Dr. Heinz Schimmelbusch Chairman and CEO, Advanced Metallurgical Group Anthony Siwawa Managing Director, Venture Partners Botswana

JUNE 2014 #10

IN THIS ISSUE

Dr. Werner Brandt Chief Financial Officer, SAP AG Prof. Julian Franks Professor of Finance, London Business School James Gorman Chairman of the Board and CEO, Morgan Stanley Prof. Dr. Steve H. Hanke Economist, The Johns Hopkins University Prof. Dr. Michael Heise Chief Economist, Allianz SE Guido Kerkhoff Chief Financial Officer, ThyssenKrupp AG Gerhard Lohmann CFO Reinsurance, Swiss Re Thomas Münkel Chief Operating Officer, UNIQA Insurance Group AG John Plender Columnist, Financial Times Dr. Konstantin Sauer Member of the Board of Management, ZF Friedrichshafen AG Dr. Heinz Schimmelbusch Chairman and CEO, Advanced Metallurgical Group Anthony Siwawa Managing Director, Venture Partners Botswana

Fields of Gold? Competing with Irrational Exuberance

#10

MARKUS PERTL PAGE THANK YOU 3

Markus Pertl Chairman of The Stern Stewart Institute

Thank you ...

In the editorial of our first edition of the periodical, I fo- Special thanks go to David Marsh for the cooperation with cused on the Distribution of Wealth. I argued that the the Official Monetary and Financial Institutions Forum as highest priority should be to reduce the social and fiscal well as to Don Chew for his collaboration with the Journal burden on lower and medium income. Why should there of Applied Corporate Finance. And, of course, I cannot be higher taxes on work than on capital returns or inherit- forget all of the helping hands. ance? This is no doubt a hot topic, and even more so today. Let me assure you that I am more than grateful to be part of this strong network of leaders and pioneers, and I am The editorial of our 10th anniversary edition for our peri- very much looking forward to our Annual Summit in odical will be written by my hardest critic yet strongest September, where we will gather and continue our entre- supporter, creative mind and Director of The Stern Stewart preneurial dialog in person, in most vivid discussions. Institute, Gerhard Nenning. For now, let’s turn the page and start with this 10th edition I would like to thank all of the friends and members of The of The Stern Stewart Institute’s Periodical. Stern Stewart Institute and the 80 authors for their stimu- lating articles and for lending us their bright entrepre- Yours, neurial minds.

Markus Pertl PAGE GERHARD NENNING 4 EDITORIAL COMMENT

Fields of Gold? Competing with Irrational Exuberance

It has been almost twenty years since Alan Greenspan These patterns that lead to decreasing average costs hold warned about the irrational exuberance in 1996. In his true not only for technology startups, but, in particular, for speech, the Chairman of the Federal Reserve Board in the very beginning of many of today’s mature businesses. Washington “invented” the expression to describe the be- In the nineteenth century, prosperous and visionary en- havior of stock market investors. Stock markets reacted trepreneurs were needed to consolidate the railroad net- with immediate slumps. Interestingly enough, however, is works, create a coherent system spanning several states the fact that he was the one who fueled the exuberance with lowered costs, increase efficiency and speed up travel with his policy of low interest rates. times. And in many centuries, eager royal heads of state were needed to pick up the bill for fixed costs in the hope Today, it feels like a flashback to the middle of the new of discovering new opportunities. Think of the discovery economy heydays: Markets are full of capital again, com- of America. panies don’t seem to know where to put all their cash and sometimes the losses of startups cannot be high enough Today, the financing of fixed costs is fortunately done not for being financed for skyscraping sums. only by taxation, but also in part by financial markets. But how to convince the capital market? The answer is quite Irrational exuberance? Well, history could tell us a differ- obvious, with irrational exuberance. Charismatic inven- ent story: How were enterprises with a large amount of tors and entrepreneurs succeed in generating enthusiasm fixed costs and low marginal costs financed long ago? among investors. They do so by applying the same strategy GERHARD NENNING PAGE EDITORIAL COMMENT 5

Gerhard Nenning Director of The Stern Stewart Institute

as Vanderbilt (Railroads) and Columbus (America): A industry? What sort of changes do low interest rates bring combination of Evangelical drive together with a bold vi- to the insurance industry? And, let’s have a closer look at sion for opportunity and skillful use of information mar- the big picture: What do central banks have to do to foster kets to create competition for funds. a stable rebalancing of the world economy? How will the Prices might be irrational, undoubtedly, but who can be African private equity market become more and more at- rational about the future value or its disruption potential? tractive? And what challenges does the American banking Seeing and accepting the dare of new rules (or no rules) on sector have to navigate? These are just some of the ques- the playing field is one of today’s major challenges. tions that are answered in this issue – without any exuber- Therefore, I am not sure whether we have too much or too ance. little exuberance right now. I trust that you will have an informative and inspiring read Let me invite you to read through the articles of this latest of the tenth edition of the Institute’s periodical. edition of our periodical. Get insights on the topics that keep top management busy: How does a multinational Yours, software corporation deal with irrational prices for acquisition targets? How to satisfy the capital market during restructuring of a multinational conglomerate? How to finance growth and react to market needs in the automotive Gerhard Nenning Contents

4 Editorial Comment Gerhard Nenning, Director, The Stern Stewart Institute

8 Capital Market Dialog during Restructuring – Meet and Miss Expectations Guido Kerkhoff, Chief Financial Officer, ThyssenKrupp AG

14 Defining the Role Mandate between Holding and Line: Balancing Responsibilities Thomas Münkel, Chief Operating Officer, UNIQA Insurance Group AG

18 Let the Data Speak: The Truth behind Minimum Wage Laws Prof. Dr. Steve H. Hanke, Economist, The Johns Hopkins University

22 Regaining Stability – Toward a More Balanced World Economy Prof. Dr. Michael Heise, Chief Economist, Allianz SE

26 Risking the Role as Global Locomotives? The Anglophone Urge to Hoard Corporate Cash John Plender, Columnist, Financial Times

30 Fit for Growth – How Innovations in the Business Model Secure Financing Dr. Konstantin Sauer, Member of the Board of Management, ZF Friedrichshafen AG 36 The Lifecycle of Family Ownership: International Evidence Prof. Julian Franks, Professor of Finance, London Business School

42 Navigating the Changing Landscape of Finance James Gorman, Chairman of the Board and Chief Executive Officer, Morgan Stanley

48 Low Interest Rates and the Insurance Industry: From Balance Sheet Impacts to Structural Industry Changes Gerhard Lohmann, CFO Reinsurance, Swiss Re

54 How to Deal with High Prices for Acquisition Targets as a Corporate Buyer: “Where’s The Beef?” Dr. Werner Brandt, Chief Financial Officer, SAP AG

58 On Measuring Greenness: A New Enabling Metric, Please Prof. Dr. Steve H. Hanke, Economist, The Johns Hopkins University Dr. Heinz Schimmelbusch, Chairman and CEO, Advanced Metallurgical Group

64 Investing in Africa – Private Equity: Where Next? Antony Siwawa, Managing Director, Venture Partners Botswana PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 8 GUIDO KERKHOFF: CAPITAL MARKET DIALOG DURING RESTRUCTURING – MEET AND MISS EXPECTATIONS PAGE THE AUTHOR 9 Guido Kerkhoff Chief Financial Officer ThyssenKrupp AG

Capital Market Dialog during Restructuring – Meet and Miss Expectations

Capital market confidence in an effective and sustainable fundamental restructuring process: For investors, the corporate strategy becomes visible in unrestricted access to company's targeted improving value proposition offers equity and debt financing. Efficient financing is especially significant opportunities, but also risks, which are often challenging in corporate restructuring phases, when the cap- initially the focus of the capital market. In this phase, capi- ital market tends to focus more on risks than on opportuni- tal market confidence is particularly important because ties, particularly when M&A measures are carried out alongside efficient debt financing, the company may also which by nature can take unexpected turns. The company be reliant on strengthening its equity capital. needs to adjust its external expectation management to this In an effort to direct the capital market focus to the oppor- and build a track record of achieving ambitious targets as tunities of restructuring, ThyssenKrupp presented a holis- early as possible to create a sound basis for trust. With this tic strategic plan in May 2011 called the Strategic Way approach and by tailoring its investor targeting strategy to Forward including details of its new performance orienta- its specific investment case, ThyssenKrupp created an inves- tion, targeted cost advantages to be achieved through the tor environment which supports the company's Strategic corporate program “impact” and the scope of planned dis- Way Forward with efficient financing on the equity and posals by its portfolio optimization. At the same time, we credit side. outlined a consistent vision for ThyssenKrupp as a “diversified industrial”. The Group no longer has any core busi- THYSSENKRUPP’S STRATEGIC WAY nesses per se. Instead, affiliation to the Group depends on FORWARD – A HOLISTIC PLAN FOR the achievement of target numbers in a clearly defined set SIGNIFICANT VALUE OPPORTUNITIES of key performance indicators. In assessing the effectiveness of a corporate strategy and The value proposition of the Strategic Way Forward is not the credibility of management, capital market confidence entirely described by an improvement in earning power and the support of shareholders are key criteria. and earning quality. ThyssenKrupp is striving to reposi- Unrestricted access to the capital market is a particular tion the company away from the “traditional steel pro- challenge to companies like ThyssenKrupp undergoing a ducer with an attractive elevator business” towards a mod- PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 10 GUIDO KERKHOFF: CAPITAL MARKET DIALOG DURING RESTRUCTURING – MEET AND MISS EXPECTATIONS

ThyssenKrupp – Strategic Way Forward

COMPANY PORTFOLIO CHANGE PERFORMANCE FINANCIAL STRATEGIC POSITIONING OPTIMIZATION MANAGEMENT ORIENTATION STABILITY PUSH

Diversified Closed  Mission Statement  Continuous  Significant  Inorganic Growth: Industrial Company ("Leitbild") Benchmarking Cash Flow Acquisitions  TK Steel USA  Leadership  Profitable Growth  Low Net  Organic Growth: Financial Debt Expand  Auto Systems Brazil  Network  Cost Control Market Position Organization  Investment Grade  Civil Shipbuilding  Capital Efficiency  Strengthen R&D  Transparency  Construction  Cash Generation  Compliance More & Better  Inoxum  People  Metal Forming  Innovation  Tailored Blanks  Systems &  Waupaca Processes  Xervon

ern performance-oriented group whose individual busi- ing process that the initiatives of the Strategic Way nesses are among the market leaders and hold benchmark Forward were effective. For us, the challenge was to tailor positions in terms of profitability. In the medium to long our expectation management to this situation in order to term this should lead to a reduction in the conglomerate fully meet the requirements of the capital market for reli- discount and more appropriate valuation multiples for its able information on the Group's future performance and individual businesses, which also support an increasing the necessary milestones, even though at the beginning of market capitalization. this journey we were still in the process of gauging the necessary measures and the strategic and financial potential CAPITAL MARKET CONFIDENCE BUILDS ON of the Group. A VISIBLE PERFORMANCE TRACK RECORD This is why we decided to increase visibility and, in addi- To develop a capital market environment that would sup- tion to the regular guidance on relevant KPIs (sales, EBIT port the Group's transformation process, we deliberately and cash flow) for the fiscal year, to provide the capital redirected the focus of our investor relations to investors market with corresponding guidance for each subsequent whose investment strategy suited the now prevailing spe- quarter. At the same time, we are carrying out regular and cial investment case situation of adding value through re- detailed monitoring of the capital market's estimates to structuring. In detailed one-on-one and group meetings ensure that we can identify and address potential devia- with executives at the Group and Business Area levels, we tions early on. give investors the opportunity to obtain information and Effective external expectation management is built inter- value growth commitments directly from the responsible nally on a high-quality reporting system and on a high leadership teams. level of planning certainty for financial key figures In order to create a sound basis for trust in the capital mar- throughout the Group. At the beginning of the Strategic ket it became important to show early on in the restructur- Way Forward the reporting system needed improvement THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE GUIDO KERKHOFF: CAPITAL MARKET DIALOG DURING RESTRUCTURING – MEET AND MISS EXPECTATIONS 11

to achieve the necessary quality level and continues to be role of the CFO at the Group level and in all Group enti- adjusted on an ongoing basis in tune with increased re- ties. The CFO, who is responsible for the company's finan- quirements. The new management approach replaced the cial earning power, acts as a business “co-pilot” and equal reporting lines within the Business Areas with new inter- partner. The CFO also takes on the role of a “challenger” of faces and a central reporting system was installed. strategic decisions, and propels the improvement of operating performance as an “enabler”. In addition, we set up EFFICIENT CHANGE MANAGEMENT NEEDED the “Finance Community”, which is headed by the Group A NEW UNDERSTANDING OF THE CFO ROLE CFO and comprises his direct reports and the CFOs of the As part of a new leadership culture (change management) Business Areas to emphasize the new understanding of the and to provide the support needed for this throughout the CFO role and help strengthen the Business Areas' sense of Group, we also established a new understanding of the responsibility toward the Group. PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 12 GUIDO KERKHOFF: CAPITAL MARKET DIALOG DURING RESTRUCTURING – MEET AND MISS EXPECTATIONS

RISK OF EXECUTION SETBACK BY CORPORATE At Steel Americas we decided not to sell the steel mill in LEGACY AND THE THIRD PARTIES INVOLVED Brazil (ThyssenKrupp CSA) for the time being but only to The transformation of ThyssenKrupp confirms that fun- sell the steel processing plant ThyssenKrupp Steel USA. damental restructurings are protracted processes in which Owing to the tight situation on the steel market, the slow- temporary setbacks can occur. Restructuring necessities ing economy in Brazil and operating performance prob- and remedying inherited problems result in costs, for ex- lems at CSA, a disposal could not be achieved on accepta- ample by recognizing asset impairments, which cannot ble terms. However, a sustainable solution was achieved always be estimated in full from the outset. In addition, the for ThyssenKrupp CSA in Brazil in the form of a long- implementation and value realization of M&A measures term slab supply agreement. depend to a large extent on third parties or parameters Having sold our stainless steel business to Outokumpu we which may change in the course of the processes. decided to claim back the two Inoxum units AST and Right at the beginning of the Strategic Way Forward we VDM and swapped them for our financial receivable provided the capital market with a list of Group compa- against Outokumpu. At the same time, we surrendered nies that we had decided to sell, which accounted for more our minority shareholding in Outokumpu. As a result we than 25 percent of the Group's sales and to which we facilitated the necessary refinancing of Outokumpu and added the Steel Americas Business Area after the first 12 avoided further significant losses for ThyssenKrupp. months. We made faster progress with the disposals than In both cases we made responsible decisions which served planned, which meant we were able to demonstrate disci- to secure value and reduce risk for the Group and its stake- pline and competence also in the execution of M&A trans- holders, even if this meant that we did not directly achieve actions. However, the two biggest projects, the sale of the the complete targeted divestment. Since we openly and two steel plants of our Steel Americas Business Area and quantitatively described the reasoning of our decisions to- the sale of our stainless steel business, Inoxum, were sub- gether with our clear statement that the changes to our ject to delays and developments that were not always in originally planned transaction volume were “tactical and line with expectations. not strategic steps”, we gained the support of the capital market, as our subsequent financing measures showed. THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE GUIDO KERKHOFF: CAPITAL MARKET DIALOG DURING RESTRUCTURING – MEET AND MISS EXPECTATIONS 13

Capital Increase Backed by Supportive Investor Environment

133 investors ~140 m shares ~140 m shares

10% 10% 8% GER

23% EU 30%  book covered within 1 hr and almost 3 x before 15% USA stock exchange opened 64%  discount of 2.75 % only

60% 10% GB 51.45 m Shares / € 882 m 26%

DEMAND ALLOCATION

New Names IR Regular Top Targets IR Priority Targets

SUPPORTIVE INVESTOR ENVIRONMENT The subsequent performance of ThyssenKrupp's stock PROVEN BY EFFICIENT EQUITY AND DEBT FI- confirms the success of the placement for all participants: NANCING The share has so far outperformed the DAX and its peer In December 2013, only a few days after our decision to group. keep CSA and to swap the loan note for AST and VDM, Further evidence of our unrestricted access to the capital ThyssenKrupp carried out a 10 percent capital increase market is provided by our bond issues. Each year since which met with strong investor demand. The order book 2012 ThyssenKrupp has issued a benchmark bond. Most was almost three times covered and with a discount of 2.75 recently, we issued a bond on favorable terms in February percent the subscription price was only slightly below the 2014, even though ThyssenKrupp still had a sub-invest- previous day's closing price. The composition of the order ment grade rating. The order book was almost five times book reflected the effectiveness of our investor targeting: covered and the bond carried the lowest coupon of all Ninety percent of orders came from ongoing investor rela- ThyssenKrupp's bonds to date – a further indication of tions targets, with 60 percent coming from priority targets confidence in ThyssenKrupp's Strategic Way Forward.  and 30 percent from further top targets identified by us. PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 14 THOMAS MÜNKEL: DEFINING THE ROLE MANDATE BETWEEN HOLDING AND LINE: BALANCING RESPONSIBILITIES PAGE THE AUTHOR 15 Thomas Münkel Chief Operating Officer UNIQA Insurance Group AG

Defining the Role Mandate between Holding and Line: Balancing Responsibilities

When managers are bored of dry discussions and seek real ing types. The first type is a governance model with quite a engagement, there is a proven concept to find this: Just limited holding role (1.) which is followed by a model with start a discussion about the definition of roles and respon- a very strong holding mandate (4.). These types are: sibilities between the holding company/headquarters and the line organization. It is highly probable that this will 1. Financial Holding lead to heated debates, bold statements, and emotional 2. Strategic Holding outbursts. Since the beginning of the financial crisis in 3. Management or Functional Holding 2008, the topic has gained new relevance. The more diffi- 4. Operator or Centralized Model. cult the business environment, the stronger the tendency is towards more centralization and a stronger role of the holding company. Especially in the financial services in- The different holding types can be sorted by the functional dustry this tendency was supported by new regulatory re- responsibilities typically covered: quirements that forced the industry to steer their subsidi- aries more rigorously, regardless of existing governance  Balance sheet management models in the respective banks or insurance groups.  Portfolio management  Performance management Following the many publications on corporate structures  Strategy or organizational development and governance models in recent years, one conclusion  Talent management seems to be pretty clear: There is no ideal solution for the  Support functions perfect governance model and for the best balance be-  Operations tween the roles and responsibilities of holding and line. So  Marketing how do we grasp this difficult and emotional topic? Let us  Sales start with a rather simple clustering of the different hold- PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 16 THOMAS MÜNKEL: DEFINING THE ROLE MANDATE BETWEEN HOLDING AND LINE: BALANCING RESPONSIBILITIES

Holding types and functional responsibilities (simplified clustering)

Financial Holding Operator

IT SALES PRODUCTS MARKETING OPERATIONS STRATEGY OR OR STRATEGY DEVELOPMENT TALENT MGMT. TALENT ORGANIZATIONAL ORGANIZATIONAL SUPPORT FUNCTIONS PERFORMANCE MGMT. BALANCE SHEET MGMT. PORTFOLIO MGMT. M&A PORTFOLIO MGMT.

FINANCIAL HOLDING

STRATEGIC HOLDING

MANAGEMENT HOLDING

OPERATOR

This picture varies across industries, cultures and regions 2. When in doubt, limit the holding as well as depending on company history. You will find Holding companies and headquarters in general have a many articles about the different models. The holding tendency to build unnecessary overhead structures and types can be used to perform an initial cross-check be- non-value adding activities. I do not have to list examples; tween the intended strategy and steering mechanisms of a we know them all. group. There is not enough space here to discuss these concepts in depth. However, it might be worth taking a 3.Proper checks and balances instead of one central power look at some general design principles for defining the We often hear about successful models involving a strong, holding and line mandates that have proven helpful in dif- central power that assures the prosperity of the company ferent contexts: even in times of crisis. These stories are quoted as proof of the concept for a holding model with centralized power DESIGN PRINCIPLES FOR ROLES OF HOLDING where the line executes the superior strategy and vision of AND LINE: the headquarters (typically a company with a strong visionary founder). Even if this is true, it is the exception to 1. Strategy first, governance follows the rule. In times of ever increasing complexity, strict com- It might sound trivial, but the company’s governance pliance rules and international growth, a good balance of model should be derived from the strategy and not the responsibilities between holding and line is normally the other way around. First the overall strategy, then the gov- best choice. Independent local kingdoms can quickly be- ernance strategy, and then the organizational design. come a problem for the holding company, just look at com- Redesigning the governance model, for instance, because pliance cases across the industries. One solution is to set up of regulatory changes without rethinking the conse- committees that bring the relevant line and holding func- quences for the business strategy is a recipe for failure. tions to the table. It is important that these are real joint decision-making bodies and not just bogus set-ups. THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE THOMAS MÜNKEL: DEFINING THE ROLE MANDATE BETWEEN HOLDING AND LINE: BALANCING RESPONSIBILITIES 17

4. Context matters: There is no easy copy and paste 7. Be pragmatic solution If a decision has been made in favor of a certain holding I have often heard that we should import successful hold- model or a balancing of mandates between line and holding concepts from the US where companies like Berkshire ing, there is no need to stick to it at all costs if it becomes Hathaway or managers of company portfolios (e.g., in the evident that the chosen model does not fit with the current private equity industry) prove that a small holding with environment. In times of crisis it is often necessary to limit limited roles is best for running even multinational con- the line’s degree of freedom. And if there are strong local glomerates. These ideas ignore the context. If we want to companies with a sustainable business model and a proven have the “good” parts of a holding model, i.e. slim over- track record they should have more leeway. head structures, etc., we have to be prepared to introduce the “bad” part as well, which in this case means the quick 8. Be fast replacement of top management given non-delivery. We Governance discussions take a lot of energy and focus can easily limit headquarters functions if the top line man- away from the business, especially in top and middle management knows that they will be replaced if they fail to de- agement. This is unavoidable so this period should be as liver for two consecutive years. short as possible. It is better to adapt topics on the run in- The same can be said of the cultural context. If the com- stead of discussing them for three years. pany was managed for decades as a rather loose conglomerate, we cannot switch immediately to a functional holding unless it is in “survival mode”. If we apply these principles to the different holding types mentioned at the outset, then in most cases the extremes 5. Rethink the strategy function in the holding do not work (financial holding or operator) since the bal- In the past there were often large strategy departments in ance of roles and responsibility between holding and line the holding which developed strategies that were executed is lost. A stringent and consistent governance model with by the line. With this set up there is a risk of losing line a strategic or functional holding seems to be a better fit for know-how that is normally much closer to the business most cases. and local markets. A better strategy is to rebalance the role The design principles might sound very simple and obvi- between line and holding in this important area by includ- ous and they are, indeed, just that. But very often they are ing the line systematically in the strategy development. not followed and the ensuing consequences are negative One possible set-up is the strategy development via a port- and beg lots of unwanted discussions – even if manage- folio of initiatives which includes the best minds from the ment was bored before.  line and holding functions.

6. Match mandates with people If a company decides in favor of a certain governance model, it should make sure that it has the right people to fill the new roles. Giving strong holding mandates to un- experienced headquarters functions with limited business experience is a sure way to kill the best theoretical model. PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 18 PROF. DR. STEVE H. HANKE: LET THE DATA SPEAK: THE TRUTH BEHIND MINIMUM WAGE LAWS PAGE THE AUTHOR 19 Prof. Dr. Steve H. Hanke Economist The Johns Hopkins University

Let the Data Speak: The Truth behind Minimum Wage Laws

President Obama set the chattering classes abuzz after his ployment. In the 21 countries with a minimum wage, the recent unilateral announcement to raise the minimum average country has an unemployment rate of 11.8 per- wage for newly hired Federal contract workers. During his cent, whereas the average unemployment rate in the seven State of the Union address in January, he sang the praises countries without mandated minimum wages is about one for his decision, saying that “It’s good for the economy; it’s third lower – at 7.9 percent. good for America.” As the worldwide economic slump drags on, the political drumbeat to either introduce mini- Average Unemployment Rate of EU Countries With / Without Minimum Wages mum wage laws (read: Germany) or increase the minimums in countries where these laws exist – such as 14 Indonesia – is becoming deafening. Yet the glowing claims 12 about minimum wage laws don’t pass the economic smell

10 test. Just look at the data from Europe (see the accompany- With Minimum Wage ing chart). 8

Without Minimum Wage MINIMUM WAGES AND UNEMPLOYMENT 6

UNEMPLOYMENT RATE (%) UNEMPLOYMENT RATE 4

There are seven European Union (EU) countries in which 2 no minimum wage is mandated (Austria, Cyprus, Den- 0 mark, Finland, Germany, Italy and Sweden). If we com- 2004 2006 2008 2010 2012 pare the levels of unemployment in these countries with Sources: Eurostat (Unemployment rates – Annual Average), and calculations by Prof. Dr. Steve H. Hanke,The Johns Hopkins University. EU countries that impose a minimum wage, the results are Note: The averages displayed in the chart are arithmetic means. clear. A minimum wage leads to higher levels of unem- PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 20 PROF. DR. STEVE H. HANKE: LET THE DATA SPEAK: THE TRUTH BEHIND MINIMUM WAGE LAWS

This point is even more pronounced when we look at rates is considerably higher than the youth unemployment rate of unemployment among the EU’s youth – defined as in the seven EU countries without minimum wage laws – those younger than 25 years of age (see the accompanying 19.5 percent in 2012 – a gap that has only widened since chart). the Lehman Brothers collapse in 2008.

Average Youth Unemployment Rate of EU Countries So, minimum wage laws – while advertised under the ban- With / Without Minimum Wages ner of social justice – do not live up to the claims made by

30 those who tout them. They do not lift low wage earners to a so-called “social minimum”. Indeed, minimum wage 25 With Minimum Wage laws – imposed at the levels employed in Europe – push a

20 considerable number of people into unemployment. And, unless those newly unemployed qualify for government Without Minimum Wage 15 assistance (read: welfare), they will sink below, or further below, the social minimum. 10 UNEMPLOYMENT RATE (%) UNEMPLOYMENT RATE

5 As Nobelist Milton Friedman correctly quipped, “A minimum wage law is, in reality, a law that makes it illegal for 0 2004 2006 2008 2010 2012 an employer to hire a person with limited skills.” Dr. Jens Weidmann, President of Germany’s Bundesbank, Sources: Eurostat (Unemployment rates – Annual Average; Age: Less than 25 years), and calculations by Prof. Dr. Steve H. Hanke,The Johns Hopkins University. Note: The averages displayed in the chart are arithmetic means. must have heard Prof. Friedman and looked at these European data before he took on Chancellor Angela Merkel for proposing the introduction of a minimum In the 21 EU countries where there are minimum wage wage law in Germany. In short, Dr. Weidmann said that laws, 27.7 percent of the youth demographic – more than this would damage Germany’s labor market and be a one in four young adults – was unemployed in 2012. This German job killer. He is right. THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE PROF. DR. STEVE H. HANKE: LET THE DATA SPEAK: THE TRUTH BEHIND MINIMUM WAGE LAWS 21

Survey of Company CFOs in the:

RETAIL INDUSTRY SERVICE INDUSTRY MANUFACTURING INDUSTRY

Question 1: Would you reduce hiring if the minimum wage 43% 44% 40% increases? 57% 56% 60%

Question 2: 7% If yes, would $10 an hour 18% 19% reduce your hiring?

82% 93% 81%

YES NO Source: CFOsurvey.org. Prepared by: Prof. Dr. Steve H. Hanke, The Johns Hopkins University.

ASKING THE CFOS ... they obey the laws of economics, too. Indeed, if something – like unemployment – is subsidized, more of it will be The executives surveyed in the recently released Duke produced. When the data on unemployment benefits University/CFO Magazine Global Business Outlook speak, they tell us that if the unemployed receive unem- Survey agree, too. Indeed, Chief Financial Officers from ployment benefits, the chances that they will become em- around the world were interviewed and a significant num- ployed are reduced. Those data also show that the proba- ber of them concurred: a minimum wage increase in the bility of an unemployed worker finding employment in- United States – from the current $7.25/hour to President creases dramatically the closer an unemployed worker Obama’s proposed $10.10/hour – would kill US jobs. comes to the termination date for receipt of his unemploy- The accompanying table shows what the CFOs had to say. ment benefits. In short, when the prospect of losing welfare benefits raises its head, unemployed workers magi- Perhaps, Prof. Friedman said it best when he concluded cally tend to find work. that “The real tragedy of minimum wage laws is that they are supported by well-meaning groups who want to re- TIME TO FACE REALITY duce poverty. However, the people who are hurt most by high minimums are the most poverty stricken.” The most important lesson to take away from allowing the minimum wage and unemployment benefit data to talk is High mandated minimum wages will throw people out of that abstract notions of what is right, good and just should work and onto the welfare rolls in cases where unemploy- be examined from a concrete, operational point of view. A ment benefits exist. When it comes to welfare payments, dose of reality is most edifying. PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 22 PROF. DR. MICHAEL HEISE: REGAINING STABILITY – TOWARD A MORE BALANCED WORLD ECONOMY PAGE THE AUTHOR 23 Prof. Dr. Michael Heise Chief Economist Allianz SE

Regaining Stability – Toward a More Balanced World Economy

Massive external-account imbalances were a major factor it looks unlikely that the gigantic surplus positions that we behind the global financial and economic crisis that saw in 2007-08 will reappear in the foreseeable future. The erupted in 2008, as well as in the eurozone instability that ongoing rebalancing of China’s economy from exports to- followed. However, the crisis itself brought forced adjust- ward domestic demand is the main reason for this, al- ment: As capital flows ebbed and economic activity though private consumption growth is still moderate and dropped, current account surpluses and deficits shrank authorities will grapple with the difficult task of maintain- across the board, and in some cases, notably in peripheral ing growth without creating further over-supply. Europe, the correction was quite brutal. Now, however, with the recovery finally gaining more traction, many ob- The United States, meanwhile, continues to run a sizeable servers fear the re-emergence of destabilizing imbalances; current-account deficit of around $380 billion. But its but this time, the usual suspects are no longer China, Japan magnitude – 2.3 percent of GDP – is less than half the level and the US but rather the eurozone and Germany, in par- before the crisis. And similar to China’s situation, a return ticular. to the status quo ante is very unlikely although the US consumer has proven to be a reliable engine of demand de- In fact, Asia’s formerly huge external surpluses have despite the necessary deleveraging. Certainly, some debt clined astonishingly fast, and Japan’s trade balance has write-downs helped stabilize demand. However, there are even slipped into deficit. China’s current-account surplus other forces curbing the deficit. First and foremost, rapidly has fallen to 2 percent of GDP, from 10 percent in 2007. growing domestic energy output should shrink the oil im- Investment is the Chinese economy’s main driver, but it port bill and thus help to reduce the large trade deficit. has led to soaring debt and a bloated shadow banking sec- This effect would be reinforced if the US started to export tor, which the authorities are trying to rein in. Nonetheless, some of its shale gas and oil. PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 24 PROF. DR. MICHAEL HEISE: REGAINING STABILITY – TOWARD A MORE BALANCED WORLD ECONOMY

This continued growth in the EU’s surplus is quite surpris- Global Re-Balancing Current account surplus/deficit in % of GDP ing. The collapse in imports suffered by bailed-out coun-

% 12 tries – Greece, Ireland, Portugal and Spain – was entirely

10 predictable, given how sharply their economies declined.

8 However, few economists expected that these countries’ 6 exports would improve as quickly as they did, especially in 4 a subdued international environment. While Germany’s 2 current-account surplus is roughly where it was in 2007, 0 the combined external balance of the bailout beneficiaries -2 plus Italy (which has been part of the trade turnaround) -4 has swung from a pre-crisis deficit of more than $300 bil- -6 lion to an expected surplus of around $60 billion this year. -8 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

CHINA USA Source: Ecowin MAKING GERMANY INVESTOR-FRIENDLY

Moreover, the European surplus is now too large to ignore, and Germany, in particular, will be asked once more to rebalance its economy toward higher domestic demand, The European Union, however, has built up a large exter- which for many people implies the need for a fiscal boost. nal surplus in the last two years, owing mainly to positive However, the government is not obliging: Finance Min- trade balances in the eurozone. The EU’s current-account ister Wolfgang Schäuble has just presented a balanced surplus in 2014, estimated to be almost $250 billion, will budget for 2015 – the first since 1969. And, while some be even higher than that of emerging Asia. observers are calling for Germany to “end wage restraint” and thereby encourage higher household spending, this Rising EU surplus has actually happened already. Current account surplus/deficit in USD and % of GDP

USDbn % There is, however, a lot that the government could do 300 2 about investment, which has fallen by almost four per- 200 1.5 centage points of GDP since 2000, to just over 17 percent 1 100 in 2013 – low by international standards. The government 0.5 0 could shift more government spending toward infrastruc- 0 -100 ture investment. However, even more important, it should -0.5 -200 improve conditions for corporate investment at home, -1

-300 rather than watch German businesses move their capital -1.5 expenditures abroad. -400 -2

-500 -2.5 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Germany’s attractiveness to investors would rise with sim-

in USDbn (lhs) in % of GDP (rhs) Source: Ecowin pler and more investment-friendly taxation, improved incentives for business start-ups and R&D, less bureaucracy THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE PROF. DR. MICHAEL HEISE: REGAINING STABILITY – TOWARD A MORE BALANCED WORLD ECONOMY 25

and red tape, and no further energy-cost increases. Getting there will take time. However, given the favorable earnings situation and the corporate sector’s large cash balances, a rebalancing of the tax system could have a rapid impact. Investment from retained earnings should be as attractive as debt financing. And some temporary adjustments of depreciation allowances could kick-start capital spending.

The need for more investment in transport, telecoms, energy and education is certainly not only a German issue. Given the debt problems of most European governments, the challenge is to attract more private capital into these areas. Improved regulatory conditions for long-term investments and savings would help. So would expansion of financing instruments for infrastructure investment – for example, by substantially increasing the supply of project bonds supported by the European Investment Bank.

Indeed, why not create “European Infrastructure Bonds,” backed by revenues generated by the investments or tax income from the countries that emit EIBs? This would not only spur jobs and long-term growth; it would also stem the rise in Europe’s external surplus. this may change. If the Fed remains alone in scaling back THE ROLE OF MONETARY POLICIES its monetary stimulus and bond yields rise further, the dollar will almost certainly strengthen. The challenge of rebalancing the global economy is also closely connected to the monetary policies of central Clearly, a coordinated effort to limit exchange-rate varia- banks. With credit and asset bubbles slowly but surely re- tions is advisable. The fact that inflationary pressure is still appearing, the authorities’ goal should be to keep growth low is not a reason to postpone planning an exit from ul- on a balanced and sustainable path – and thus to discour- tra-loose policy; on the contrary, the time for such discus- age excessive risk taking which precedes the reemergence sions is when inflation is low and markets are calm. Twenty of new imbalances. years ago, markets panicked and bond rates soared as central banks hiked interest rates in the face of rising inflation. This justifies the US Federal Reserve’s gradual exit from They should not repeat that mistake by waiting for infla- ultra-loose policies. Somewhat surprisingly, the Fed’s re- tionary pressures – fueled by rising oil and commodity duction of its monthly asset purchases has been accompa- prices and economic recovery – to return. The sooner cen- nied so far by dollar weakness against the euro, which is tral banks start to wean markets off easy money the more fostering external adjustment. Looking forward, however, stable the necessary rebalancing process will be.  PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 26 JOHN PLENDER: RISKING THE ROLE AS GLOBAL LOCOMOTIVES? THE ANGLOPHONE URGE TO HOARD CORPORATE CASH PAGE THE AUTHOR 27 John Plender Columnist Financial Times

Risking the Role as Global Locomotives? The Anglophone Urge to Hoard Corporate Cash

Locomotive theories have been out of fashion with eco- US and UK business ran savings deficits for most of the nomic policymakers since the 1980s when the US tried, business cycle while borrowing from the household sector with mixed results, to persuade Germany and Japan to which traditionally ran a significant savings surplus. This embark on expansionary policies to drag the world econ- relationship broke down shortly before the turn of the mil- omy out of the doldrums. Yet there is an interesting ques- lennium when the corporate sector in both countries tion today as to whether the US and UK may turn into lo- started to run a structural savings surplus. comotives for the anemic economies of the eurozone. In the US, business went from being a net borrower from Certainly the US is closer to the point where the corporate the rest of the economy in 1999 to a net lender to the rest of sector ought to be able to pick up the baton and increase the economy to the tune of 12 percent of gross domestic currently depressed levels of investment in plant and ma- product in 2008. Since then net lending by business has chinery. And within Europe, the UK is forecast to grow come back a little to just under six percent of the GDP, more strongly this year than even Germany. There, too, which nonetheless looks remarkably high by historical higher investment might be expected to materialize. standards. The UK has followed a broadly similar pattern.

FROM BORROWERS TO SAVERS At the same time, fixed capital investment in both the US and the UK went into something that looks suspiciously The reality may prove to be more complicated because the like secular decline. In effect, companies became endemic corporate sector in these countries has undergone a curi- hoarders of cash, in stark contrast with Germany and ous change of behavior. For most of the postwar period, France. Somewhat paradoxically, given its newfound PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 28 JOHN PLENDER: RISKING THE ROLE AS GLOBAL LOCOMOTIVES? THE ANGLOPHONE URGE TO HOARD CORPORATE CASH

thrift, Anglophone business also managed to burden its to such benchmarks as earnings per share or return on eq- balance sheet with a vast increase in debt. Business debt in uity. A striking characteristic of these metrics is that they the US rose from 50 percent as a percentage of the GDP in are readily manipulated. One of the more obvious ways to the late 1970s to a peak of more than 80 percent in 2008. juggle the numbers in the interests of raising executives’ Since then it has fallen back to 76 percent in 2012, which rewards is to reduce investment at the cost of long-term remains an astonishingly high figure. Once again, the UK market share. Another is to shrink the equity capital of the has followed a similar trajectory. business through share buybacks. The result is that Anglophone business does invest, but it prefers to invest in All manner of explanations have been offered for this be- its own equity rather than in plant and machinery. That in havioral shift. The most plausible, in my view, is the one turn increases balance sheet leverage. offered by the British economist Andrew Smithers, who argues that Anglophone businesses now fundamentally STRUGGLING TO MAINTAIN diverge from their continental European counterparts in MACROECONOMIC BALANCE motivation and that the structure of incentives militates against investment. For it is no coincidence that the behav- This gives rise to a problem for macroeconomic policy. If ioral change has occurred over precisely the period in the corporate sector runs an endemic surplus the wider which American and British executives moved from con- impact is potentially deflationary. Therefore, some other ventional pay to equity related bonuses. Today, the people part of the economy has to accommodate the surplus by who run companies in the S&P 500 or the FTSE 100 are running a counterpart deficit if endemic recession is to be rewarded substantially by bonuses, equity and stock op- avoided. In practice, the burden of doing that falls on ei- tion awards. The performance criteria are usually related ther the public sector or the foreign sector. THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE JOHN PLENDER: RISKING THE ROLE AS GLOBAL LOCOMOTIVES? THE ANGLOPHONE URGE TO HOARD CORPORATE CASH 29

Unfortunately, neither the US nor the UK has been very successful in rebalancing away from consumption-led growth to export-led growth. However, if the burden of off-setting corporate thrift then falls on the public sector, the outcome is very unhelpful. The governments of both countries have been running high fiscal deficits and their outstanding public sector debt has risen to worryingly high levels since the financial crisis. And since their fiscal deficits have been scaled back, their economic recoveries have depended heavily on upturns in the housing market that have been substantially driven by credit and a reduction in household savings.

This sits oddly with the widespread assumption that households have been deleveraging since the crisis and rebuilding their balance sheets. In reality, little deleveraging has taken place. To the extent that it has in the US, it results largely from borrowers walking away from home loans that then have to be written down to realistic valuations. In the UK, borrowers cannot walk away and there has been some modest rebuilding of savings. But this is now at an end. We are back to a cycle that looks all too similar to the one that brought the last bubble and bust, though if there is going to be a bust it is some way off because the degree of leverage in the property market is nowhere near where it was back in 2008.

SUSTAINABILITY… NOT INCLUDED

It follows that the Anglophone economies could be locomotives for the global economy over the next two years – but more on the basis of a consumption-driven deteriora- tion in the current account of the balance of payments than a big upturn in fixed capital investment. That would be a boon to a low-growth eurozone this year and next, but unfortunately not one that is sustainable in the long run.  PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 30 DR. KONSTANTIN SAUER: FIT FOR GROWTH – HOW INNOVATIONS IN THE BUSINESS MODEL SECURE FINANCING PAGE THE AUTHOR 31 Dr. Konstantin Sauer Member of the Board of Management ZF Friedrichshafen AG

Fit for Growth – How Innovations in the Business Model Secure Financing

GROWING IN TIMES OF VOLATILITY FINDING THE RIGHT FINANCE STRATEGY

In the last 5 years, the automotive industry grew by about The finance strategy of the ZF Group is essentially deter- 3.5 percent and is expected to grow substantially in a vola- mined by its shareholder structure; the shareholders of ZF tile environment. The ZF Group is among the 10 largest Group are two foundations. As a result, the Group has automotive suppliers and its growth rates in recent years fewer options, particularly when it comes to financing were significantly higher than those posted by the market. huge growth-driven investments. In comparison to the This development can be explained by two main factors: listed competitors, the ZF Group can neither execute a re- growth with innovative products and growth in emerging capitalization nor is it willing to raise its debt substantially. markets. To keep this strong position in the world market, Therefore, the main challenge is to generate sufficient free it is important to understand the global mega trends and cash flow (FCF) from the operating business when equity derive suitable strategic options. ZF has identified good financing is limited given the shareholder structure. This business perspectives to continue this growth scenario. is a permanent and unchangeable constraint that forces The challenge for the company has always been to find the the Group to find equally permanent self-financing op- right balance between business opportunities and financ- tions. ing the growth – and this will not change in the years to To this end, two dimensions have come into focus: come.  Value creation based on the value-based management concept (VBM) and  Cash generating based on the FCF. PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 32 DR. KONSTANTIN SAUER: FIT FOR GROWTH – HOW INNOVATIONS IN THE BUSINESS MODEL SECURE FINANCING

WHY CHANGE THE BUSINESS MODEL? RESHAPING THE VALUE CHAIN

In the growth mode over the last years, we experienced In a strong growth mode, the investment quota is higher that in the short term the financial targets of the VBM than the depreciation rate – as long as the structure of the concept and the liquidity-based targets (FCF) were not al- value chain remains unchanged. This imbalance can be ways in sync. During the growth phase, the FCF shifted its accepted for a short and foreseeable period of time. focus and triggered some corrective actions. The discus- However, after a while, long-term corrective actions have sions in top management have been very much strategic to be taken, not only to secure liquidity, but also to keep and, of course, were not only finance-oriented. We recog- the fixed-cost development under control. Central to the nized that both dimensions were somewhat contrary to discussions leading up to these corrections were the core one another. competencies of the company because this is the basis to prioritize and weigh investments against each other. This is why our management began to consider changing Equally important is the notion that these competencies some elements of our business model. Only by adjusting it are not static characteristic of an enterprise, but to a large thoroughly and sustainably, could we bring our financing degree business-specific and influenced by market and strategies back into line. technology trends. Therefore, the notion of “core competency” must not be misunderstood as something that “has In this article, I will describe some of these changes, always been an integral part of one’s business”. Instead, I namely the adjustments of two key elements of our busi- favor a different definition – “primary drivers of innova- ness model: Value Chain and Revenue Models. tion and competitive advantage”. Here, one has a pretty good idea of what it is all about, namely, flexibility. THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE DR. KONSTANTIN SAUER: FIT FOR GROWTH – HOW INNOVATIONS IN THE BUSINESS MODEL SECURE FINANCING 33

CORE COMPETENCES CHALLENGED? When it comes to services, similar make-or-buy criteria can be applied. It is very common in our industry to out- Having said that, defining one’s core competency to create source logistic services, IT services or engineering ser- a starting point from which we can remodel our value- vices (to name just the big ones). There are several good chain becomes all at once much easier: We just have to examples including big engineering providers like bear in mind that this depends on two key factors that re- Bertrandt or IT services like SupplyOn AG, a collabora- quire constant and careful observation: tion platform for supply chain optimization. SupplyOn is a  What are the mega trends in our industry? very successful model when it comes to common out-  Which other endogenous and exogenous factors sourcing projects. Initiated by the four big German auto- in our business have to be taken into account? motive suppliers 14 years ago, it links them today and currently is expanding its success into other industries world- Normally, these two factors do not exclude each other, but wide. For a long time, this approach was highly controver- rather interact and work together. Take for example one sial, but in an increasingly globalized business world it common mega trend in our industry, namely, reduced fuel turns out that collaboration even with competitors often consumption and carbon dioxide emissions. New mobil- proves to be the best choice. Of course, this only applies as ity and drivetrain concepts which are needed to comply long as no competitive advantage is at risk. with these new demands trigger innovations in light- weight technology and electronics. ZF has in recent years Precondition for such decisions is a thorough decision- invested in these fields organically as well as through ac- making process that assesses and evaluates where to invest quisitions. For example, ZF bought the Cherry and where to disinvest. The purpose of this process is two- Corporation, which is now the core of the electronic ex- fold. Firstly, it ensures our innovation capabilities. Secondly, pertise within the ZF Group. What we see here can be it guarantees our cost leadership through a still high degree called “an extension” of the previous core competencies of vertical integration and flexible cost structures. and slight shifts or re-definitions. ADJUSTING REVENUE MODELS On the other hand, one also has to redefine which competencies are no longer “core” and should be sold or trans- A much deeper understanding of the revenue models ferred to the supply market. Obviously outsourcing exist- gains in importance, because there are clear indications ing business is a critical transformation process. In the that automotive suppliers are facing increased upfront re- growth mode there is an opportunity to keep a critical quirements from their customers, e.g., investments in pre- mass in-house. The main criteria that justify in-house so- development efforts, pre-financing of tooling, and so on. lutions are technical expertise and/or employment level. This is one of the reasons why it is often advisable to mix Yet, another challenge stems from the fact that our growth make-or-buy decisions with make-and-buy decisions, the is mainly driven by new customers and new markets. Very latter being a mix of in-house production and outsourced often when dealing with new customers, we are con- volume. These considerations are not restricted to specific fronted with new business models, new paying habits and processes or parts. Recently, for example, we decided to payment terms. These can pose an increased risk to our outsource a good portion of the European production of cash situation. One example for this is that in China bank our transmissions to a supplier in an “operator model”. drafts are widely used, a fact which has a massive impact PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 34 DR. KONSTANTIN SAUER: FIT FOR GROWTH – HOW INNOVATIONS IN THE BUSINESS MODEL SECURE FINANCING

on our FCF ratio, and needs to be balanced. One way to do according to the criteria “financial benefit for ZF”, “already this is to convince the customer to split larger drafts into implemented”, “not yet implemented” and “potential fu- smaller units, enabling us to use them with our own sup- ture use”: Easy Fit, Broad Greenfield, Niche and Special pliers. Fit.

All of these developments necessitate adjustments to new “Easy Fit” means “successfully implemented within the ZF revenue models. The first step in this process is to identify Group” and implies “considerable potential for future use”. existing revenue models to assess their respective risk pro- One example of this is an electronic order in the context of file. To this end, a total of 27 different revenue models have e-commerce activities. The conceptual approach is to im- been identified; most of them can be further differentiated plement this model which has been successfully devel- and adjusted for specific uses and needs. Keep in mind oped in the After Sales division and in other corporate that ZF mainly operates as a B2B and is, therefore, limited Group areas with a view to best practice and lessons to new approaches. Nevertheless, we developed an effec- learned. The purpose is to consistently apply a successfully tive and easy-to-manage, three-dimensional toolbox, di- established revenue model throughout the Group. On the vided into four different segments, which are classified other hand, “niche” revenue models are not yet well established within the ZF Group and, therefore, should be han- dled with care because by their very nature they only have limited application potential, for example, in frequent buyer or bonus programs and in a very specific segment of our sales structure. One of the “Broad Greenfield” revenue models with a wide potential, but presently not executed within ZF, is the model of a bank payment obligation – a simple, electronic form of a letter of credit.

In general, every new business opportunity has to be matched with suitable revenue models and, if necessary, weighed against the possible risks identified with the above mentioned toolbox.

CONCLUSION Adjusting one’s business model is not a one-off necessity. In times of increasing volatility, the management has to be ready to engage in a constant adjustment process. This also implies a readiness to challenge business models currently applied and, if necessary, to develop and adopt new ones. However, apart from these procedural questions there has to be a standardized toolbox. This will not only help reduce risks, but will also give your management more leeway for creativity and entrepreneurial spirit.  THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE DR. KONSTANTIN SAUER: FIT FOR GROWTH – HOW INNOVATIONS IN THE BUSINESS MODEL SECURE FINANCING 35 PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 36 PROF. JULIAN FRANKS: THE LIFE CYCLE OF FAMILY OWNERSHIP: INTERNATIONAL EVIDENCE PAGE THE AUTHOR 37 Prof. Julian Franks Professor of Finance London Business School

The Life Cycle of Family Ownership: International Evidence

We show that in countries with strong investor protection, tion declines over time in US firms following their IPOs. developed financial markets and active markets for corpo- Moreover, more liquid stocks tend to become widely held rate control, family firms evolve into widely held companies more quickly. Franks, Mayer and Rossi (2009) show that in as they age. In countries with weak investor protection, less UK firms, shareholder concentration is diluted over time developed financial markets and inactive markets for corpo- as a result of M&A activity. In a comprehensive study of rate control, family control is very persistent over time. IPO firms in 34 countries, Foley and Greenwood (2010) While family control in high investor protection countries is find that shareholder concentration decreases faster in concentrated in industries with low investment opportuni- firms in countries with stronger investor protection than ties and low M&A activity, this is not so in countries with in countries with weaker investor protection. low investor protection, where the presence of family control in an industry is unrelated to investment opportunities and FAMILY CONTROL IN PRIVATE AND M&A activity. PUBLIC FIRMS

There is a common view that firms evolve over time from We contribute to this literature by analyzing the evolution closely-held, family-owned enterprises into managerially of family control over time and across countries in listed controlled, widely-held corporations. According to this and private firms.1 Our focus is, therefore, on family con- 'life cycle' view, family control should be negatively corre- trol rather than shareholder concentration in private as lated with a firm's age. well as public firms. Family control is important because it There is some evidence to support this view. Helwege, dominates many financial markets around the world. Pirinsky and Stulz (2007) find that shareholder concentra- Focusing on private as well as public firms is important

1 Silanes and Shleifer (1999) sample the 20 largest publicly traded companies in each of 27 countries; Faccio and Lang (2002) consider 5,232 publicly traded companies in Western Europe; Villalonga and Amit (2006) focus on listed Fortune 500 corporations; and Anderson, Duru and Reeb (2009) select the largest 2,000 US industrial firms from COMPUSTAT. Exceptions are Bloom and Van Reenen (2007), who study family ownership in 732 private manufacturing firms in the US, France, Germany and the UK; and Almeida et al. (2009), who analyze ultimate ownership for both private and listed firms in Korean chaebol groups; Giannetti (2003) studies the capital structure choices of 61,557 mostly private European firms and obtains direct shareholder data from AMADEUS for a subsample PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 38 PROF. JULIAN FRANKS: THE LIFE CYCLE OF FAMILY OWNERSHIP: INTERNATIONAL EVIDENCE

Ultimate Control of Listed Versus Private Firms

OWNERSHIP STATUS OF THE LARGEST 1,000 FIRMS

Ownership types (%) Germany France UK Italy Total MULTIPLE BLOCKS 4.4% 2.0% 0.3% 2.0% 2.1% FAMILY 38.6% 43.8% 21.0% 53.1% 39.0% OTHER 2.1% 3.2% 2.8% 2.2% 2.6% STATE 13.5% 10.1% 2.0% 12.7% 9.5% WIDELY HELD 9.9% 8.9% 27.4% 5.6% 13.0% WIDELY HELD PARENT 31.5% 32.1% 46.4% 24.4% 33.7% TOTAL NUMBER OF FIRMS 923 970 980 954 2827

This table reports statistics for the largest 1,000 firms by sales in France, Germany, Italy and the UK in 1996 (the TOP 4,000 sample). It reports all firms with available ownership data. The total number of firms excludes firms with unknown ownership and is, therefore, lower than 1,000.

because the decision to go public is endogenous; hence, ferences in these. Specifically, if family firms become looking only at listed firms may give a biased measure of widely held through the channels of investment opportu- the evolution of family ownership in a country. nities, external financing and M&A activity, then we ex- Our analysis is based on two separate data sets of non-fi- pect family control to be reduced or to disappear in indus- nancial European firms – one detailed panel drawn from tries where investment opportunities, external financing the four largest economies (the UK, France, Germany and and M&A activity levels are high. Thus, we expect the inci- Italy) that includes 4,654 firms, and one larger cross-sec- dence of family ownership to be related to industry-spe- tion of 27 European countries that includes 27,684 firms. cific economic factors, namely the growth opportunities, The novel features of these data are that they cover a large the need for external financing, and M&A activity. number of unlisted firms, they include the ultimate own- ers for all companies and they track ownership over time. LOCAL DIFFERENCES IN INVESTOR The proposition underlying our analysis is that it is the de- PROTECTION gree of investor protection, the development of financial markets and the activity of the market for corporate con- We focus on four countries, France, Germany, Italy and trol that determine the prevalence and speed of the life cy- the UK Since the UK can be regarded as having strong in- cle evolution of family control. We define a transition from vestor protection, high financial development and active a family firm to a widely held one whenever newly issued markets for corporate control, and France, Germany and shares or sales of all or part of the family's existing shares Italy as having weak investor protection, low financial de- cause family control to fall below a threshold of 25 percent velopment and less active markets for corporate control, of voting rights, held directly or via a control chain. We we expect UK family firms to follow the life cycle theory of investigate three factors that might cause this to happen – ownership more closely than their Continental European investment opportunities, external financing require- counterparts. Our results on the life cycle of family control ments and M&A activity – and exploit industry-level dif- are consistent with this prediction. First, we find a strong THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE PROF. JULIAN FRANKS: THE LIFE CYCLE OF FAMILY OWNERSHIP: INTERNATIONAL EVIDENCE 39

negative correlation between family control and firm age higher prices in countries where widely-held firms face in the UK – the older a firm is, the less likely it is to be lower agency costs because of more efficient markets for family-controlled – whereas we find no such relation in corporate control. In our 27-country analysis, we find sup- the other three countries. Second, over a ten-year period, port for this prediction: family control decreases with firm UK family firms have a significantly lower chance of re- age only in countries with more active markets for corpo- maining family-controlled than French, German and rate control. Italian family firms. Third, at the firm level, we make use of the more detailed In summary, our evidence points to a life cycle of family information available for listed firms to understand the control in countries with strong investor protection, de- exact channel through which M&A activity affects the veloped financial markets and active markets for corpo- evolution of family ownership. On the sell side, we find rate control, but not in countries with weak investor pro- evidence that family firms are more likely to be taken over tection, underdeveloped financial markets and inactive in the UK than in Continental Europe; on the buy side, we markets for corporate control. This dilution of control is find that UK family firms are more likely to evolve into stronger in the presence of better investment opportuni- widely-held firms as a result of stock-financed acquisi- ties, more external financing requirements and higher tions. M&A activity. Using the latter sample of listed firms, we also examined THE INFLUENCE OF MERGERS AND how family-controlled businesses become widely held. ACQUISITIONS The evidence shows that primary issues are the single most important channel, responsible for about half of the One of the contributions of our paper is to emphasize the transitions from family control to widely held corpora- role of mergers and acquisitions in the evolution of family tion. Secondary sales in the form of block trades and open ownership; this we did in three ways: First, we measured market sales explain the remaining cases. Primary equity the opportunities for synergistic gains through mergers issues (to finance acquisitions) are particularly important and acquisitions by the volume of M&A activity in an in- in the UK, suggesting that the larger use of equity financ- dustry in the US We find that in industries with more ing is an important explanation for the life cycle differ- M&A activity, family control is less common. This effect is ences between UK and Continental European family more pronounced in countries in which concentrated firms. This is consistent with the finding for IPO firms in ownership is less valuable, that is, in the UK in our four- Foley and Greenwood (2010), according to whom declines country analysis, and in countries with strong investor in shareholder concentration over time in strong investor protection (high financial development, active markets for protection countries are primarily driven by new equity corporate control) in our 27-country analysis. issues rather than secondary equity sales. Second, at the country level, we argue that the evolution of The striking conclusion to emerge from this paper is that, family ownership is affected by the efficiency of the mar- while the life cycle theory is one of the most widely cited ket for corporate control. As argued before, hostile takeo- “stylized facts” about firms, it receives little empirical sup- vers are a powerful disciplining device for managers of port from international evidence: it applies in some coun- widely-held corporations. If families choose to sell their tries, but in most it does not hold. controlling stake in a firm, they will be able to do so at PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 40 PROF. JULIAN FRANKS: THE LIFE CYCLE OF FAMILY OWNERSHIP: INTERNATIONAL EVIDENCE

Family Control and Firm Age

1 0.03

0.8

0.02 0.6

0.4 DENSITY 0.01

0.2 PREDICTED PROBABILITY OF FAMILY CONTROL PREDICTED PROBABILITY OF FAMILY 0 0 0 50 100 150 AGE IN YEARS

Continental European firms UK firms Continental Europe UK

The figure shows the predicted probability of a firm being family-controlled in France, Germany and Italy versus the UK and histograms of the actual distribution of firm age in the sample. Data are for the TOP 4,000 sample, i.e. the largest 1,000 firms by sales in France, Germany, Italy and the UK in 1996, both private and listed. 127 very old firms (firm age more than three standard deviations (36.0) above sample average (39.8)) are not shown in the histograms.

THE BIG PICTURE more than 80 percent of the top 1,000 companies in France, Germany and Italy, their exclusion from previous Basically, family firms evolve into widely held companies analyses has been a serious omission. Second, we traced as they age only in countries with strong investor protec- ownership through its intermediate layers to its ultimate tion, well developed financial markets and active markets source, even in cases where it is held via private firms. The for corporate control. In countries with weak investor pro- previous attribution of ownership in these cases to con- tection, less developed financial markets and inactive centrated family holdings has been found to be frequently markets for corporate control, family control is very per- incorrect. Third, and perhaps most significantly, we sup- sistent over time. This happens for both private and public plemented cross-section analyses of the nature of owner- firms. In countries with strong investor protection, well ship at a particular point in time in a large number of developed financial markets and active markets for corpo- countries with more detailed panels of evolution over rate control, family control is concentrated in industries time. This is important in light of the large amount of con- with low investment opportunities and low M&A activity. trol changes that occur in some but not all circumstances New equity issues are a primary source of dilution of fam- in a relatively short space of time. ily ownership in these countries. This is not so in countries However, we did not address the welfare or efficiency with low investor protection, where family control in an properties associated with the different patterns of evolu- industry is unrelated to investment opportunities and tion. Whether strong investor protection, well developed mergers and acquisitions. financial systems and active markets in corporate control The emergence of these insights is a combination of three are beneficial in providing families with portfolio diversi- aspects of our analysis. First, we used data on private as fication and financing opportunities that do not exist else- well as listed companies. Since private firms account for where or whether dilution of control is imposed on them THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE PROF. JULIAN FRANKS: THE LIFE CYCLE OF FAMILY OWNERSHIP: INTERNATIONAL EVIDENCE 41

Family-Controlled Listed Firms

PANEL A: SUMMARY STATISTICS FOR LISTED FAMILY FIRMS IN 1996

Germany France Italy UK Total

FOUNDING FAMILY STILL IN CONTROL 49.0% 72.3% 60.4% 91.2% 69.7%

CEO IS A FAMILY MEMBER 59.0% 80.8% 74.5% 81.1% 74.1%

CONTROL DIVIDED WITHIN FAMILY 63.4% 81.0% 61.3% 47.0% 58.5%

DUAL CLASS SHARES 23.7% 0.8% 43.4% 16.6% 17.4%

CONTROLLED VIA PYRAMIDS 15.8% 13.1% 22.6% 2.3% 12.3%

2ND OR HIGHER GENERATION IN CONTROL 84.2% 55.4% 42.5% 43.8% 59.5%

RATIO OF CASH-FLOW TO VOTING RIGHTS 88.2% 98.1% 73.6% 96.1% 91.4%

VOTING RIGHTS 68.1% 62.1% 58.7% 41.8% 57.9%

FIRM AGE 91.5 71.7 48.6 38.6 66.2

PANEL B: EVOLUTION OF OWNERSHIP FROM 1996 TO 2006

Germany France Italy UK Total

NO CHANGE (N) 109 119 56 54 338

WENT PRIVATE 18 34 22 16 90

WIDELY HELD IN 2006 (A) 9 10 3 44 66

TAKEOVER (B) 75 82 16 84 257

DEFAULT (C) 26 6 9 19 60

UNKNOWN STATUS 18 0 0 0 18

TOTAL 253 251 106 217 827

FREQUENCY CONTROL CHANGES (A+B+C) 43.5% 39.0% 26.4% 67.7% 46.3%

This table is based on the population of 827 family-controlled listed firms in France, Germany, Italy and the UK in December 1996, i.e. the LISTED FAMILY sample. In Panel A, summary statistics are country averages, unless otherwise noted. FirmAge is measured in years. Panel B reports whether and how the status of the firm changed from being a listed family-controlled firm in 1996 over the decade. “No change (N)” indicates the firm is still a listed firm controlled by the same family as in 1996. “Went private” indicates the firm delisted. “Widely held in 2006 (A)” indicates the family no longer holds a controlling stake in 2006 but the firm was not subject to a takeover. “Takeover (B)” indicates the firm was subject to a takeover.

in the absence of alternative financing or control arrange- the continuation of family ownership. In other economies, ments remains an open question. The co-existence of dif- family businesses may be less influential so that liquid ferent institutional arrangements points to possible multi- markets in equity financing and control develop to en- ple equilibria sustained by a complementarity between fi- courage the dispersion of ownership and control. These nancial institutions and corporate ownership. In some differences in ownership may in turn be associated with economies, family businesses may be so influential that different types of productive activities rather than the eco- they are able to shape institutions and overcome financial nomic dominance of one form over another.  constraints without giving up control. In those economies, bank finance and control vehicles may emerge to promote

The full article was published by Julian Franks, Colin Mayer, Paolo Volpin and Hannes F. Wagner in the Review of Financial Studies. PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 42 JAMES GORMAN: NAVIGATING THE CHANGING LANDSCAPE OF FINANCE PAGE THE AUTHOR 43 James Gorman Chairman of the Board and Chief Executive Officer Morgan Stanley

Navigating the Changing Landscape of Finance

Contrary to the popular perception, the fundamental sheets became over-levered with more and more illiquid problem with US banks had almost nothing to do with risky assets. As time went by and it became apparent that their size, or their complexity. It was in fact the smallest of some of those assets were problematic as well as risky and the large US financial institutions that got into the most illiquid, banks started taking losses to their capital. Their trouble – while the largest, JPMorgan Chase, saw the least capital bases were already pretty thin to begin with, since destruction of value during the crisis. Complexity itself in most cases they were operating with leverage of about was not the culprit either. Some complex banks managed 30 times. Therefore, it didn't take investors and creditors their risks effectively, while many conventional deposit- very long to figure out that banks' over-levered balance takers and lenders failed, reflecting significant differences sheets had exposed them to the risk of running out of cap- in the quality and judgment of management. ital and going out of business. The response of the US government to the crisis, mainly in And it was that concentration of losses to capital in already the form of Troubled Asset Relief Program (TARP), overleveraged institutions that created a crisis of confi- proved highly effective in limiting the damage to banks dence. and the global economy. And to reduce the probability of a Banks are conduits. They don't keep most of the cash their future banking crisis, US regulators are now well along in depositors give them. Therefore, when there's a crisis of implementing a new three-part regulatory model. confidence and everyone wants their money, you have a Thanks to such regulatory changes, and to the response of liquidity problem. And if the crisis of confidence becomes most financial institutions to them, the US financial sys- deep enough, you get a good old-fashioned run on the tem has been restored to stability. bank. Once you've had a run on one bank, people start Let's start by looking back and trying to understand what looking around and saying, “Well, how good are the other happened. My simplistic explanation is that bank balance banks?” PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 44 JAMES GORMAN: NAVIGATING THE CHANGING LANDSCAPE OF FINANCE

Eventually, the crisis hit every financial institution. larger balance sheets and little if any of their own capital at Anyone who says that this crisis didn't affect them has a risk; it was now somebody else's capital. In some impor- fundamental lack of understanding of what a liquidity cri- tant ways, the Wall Street fraternity had not grown up sis is. It affects the whole system and, ultimately, it under- quickly enough with the size of their institutions, particu- mined confidence in the US financial system and every- larly in terms of developing risk management processes thing that we stand for. and controls. And there were some other kinds of bad management de- Interestingly, such failures and restructurings did not hap- cisions. For example, some failed institutions passed up pen in certain other heavily banked markets with very opportunities to act preemptively by selling off assets at large banks, notably Canada and Australia. Although I maybe not the optimal prices, or the prices they wanted, won't go into the whys and wherefores, the success of these but at prices that would have saved them. Therefore, don't other banking systems in weathering the crisis raises a underestimate the ability of management to really screw fundamental question: Did our system nearly fail because things up. our banks are too big? Taking all this into consideration, there was no single cul- My sense is that the crisis had almost nothing to do with prit in this crisis; there were many contributing factors. the size of US banks. It was actually the smallest of the However, at the core of the problem was what I aforemen- large US financial institutions that got into the most trou- tioned: When you use very high leverage on very thin ble. Among the biggest US banks, it was in fact the largest capital bases to acquire risky and illiquid assets, then if any – JPMorgan Chase – that saw the least destruction of value shock hits the system you've got a problem. The smaller during the crisis. And as someone pointed out to me, and more concentrated you are, the bigger the problem Chase's balance sheet is by no means the world's largest; in that you have got. fact, it ranks eighth – and it's the only US institution in the world's top ten. Regulators have put in place a new set of protectors, or So, again, I don't see the size of our banks as the culprit. preventive measures, at the front end. At the same time, For historical reasons, the US has the most fragmented they have put in a back end that is meant to deal with the banking system in the world. In the mid-1980s, we had possibility of financial trouble. They have said to the over 15,000 banks; and though their numbers keep com- banks, “Let's assume our new capital and liquidity require- ing down, we still have 7,000 banks – the vast majority of ments aren't completely effective, and we have to unwind them are quite small. an institution or put it in a bankruptcy or resolve it by sell- On the other hand, I think there were a lot of institutions ing off pieces. Do we have a process for doing that? Do we that had not properly grown up from their days as Wall know what all the legal entities are globally? How do we Street partnerships, when their capital was their own run that very complicated set of legal entities through a money. When these partnerships suddenly became public machine that helps us sell them off, unwind them, and ef- companies – and I think DLJ was the first to go public, and fectively put them into bankruptcy?” These are important then Merrill Lynch – they didn't necessarily put in place all questions because, as we saw in the case of Lehman the gates that you would if you were a true public com- Brothers, there was a major problem, particularly in the pany. They continued to rely on aspects of the partnership UK, in releasing capital that was “trapped” on its balance model, but in a public company spectrum with much sheet. THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE JAMES GORMAN: NAVIGATING THE CHANGING LANDSCAPE OF FINANCE 45

Therefore, regulatory response at the back end has taken ends, if you will – all large banks also get a report card once the form of a resolution plan for banks. The plan has been a year from the Federals Reserve known as a “CCAR” put together by the Federal Deposit Insurance Corporation (Comprehensive Capital Analysis and Review) that re- (FDIC) in collaboration with the Bank of England and our quires the banks to put their businesses and balance sheets Federal Reserve. The regulators have told the banks, “We through stress tests that are worse than the financial crisis will walk into your institutions and if those gates that you we just went through. The point of these tests is to see if put up at the front don't work and the bad stuff is happen- banks would survive a theoretical set of scenarios, with ing, here's how those problems will get resolved. Here's survival defined as a capital ratio that never falls below five how any problems at Morgan Stanley will get worked out.” percent. The government and the regulators have put in place new front-end requirements that are designed to keep banks Therefore, the new regulatory regime consists of three from getting into financial trouble. Moreover, they have main phases and sets of requirements. At the front end, developed a plan to deal with any cases where the new re- you have some blunt instruments that say that banks have quirements fail to keep institutions out of trouble. And in got to have more capital, more liquidity, and less leverage. the meantime – in between these front and back book- The back end says that if this thing doesn't work for some PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 46 JAMES GORMAN: NAVIGATING THE CHANGING LANDSCAPE OF FINANCE

banks, there's a way to unwind them. And in the middle, Encouragingly, we've gotten high enough marks on our we have annual report cards that give each bank a “score.” annual “CCAR” that we have been given permission by the That score dictates whether the bank can do buybacks, ac- regulators to do two things: One is to commence a stock quisitions, or pay dividends – or whether it has to raise buyback program, which we've done very modestly. more capital instead. And that three-part regulatory model Second, we completed our acquisition of a wealth manage- is now starting to be rolled out globally. ment business that we've been working to buy in a complicated deal with Citigroup over the last four or five years. When evaluating the government's overall response to the As a result of this acquisition, we are now one of the world's crisis, let's not forget the effect of its actions on US taxpay- largest wealth managers, which gives us balance and sta- ers. By that I mean TARP, the money that was given partly bility. to banks to recapitalize them to the point where they could However, at Morgan Stanley, we probably made more fun- go out and raise their own capital. First of all, most people damental and important strategic changes in the past two seem to have forgotten that most of the $700 billion did years than I saw those institutions as a group accomplish not go to banks. The amount that went to the banks was in over two decades. about $245 billion; the rest went to govern-ment-spon- The most important part of my message is not about sored enterprises (GSEs) like Fannie and Freddie, insurance Morgan Stanley. The real story is that the US financial sys- companies, auto manufacturers, and so on. And the big tem is now, I believe, safe and sound. banks all paid back TARP, as they should have; that was their responsibility. And the banks ended up providing If the industry is to make an effective response, it seems taxpayers with a high return on investment in the form of clear to me that the response has to address the question: interest payments and warrants. In the case of Morgan Why do banks matter? The answer has to begin with the Stanley, the return to taxpayers was 21%. basic function of the industry, which is to mobilize capital. We like to think we did some of these things before our You can't take capital out of capitalism. We as a society regulators told us to do them because we were sufficiently need banks to match savers and borrowers, investors with introspective or self-aware to know that we had to make money to invest and companies that need capital. Pro- the changes. For example, we didn't need someone to tell viding hundreds of billions of dollars to today's large mul- us that we were undercapitalized, and so we went out and tinationals is just not going to happen with a bunch of raised a lot of capital. As a result, we now have two very small banks. And in terms of meeting global competition, large investors: China Investment Corporation (CIC), which US banks, for all their recent failings, have continued to is the sovereign wealth fund of China; and Mitsubishi UFJ succeed in – if “dominate” is not the right word – a num- Financial Group, the largest Japanese bank that now owns ber of important categories of financial products and ser- 22% of Morgan Stanley in a unique global partnership. vices. Why we would want to cede that competitive edge to So we've created strength and stability at the front end. other nations in the name of smaller banks makes no sense Our liquidity at the time of the crisis was about $80 billion to me. There is no compelling argument – no theory or on a balance sheet of $1.25 trillion. It's now about $180 bil- body of evidence – that says that our financial institutions lion on a balance sheet of about $800 billion. Our leverage are too big.  at the time was about 35 times; it's now about 12 times. Our capital was $30 billion; it's now $62 billion.

The full article was published in the Journal of Applied Corporate Finance, Vol. 25 THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE JAMES GORMAN: NAVIGATING THE CHANGING LANDSCAPE OF FINANCE 47 PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 48 GERHARD LOHMANN: LOW INTEREST RATES AND THE INSURANCE INDUSTRY: FROM BALANCE SHEET IMPACTS TO STRUCTURAL INDUSTRY CHANGES PAGE THE AUTHOR 49 Gerhard Lohmann CFO Reinsurance Swiss Re

Low Interest Rates and the Insurance Industry: From Balance Sheet Impacts to Structural Industry Changes

THE ROLE OF INTEREST RATES AND ITS real value of goods and services, they are prone to irra- IMPERFECTIONS tional actions when it comes to understanding prices, and their actions can become completely irrational when it Interest rates are “prices” of a very special nature. They are comes to interest rates. This is due to the fact that eco- an indicator of the cost of the future, as they guide invest- nomic actors have few ways to predict the course of prices ment decisions versus consumption decisions over time. If and interest rates over time. Most take prices and interest interest rates are high, the hurdles for investing today in rates as a given and accept their historic development as a order to generate future returns are also high. Similarly, if good prediction for the future. If the stock market rises, interest rates are low, the hurdles for investing today in or- private investors increase their equity portfolios which are der to generate returns in the future are also low. If interest the most exposed when the market finally does collapse. rates are high, saving today versus consuming now be- Homeowners take out more equity loans when housing comes more attractive, and if interest rates are low, there is prices rise, thinking that the value of their homes will con- no point in setting financial resources aside to save for the tinue to go up forever. Private investors lock funds in for future. They do not yield sufficient returns nor does it the long term even if interest rates are trading below the seem logical to save in the context of abundantly available long-term average. Household loans and mortgages will financial means. increase because low interest rates make loans attractive, The last point is worth exploring further. Steering eco- and they will still rise when indications of higher rates lurk nomic behavior over time via interest rates would be a on the horizon. Some investors believe it is rational to lock wonderfully simplistic mechanism if individuals behaved in their long-term mortgage rates when rates are at their rationally at all times. The truth is less rosy, though. While highest compared to the long-term average rate. economic actors usually have a good understanding of the

The author expresses his personal views. PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 50 GERHARD LOHMANN: LOW INTEREST RATES AND THE INSURANCE INDUSTRY: FROM BALANCE SHEET IMPACTS TO STRUCTURAL INDUSTRY CHANGES

THE "GREAT CAPITAL ILLUSION" … tion-matched invested assets. In the casualty segment, insurance companies are happy to increase their books at What private investors often get wrong is the effect of ris- thin combined ratios, underestimating the possible im- ing and falling interest rates on the economic values of pact of consumer price inflation on their long dated liabil- their investments and liabilities. This is an error that fi- ities. 1 Even professional investors often mistake the spike nancial institutions appear happy to make as well. Banks in the equity book value of insurance companies (due to are willing to increase lending at high loan-to-value ratios low interest rates) for corporate strength, not understand- while interest rates are low, taking the greed for cheap ing that rising rates will erase the value of long-dated as- money as a sign of economic prosperity, systematically sets and thereby evaporate equity values. 2 While low inter- underestimating the extent to which homeowners and un- est rates create a monetary illusion on the side of consum- secured lenders will declare bankruptcy when rates rise. ers, financial institutions and investors often fall victim to Life insurance companies are happy to increase long-term a “capital illusion” following the same logic. Abundant liabilities in times of low interest rates, underestimating capital created through low interest rates is usually ex- the effect rising rates will have on the values of their dura- pected to last forever.

1 cf.: "Facing the interest rate challenge" in: SIGMA No. 4, 2012. See also: Daniel M. Hofmann: "The Poisonous Prescription of Low Interest Rates – Were Banks Rescued at the Expense of the Insurance Industry?" in: Insurance Economics No. 68, July 2013 2 cf.: Kurt Karl, "Rising Rates: Mixed Implications for Recovery, Longer-term Blessing for Insurers" in: gtnews Weekly Bulletin, 24 January, 2014 THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE GERHARD LOHMANN: LOW INTEREST RATES AND THE INSURANCE INDUSTRY: FROM BALANCE SHEET IMPACTS TO STRUCTURAL INDUSTRY CHANGES 51

… IN THE ABSENCE OF FREE MARKETS at cheap rates when economic activity has already started to grow, and private individuals and financial institutions All of the above combined would have little impact if rates are anticipating this policy error, decreasing their spend moved like free market prices. Greed for cheap money rates and investments in an almost heroic act of with- would cause interest rates to rise, and excessive savings standing cheap financing of almost secure economic re- would automatically lower the rates investors are willing turns. Finally, economic actors might “get it wrong” in a to pay for their financing arrangements. Temporary im- situation where cheap money is available when growth balances in lending would cause minor bankruptcies, with should have told central bankers to hit the brake, and in- no relevance for the economy overall. stead they keep on happily spending along the policy er- However, rates are not free market prices. They are man- ror. It is likely that the current situation will not lead to a aged by powerful institutions called central banks, and the happy ending. activities of central banks could not be more diverse. Some central banks are bound to maintain inflationary stability. Some central banks have the goal to manage growth and THE INSURANCE SECTOR IS A HIGHLY employment. Some central banks even include the task of EFFECTIVE MECHANISM TO DISTRIBUTE RISK managing exchange rates in their strategies. In the current environment, almost all relevant central banks are keeping This is most relevant in the context of the insurance mar- rates low for a variety of reasons, but the jury is out on the kets. Under normal circumstances, insurance markets are question as to when this almost concerted provision of characterized by a well-developed interplay between pri- cheap financial means will cease to exist so that the “capi- mary insurers and wholesale suppliers of risk capacity, tal illusion” can be contained. called reinsurance, as well as intermediaries focusing on the securitization and distribution of insurance risk to institutional and private investors. Risks, whether short THERE'S NO EASY WAY OUT tailed or long term, liquid or illiquid, complicated to predict or simple to understand, are underwritten by primary Four possible outcomes are in reach, depending on insurance companies, which mostly operate on a local whether the central banks get the timing right to end the scale and focus, and they are partially sold to reinsurance current supply of cheap money, and whether economic ac- companies and/or to the market in an attempt to minimize tors correctly anticipate central bank behavior. Central single balance sheet exposure. It is fair to say that over the banks might “get it right” when it comes to ending the past 150 years the industry has developed a system of cheap money supply, and refrain from oversupplying highly efficient risk distribution mechanisms, capable of when economic activity has caught up and economic ac- digesting even large catastrophes and asset crises due to its tors are anticipating this development correctly. This is the well diversified structure and stability. best possible way out of the current situation. Secondly, economic actors might not “get it right” and remain vic- tims of the capital illusion when money has already started to become more expensive. Alternatively, central banks might “not get it right”, and still continue to supply funds PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 52 GERHARD LOHMANN: LOW INTEREST RATES AND THE INSURANCE INDUSTRY: FROM BALANCE SHEET IMPACTS TO STRUCTURAL INDUSTRY CHANGES

CAPITAL ILLUSION AND THE INSURANCE nies, but that there is also an indirect impact on estab- SECTOR lished industry structures and risk distribution mechanisms which under normal circumstances provide a very Low interest rates as well as the unclear way out of the cur- relevant service to society. Arranging low interest rates in rent oversupply of financial means might have a very di- order to stimulate the economy, as is currently happening rect impact on this structure. As stated above they affect among central banks, has a cost in the sense that economic insurance companies directly through the economic val- actors might be driven away from utilizing mechanisms ues of interest-rate sensitive long-dated liabilities or which are almost of a public good character in normal through the revaluation of interest-rate sensitive long- times. term assets. On the other hand, the current “capital illusion” runs the risk of driving apart the traditional relation- ships between primary insurers and reinsurance compa- AVOIDING THE WORST THROUGH nies as the oversupply of cheap capital is letting primary IMPERFECTION insurers believe that bearing higher portions of risk or selling them to aggressive investors with little standing The question remains of how to end the current oversup- and track record is a better strategy than optimizing their ply of money so that the industry can return to more nor- balance sheets in collaboration with the established rein- mal behavior. Ending the concerted action of keeping insurance sector, which has a long-standing reputation of terest rates low will almost surely cause imbalances: Not maintaining its business model even if catastrophes hit only do central bank policies need to be coordinated but and interest rates rise. It is this “capital illusion” which runs the expectations of economic actors need to be steered in a the risk of negatively affecting established industry struc- way that signs are understood and behavior is adapted tures, as it has the potential to break up established risk early. Interestingly, there seems to be a tendency on the distribution mechanisms which in the grand scheme of part of investors to believe in rising rates, driven by a fun- things offer society a very effective way of supporting risks damental optimism about the return to economic growth, which would otherwise be impossible to bear. at almost every point in time, and even when indicators This might sound like an exaggeration to some readers, point to the opposite direction (cf.: Swiss Re Economic and the argument is surely not meant to indicate the com- Research and Consulting; Oxford Economics). This might plete standstill of risk distribution mechanisms in the in- limit the downside effects of central banks “getting it surance sector. It is, nevertheless, meant to make the point wrong” and it might help to avoid the worst if the oversup- that the current low interest rate scenario not only has a ply of money extends when economic growth has started. direct impact on the balance sheets of insurance compa-  THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE GERHARD LOHMANN: LOW INTEREST RATES AND THE INSURANCE INDUSTRY: FROM BALANCE SHEET IMPACTS TO STRUCTURAL INDUSTRY CHANGES 53 PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 54 DR. WERNER BRANDT: HOW TO DEAL WITH HIGH PRICES FOR ACQUISITION TARGETS AS A CORPORATE BUYER: “WHERE’S THE BEEF?” PAGE THE AUTHOR 55 Dr. Werner Brandt Chief Financial Officer SAP AG

How to Deal with High Prices for Acquisition Targets as a Corporate Buyer: “Where’s The Beef?”

Valuations in the software sector – especially for cloud- management space while Ariba was the leader in supplier based companies – have increased significantly over the relationship management, offering an inter-enterprise last few years since investors and corporate buyers have Business Network connecting more than 1.4 million com- shown themselves willing to pay substantial premiums to panies and generating an annual transaction volume of get exposure to high-growth assets. Take Twitter, for ex- more than $500 billion. To complement and bridge those ample, which was priced at 28 times its 2013 revenue and prior deals, earlier this year SAP acquired Fieldglass, the then rose over 70 percent on its first day of trading or leading provider of cloud solutions for procuring and Facebook which acquired the messaging company managing contingent labor and services. Companies are WhatsApp with its 50 employees for $19 billion. now able to collaboratively manage all their permanent In 2010, SAP introduced a customer-focused innovation employees, flexible workforce and goods and services pro- strategy, doubling its addressable market by 2015 by offer- curement – all in the SAP Cloud. ing solutions across three additional market categories be- Given the high prices for high-growth assets over the past yond the Applications and Analytics markets it had tradi- several years, a key question for SAP as a corporate buyer tionally addressed. The SAP HANA platform has been the has been how to generate financial return for its share- catalyst for growth in Database and Technology while tar- holders in such an environment. This is especially true in geted acquisitions have been used to accelerate growth in the cloud space, where not only many of the potential ac- the Mobile and Cloud markets. quisition targets are expensive, but hardly any are earning After monitoring several cloud targets, SAP acquired money or have any near-term likelihood of doing so. Since SuccessFactors in early 2012 and Ariba later that year. profitability in the software industry comes with a com- SuccessFactors was the market leader in the human capital pany’s ability to scale that still takes some time to achieve. PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 56 DR. WERNER BRANDT: HOW TO DEAL WITH HIGH PRICES FOR ACQUISITION TARGETS AS A CORPORATE BUYER: “WHERE’S THE BEEF?”

ware is eating the world”. This continuous transformation leads to an increase of software wallet share of overall IT spending. This bolsters investor confidence in software growth – and fuels high valuations. So what is it about these high-priced software companies? Many of these companies look expensive. A lot of them are probably overpriced, but among them may be the next Amazon or Google. Whether you are a private investor looking to invest in the stock market or whether you are a corporate buyer, how can you make sure you come up with the “right” valuation?

PRICE VERSUS VALUE – THROW THE TEXTBOOKS AWAY?

When it comes to valuing young, high-growth companies there is a tendency to throw the valuation textbook out the window. Aswath Damodaran has written several interesting articles on Investors versus Traders. Certainly some HEALTHY MARKET ENVIRONMENT & investors would question the efficacy of trying to estimate SOFTWARE EATING THE WORLD the value of these companies, and would focus instead on momentum. These investors are trading based on price Overall conditions in the financial markets are relatively rather than intrinsic value and have to be right about the strong. The worldwide economy has recovered from the direction the price will take and ride the wave until it lasts. debt crisis, money is still cheap and returns on safe-haven investments are low. Corporate buyers have cash reserves “WHERE’S THE BEEF?” at all-time highs and are now seeking ways to grow and to generate returns for their shareholders. Momentum trading can yield great returns and can be a great investment strategy, but it shouldn’t be used by a cor- Combined with the healthy market environment, we see porate buyer who knows that they will be left holding the software transforming industries at a dizzying pace. The bag when the music stops. Corporate buyers cannot undo world's largest bookseller, Amazon, is a software company. an acquisition the way that an investor could unwind a Google, the world’s largest direct marketer, is a software trading position and sell his or her shares if the tide started company. Spotify, Pandora and Apple have changed the to turn. While it’s hard not to chase a great company, a cor- music industry forever. Software is also taking over more porate buyer has to understand its fundamental value. As and more parts of the value chain of the brick and mortar in the famous 1984 ad for the Wendy’s burger restaurants, industries, whether it is software powering the distribu- where three elderly ladies examine an exaggeratedly large tion for retailers or software used to optimize oil and gas hamburger bun topped with a miniscule hamburger patty, exploration. As Marc Andreessen famously put it, “soft- you have to ask the question “where’s the beef?”. THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE DR. WERNER BRANDT: HOW TO DEAL WITH HIGH PRICES FOR ACQUISITION TARGETS AS A CORPORATE BUYER: “WHERE’S THE BEEF?” 57

Wendy’s „Where’s the beef?“ Commercial (1984) “WHERE’S THE BEEF?” – AS A CORPORATE BUYER, STICK TO IT!

Acquisitions need to generate financial returns for shareholders of the acquiring company. Thus, it always comes down to a financial decision. As a corporate buyer you have to develop a solid operational plan how to derive incremental cash flows from an acquisition. You need to get buy-in from top and line management who both have to be held accountable for achieving the numbers. Going through this process of developing the story and vision, bringing it into numbers, making a plan you can execute and track against is a crucial piece of corporate deal making. Going through this exercise you will realize that some acquisition ideas do not work. Not every asset is suitable Good old Discounted Cash Flow valuation helps to an- for any corporate buyer since it is not always possible to swer that question, with cash flow and risk being the major generate a return on the requested price. value drivers. DCF valuations are far from perfect – important parameters can vary greatly, especially for nas- At SAP, we always evaluate acquisition ideas based on fun- cent, high-growth businesses. DCF valuations do, how- damental financial analysis to assess whether the value we ever, offer a framework with a fundamental underpinning are getting and creating is exceeding the price we are pay- and they can certainly be used to help define a reasonable ing. Profitability is a matter of size in software: marginal valuation range. As important as anything, constructing a costs can be much lower than in other industries. As a cor- DCF raises the question “what would I need to believe porate buyer we found it to be critical to pick high-quality here for an acquisition at this price to make sense?” companies in large addressable markets and where we could accelerate growth (accelerating the route to profita- Corporate investors should avoid the temptation to tweak bility). Our acquisitions in the cloud space – Success- their fundamental analysis to close a potential gap be- Factors, Ariba or most recently Fieldglass – have been tween price and value, and should avoid arguing for an qualified through this process and are on track to provide acquisition simply because it is “strategic”. Too often this great returns to SAP. really means that the numbers do not make sense, but the acquirer wants to do it anyway. Alternatively, a corporate No matter what the market is doing or what competitors buyer might move away from fundamental financial anal- are doing, as a corporate buyer or a value investor you ysis and just use relative valuations such as Price/Earnings should always ask yourself “where’s the beef?” since ex- or Revenue Multiples. This is the worst a value-driven in- pensive deals can be great deals, just as cheap deals can be vestor can do: to align with the market while pretending to unmitigated disasters.  make an investment decision based on fundamentals. PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 58 PROF. DR. STEVE H. HANKE & DR. HEINZ SCHIMMELBUSCH: ON MEASURING GREENNESS: A NEW ENABLING METRIC, PLEASE PAGE THE AUTHORS 59 Prof. Dr. Steve H. Hanke Dr. Heinz Schimmelbusch Economist Chairman and CEO The Johns Hopkins University Advanced Metallurgical Group

On Measuring Greenness: A New Enabling Metric, Please

For some time, the flavor of the day has been “green”. market capitalization stood at a whopping $16.8 trillion. Indeed, companies around the world are scrambling to go This is almost exactly the same size as the current GDP of green. Some are so desperate that they engage in “green- the United States – $17.1 trillion. washing”. This practice amounts to little more than the use of public relations campaigns to assert greenness. Mc- Donalds, for example, literally became green by changing the colors on its signature logo. Now, McDonalds’ classic Global New Investment in Renewable Energy (Billions of $) yellow “M” is displayed with a green, not a red, back- ground. That said, many companies are, and have been, 279 engaged in producing products and employing produc- 244 tion processes that, by any definition, would qualify as 227 214 green.

172 168 GREEN INVESTMENTS GROWING 146 100

Just how large is the green investment space? Well, it’s 65 40 large, and it’s growing rapidly. For example, the FTSE- 4Good, which is a sub-index of London’s FTSE, has the 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 largest market capitalization of any of the green equity in- Source: Bloomberg New Energy Finance. dices. At the end of April 2014, the global FTSE4Good’s PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 60 PROF. DR. STEVE H. HANKE & DR. HEINZ SCHIMMELBUSCH: ON MEASURING GREENNESS: A NEW ENABLING METRIC, PLEASE

When we turn to the growth of green investments, annual investments in renewable energy serve as a useful proxy. Chart 1 shows the picture from 2004 – 2013. In a decade, these investments have exploded, increasing more than fivefold.

Even the Oracle of Omaha, Warren Buffett, has touted green and jumped on the bandwagon. Indeed, Berkshire Hathaway, through its subsidiary MidAmerican Energy, is heavily invested in renewable energy, and Buffett wrote in a recent letter to shareholders that MidAmerican’s total investment in renewable energy will surge to $15 billion, when current projects are completed (Buffett 2013).

MEASURING GREEN

With investors favoring green, and investment flows being earmarked as green, the obvious question arises: “How does an investment qualify for the coveted green designation?” The two generic methodologies used to determine what constitutes the so-called green investment grade are screening methodologies and green theme investing. Screening methodologies are ones that allow only the greenest companies through the screen. Screen processes result in all the green companies being lumped together, without any differentiation for the wide variety of screens that are used. This is an important flaw in the screening methodology, because the screening methodologies range from those that evaluate a company’s balance sheet to determine the green, non-green composition of a company’s assets to a simple classification of a company’s business activities into different so-called green categories – such as wind, solar, and so forth. With screening, two companies with a green designation would be grouped together, regardless of the fact that one company’s green assets are ten times larger than another company in the same class. The green theme methodology is even cruder than screening. An investment is deemed green only if it fits into a pre-defined green designation. THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE PROF. DR. STEVE H. HANKE & DR. HEINZ SCHIMMELBUSCH: ON MEASURING GREENNESS: A NEW ENABLING METRIC, PLEASE 61

THE ENABLING GREENNESS RATIO

In order to firm up the green investment house’s foundation, we propose a methodology that is simple, transparent, and one that can be objectively replicated. Our metric is determined by starting at the origin of the supply chain. It is from that starting point that we measure the amount of greenness ultimately enabled by the production of a so- called green enabler.

For example, the reduction in CO2 is a green good. If a company produces graphite that enables the production of more efficient insulation, which results in lower demand for energy required for heating and cooling, then the graphite producer is a net supplier of a green good – the

net reduction in CO2. In short, the enabler of the production of the green good is the supplier of graphite. So, the source of greenness resides at the very beginning of the supply chain. When it comes to the measurement of greenness, this enabling notion leads to simplicity and transparency, as well as an objective measure of the amount of greenness associated with each supplier that is enabling the production of green goods.

Therefore, the green theme methodology results in little To operationalize the enabling concept in the context of more than a loose, nominal – but important – designation. CO2 emissions, the following transparent and replicable Yes, if a company can obtain a green designation, no mat- formulation for measuring greenness with precision can ter how it is determined, that recognition of greenness en- be used: Net CO Reduction hances the firm’s attractiveness to investors. Enabling Greenness Ratio = 2 , where Total Assets

The current methods of measuring green fail to meet rudi- The Net CO2 Reduction = the Net CO2 reduced by a com- mentary standards of measurement. The most basic prin- pany, and Total Assets = the Total Assets as listed on a cipal of measurement is replication. However, the current company’s balance sheet. The enabling greenness ratio methods are, for the most part, subjective and opaque equates to the net CO2 reduced by the level of invested (Kennedy 2012 and Inderst 2012). In consequence, they capital in a company. Because this metric is divided by to- fail to meet the replication test. This leaves a multi-trillion tal assets, it provides net CO2 reduction relative to a com- dollar green investment house wobbling on stilts, rather pany’s size. This is analogous to the traditional accounting than a sound foundation. measure – return on assets. PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 62 PROF. DR. STEVE H. HANKE & DR. HEINZ SCHIMMELBUSCH: ON MEASURING GREENNESS: A NEW ENABLING METRIC, PLEASE

Table 1: Enabling Greenness Metrics: Advanced Metallurgical Group

Product Enabled Total Equivalent CO2 Emissions Reduced (millions of metric tons)

2010 2011 2012 2013 2014 2015 2016 2017 Ford F-150 0.68 1.37 2.05 Graphite 0.93 1.87 2.80 3.74 4.67 5.61 6.54 7.47 Transmission Heat Treatment 0.42 0.84 1.26 1.68 2.10 2.52 2.94 Fuel Injectors 0.88 1.75 2.63 3.50 4.38 5.25 6.13 Aerospace Ti Alloys 5.17 6.20 7.23 8.27 9.30 10.75 12.28 13.89 Aerospace Coatings 0.83 0.96 1.10 1.24 1.38 1.58 1.79 2.01 Gamma Ti Aluminide 4.13

TOTAL CO2 Emissions Reduced (millions of metric tons) 6.93 10.33 13.73 17.13 20.53 25.09 29.74 38.62

TOTAL CO2 Emissions Produced (millions of metric tons) 0.12 0.15 0.48 0.58 0.68 0.77 0.87 0.97

NET CO2 Emissions Reduced (millions of metric tons) 6.80 10.18 13.25 16.55 19.85 24.32 28.87 37.65 TOTAL ASSETS 855.075 900.797 947.921 832.216 929.436 1026.656 1123.876 1221.096

Metric Tons of CO2 Reduced per $1,000 of Assets 7.96 11.30 13.98 19.89 21.36 23.68 25.69 30.84

Source: Advanced Metallurgical Group and calculations by Prof. Dr. Steve H. Hanke and Dr. Heinz Schimmelbusch. Notes: These data assume that all products produced since 2008 are still in use by 2017. All data from 2014-2017 are estimates made by the authors.

Our suggested methodology can be applied with preci- REFERENCES

sion. We use the Advanced Metallurgical Group (AMG) to Bloomberg New Energy Finance (2014), Global Trends in Renewable Energy illustrate. Table 1 contains our results. Investment 2014. Available at http://fs-unep-centre.org/system/files/global- trendsinrenewableenergyinvestments2014.pdf

Over the past four years AMG has produced products that Buffett, W. (2013), Annual Shareholder Letter, 18 April, 2014. Available at http://www.berkshirehathaway.com/letters/2013ltr.pdf have enabled a net CO2 reduction of 46.78 million metric tons. Very green, indeed. However, that’s not the end of the Inderst, G., Kaminker, Ch., Stewart, F. (2012), Defining and Measuring Green Investments: Implications for Institutional Investors’ Asset Allocations, OECD story. Reliable projections indicate that AMG will enable Working Papers on Finance, Insurance and Private Pensions, No.24, OECD the reduction of an additional 110.69 million metric tons, Publishing. Available at http://dx.doi.org/10.1787/5k9312twnn44-en

an increase of 137 percent, over the next four years. And Kennedy, C. and J. Corfee-Morlot (2012), Mobilising Investment in Low yes, there’s more, due to the cumulative nature of supplying Carbon, Climate Resilient Infrastructure, OECD Environment Working Papers, No. 46, OECD Publishing. raw materials that enable the production of green goods, AMG’s greenness enabling ratio soars over time – indicat- ing that AMG’s green rate of return is growing rapidly.  THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE PROF. DR. STEVE H. HANKE & DR. HEINZ SCHIMMELBUSCH: ON MEASURING GREENNESS: A NEW ENABLING METRIC, PLEASE 63 PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 64 ANTHONY SIWAWA: INVESTING IN AFRICA – PRIVATE EQUITY: WHERE NEXT? PAGE THE AUTHOR 65 Anthony Siwawa Managing Director Venture Partners Botswana

Investing in Africa – Private Equity: Where Next?

The African Private Equity industry was pioneered by To date, DFIs have invested roughly $7 billion in Sub- Development Finance Institutions (DFIs), prior to the Saharan Africa alone, which amounts to between 60 per- 1990s that had predominantly supported development cent and 75 percent of investment in private equity funds. objectives by providing debt capital to government-initi- Their returns have been stellar, with the IFC reporting that ated development projects. This was also done through its Africa portfolio has historically outperformed their en- the provision of long-term credit lines to government- tire emerging markets portfolio. Between 2000 and March owned development institutions in African countries. 2010, the Africa funds portfolio posted a 21.7 percent return from 42 Sub‐Saharan African private equity funds. During the 1990s, the DFIs extended their activities to investing directly in private business. A significant factor THE PE OPPORTUNITY that contributed to this was the wide scale privatization processes of the 1990s, which required the availability of The underlying premise for a fledgling African PE indus- equity capital to de-risk some of the transactions. At the try is that the demand for growth capital significantly ex- time, the only source of risk capital was from the DFIs as ceeds the supply. In addition, the exponential growth ex- very few foreign institutions had an appetite for African perienced by entities with access to risk capital confirms risk. The need for risk capital was further accentuated by the posit that African PE has great potential for generating the tacit acknowledgement by DFIs that equity capital was alpha. Some of the factors that point to this fact include: a better instrument to better support the growth required by private sector companies. PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 66 ANTHONY SIWAWA: INVESTING IN AFRICA – PRIVATE EQUITY: WHERE NEXT?

LOW PENETRATION LEVELS LACK OF ACCESS TO CREDIT

The underpenetrated private equity industry offers sub- Funding from other sources is also limited due to under- stantial growth potential given that Sub-Saharan African developed stock and bond markets in most African coun- (‘SSA’) private equity represents only 0.09 percent of the tries. With the exception of South Africa’s JSE, the conti- total GDP for the region. Furthermore, the potential of the nent's stock markets are relatively small and illiquid. private equity market in SSA is substantial given the esti- Although the JSE is the only exchange in Africa to fall mated 400,000 private companies compared to 388 pub- within the world’s top 20 largest stock markets, it has less licly listed companies in South Africa alone. Public mar- than 400 companies listed on the exchange while an esti- kets are concentrated on larger companies and lack repre- mated 400,000 companies in South Africa remain pri- sentation of many companies and industries that could vately held. benefit from access to capital on public markets. Traditionally FDI has been attracted to extractive indus- African private equity markets are also underfunded. Sub- tries and the global demand that expanded the commod- Saharan Africa private equity funds raised $11.0 billion, ity sector. The changing macro-economic environment, while they invested $12.3 billion between 2005 and 2011 investments in the infrastructure and growth in other sec- according to EMPEA statistics. By comparison, Asia pri- tors of the economy have created alternative opportunities vate equity funds raised $26.3 billion and invested $18.7 for investors. Therefore, there have been increasing flows billion during the same period. The difference is that Sub‐ of FDI away from traditional resource sectors into ser- Saharan Africa has more investment opportunities for vices, manufacturing and infrastructure. capital than capital raised, leaving the market underfunded. China has contributed significantly to the growth in The ratio of private equity investments to GDP in Sub‐ African economics as a function of the commodity cycle. Saharan Africa stood at 0.09 percent compared to 0.98 China has had a commodity resource deficit since the late percent in the US and 0.14 percent in China in 2011. The 1990s. This resource deficit has led to a significant invest- region has only attracted between 3 percent and 6 percent ment in African extractive industries by China. The con- of total funds raised in emerging markets between 2005 sequence has been a correction and a positive correlation and 2011. between African GDP growth and the Chinese GDP growth momentum. As shown in Figure 4, the impact of LOW PUBLIC MARKET REPRESENTATION Chinese incremental cashflows to correct the resource deficit has led to the development of primary non-extrac- Africa has a large number of private companies relative to tive industries in Africa. public markets, which require growth capital. Despite this, the continent is relatively underpenetrated in terms of bank credit. Low bank credit to private sector growth ratios in a fast growing GDP environment points to the huge potential for banking and capital markets as a growth focus for PE. THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE ANTHONY SIWAWA: INVESTING IN AFRICA – PRIVATE EQUITY: WHERE NEXT? 67

FUND MANAGERS SECTOR FOCUS Figure 1: China & Africa's new growth coupling

16 1996 1999 2007 Generally 50 percent of the private equity funds in Africa 14 are generalists or sector agnostic and the balance has a sin- 12 gle focus on a particular industry or sector. The specific

10 sector funds are principally focused on primary sectors

8 such as agriculture, infrastructure , and real estate. The

6 majority of funds target the mid‐market, fast growing medium and small companies. 4 Overall, the strategies for Africa funds have largely tar- 2 geted investment opportunities in business services (in- 0 cludes financial services) (38 percent), information tech- -2 1980 1990 2000 2010 nology (34 percent) and telecoms (32 percent), supported

China real GDP growth Africa real GDP growth by big‐ticket industrial and mining projects (see Figure 5).

1996 Beginnings of growth correlation 1999 Almost an absolute correlation after 1999 – coincided with China's New Africa Policy 2007 Africa's growth is tracking the V-shaped recovery of China since early 2009 Sector-specific funds which are increasing across the con- 1999 – 2008: Growth correlation of 92 percent tinent have predominantly focused on real estate, infrastructure, agriculture and agri-processing.

INDUSTRY STATUS FUND GEOGRAPHIC DISTRIBUTION

According to current research there are 158 private equity A sizeable number of the large funds operate outside of the funds (115 fund managers) in Africa with a total of $32.9 continent. However, of those fund managers based in billion in capital closed since 2002 or currently being Africa, 53 percent operate out of South Africa, while raised (average fund size is $216.5 million). Out of the 158 Egypt, Mauritius and Morocco are home to 8 percent each funds, 60 percent have a fund size below $200 million, 32 and Nigeria and Kenya hold 5 percent and 4 percent re- percent are in the middle market ($200-800 million) and spectively, according to September 2011 data from Prelim. only six have fund sizes above $800 million. All of these countries are home to regional ‘capital capitals’ The landscape of private equity funds in Africa is small for the East, West, Southern and North Africa sub‐regions, compared to emerging Asia (excludes the developed while Mauritius offers easy access to the continent for in- countries) where there are 427 funds (286 fund managers) ternational investors. with a total of $184.3 billion in capital closed since 2002 or currently being raised (average fund size is $475 million). FUNDRAISING Latin America has a similar number of funds to Africa at 165 with the number of fund managers being 110 but the Fundraising in Africa peaked in 2007, when fund manage- total capital closed since 2002 or being raised is currently ment firms raised a total of $4.7 billion. This declined sub- at $54.0 billion, and the average fund size of $330 million stantially in 2008 and 2009. There was a subsequent re- is nearly double that of Africa. bound in 2010 and 2011 with fundraising reaching $3.3 billion. In 2012, Africa-focused PE funds raised only PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 68 ANTHONY SIWAWA: INVESTING IN AFRICA – PRIVATE EQUITY: WHERE NEXT?

Figure 2: Fund managers sector focus Figure 3: Fund geographic distribution

Other 8% 8% Ghana 9% 38% 13% Botswana 3% 3% 16% Kenya 4%

16% 34% Nigeria 5%

53% South Africa 20% 8% Mauritius

32% 23% 8% Egypt

27% 32% 8%

Morocco

Business Services Materials Information Technology Energy and Utilities Industrials Health Care Source: Prequin Private Equity Spotlight Datapack, September 2011 Telecoms, Media and Communications Real Estate Consumer Discretionary Clean Technology Food and Agriculture Infrastructure

Source: Prequin Private Equity Spotlight Datapack, September 2011 Note: Fund managers may have multiple industry preferences and therefore the total does not add to 100 percent.

$1.1 billion less than half that was raised in 2011. These 2005 onward, this type of growth driver has declined as an challenging conditions were reflected across the globe for overall share as have other strategies, such as M&A and the Private Equity industry. In Africa no funds greater margin improvement, which have started to become a than $300 million closed in 2012. greater part of the PE toolkit in Africa. In particular, M&A Although funds are taking longer to close across the world, has been used in financial services deals to assist these investors are generally optimistic about investing in Afri- businesses build scale and adopt a pan-regional approach can Private Equity as reflected in the EMPEA Global LP to business. Leverage is not a factor because access to debt survey where 41 percent of global investors in PE are plan- on the African continent is fairly limited. ning to invest or expand their current investment in Sub- Saharan Africa over the next two years. African PE value creation reviews consistently demonstrate that PE outperforms the public markets. African PERFORMANCE PE’s strategic and operational improvement measures have returned 0.6x more than the MSCI Emerging Markets As a consequence of Africa’s fast-growing markets, one of Index between 2007 and 2010. When compared to a the major findings has been that organic revenue growth is benchmark more suited to less developed economies – the the most important driver of EBITDA growth by far. MSCI Frontier Markets Index – African PE’s performance Organic revenue growth accounted for 67 percent of profit record improves still further. PE’s value creation capabil- growth for PE portfolios on the continent. However, from ity, involving strategic and operational improvement, THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE ANTHONY SIWAWA: INVESTING IN AFRICA – PRIVATE EQUITY: WHERE NEXT? 69

Comparisons with other PE markets also show Africa in a Figure 4: Fundraising in Africa and other emerging markets favorable light. African PE outperforms the established markets of North America and Europe. Indeed, African 32.2

28.5 PE exits during 2010-12 outperformed North American

22.7 exits by one-fifth.

EXITS 15.2

Historically, trade sales to corporates have been the princi- 7.9 6.8 4.5 3.8 3.9 pal exit route for African PE. Forty-four percent of exits 2.4 3.3 1.1 between 2007 and 2013 were trade sales as depicted in the 2010 2011 2012 table below. Secondary buyouts are increasing, which Africa China India Latin America point to a maturing market. IPOs and the attraction of Source: Preqin Venture Intelligence and Factiva public markets will assist the realization of investments by PE firms on the basis of an agreement by the FTSE and 16 essentially doubles the return to investors from what they of the 22 members of the African Securities Exchange would have earned by investing in the MSCI Frontier Association (ASEA) to launch the FTSE-ASEA Pan Afri- Markets Index companies. It is worth noting that these re- can Index. turns are based largely on equity, unlike most other PE markets, where leverage contributes a larger part of the GROWTH SECTORS overall PE return. Even more encouraging for the African PE industry is the Current investor focus has been on consumer-driven in- improvement in outperformance measured over time. dustries as a function of the growing per capita income Exits completed between 2007 and 2010 outperformed the and a growing urban society with fewer dependents. MSCI Emerging Markets Index by 0.3x and the MSCI Frontier Markets benchmark by 0.5x. Against the MSCI Emerging Markets, PE outperformed by 1.1x in 2011 to Figure 6: Relative multiples, Africa vs Europe and North 2013, and against the Frontier Markets Index, outper- America 2010 – 12 exits formance was a full 2x. 1.25

1.20 1.2

Figure 5: Perceived drivers of performance 1.15

1.10 16%

1,05 2% 1.04 1.00 1.00 12% Earning growth Multiple expansion 0.95 Use of leverage 69% Gains in efficiency 0.90 Africa Europe North America Source: Riscura – search for returns 2014 PAGE THE STERN STEWART INSTITUTE PERIODICAL #10 70 ANTHONY SIWAWA: INVESTING IN AFRICA – PRIVATE EQUITY: WHERE NEXT?

These sectors include: FORECAST  ICT such as telecommunications and web-related infrastructure industries In general, African private equity deal multiples have been  Transport, logistics and distribution increasing accordingly for African PE transactions. The  Retail entry multiples for African PE transactions completed  The food industry, agri-processing and agriculture from 2005 onwards are 33 percent higher than transac-  Education tions completed before 2004. While the level of entry value  Healthcare and return multiples is not ubiquitous across the conti-  Financial services which include real estate financing, nent, variations do indeed occur and are largely driven by: mortgage and property development.  The level of competition for deals in specific markets. REGIONAL FOCUS For instance, the South African market tends to be more mature than the rest of the continent and thus The majority of African fund managers are now transi- transactions there attract higher entry multiples due tioning from single-country fund managers to regional to the concentration of capital. investors looking for growth investments that have a re-  Transaction sizes. Larger companies or transactions gional focus. This is due to: attract higher deal multiples. This is compounded  A need for scalable investment opportunities by the fact that in Africa larger transactions are limited  Exit challenges relative to smaller single-country in number thus increasing the transactions multiples. focused investments The use of debt in African deals has not recovered post  Geographic diversification the financial crisis. (political risk management) Higher entry enterprise values also correlate to better rela-  Access to a larger institutional investor base looking tive returns. Transactions in the range $30-$75 million at- to access sizeable regional focused funds. tracted higher returns than transaction above the $75 million mark. It is thus expected that multiples will continue to inch up- wards also as a function of investor expectations due to the Figure 7: Relative returns by exit route high growth of African GDP, which has driven organic revenue growth to date. AVERAGE HOLD EXIT ROUTE RELATIVE RETURN PERIOD (years)

Stock sale on public market 2.2 x 5.5

IPO 1.8 x 5.3 AFRICAN INSTITUTIONAL CAPITAL

Trade 1.4 x 5.0 PE 1.3 x 5.5 Increasingly, African fund managers are looking to tap lo- Private 1.0 x 6.1 cal continental pools of capital. With the rise of the middle Other 0.6 x 2.7

Creditors / banks 0.1 x 4.0 class leading to growing pension pools, Nigeria and South Africa are increasingly allowing local pension funds to in- In calculating the relative return, the return for "private" is taken to be 1.0, and other returns are calculated relative to this base. vest in private equity on a much larger scale. Domestic in- Source: Broadening Horizons, Africa value creation study PWC 2014. stitutional capital in Africa is starting to play a role in pri- THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE ANTHONY SIWAWA: INVESTING IN AFRICA – PRIVATE EQUITY: WHERE NEXT? 71

vate equity, increasingly outside of the home country of CONCLUSION the institutions. The large and growing size of domestic institutional capital is a significant opportunity for private The growth of the African PE market is no longer a one- equity on the continent. For instance, in Nigeria, the dimensional process with both skill and capital coming Contributory Pension Scheme (CPS) has grown to $13 bil- from offshore. There is a significant growth in: lion assets under management (AUM), exceeded in size on the continent by South Africa ($256 billion) and Egypt  Continental institutional investor capital ($73 billion). In a further sign of growing support for pri-  Emerging African regional fund managers vate equity investments, South Africa’s Regulation 28  Awareness of PE investment instruments by (governing pension fund investments) was amended in promoters of transactions early 2011 to boost the private equity allocation from 5  A support ecosystem for the PE industry percent to 10 percent. According to SAVCA, over $13.5 billion was invested in private equity in South Africa by As a result, domestic pension funds, hitting the 5 percent private eq-  Africa is perceived to be and proving to be more uity cap, at the end of 2010, but commitments are expected attractive than other emerging markets. to double, given the higher cap at the end of 2010.Namibia  earnings growth continues to be the major driver has also recently promulgated Regulation 29 to enable al- of superior African private equity returns. location by pension funds to private equity.  regional PE funds are becoming the preferred route to accessing African private equity in the near term.  institutional investors in PE have developed a preference for African managers to be based in Africa. Figure 8: Estimated total pension assets – $ billion  environmental, social and governance (ESG) factors are at least equally important in Africa compared to other emerging markets.  the PE ecosystem is growing in sophistication and capability. Egypt: $ 73 billion  debt providers are providing further opportunities for leverage.

Uganda: $ 0.9 billion The stage is set for the continued growth of the African PE Ghana: $ 2 billion Kenya: $ 5 billion Nigeria: $ 13 billion industry, which is spotting opportunity in the rapid eco- Tanzania: $ 0.7 billion nomic growth across the continent. This is further accentuated by increasingly sophisticated value creation tech- niques. Therefore, a well‐constructed Africa private equity funds portfolio is expected to provide financial inves- South Africa: $ 256 billion tors with strong returns, balanced risks through diversification and appropriate exposure to the most promising  Source: AVANZ and AVCA research. industries and companies across the region. About this publication The Stern Stewart Institute’s Periodical

10th Edition, June 2014 Published half-yearly

Board of Editors Markus Pertl Gerhard Nenning

Chief Editor Gerhard Nenning

Editorial Production Anja Deucker

Design Production and Artwork KW Neun Grafikagentur

Printing Industrie-Druck Haas

The opinions, beliefs, and viewpoints expressed by the various authors in this publication do not necessarily reflect the opinions, beliefs, and viewpoints of the editorial staff or of The Stern Stewart Institute. The publisher accepts no responsibility for errors, omissions, or the consequences thereof.

The Stern Stewart Institute e.V.

1330 Avenue of the Americas Suite 23 New York, NY 10019 United States T +1 212 653 0636 F +1 212 653 0635 E [email protected]

Salvatorplatz 4 80333 Munich Germany T +49 89 242071 0 F +49 89 242071 11 E [email protected] tssi.org