beef grown with hormones. In the first year after the tariff was instituted, about $140 million worth of American beef was blocked.  In 2008, the WTO decided that the EU had no legitimate reasons to impose and maintain such restrictions, and therefore the US were allowed to impose retaliatory import duties on EU products if the ban was not lifted. The EU decided not to lift the ban, and the US imposed supplementary restrictions to European products such as canned tomatoes, French cheese or ham. All products banned had a market value of $38 million but under the WTO ruling, the US could raise the tariff barriers to a value of $116.8 million, that is an additional $79million. These numbers show immediately what countries can lose due to tariffs and other restrictions, but the real victims of such games are consumers. As said before, because of tariffs which induce lower competition, price increases, but in addition to higher prices they are also confronted with less choices: in the USSR for instance, which is an extreme example of what barriers to free trade can do to an economy, people had very few choice for basic products such as dairy products or linen etc. even if due to communism they did not face higher prices. This lack of choice, associated to an increasing attraction towards western products, was one of the reasons for social unrest in the USSR and eventually for its collapse.

However, even if on the long run tariffs and barriers to free trade are harmful for the global economy, they do not only have a negative impact; they have always been used (and still are) by developing countries to increase government revenue and boost investment and growth. The strategy China used for its development nicely clarifies this statement.

It started developing in 1978, when it initiated market reforms and shifted from a centrally-planned economy to being market-based. GDP growth has averaged nearly 10 percent a year and has lifted more than 800 million people out of poverty. To achieve that, China has used a classical technique that we could describe as the “infant industry” argument. As said before, tariffs can be used to protect a domestic industry against foreign competition. When countries start to develop, it is common knowledge that they should protect domestic industries until they become profitable: at the beginning of its development, China imposed heavy restrictions and tariffs, with absolutely no subtlety. Some western products were simply banned with no further explanation. When it joined the WTO in 2001, it had to change its policy and adapt to the standards of the organisation, but restrictions are objectively still very heavy. The Custom General Administration (CGA) assesses and collects tariffs, which are divided in two categories: the general tariff, and a minimum one for “most-favoured” nations such as the US, who have a commercial agreement with China. On top of paying tariffs, imports are also subject to a VAT of 17% or a business tax.

Quotas also still limit over 40 categories of products such as watches, automobiles, or and in 1996, China introduces tariff rate quotas (TRQ) on imports of wheat, corn, rice, soybeans, and vegetable oils and out-of-quota rates can still be as high 121% of the market value of the product. Certain commodities still have an automatic registration process, the inspection standards (especially for commodities) are very high while the legal framework is much more general than in most OECD countries, which allows the Chinese government to use it in a very flexible way. This may result in inconsistency and companies have real trouble understanding whether they are breaking rules. Certain sectors such as textiles also have to pay extra import taxes. Services remain even more regulated, since it is a sector that China wants to develop and protect from foreign competition. As a matter of fact, foreign services providers are largely restricted to operations under the terms of selective “experimental” licenses, and have to face strict restrictions on entry and on the geographical scope of the activity. This severely limits the profitability and growth of such activities.

GDP by sector

As we can observe from this graph, this strategy of the “infant industry” was very efficient for China and allowed it to experience the fastest sustained expansion by a major economy in history. But as research as shown, protectionism can only be a temporary policy; in order to have a sustainable growth, a country has to open up and reduce barriers to free trade as much as possible. And de facto that is exactly what China is trying to do. At the end of January 2017, China’s State Council announced it would further open some sectors such as mining or services to foreign investments. Besides, China is expected to import $8trillion worth of goods and services within the next five years, and Chinese outbound investment should reach $750 billion over the same period.

Ultimately, free trade seems to be the path that all nations should follow to maintain sustainable and strong growth as China demonstrates. Even though physical obstacles to free trade still exist under the form of restrictions, quotas, etc. China is willing to reduce them and to open its doors to foreign companies and investments. As President Xi Jinping said in Davos: “China will keep its doors wide open. We hope that other countries will also keep their doors open to Chinese investors and maintain a level playing field for us.”. This last sentence was a direct attack to President Donald Trump, who some days earlier declared a trade war against China which he accuses of toying with its currency.

The election of Donald Trump, whose campaign slogan was “Make America great again”, and who intends to fulfil this by instating a much more protectionist policy, as well as Brexit are two symptoms of a greater illness. In fact, if free trade has not won over the entire world yet, it is mainly because people are afraid of foreign competition. They have the feeling foreigners will try to take their place and replace them, leaving them with no jobs and no opportunities. Especially in countries such as the UK or the US, where income inequalities are important and have increased since the financial crisis of 2008[4], people tend to show more protectionist tendencies. Populists such as Donald Trump or even Marine Le Pen in France have understood this phenomenon and use it in their campaigns to win over voters. But as Xi Jinping said during the World Economic Forum in Davos this year, “many of the problems troubling the world are not caused by economic globalisation. During the same event, his compatriot Jack Ma, founder of Alibaba and richest man in Asia agreed, saying that globalisation is good. But he also said globalisation should be improved, it should become inclusive in order to guarantee that everyone can benefit from it.  Especially in a context of slowing growth, the voices against globalisation are easier to hear, because the benefits are harder to distribute, but we should not forget that globalisation has powered global growth, and facilitated advances in sciences, technology and civilisation. Xi Jinping concluded this way, and so will we: “Pursuing protectionism is just like locking oneself in a dark room; while wind and rain may be kept outside so are light and air. No one will emerge as a winner in a trade war.”

Author: Elsa Leger

[1] Oil prices have gone up since the officialization of Brexit on 27th of March, growing from around £48 a barrel to £53 on 10th of April.

[2] Fitch Ratings still grades the UK AA but decided to put a negative outlook after the 27th of March.

[3] It is probably no coincidence that this new policy was decided when China’s growth started to slow down due to a decrease in domestic demand.

[4] According to the Gini Index, which ranks countries in accordance with the level of inequalities, The UK and US have a coefficient of 0.34 and 0.37 respectively. The European average is about 0.3, and Turkey has a coefficient of 0.40.

India: A brief analysis of the world’s fastest-growing economy

We are living really hard times. The fear caused by the growing terrorist activities, the distrust of the stranger induced by rising nationalisms and by a propaganda good at riding the wave of growing frustration, the uncertainty caused by the dissolution of our certainties. Many are the reason that keep investors awake and contribute to the current atmosphere of  anxiety and restlessness.

Nevertheless, there is a safe-haven which seems to be insulated by all these factors and that is living the most prosperous period of its history. A tireless nation that continues its seemingly unstoppable growth process. A bright spot of positive two-digit returns in a world of incredibly low yields.  We are talking of course about India, the fastest-growing large economy in today’s world, whose economy grew at an incredible rate of 7.5% in 2015 – faster than the 6.9% growth observed in China, the former leading emergent economy and currently the third largest economy after the US and EU – and is still expected to grow at 6% in 2020.

Since the Republic constitution in 1950, Indian economy was characterized by heavy state regulation and intervention and by protectionist policies that kept it off from the outside world. In 1991, an acute balance of payments crisis – due particularly to the currency devaluation and the high budget deficit – forced the government, led by Narasimha Rao[1], to liberalize the economy moving toward a free-market and capitalist system.

The large population, the bustling manufacturing sector, the high saving rate and the emphasis on foreign trade and direct investment inflows, contributed to a rapid progress, with an incredible average rate of about 5% GDP growth since then. We can easily see how an investment in the Indian stock market made ten years ago, would have more than doubled our investment. Actually, the chart below compares different stock market indices. We can notice at a glance how both the Sensex and the Nifty (indices of the two Indian stock markets), with an average growth rate of 90%, have considerably outperformed the average of emerging markets (given by the MSCI Emerging Markets Index). Only the S&P500, with a return of 67%, has almost kept up with such huge returns.

STOCK Markets

Since the election of Narendra Modi as prime minister in May 2014 – after a controversial campaign in which the leader of the Bharatiya Janata Party focused on fighting corruption and sustaining economic development – we assisted to a progressive liberalization of the economy, mainly aimed at increasing the attractiveness for foreign businesses. The labor market was deregulated (to make it easier for the employers to hire and fire workers and harder for them to form union), corporate taxes and customs duties were lowered, the wealth tax was abolished, digital infrastructure were built – through to the “Digital India” campaign – and more Foreign Direct Investments (FDI) were allowed in areas like Construction Projects, Cable Networks, Agriculture and Plantation and Air Transportation. The shadow economy has been harshly limited by the demonetization of all ₹500 and ₹1,000 banknotes, in order to crack down the financing of terrorist and illegal activities. A new “Insolvency and Bankruptcy Code” has been issued on May 2016. At last, the huge problem of different taxation between different regions –  past cause of confusion and uncertainty – is being solved as today is under review the single biggest tax reform under the ‘Goods and Services Tax’ or GST bill, whose aim is to create a consistent tax structure across the entire country and one single marketplace.

Moreover, the following initiatives were launched: “Make in India”, to encourage foreign companies to manufacture products in India; “Standup India”, to support entrepreneurship among women and SC and ST communities (Scheduled Castes and Scheduled Tribes); “Startup India”, aimed at promoting bank financing for start-up ventures to encourage entrepreneurship and jobs creation. Large investments have been made in Africa in sector as energy, mining and infrastructure, with the main purpose to reduce the dependence on imported goods such as oil, coal and gold (almost 50% of Indian overall imports).

Furthermore, Modi achieved a drastic reduction of the budgetary deficit – from more than 4% to 3% – at the expense of the funds invested in environmental and social programs as poverty reduction, family, healthcare and education (reduced by almost 15%). As a result, we assisted to an enlargement of inequalities in income distribution[2], mainly because rising inequalities between urban and rural areas.

The economy was spurred even more by the consecutive rate cuts pursued by the Reserve Bank of India, as a response to the preoccupant level of inflation observed at the end of 2013, which reached the peak of 11.5%. The repo rate was lowered from 8% to 6.25% in less than two years.

The measures achieved soon the expected results, boosting the economy (GDP grew at the incredible rate of 7,5% after Modi’s first year as prime minister) and increasing much the attractiveness for foreign companies. The amount of Foreign Direct Investments jumped from $34 billion in 2014 to $44 billion in 2015[3], the unemployment rate dropped to 6.3% in 2016, the time required to start a new business dropped from 33 days to the current 26. Therefore, the IPO activity is expected to rise by more than 40%, while M&A activity should more than double in 2019, above all in sectors as financials, consumer and healthcare. Among the countries with the largest share of FDI inflows to India we can find in first position Singapore, followed by Mauritius Islands and United States. Among the European countries, Netherlands is first in rank, followed by Germany (whose car manufacturers are outsourcing part of the production), UK and France. The main reason behind the huge amount of FDI from Mauritius Islands and Cyprus is the low taxation of these two countries – considered tax heaven – which induced many Europe and US based companies to route their investments into India through these countries, deriving double tax avoidance and tax evasion. By the way, with the renegotiation of the double taxation avoidance agreement (DTAA) with India, this phenomenon is likely to decrease soon.

There are other positive factors behind the Indian growth that justify good expectations. Differently from China, Indian growth has been sustained above all by its internal consumption and a fast-growing middle class[4]. Moreover, we can consider such growth as approximately unleveraged[5]. Therefore, the country can easily increase its debt issuance in the near future, especially considering the high rating of BBB- confirmed by Fitch last summer. Third, the expansion has been demographically propelled. Today, India has still a population growth rate of 1,26%[6], thus by 2050 India’s workforce (people between 15 and 59 years old) is expected to have grown from the current 674 million to a staggering 940 million. On the contrary, China is likely to be facing a shrinking workforce, which will potentially drive up labor costs, undermining its competitiveness against other cheap-labor countries. As a matter of fact, India is already much cheaper with an average hourly rate of only 0,48$ per hour[7], largely due to the very low level of gross domestic product per capita[8]. We have to consider also its people’s ability to speak English and its large pool of computer engineering graduates, which make India a popular destination for outsourcing activities.

As we could see, with the advent of N. Modi as prime minister, many are the initiatives carried forward to increase the attractiveness of India. The results so far are extraordinary and India can really overtake the US as the world’s second largest economy by 2050 according to a recent report published by PricewaterhouseCoopers (PWC).

Nevertheless, many challenges are still ahead. The education sector needs to dramatically improve its quality. Considering the future increase in population, the push to allow more private universities and to allow foreign universities to operate in India will strengthen.

Another crucial point is the delay in the spread of Internet and the smartphones. From this point of view, China has a great advantage against its rival. Since 2013, the Chinese have consistently reported rates of internet and smartphone use that are at least triple that of Indians (71% of Chinese adults report using internet occasionally, against the 21% Indians). The gap is similarly large when it comes to social media use[9].

Much will depend also on the foreign policy that could be pursued under Trump’s presidency, as the US, second largest trading partner of India, count for more than the 15% of Indian exports[10].

Last but not least, the conditions of women are still far by those of civilized countries. Although the Supreme Court of India said that ‘equal pay for equal’ work is an unambiguous constitutional right, the implementation is resulting very difficult[11].

The world is changing fast. Everything seems to be uncertain and unpredictable. One thing is certain, India will not stand by but it will play a leading role.

AUTHOR: Niccolò Ricci

[1] Narasimha Rao was an Indian lawyer and politician who served as the 9th Prime Minister of India, from 1991–1996.

[2] The income inequality reached the worrying level of more than 50% according to the Gini Index. Only China had greater inequality at that time.

[3] An impressive increase of almost 30%! India is currently the first country for FDI after China and US. World Bank Data.

[4] India is ranked 128th according to the Index of Economic Freedom , meaning that the country is less dependent on the external demand and thus more insulated by global evolutions.

[5] Indeed, in 2015 domestic credit to the private sector (percentage of GDP) stood at 52.6 per cent for India, compared to 153.3 per cent for China. Also the government debt is very moderate, with a ratio of roughly 70%.

[6] Well above the rate of China (0,52%) and aligned to those of most African countries, despite the higher degree of development.

[7] “Countries with the cheapest labor”, The Richest. The cheapest country in the world is Madagascar (0.18$ per hour), followed by Bangladesh, Pakistan, Ghana and Vietnam.

[8] India is ranked only 122nd globally (about 6.000$ per person, against an average of 15.000$), World Bank Data.

[9] According to the Spring 2016 Global Attitude Survey, by PEW Research (www.pewresearch.org).

[10] China is the largest trading partner of India, followed by USA, United Arab Emirates, Saudi Arabia and Switzerland. Department of Commerce of India.

On the other hand, India is the main counterparty of Buthan, Guinea-Bissau, Nepal and Afghanistan. CIA World Factbook, 2015.

[11] According to the Gender Gap Index 2015, set by the World Economic Forum, India is ranked only 108th. Iceland leads this special rank.