The Impact of an Emerging European Corporate Bond Market on Corporate Governance

Exploratoty roundtable on Corporate Governance, Innovation and Value CreationIstanbul, Turkey, 1 February 2012

- PRIVATE AND CONFIDENTIAL -

I. THE EUROPEAN CORPORATE FUNDING MARKET

II. IMPACT ON CORPORATE GOVERNANCE

III. CONCLUSION

1

Refinancing -

Other

41%

Recap

8%

General

Corporate

Purpose

5%

M&A

19%

Refinancing -

Bank Debt

27%

DEMAND FOR CAPITAL WILL CONTINUE TO BE SIGNIFICANT

Deal Purpose Diversification (based on volume)

2

0,0x

1,0x

2,0x

3,0x

4,0x

5,0x

6,0x

7,0x

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Jan-Sep

11

First Lien/EBITDA Second Lien/EBITDA Other Debt/EBITDA

High Yield Issuance Q1-Q3 2011 by use of proceeds

Estimated maturity profile of European leveraged loans Pro Forma Debt/EBITDA Ratios

0%

20%

40%

60%

80%

100%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Jan-

Sep

11

Acquisition Related Recapitalization Refinancing Other

Source: S&P

Senior Senior Senior Senior lendinglendinglendinglending::::

• Deleveraging reduces access to funding

• New regulation; Basel III reduces access to funding and increases cost of capital

• Crowding-out from sovereign funding needs as well as bank funding needs

AND SUPPLY IS CHANGING; BANK LENDING

Basel III impact (estimated shortfall in 2019)

3

European bank assets to GDP (%)

Source: SEB

500

750

100

300

0

200

400

600

800

1000

1200

US EUR

Core Tier 1 Tier 1

EUR bn

Equity markets:Equity markets:Equity markets:Equity markets:

• Demography will decrease demand for equity

• New regulation; Solvency II will decrease allocations to equity

• Equity markets are primarily secondary markets – SSE; new issues equal approximately 1 % of trading volume: financial

market vs market for funding/financing

• Equity gap for Europe (2010-2020) projected to be 3 trillion USD (needs 6 trillion and demand 3 trillion)

SUPPLY IS CHANGING; EQUITIES

4

Insurers reducing equity allocations ahead of Solvency II (and majority of current holdings in unit-link accounts)

McKinsey estimates equity allocation to decrease from 28% to 22% globally over the next ten years

Source: SEB

5

European High Yield Bond issuance

• Banks are likely to take a decreasing share of corporate funding due to deleveraging, regulation etc.

• Equities are unlikely to be able to “fill the gap” due to demographics, regulation etc.

• We need a much more active, liquid and transparent market for funding from other sources such as bonds and private loans

• Bonds may also be a more efficient form of financing at this time – both from a capital allocation and a governance

perspective

• A developed market for financing is a prerequisite for efficient allocation of capital and supply for midsized European A developed market for financing is a prerequisite for efficient allocation of capital and supply for midsized European A developed market for financing is a prerequisite for efficient allocation of capital and supply for midsized European A developed market for financing is a prerequisite for efficient allocation of capital and supply for midsized European

companies and thereby for growth and employment rates in Europecompanies and thereby for growth and employment rates in Europecompanies and thereby for growth and employment rates in Europecompanies and thereby for growth and employment rates in Europe

Source: S&P LCD 5

CONCLUSION REGARDING FUNDING MARKETS

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1Q06

2Q06

3Q06

4Q06

1Q07

2Q07

3Q07

4Q07

1Q08

2Q08

3Q08

4Q08

1Q09

2Q09

3Q09

4Q09

1Q10

2Q10

3Q10

4Q10

1Q11

2Q11

3Q11

Leveraged Loans Mezzanine HY Bonds

European Leveraged Loans – Share of Total Volume

0

5

10

15

20

25

30

35

40EUR bn

I. THE EUROPEAN CORPORATE FUNDING MARKET

II. IMPACT ON CORPORATE GOVERNANCE

III. CONCLUSION

6

Equity Bonds Loans

Exit

Voice

Contractual

In public markets relatively easy thanks to good liquidity

At AGM, board appointment etc and increasingly through informal channels such as

the press etc

As with equities although liquidity more limited

Usually not

1) At establishment of the contract, 2) In case of default

or sometimes through bondholder committees etc.

1) At establishment of contract, 2) In case of default,

rarely through informal channels

Limitations on the management of a company

Equity is a standardised contract and a perpetual instrument and regulated by law, while bonds and loans are limited in time and regulated mainly by contract

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EQUITY VS DEBT INSTRUMENTS

• Debt holder’s main impact from a governance perspective is at the establishment of the contract, somewhat more limited during monitoring and redemption.

• The loan contract means that debt holders (somewhat counter intuitively) may have a much more direct influence on the company than shareholders.

• Shareholders govern for maximizing potential given a certain risk level, whereas bondholders/lenders govern to minimize risk.

• Terms in the contract are there to prevent the risk from increasing without the bondholder/lender having a say.

• The relationship between managers and bondholders/lenders centers around the terms of the contract.

THE LOAN CONTRACT AS A GOVERNANCE TOOL

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Lenders and bondholders have significant influence via the contract. Most of this influence is in the negotiation of terms when the contract is put in place, such as;

• Information requirements, dialogue

• Observer seat on board

• Financial covenants (maintenance)

• Financial covenants (incurrence)

– Change of control

– Limitations on acquisitions

– Limitations on investment

– Limitations on additional indebtedness

– Restrictions on transfer of assets

– Restrictions on dividends and group contributions

– Restrictions on change of business

– Restrictions on group/internal dealings, arms-length etc

Lenders influence via contracts

• The bond holders and lenders will over time constitute a new and more active player on stage in the corporate governance system.

• There is (and will be) the same range of players as in equity markets, everything from passive long only actors to “activists”.

• In a widely held company, the management and board may be (or at least should be) closer to the debt holders than to the shareholders.

• Valuation of bonds and loans also has a much greater impact on the company that the valuation of shares.

• Bondholders and lenders have a lower risk tolerance then shareholders

• But, constructive lenders and bond holders will guide the focus to value creation and also drive discipline in But, constructive lenders and bond holders will guide the focus to value creation and also drive discipline in But, constructive lenders and bond holders will guide the focus to value creation and also drive discipline in But, constructive lenders and bond holders will guide the focus to value creation and also drive discipline in strategy and financial decisions such as investments.strategy and financial decisions such as investments.strategy and financial decisions such as investments.strategy and financial decisions such as investments.

IMPACT OF THE CHANGES IN THE FUNDING MARKET

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I. THE EUROPEAN CORPORATE FUNDING MARKET

II. IMPACT ON CORPORATE GOVERNANCE

III. CONCLUSION

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• Non-bank debt funding will be crucial to address the financing of mid-sized companies going forward, not least in Europe• Debt instruments have interesting potential as tools of corporate governance – not least in the creation of an informed and

motivated community of financiers.• The debt contract has the potential – if rightly applied – of being a positive influence on the governance and management of

the company; for value creation rather than rent seeking.

• In all In all In all In all –––– new debt investors will be crucial for funding of midsized companies in Europe over the next decade at least new debt investors will be crucial for funding of midsized companies in Europe over the next decade at least new debt investors will be crucial for funding of midsized companies in Europe over the next decade at least new debt investors will be crucial for funding of midsized companies in Europe over the next decade at least and they will also change the dynamics of corporate governance.and they will also change the dynamics of corporate governance.and they will also change the dynamics of corporate governance.and they will also change the dynamics of corporate governance.

• Paradoxically, some of the efforts discussed to incentivize equity investments – notably tax neutrality – risk stimulating the secondary equity market and at the same time dis-incentivizing the market for corporate funding.

• Regulators, politicians and market actors in Europe should put a greater emphasis on stimulating the development of a well functioning bond market, such as:– Improved transparency and liquidity– Improved legal environment – trustee functions, standardization of terms, disclosure requirements– Broadened investor base – retail as well as institutional investment policies

CONCLUSIONS

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