| Sound exits need sound capital markets |
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| The recent stockmarket aversions to high tech and telecoms companies has left the international market jittery and, according to Ruairi O Nuallain, this demonstrates the need for sound investment principles when approaching mergers and acquisitions. |
‘NASDAQ hits low’. ‘Earnings warning sends Dow down 100’. ‘Brief rise cannot halt FTSE’s downward trend’. ‘Tech stocks take a battering’. ‘Telecoms out of favour’. ‘Concerns about 3G licence spends’. The recent downturn in international stock markets, and particularly for the TMT sectors, indicates that confidence can change markets. Liquidity of stocks can be maintained, albeit at lower prices. Good exits are feasible in good capital markets. The risk of investing generally is regarded as being remunerated by the potential for up-side. This is fine when markets are operating within predictable parameters, and when they adequately price risk. This is not fine when the basis for pricing is based purely on a trend, without being grounded in the more fundamental basics of sound investment.
Confidence is quite an intangible feature in business. When confidence in markets, consumer behavior and economic principles is strong, there is little risk of exposure for creditors, lenders, and shareholders. Even though an economy as a whole can be operating quite effectively, there can be aberrations affecting certain sectors from time to time. This can occur from extraneous influences such as exchange rate movements, policies in other countries, taxation competitiveness, technology shifts and so on. However, as in economics, there can be presumptions of common behavioral patterns among consumers, so also there can be common swings in confidence, with potentially significant effects. Because the US and Irish economies have experienced a relatively sustained period of growth, many of the newer entrants into jobs providing investor advice, or managing equities or banking will not be familiar with the knock on effects of a shift in confidence. Whether such shifts in confidence can be controlled is a challenge for the stability of capital markets.
Resilient
The Irish economy is very resilient. In the earlier days when currencies tried to converge within agreed bands (some will remember the ‘snake’), considerable pressure was mounted by the markets on the stability of the exchange rate mechanisms and on individual currencies. At the height of the market onslaught, exchange rates reached levels not recorded in the previous 50-100 years. At the time, the stress was taken by way of substantial movements of capital between currencies (amounting to over 20 times trade flows), and by substantial knock-on effects in liquidity and interest rates. Inter-bank rates in Ireland reached between 40 per cent and 60 per cent, thankfully for a very short period. Companies survived this turbulence in many cases with difficulty, but changes in banking administration technology enabled banks to change their approach to providing loans, facilitating roll-overs as distinct from the more traditional default and fixed repayment schedules. The roll-over capabilities and disposition of lenders prevented more traumatic consequences, kept business failures at an acceptable level, and kept creditors in a position to recover amounts due to them. This roll-over feature of capital markets was relatively new at the time, but played a key role in the resilience of companies to survive the stresses at the time. But more importantly, it retained confidence in the capital markets systems in Ireland, and kept the overall country ratings at their high grading levels. This added to the resilience of the Irish economy.
In recent years, the ratings attaching to many of the newer technology companies, particularly those which obtained quotations on NASDAQ, in many cases, were incredibly high. In one case, I recall selling a business which had sales of around ?1 million but with profits at breakeven level to another company which was incurring sizeable losses, but yet had a large treasure chest of capital in its balance sheet held in liquid assets. We completed the deal for a substantial sum, and it was difficult to rationalize the buyers valuation in terms of the more traditional tenets of company valuation. Obviously, it was justified by the ratings in the markets at the time, and for the ‘black box’ dimension in the target company (besides the good financial advice). Nonetheless, the usual rules using discounted cash flows, and net present values of earnings streams did not apply.
With the benefit of hindsight, it now seems that, in the case of many telecoms companies, the full extent of the impact of heavy capital expenditures on licences was not taken into account adequately in the bid valuations. This has affected not only stock market ratings for telcos, but also the pricing of credit to such entities. Spreads or margins on facilities for some of the top ranked international names have increased considerably, and for long term paper in US dollars the yield recently reached almost 20 per cent (compared with inter bank rates of 5 - 6 per cent). Clearly capital markets have reviewed the cash flow capabilities of such companies in retrospect and their ability to sustain substantial capital expenditure on the roll-out of new services (broadband, fibre optic, digital, GPRS, UMTS and so on). This has led to some concerns at sovereign level for the sector. One wonders whether the full impact of the licence acquisition costs and the cost of roll-out, together with assumptions concerning the leveraging and financing of them were factored into the bidding of such companies. In some cases, they most likely were - hence for those bidders, they probably did not proceed to bid at the levels finally awarded. The fact that some of the winning bidders got it wrong, is a risk not only for them but also for other creditors within the sector’s supply chain. If there were to be a substantial collapse of one of these operators, then sovereigns would rightfully be concerned. The knock-on risks potentially could affect the sovereign itself, and adversely affect capital markets for the particular country concerned (it is worth noting that Ireland did not pursue the open bid auction route).
So should companies be concerned about such risks. At the macro level, there are grounds for concern. Healthy capital markets (in the sense that they are not boom and bust) provide a solid base of liquidity for investors, for venture capital investors, and for shareholders. Given the tendency for investors to look for trends and cycles, and for consumers to shift their spending/saving ratios, it is probably impossible to totally eliminate cycles. Nonetheless, it is in the interests of sovereigns to have smooth economic vibrancy, and to have moderate risk exposures for businesses, and creditors within their jurisdictions. This preserves access to liquidity in their systems and retains the prospects for exits for investors. The boom-bust scenarios frighten off investors and participants in capital markets, lead to lower ratings, and riskier creditor positions. The steady as it goes model is easier to rely on forecasting and realizing investments, and the internal rates of return (rewards) for such investors.
Investors
For investors, and particularly venture capital investors, who take shareholdings in private (i.e. unquoted) companies, sound capital markets are key. So how do ‘sound’ capital markets emerge? In Ireland’s case, it has been an evolution of the economy and policies over quite a lengthy period, but with substantial acceleration in recent years. For quoted companies, the Irish Stock Exchange has provided considerable capital and has had many success stories over the years. For private companies, the market between buyers and sellers of shares is imperfect. Government policies can help capital markets to become more liquid in many ways. These policies cover issues such as the free movement of capital - investors want their money back at some stage, and preferably benefiting from the up-side of any risks involved. Other policies can affect the returns that an investor earns. These include the treatment of dividends, profits, revenues, and capital gains. Capital markets enhancers include low taxation on corporate activities (including use of labour, capital and other resources), low taxation on capital gains, and an approach which supports wealth creation (infrastructure, communications, education). When investors perceive that the chances of earning a fair return on investment, after allowing for risks, capital markets operate more fluidly. One element which supported this in Ireland’s case in recent years was the reduction in the rate of capital gains tax from 40 per cent to 20 per cent - and in a recent budget, the Minister for Finance noted that the receipts from such taxation had increased more rapidly than in the preceding years - indicating that the measures supported greater activity, and hence liquidity in the markets.
Because investors want to get their money back, with a return that rewards risk-taking, it is important that exits from private companies are feasible. One of the main elements that a venture capital investor looks at before making an investment is the likelihood of a successful exit. If they cannot see the exit up-front, then they are less likely to invest. Many calculate the internal rate of return for their investment using assumptions concerning the exit, when they are appraising proposals. If they can assume that capital markets will be sound in 5-7 years time, they are more assured of achieving an exit, and hence of making an investment. This is why the soundness of capital markets is so important for a vibrant economy, and for the continual roll-over of capital in businesses. |
The views in this article are those of Ruairi O Nuallain personally. O Nuallain is executive director of ICC Bank’s mergers and acquisitions advisory wing - ICC Corporate Finance Ltd.
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| Article appeared in the April 2001 issue.
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