corporate finance priorities in 2015 - … for their assistance with data; our fsg analysts –...

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Citi GPS: Global Perspectives & Solutions

January 2015

CORPORATE FINANCE PRIORITIES IN 2015

Ajay Khorana Gabriel KimyagarovElinor Hoover Anil Shivdasani Arturo Lorente

Driving Corporate Growth in Divergent Markets

Citi GPS: Global Perspectives & Solutions January 2015

Authors

Elinor Hoover +1 (212) 816-1212

[email protected]

Ajay Khorana +1 (212) 816-7076 [email protected]

Anil Shivdasani +1 (212) 816-2348 [email protected]

Gabriel Kimyagarov +1 (212) 816-9031 [email protected]

Arturo Lorente +44 (20) 7986-7450 [email protected]

Contributors

Jeffrey Colpitts Sergey Sanzhar Gustav Sigurdsson

Nikolina Kalkanova Talia Schaap Cecil Wang

Chengyu Li Nikolai Semtchouk

Acknowledgements We thank Peter Orszag, Doug Adams, Peter Babej, Steve Becton, Michael Berkowitz, Ron Chakravarti, John Chirico, Tyler Dickson, Laura Drumm, Flavio Figueiredo, Mike Fossaceca, David Head, Cary Kochman, Dan Pakenham, Michael Roberts, Carolyn Sheridan, Peter Tague, Dylan Tornay, and Bob Waldman for their helpful insights and comments; Scott Davis and Stan Suen for their assistance with data; our FSG analysts – Lavesh Daryanani, Philip Gunnarsson, Miraj Hossain, Tim Liu, Sean Ma, Amrit Malothra, Mike Zhang, and Guocheng Zhong for their analytical support; and Celia Gong for her editorial support. Anil Shivdasani is a Professor of Finance at the University of North Carolina at Chapel Hill.

About the Financial Strategy and Solutions Group The Financial Strategy and Solutions Group (FSG) is the corporate finance advisory team in Citi’s Corporate and Investment Banking division. We advise corporate and financial institution clients globally on the full spectrum of corporate finance issues including valuation, capital structure, credit ratings, risk management, liability management, shareholder distributions, and acquisition and funding strategies. In partnership with Citi’s product and industry experts, we design innovative solutions to assist our clients.

January 2015 Citi GPS: Global Perspectives & Solutions

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CORPORATE FINANCE PRIORITIES 2015 Driving Corporate Growth in Divergent Markets The corporate growth agenda remains at the heart of both corporate decision making and investor expectations. With a broad divergence in global growth prospects, a decoupling of rates and currencies, and a rapid decline in oil prices, it is critical to understand the implications of these changing dynamics and address how best to optimize growth.

Global corporate growth prospects are widely decoupled from economic growth prospects, with companies in some regions expected to grow at rates that significantly exceed economic growth forecasts. In this environment, the corporate finance challenge will be how to achieve growth while prudently managing heightened market and geopolitical risk. This decoupling will also heighten investors’ attention on capital deployment, and will in many cases require companies to shift their capital allocation priorities.

In addition to capital deployment prioritization, this report focuses on how to use M&A and restructurings to support equity growth premiums; how global capital markets can best be tapped to fuel growth; and how to manage risk in a complicated global marketplace while driving prudent growth.


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Divergent Macroeconomic Outlook and the Corporate Growth Agenda Divergence in Global Growth Prospects The outlook for economic growth headed into 2015 differs dramatically across regions. The US and UK appear to be headed towards recovery with expected GDP growth rates at 3%. In China, while absolute growth rates remain strong at 6.9%, the pace of growth has slowed from prior years. Key policy concerns in these countries range from determining how best to unwind quantitative easing programs (the US and UK) to ensuring that the economy does not overheat due to lenient lending standards (China).

The outlook in other regions is less promising, with significant divergence across countries. Western Europe generally remains a weak spot. Germany, a source of relative strength throughout the Euro crisis, is now faced with the prospect of GDP growth below 2%. The picture is worse in other countries ‒ growth in France is expected to be below 1.5%, while in Italy median growth estimates are below 1%. In Japan, despite the high profile “Abenomics” reforms and a quantitative easing effort of as much as 12 trillion Japanese yen per month, growth projections remain dire.

Figure 1. Global GDP prospects have diverged Figure 2. Dispersion in global GDP growth forecast

Source: Citi Global Economic Outlook & Strategy, December 2014, and Bloomberg Source: Citi Global Economic Outlook & Strategy, December 2014, and Bloomberg

These divergent growth prospects are subject to considerable uncertainty which is reflected in the wide dispersion of individual GDP forecasts in most economies. For example, in China, credit quality and property value concerns are significant risk factors. In Europe, there remains considerable uncertainty about the effectiveness of monetary stimulus in the absence of structural reforms.

Geopolitical concerns are also weighing heavily on the global growth outlook. For example, the conflict between Russia and Ukraine has cast a shadow over Europe’s prospects. Notwithstanding these risks, equity market volatility has remained muted, but could rise significantly should these geopolitical tensions be exacerbated.

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Driving Corporate Growth in a Divergent World The divergence in macroeconomic outlook has differing implications for corporate growth prospects across regions. Topline growth estimates for US and UK corporates look robust at 5.2% and 4.8%, respectively, and are reasonably aligned with GDP expectations. On the other hand, companies in Japan and many Eurozone countries face the largest gap between GDP growth and revenue growth (2.6% and 3.5%, respectively) and will likely have to look abroad to find ways to drive growth.

The expectation for corporate growth to outstrip GDP growth can also be observed at the regional level. In North America, while GDP estimates remain at 2.9%, topline corporate growth estimates are 2.3% higher at 5.2%. An even wider growth gap exists in Western Europe, DM Asia, and EM Asia — with gaps of 3.6%, 2.5%, and 2.9%, respectively. Eastern European and LatAm corporates face even higher hurdles to achieving their growth gaps of 5.8% and 7.0% above GDP growth, respectively.

Figure 3. Significant gap between sales and GDP growth

Note: Median Analyst sales growth forecast for MSCI Global non-financial firms. Source: Factset and Citi Research

If geopolitical risks become more acute, the premium that equity investors ascribe to future growth is likely to come down. Therefore, the corporate finance challenge for 2015 will be how to achieve growth prudently in an environment of elevated political and market risks.

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Rate, Currency, and Commodity Markets Decoupling The divergent economic growth expectations are mirrored in both the differing absolute level of rates across regions as well as the significant variation in interest rate projections within regions. In the US and the UK, with the recovery underway, the conversation has moved from being about when quantitative easing will end to how the legacy of quantitative easing will be unwound. Correspondingly, discussions in these markets center on when and how quickly interest rates will rise. In Western Europe, the ECB has now announced a number of monetary stimulus measures. In Japan, quantitative easing looks set to continue with no end in sight. 10-year government bond yields show that the dramatic divergence between these regions started in 2012, with the widest divergence in rates existing today. Citi’s rate outlook suggests that this wide gap will continue to persist for the next several years.

Figure 4. Interest rates show dramatic bifurcation Figure 5. Dispersion in long-term interest rate forecasts

Source: Citi Global Economic Outlook & Strategy, December 2014, and Bloomberg Source: Citi Global Economic Outlook & Strategy, December 2014, and Bloomberg

Among global currencies, the decoupling could almost be described in terms of two groups ‒ the US dollar, and Every Other Currency. Citi forecasts suggest that the US dollar will appreciate against nearly every other major currency over the next few years. The US dollar appreciation has significant implications for multinationals. US-based global firms may have to continue to confront a world where the value of cash flows they earn abroad, even in fast growing emerging markets, as well as their overseas cash balances will continue to be dragged down by an ever-strengthening US dollar. Multinationals based elsewhere may benefit from an increase in the value of cash generated in the US. However, those firms that have issued US debt on an unhedged basis may find themselves at risk.

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Figure 6. Significant projected appreciation of the USD Figure 7. Currencies and commodities decoupling

Source: Citi Global Economic Outlook & Strategy, December 2014

Note: USD is trade-weighted average exchange rate, oil is Brent Crude, metals is LME index, and yield is 10-year Treasury Source: Bloomberg

The correlations between commodities, interest rates, and FX rates have declined since the financial crisis. In particular, the correlation of oil with other assets has declined dramatically in the past two years. An exception to this trend of falling correlations is the USD / 10-year Treasury yield relationship, which has strengthened. These correlation dynamics have important implications for risk management due to changing diversification benefits across asset classes. Firms will need to holistically evaluate the consequences of these changing market dynamics for corporate finance and risk management policies.

Implications of a Lower Oil World Drastic drops in energy prices are forcing many executives to evaluate the corporate implications of the new oil price paradigm. Not surprisingly, the majority of non-commodity producing sectors are benefiting from lower energy costs, boosting margins and enhancing valuations. Indeed, over the past three years, for every 10% decrease in oil prices, these firms have experienced a 2.1% pickup in equity returns. On the other hand, for energy companies, whose cash flows are highly sensitive to energy prices, a 10% drop in oil prices has led to a 3.9% decline in their equity returns.

While oil has declined by approximately 30% in the past two months, questions remain as to how much further it could drop and what actions need to be taken to protect the growth agenda. While a two standard deviation downside move in oil (a further 36% drop) may seem unrealistic, swings of 25% or more have occurred five times since the crisis. The net effect of lower oil prices may be a significant benefit to consumer spending and economic growth, however, oil producing and oil consuming regions will be affected very differently.

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Figure 8. Equity performance sensitive to oil price movement

Note: Based on weekly returns of MSCI Global non-financial firms, net of correlations with the overall equity market. Source: FactSet

For oil producers, lower oil prices can materially impact credit ratings and their ability to maintain corporate capital expenditures (capex) and return capital. If lower energy prices persist, global energy companies may need to curtail capex which currently represents about 95% of their operating cash flow. Adjusting to the new oil price environment will require a broader rethinking of capital deployment strategies.

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Capital Deployment to Drive Growth Adopt a Proactive Approach to Capital Deployment Decisions on how to deploy capital to achieve topline and earnings growth will be at the forefront of financial strategy in 2015. Due to divergent economic conditions across regions, optimal strategies for firms across the globe are likely to differ substantially. With about $4.7 trillion in cash held by MSCI Global firms, companies should be prepared for substantial investor attention on how this capital will be deployed. Large excess cash balances often serve as a drag on valuations and attract the attention of activist shareholders, leading to broader debates on corporate strategy and a heightened focus on growth.

In 2015, the attention on deploying capital will be magnified by the divergence between analyst revenue and earnings growth projections and global GDP forecasts. Although capital expenditure growth is projected to be robust in North America, forecasts for 2015 suggest a slowdown globally, with a contraction in Asia.

Rethink Capex in Light of Varying Returns across Regions The investment policies of many companies have not been recalibrated to the divergence in economic outlook across regions. While North American companies have spent an average of 52% of their operating cash flow on capex, Western European companies have spent a much greater percentage (69% of OCF) despite significantly lower GDP growth prospects for the region. Furthermore, Asia has seen some of the most rapid deceleration in GDP growth and yet Asian companies spend the highest percentage, 77% of cash flow, on capex.

Figure 9. Overreliance on capex in Europe and Asia Figure 10. Potential to boost ROIC in Europe and Asia

Note: Return on invested capital and fraction of operating cash flow for capex dividends, and share repurchases is the median across all MSCI global non-financial firms; for each firm, fraction is the average from 2008 through 2014 Q3. Source: FactSet

In certain capital intensive sectors such as industrials, the differences are even starker. Despite their higher investment, the return on invested capital (ROIC) has been much lower for Western European companies at 8.5%, compared to 11.4% for North American companies, highlighting the need for substantial recalibration of investment policies.

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As a result of their long-standing emphasis on capital expenditures as a primary growth driver, aggregate invested capital among Western European MSCI Global firms stands at about $7.5 trillion. Our estimates suggest that to achieve parity in ROICs with North American firms, Western European companies need to reduce their invested capital by about $1.9 trillion, requiring a careful review of their business portfolio mix. Further, the large shifts in energy and commodity prices, the strengthened US dollar, and the divergence in GDP prospects indicate that a reassessment of business portfolios will be an important priority for all firms to ensure that capital is efficiently deployed in the current environment.

Shift Capital Allocation to Enhance Returns For many companies, improving ROIC will also require enhancing operating margins. Achieving this objective will be particularly important for Western European companies, where our estimates suggest that operating margins need to rise by 34% for their ROIC to equal that of North American firms. Accomplishing such large increases in margins will require redirecting investment towards regions with higher or more stable economic growth.

Globally, firms in the top quartile of investment in their sectors trade at a 0.8x P/E multiple premium relative to their peers in the bottom quartile. However, this premium exists only in higher growth or more stable regions such as North America (2.4x P/E premium) and the emerging markets. In contrast, Western European firms with high capex actually trade at a discount to their peers.

Raising dividends will remain a value enhancing strategy in 2015. Currently, a sizeable multiple premium exists for high dividend paying firms in the US, and this dividend premium exists across most regions. In fact, the magnitude of the dividend premium in Western Europe and Asia indicates that using cash flows to fund shareholder distributions may be a more effective path to multiple expansion than increasing capital expenditures in these regions.

While many companies have used share repurchases to support earnings growth, the effectiveness of this approach may be diminishing. In the US, the equity market response to share repurchases has declined over the past three years, potentially reflecting the reduced importance of buybacks as an undervaluation signal in an environment of robust valuations. Share buybacks may, however, be more effective in supporting valuations in regions with muted economic growth. Firms with high repurchase activity trade at valuation premiums in Western Europe and developed Asia, but this pattern does not hold in higher growth regions such as North America and the emerging markets. For these regions, topline growth may be a more effective path to enhanced valuation than share repurchase driven EPS growth.


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Figure 11. Equity investors respond differently to capital deployment strategies

Note: PE premium is the different in price-to-2015 earnings estimates between firms in top and bottom quartiles of capex, dividends, and share repurchases for MSCI Global non-financial firms. Financials are as of Q3 2014 LTM; prices and estimates are as of December 1, 2014. Source: FactSet

Achieve Working Capital Efficiencies Working capital solutions such as global cash management centralization and trade finance solutions can also help lower invested capital and enhance ROIC by increasing the efficiency of working capital and treasury functions. For example, global cash pooling shrinks a company’s net working capital at the consolidated level by netting subsidiary level bank cash and short-term debt positions, allowing the company to run at a lower operating cash level. Similarly, centralization of payments processing can lower working capital requirements by giving companies better control over their cash conversion cycles. Such tactical steps can allow companies to free cash trapped in treasury management to be deployed more effectively for funding growth initiatives or shareholder distributions.

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M&A to Support the Growth Premium Global M&A volume surged in 2014 as companies sought to deliver sustained earnings growth, realize synergies, improve efficiency, and adjust to changing global dynamics. An accommodative financing environment facilitated the use of M&A to capitalize on changing global growth patterns and shifts in energy production, manufacturing costs, and consumer demand. M&A volumes are approaching $3.5 trillion in 2014, which would make it the third strongest year for M&A ever.

US firms are leading the consolidation wave both domestically as well as with acquisition of overseas firms as a means to expand geographic footprint, deploy offshore cash, and align their overseas production and cost base. Additionally, US targets accounted for almost half of global M&A volume in 2014, as they were also desirable targets for overseas buyers. Inbound M&A to the US rose by 87%, driven by Western European buyers executing large acquisitions in North America. Outside of Western Europe, inbound cross border activity into the US grew at a slower rate from China and Japan.

Use M&A to Drive Corporate Transformation Firms are increasingly looking to transformational M&A actions to reshape their businesses, leading to an approximate 70% increase this year in the volume of announced M&A deals that were $5 billion and larger, representing about 40% of all M&A transaction volume in 2014.

Investor reaction to M&A announcements in the current environment has been strikingly positive with share prices of acquiring companies appreciating by the largest amounts seen in recent history. Buyers in 2013 and 2014 saw their share prices outperform by 3.4% on average over the 20 days surrounding the announcement and by 5.9% over six months.1 This outperformance represents a threefold increase in the short-term market response relative to deals announced prior to 2009.

Larger transactions, despite their greater execution risk, were particularly well received. Buyers announcing deals valued at $10 billion or larger saw their share prices outperform by about 6.9% over six months. Firms announcing deals greater than $5 billion and $1 billion experienced, on average, six-month outperformances of 6.1% and 5.1%, respectively. All of these stock price responses are more positive than observed in prior years. Clearly, investors have applauded firms seeking to execute transformational actions as a means to expand capabilities, realize synergies, and deliver topline and earnings growth. In addition, the recent rapid decline in oil prices has accelerated the role of M&A across many sectors in the context of optimally deploying capital to achieve growth. At the center of this discussion, in the energy sector in particular, is whether acquisitions may be a more attractive route to achieve growth than expanding exploration.

1 Excess returns are computed on a market- and risk-adjusted basis.


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Figure 12. Stronger buyer out performance than ever before Figure 13. Investors rewarding transformational deals

Note: Based on announced M&A transactions over $500 million from 2010 to October 2014. Source: SDC and FactSet

Note: Based on announced M&A transactions over $500 million from 2010 to October 2014. Source: SDC and FactSet

Deploy Excess Cash to Acquire Growth Over the past two years, equity markets have been particularly receptive to transformational acquisitions that offer new growth opportunities to buyers. Our analysis considered $5 billion and larger deals where the target’s revenue growth over the prior year exceeded the buyer’s revenue growth. Since 2013, such acquisitions have been accompanied by an average six month post announcement excess return of 8.3%. By contrast, in acquisitions where the buyer’s growth rate exceeded the target’s growth, excess returns averaged 1.9%, highlighting that growth driven deals have been much more favorably received in the current M&A environment. While the difference between high growth and low growth acquisitions also existed in 2010-2012, the outperformance of high growth acquisitions was significantly lower.

Since 2013, the equity market has also been highly receptive to acquirors with substantial cash holdings that have engaged in M&A. For deals valued at $500 million or greater, buyers in the top quartile of cash-to-assets generated excess returns of 8.6% over the subsequent six months, outperforming buyers that were in the bottom quartile of cash-to-assets, who generated six month excess returns of 4.9% post-announcement. While the market was also more receptive to acquisitions by cash-rich buyers in 2010-2012, the outperformance of cash-rich buyers has widened substantially over the past two years, reflecting the increased investor focus on excess cash holdings. Further, the positive market receptivity to acquisitions by cash-rich firms is not simply an artifact of higher returns from cash financed deals in general. In fact, over the past two years, equity financed transactions have outperformed cash deals. These patterns indicate that in the current environment, firms that deploy excess cash to execute on well designed and strategically important M&A opportunities are likely to be rewarded with significant share price appreciation.

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Figure 14. Acquisitions of high-growth targets rewarded Figure 15. Cash-rich companies rewarded for deployment

Note: Based on M&A transactions over $5 billion announced from 2010 to October 2014. Acquirer and target growth defined by prior year’s revenue growth. Source: SDC and FactSet

Note: Based on M&A transactions over $500 million announced from 2010 to October 2014. Cash-rich and cash-light acquirers are those with cash/ assets in the top and bottom quartile, respectively. Source: SDC and FactSet

Anticipate Activist Involvement in M&A Unsolicited and hostile deals have become more common, reflecting the bolder outlook of buyers, the interest on the part of multiple buyers for attractive targets, as well as the growing involvement of activist hedge funds in M&A situations. Since 2013, 223 activist campaigns have been launched with the goal of influencing M&A transactions. Shareholder activists are more likely to be involved in larger transactions and in hostile situations ‒ in some cases, their advocacy for a higher price for the target contributed to a hostile posture or the entry of competing suitors. This trend is likely to continue in 2015 as M&A related activism has led to stronger share price performance than that of other types of campaigns ‒ reinforcing M&A as the preferred route for generating fund performance for activist funds.

An activist campaign can have a profound effect on overall corporate governance and strategy. M&A related campaigns frequently morph into campaigns around board representation, and their efforts to gain board seats are often met with a high degree of success. Since 2010, activists have gained board representation in over half of the campaigns in which board seats were explicitly demanded. Furthermore, in nearly 43% of these successful campaigns, the activist gained three or more seats on the target’s board. Therefore, anticipating potential activist hedge fund involvement will continue to be critical to M&A decision-making in 2015.

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Figure 16. M&A driven activism generating higher returns Figure 17. Board change more likely with M&A activism

Note: Based on S&P 1500 campaigns with explicit value demands from 2010 to October 2014. M&A campaigns include demands for divestitures, spinoffs, acquisitions, or a sale of the targeted company Source: FactSet and Shark Repellent

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Unlocking Growth through Restructurings A variety of restructuring options need to be considered as firms continue to find ways to illuminate the value of their underlying businesses. Spinoffs will continue to be integral in any restructuring agenda as multi-segment firms continue to exhibit a significant valuation discount relative to pure-play peers ‒ the conglomerate discount, which in 2014 has widened to its highest level since 2005. Spinoff and divestiture volumes in 2014 have reached $1.4 trillion as of December. In addition, YieldCos have become the new asset class ‒ an efficient source of equity capital and an important way to highlight both growth and cash flow stability.

Spinoffs to Eliminate the Conglomerate Discount The conglomerate discount has continued to widen globally over the past few years ‒ rising from 5% in 2011 to 10% currently. In Western Europe, the discount is 2% higher than in the US, partly driven by the lower ROIC for Western European corporates. This discount tends to widen during periods of more muted market volatility, when the conglomerate business model is less valuable as a mechanism for providing earnings stability to fund future growth. However, spinoffs remain a value illuminating tool even during more volatile market periods.

As the discount has continued to widen, so has the short-term market response to spinoff announcements, highlighting the desire of equity investors to unlock value trapped in many large conglomerates. Part of the value enhancement can be attributed to the increased likelihood of M&A for the separated entities. These factors have contributed to an elevated level of spinoff activity this year.

Figure 18. Higher conglomerate discount during periods of low market volatility

Figure 19. Favorable market reaction to spinoff announcements

Note: Based on all non-financial firms in Worldscope from 1999 to 2014. Conglomerate discount calculated based on median FV-to-sales ratio of single-segment firms. High- and low-volatility periods defined annually relative to median value of the VIX from 1999 to 2014. Source: Bloomberg, SDC, and FactSet

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However, not all conglomerate firms suffer from a discount. Multi-segment firms with related business segments that exhibit similar growth profiles actually trade at a slight premium, illustrating the fact that if managed correctly, the conglomerate business model can be value enhancing. Most importantly, our analysis shows that by refocusing their businesses, conglomerate firms are able to improve their industry adjusted sales growth by 2.5% subsequent to the spin. Those conglomerates that trade at a discount are able to achieve even greater improvements in their topline growth.

Activist investors have also recognized the heightened potential to unlock value from conglomerate firms, and 2014 saw a large number of activist calls to separate target companies into two or more businesses. Moreover, target companies were far more likely to heed an activist’s call to spin off or divest a part of their business than a call to sell the company outright or merge with another company. In nearly 37% of campaigns since 2010 that explicitly asked for a spinoff or divestiture, target companies took action to separate one or more of their businesses from the rest, with Dow Chemical and eBay two high-profile examples in 2014.

Increasing activist involvement in strategic decisions should not come as a surprise. The success of seasoned activist hedge funds has spawned a large number of new funds, and activism has become an integral part of the institutional investors’ playbook. In this crowded field, the goal of replacing weak management teams and pushing firms with conservative financial policies to increase leverage and payouts has increasingly been accomplished, leaving more transformative changes as an attractive agenda for today’s activists.

In light of these trends, a closer examination of all business segments needs to be a critical step in any strategic planning process. Close attention also needs to be paid to optimizing the capital structure, managing the credit rating dynamics and the underlying liability structure of each respective entity, and evaluating potential changes in the shareholder base of the spun-off entity post separation.

YieldCos to Illuminate Growth The past year has seen continued momentum in the formation of various “yield equity” vehicles such as master limited partnerships (MLPs) and real estate investment trusts (REITs). While part of the momentum behind MLP and REIT formations is supported by their tax attributes, broader forces at work have led to the emergence of large non-MLP, non-REIT “YieldCos.” The power sector has been the most active user to date of the YieldCo technology; however, corporates in an ever broadening set of industries could benefit from the valuation uplift that the market is ascribing to these vehicles.

MLPs, REITs and YieldCos share a number of attributes. They all hold assets that deliver a steady stream of low-risk cash flows, often subject to multi-year contracts with highly-rated counterparties and the lion’s share of these cash flows is paid out as dividends. Annual dividend growth is also a key feature, as total return through dividends and growth is the primary driver of valuations. The growth can be derived from “drop-downs” of assets over time from sponsors or organic growth of new, steady cash flow assets.

The question that often arises is whether these vehicles offer sustainable value above and beyond the tax attributes associated with MLPs and REITs. YieldCos issued in the power sector, which do not have the same tax advantages, have demonstrated the ability to deliver significant valuation uplift. Over the last couple of years, parent entities with YieldCos have experienced a meaningful multiple expansion when compared to their non-YieldCo peers.


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Figure 20. YieldCos boost growth premium Figure 21. MLP IPOs spur significant growth of parent

Note: Based on energy and utility companies within S&P 1500. Base P/E is the multiple attributable to current earnings and growth P/E is the multiple due to expected earnings growth. MLP IPO sample is from 1999-2011; sales growth calculated over three years. Source: FactSet

At first glance, this valuation uplift may appear to be supported by the high yielding nature of this asset, which is particularly attractive in a low interest rate environment. However, a significant portion of this valuation uplift also appears to come from the illumination of future growth. In fact, an analysis of MLPs shows a significant pickup in topline growth over an extended period of time. This growth is fueled in large part by cost of capital advantages resulting from these more stable growth entities, which continue to attract a new investor base focused on yield plus growth. For this reason, the expansion in the investor base has been driven in large part by institutional investors for whom the growth and yield thesis may be more important than tax considerations alone. Furthermore, the growth component of these structures makes them attractive even in a rising rate environment.

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Tapping Global Pools of Capital to Fuel Growth In contemplating any growth agenda, a well-designed funding strategy will be critical to ensuring a successful outcome. So far, robust capital markets across debt and equity have been supportive. However, key questions remain: how long will this positive capital markets backdrop continue; who are the still untapped investors; what could spur these potentially marginal investors to step up; and what trends might disrupt this marketplace. Given this backdrop, what actions should financial decision makers consider today to optimize financial flexibility, to maximize the corporate growth agenda, and ultimately to enhance shareholder valuation.

Need to Remain Nimble in Today’s Global Capital Markets Over the past year, investment grade and high yield debt issuance volumes have reached $3.3 trillion, with issuers accessing funding at attractive levels. A number of positive trends could result in continued support for the capital markets. The ECB's recent announcement to extend asset purchases to corporate credit could result in significant inflows, supporting credit markets. Corporate pension plans that still hold a high equity allocation may be compelled to de-risk by rebalancing to fixed income, particularly if rates rise. Life insurance companies, as they continue to augment their portfolios, have a growing need for long duration credit. Short duration credit also benefits from the continued buying by corporates with sizable cash balances, needing to invest their excess liquidity while alternative deployment options are being evaluated. On the equity side, several hundred billion USD of incremental equity could materialize as Japan’s Government Pension Investment Fund looks to allocate more assets to equity over the coming years.

On the other hand, a number of headwinds to the capital markets loom. Continued bank regulations may have a countervailing impact on credit markets. Additionally, geopolitical tensions could have unexpected adverse consequences for global capital markets. Lastly, the continued weakness in oil prices could have a dampening effect on the buying power of sovereign wealth funds, particularly those of prominent oil exporting countries.

Tap US capital markets for maximum liquidity and utilize derivatives where possible to achieve price efficiency as well as asset and liability matching of currency exposures. Over the past several years, the US dollar debt market has remained the most sizable and liquid market and from the investors’ perspective, still commands relatively attractive yields on a global basis. As such, corporations from all over the world have tapped the US debt markets, achieving size and pricing advantages. When currency swaps are paired with USD issuances, additional pricing advantages may be achieved due to favorable basis swap levels.


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Figure 22. Continued importance of USD as primary funding market in 2014

Figure 23. Negative swap basis favorable to swapping USD issuance into EUR and JPY

Source: Dealogic Source: Bloomberg

For large scale event driven financings, tap global markets to access growing pools of capital markets outside of the US markets. For example, the last several years have seen a steady growth in the European capital markets with Eurobond issuance up over 30% from 2013, enabling issuers such as Verizon, Apple and others to meet their strategic needs.

Explore the full range of alternatives to funding growth in the emerging markets. Funding in the emerging markets such as India, China, and Brazil requires a holistic evaluation of both local funding options as well as structured financing alternatives to achieve the optimal funding strategy. A number of bespoke solutions combining intercompany lending with offshore derivatives have resulted in sizable pricing advantages for multinationals looking to fund growth in EM jurisdictions.

Need to Evaluate Impact of Evolving Bank Regulations Large global banks are now being required to comply with ever evolving capital and liquidity guidelines. Recently, regulators have been requiring banks to hold a greater proportion of high quality liquid assets to better manage their short-term and long-term liquidity. These new standards will have important ramifications for corporates as they manage their own liquidity and look to access additional bank funding.

It is also important to highlight a potentially meaningful reduction in available repo financing, especially for US banks with significant reliance on short-term wholesale funding. Furthermore, the need to issue an estimated $250-300 billion of bail-in debt by the largest US banks as part of new bank resolution guidelines, could potentially impact the borrowing cost for both banks and corporates. These guidelines are expected to be implemented over a multi-year period with full compliance expected by January 1, 2019.

While bank lending in the US has remained relatively robust to date, bank lending in Europe continues to contract, a trend that parallels declining GDP growth forecasts for the region. Irrespective of these patterns, alternative sources of capital are gaining prominence. For example, the shrinkage of bank lending in Europe is being partially offset by a greater supply of capital from the shadow banking system, which most recently represented a 25% share of bank- and non-bank lending in Europe.

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Figure 24. Strong Recovery in commercial, industrial and consumer lending in the US

Figure 25. Increasing importance of shadow banking in Europe

Note: Based on banks tracked by the Federal Reserve and ECB from July 2010 to September 2014 Source: Federal Reserve, ECB, and IMF

In light of ongoing pressures on the global banking system, corporate executives should continue to diversify their funding sources, especially given the attractiveness of the capital markets and rate environment today. In addition, new liquidity rules will have significant implications for revolving credit lines. Under the new guidelines, large banks will have to hold adequate liquidity against the undrawn portion of credit facilities. Currently, out of $2.2 trillion total credit facilities for S&P 1500 and STOXX 600 firms, approximately $2.0 trillion is undrawn. These lines will require the banks to hold more liquid securities to comply with new liquidity guidelines, resulting in a meaningful increase in the cost to the banking system.

As corporate executives assess optimal liquidity levels to manage both operational and precautionary liquidity requirements, they need to evaluate the underlying costs and benefits of various alternatives and have a plan for these potential changes. A comprehensive assessment of liquidity needs in both expected and stress case scenarios is a critical step in identifying true excess corporate liquidity.

Finally, in an effort to manage the overall bank relationship, corporate executives need to pay close attention to the allocation of their short-term cash. Under the new liquidity requirements, corporate operating balances, i.e. deposits related to working capital needs of a company, are more favorable than overnight non-operating or excess balances, which are considered to be less stable. More attractive options for excess liquidity could include bank deposits with a maturity of greater than 31 days, separately managed accounts and money market funds, with money market funds undergoing their own regulatory changes. Managing the tradeoff between liquidity and yield will become imperative in light of these regulations.

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Managing Risk in Divergent Markets As corporates consider various growth alternatives, risk management becomes paramount in pursuing a prudent growth agenda. Looking beyond the borders may often present the highest growth opportunity; however, this pursuit for growth often also comes with significant underlying risks. Market risks such as FX, rates and commodities represent some of the largest contributing factors ‒ explaining almost a third of corporate earnings volatility. Mitigation of these risks has often enabled corporations to achieve greater stability in cash flows and earnings, which in turn results in a valuation premium. Specifically, we find that companies with low earnings volatility outperformed those with higher volatility by 58% cumulatively since 2006. This striking gap may be attributed to the greater financial flexibility afforded to low volatility firms and their resulting higher sales growth rates.

Figure 26. More stable companies outperform Figure 27. Companies with lower earnings volatility have higher growth

Note: Based on MSCI Global non-financial firms. High- and low-volatility defined by year as top and bottom quartile of earnings volatility relative to industry. Sales growth is average across industry medians within each volatility category. Source: FactSet

Energy price declines, interest rate uncertainty, continued US dollar strength and the overall decoupling across markets necessitate a reevaluation of hedging strategies.

Reevaluate How Evolving Market Correlations Impact the Business The trend towards weakening correlations across certain asset classes, as described earlier, clearly alters natural diversification benefits, which has varying implications for different corporates. For a representative multinational company, the lower correlation environment has the potential to increase natural diversification benefits by 12% relative to the risk reduction benefits experienced during the crisis period. However, companies that historically benefited from strong positive correlations between market risk factors affecting both revenues and expenses could see their natural hedges dissipate. For example, a sample commodity producer ‒ with oil and FX cost exposures which offset some of the high volatility in sales due to commodity price movements ‒ could see its existing natural diversification benefit drop by as much as 22% relative to the benefit experienced during the crisis period. It is imperative that all companies understand these correlation dynamics in designing appropriate risk mitigation strategies.

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Assess Impact of Changing FX Dynamics on Financial Performance

Foreign exchange is one of the largest contributing factors to earnings volatility. The strength of the US dollar, which appears likely to persist in the coming year, could have a profound impact on top and bottom line growth of many corporates. For multinationals, a number of attractive currency basis swap pricing advantages exist in the market today that may help to mitigate potential currency headwinds. For example, multinationals with Euro and Yen asset side exposures and US dollar liabilities may consider swapping their liabilities into the respective currencies, realizing better funding costs as well as currency matching of assets and liabilities.

Challenge Conventional Wisdom Around Fixed/Floating Mix of Liabilities Swapping debt to floating rate may seem counterintuitive in today’s low rate environment, and conventional wisdom may suggest that corporates should lock in attractive long-term interest rates. However, despite the end of quantitative easing in the US, significant uncertainty remains surrounding the timing, length, and ultimate targeted policy rate of the Fed's upcoming hiking cycle. In swapping to floating, corporates would achieve an immediate saving in interest expense. Assuming that fed rate hikes start in 2015 and level off at 3.02% in 2019, it would take over 8 years for the cumulative interest savings from swapping a 10-year bond to floating to turn negative.2 These savings could accrue for an even longer period of time should the hike in rates be delayed.

Additionally, substantial benefits may be realized from matching liabilities with assets. For those companies with high cash balances, swapping liabilities to floating may reduce the exposure to interest rate risk and the negative carry caused by the mismatch between longer duration liabilities and shorter duration liquid assets. Not surprisingly, this duration mismatch has increased due to growing cash balances with cash-to-debt ratios in 2014 having reached 35% for MSCI Global firms, while these firms still hold greater than 86% of their outstanding debt in long-term fixed rate. Furthermore, for companies with significant pension liabilities, having floating rate interest exposure in their corporate debt portfolio can also hedge the substantial exposure to rates that exists in their pension plans. Finally, given the strong observed positive correlation between sales growth and interest rates for many corporates, operating performance may serve as a natural hedge to floating rate exposure.

2 Citi forecast of 2019 Fed Funds rate, Global Economic Outlook and Strategy, December 1, 2014.

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Energy 2020 Independence Day: Global Ripple Effects of the N American Energy Revolution February 2013

2013 Year Ahead Investment Themes January 2013

2013 Year Ahead Corporate Finance Priorities January 2013

Upwardly Mobile Mobile Payments: A Long Winding Road November 2012

China in Transition What We Know, What We Don’t KnowNovember 2012

Global Debt Mr. Macawber’s Vindication November 2012

Sub‐Saharan Africa The Route to Transformative Growth September 2012

China & Emerging Markets China is About to Rebalance. How Will EM be Affected? July 2012

Energy 2020 North America, the New Middle East? March 2012

Upwardly Mobile An Analysis of the Global Mobile Payments Opportunity March 2012

2012 Year Ahead Corporate Finance Priorities January 2012

2012 Year Ahead Investment Themes January 2012

Call of the Frontier The Search for a New Generation of Emerging Markets November 2011

Trade Transformed The Emerging New Corridors of Trade Power October 2011


© 2015 Citigroup

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