Raising Capital In A New Era

Raising Capital in a New Era A white paper and survey results on the future of capital markets

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Table of Contents Introduction + About the survey Key survey findings The rise of uncertainty + A questioning of old truths The tipping point The implications for capital raisers + Power shifts to investors The implications for investors + Pension funds search their souls Conclusion

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About RBC Capital Markets RBC Capital Markets is A Premier Investment Bank. Our strengths in providing focused expertise, superior execution and ­insightful thinking have consistently ranked us among the top 20 global investment banks. With over 3,000 employees, we provide our capital markets products and services from 75 offices in 15 countries and work with clients through operations in Asia and Australasia, the U.K. and Europe and in every major North American city. We are part of a global financial institution, Royal Bank of Canada (RBC). RBC has been providing financial services for over 140 years. We are a top 10 global bank by market capitalization and have one of the highest credit ratings of any financial institution: Moody’s Aaa and Standard & Poor’s AA-.

About The Economist Intelligence Unit The Economist Intelligence Unit is the business information and research arm of The Economist Group, publisher of The Economist. Through its global network of 650 analysts, it continuously assesses and forecasts political, economic and business conditions in more than 200 countries. As the world’s leading provider of country intelligence, it helps executives make better business decisions by providing timely, reliable and impartial analysis on worldwide market trends and business strategies.

Foreword Client focus is at the root of how we at RBC Capital Markets build relationships and create opportunity. Our clients are operating in unprecedented times. Therefore, we endeavour to provide them with thought leadership designed to help them navigate what appears to be a new era in the capital markets. One of the most noted challenges of the “new era” is raising capital. Together with the Economist Intelligence Unit, we polled more than 700 corporate borrowers and institutional investors from around the globe to gather sentiment and insight about lending and raising capital. This white paper is the end result of the survey. It reveals some interesting insights about how lenders and borrowers view current economic conditions and how they have affected capital markets. Some of the themes addressed in the report include: • The level of uncertainty at which decision-makers are operating • Recent and forecasted global economic shifts • Challenges to some historical tenets of finance theory • The perspectives of borrowers on raising capital in the current environment • The perspectives of lenders/investors on investing capital • The market’s confidence in the success of government and regulatory intervention We would like to thank the individuals who are quoted in this report for their valuable time and insights: George Anson, Managing Director, HarbourVest Curtis Arledge, Co-Head of Fixed Income, BlackRock Gerald Ashley, formerly of Bank for International Settlements Andrew Baranowsky, Corporate Treasury, Bombardier Federico Bazzoni, Head of International Equity Sales, Citic Securities Francis Beddington, Head of Research, Insparo Asset Management Harry Borghouts, formerly Board Chairman of ABP Pierre-Marie Boury, Capital Markets Specialist, Cleary Gottlieb Steen & Hamilton LLP Aaron Brown, Chief Risk Officer, AQR Capital Management Andrew Lo, Professor, MIT Sloan School of Management Ulf Quellmann, Treasurer, Rio Tinto Toby Segaran, Founder, Freerisk Rekha Sharma, Global Strategist, JPMorgan Asset Management Vern Yu, VP Investor Relations & Enterprise Risk, Enbridge We hope you will find the report insightful.

Doug McGregor Chairman & Co-CEO RBC Capital Markets

Mark Standish President & Co-CEO RBC Capital Markets

Introduction “This time it’s different” are dangerous words, warned Sir John Templeton long ago. The market’s cycle is never different: it tips from bubble to collapse, enthusiasm to sobriety, spending to saving, the quest for return to the avoidance of risk. Even so, more than a year after the swiftest and deepest equity market collapse in over 70 years, the question remains: is it possible that this time is different? For many market participants, the answer appears to be “yes”. This is no ordinary turn of the business cycle. Economists, accountants and credit rating professionals are under siege. Axioms of financial theory are being questioned. Many in the financial sector doubt the ability of policymakers to set the economy on a path of sustainable growth. And unlike crises that stem from cracks in investor psychology, this one is also intertwined with fundamental structural imbalances that have yet to be addressed: massive and continuing dollar purchases by the BRICs, Japan and Germany; multi-year periods of negative real interest rates in the U.S.; and extreme price movements as the unsustainability of these financial flows becomes apparent. At the institutional level, chief financial officers and chief investment officers need to make daily decisions in an environment more uncertain than any in recent memory. Amid a massive shift in credit flows, borrowers hope to strengthen their capital structure with long-term financing; investors, still hurting from last autumn’s market collapse, seek the highest possible compensation for risk (if they are willing to take on new risk at all). Both sides will have to act quickly to exploit windows of opportunity, accept higher costs or risks and possibly lower returns, and potentially rethink the links between their financial and operational strategies.

About the survey In July and August 2009, on behalf of RBC Capital Markets, the Economist Intelligence Unit surveyed senior executives at 736 borrowing and investment institutions from around the globe on their outlook for the future of capital markets. Of the executives, 415 were involved in raising capital and 321 in investing capital. Just over half of the capital-raisers came from ­non-financial corporations ranging in size from $75m to over $100bn in annual revenues, with an average size of about $5bn. About 38% (281) came from commercial or investment banks and 13% (101) were asset managers or asset owners. There were 60 hedge funds, 57 private equity investors and a handful of central banks. Financial institutions ranged in asset size from below $50bn to over $1tr, with an average size of about $250bn. Thirty percent were C-level executives and another 20% were at the SVP or VP level.

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Raising Capital in a New Era

Key survey findings The purpose of the survey was to highlight and illuminate the lessons learned by key market participants – both providers and users of capital – in the months since the financial crisis. The survey covered a range of topics united by the theme of sourcing and deploying capital. The table below describes the topics in the survey and highlights some of the findings.

Topic

Findings

Expectations for the future of the global economy and financial markets, and how the rules of global capital markets have changed

• Unparalled levels of uncertainty, especially with regards to the timing and ­ durability of the economic recovery, the future direction of prices and the prospects for inflation or deflation • The expectation of muted transaction volume over the coming year • Re-evaluation of diversification, efficient markets, CAPM and other tenets of finance theory • In general, lower levels of return relative to risk

The changing roles of market players – including central banks, intermediaries and regulators

• Pessimism about ability of governments, central banks or regulators to set the economy on a path of sustainable growth • More regulation, more competition and a persistent credibility gap for rating agencies

How seekers of capital are changing financial strategies and plans; how providers are changing the way they evaluate investments

• Stockpiling of capital as insurance against funding difficulties • For seekers of capital, more equity – especially private equity – and long-term debt • Acceptance of higher cost of capital • Among investors, stronger focus on financial strength and cash flow and a shift to a more defensive portfolio strategy

What seekers and providers of capital are now looking for in a relationship

• For seekers, openness to non-traditional providers of financing, including sovereign wealth funds, private equity funds and hedge funds • Focus on soundness of borrower’s or lender’s home economy and quality of regulation as a condition for long-term relationships

Which regional capital markets have best prospects for growth and stability

• Little confidence in Russia, Japan or the U.K. • High levels of confidence in China and India • Split on U.S. and Eurozone, with many expressing optimism and an almost equal number pessimism

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The rise of uncertainty Uncertainty curtails human activity. Uncertain weather stops people from venturing outside their homes, political uncertainty produces ineffective governments, and an uncertain diagnosis prevents a patient from taking the first steps on the path to recovery. So it is with economic activity. The economic crisis caused, and continues to cause, anxiety among issuers and providers of finance alike. Companies fear that future funding needs may not be met, while providers of financing worry about their own capital positions and are not confident that they can execute the transactions that are the lifeblood of their businesses. A survey conducted by the Economist Intelligence Unit in July and August 2009 reveals just 6% of respondents expect a sharp economic rebound in the next six months. European companies across all industries are the least optimistic, with just 4% expecting a rapid recovery, with 8% in North America. Between one-third and one-half of respondents worldwide do not expect any uptick for a year or longer. Ten percent of respondents anticipate at least two years of economic weakness; the figure is higher (15%) among Western European companies and finance providers.

Who is most pessimistic? Most optimistic? By region No recovery for at least two years, followed by neglible growth

By capital raisers and capital providers Sharp rebound in the next six months, followed by growth at previous levels

No recovery for at least two years, followed by neglible growth

Sharp rebound in the next six months, followed by growth at previous levels

Capital raisers

Asia-Pacific North America Western Europe -15%

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Capital providers -10%

-5%

0%

5%

10%

-15%

-10%

-5%

0%

5%

10%

Raising Capital in a New Era

Consider this statistic alone: just 13% of the respondents have a great deal of confidence that they can predict the direction of prices in capital markets over the next one to two years. They were not asked to forecast the absolute level of prices, just whether they would be higher or lower over a fairly long horizon. And yet 36% had little or no confidence that they could do so. Another indicator of the level of uncertainty is the close-toeven split among those who fear inflation and those more concerned about deflation (see chart below). Among those willing to voice an opinion, investors point to inflation as a slightly bigger danger, as to respondents in Asia-Pacific and North America. But the difference between the two viewpoints is small. And there is room for both to be right, depending on the time horizon.

Asset Management who was interviewed in August 2009, sums up the difficulties: “You have to be nimble as an investor at the moment. You can’t rely on any figures or numbers. In the short term, our conviction is that markets will continue to perform. The problem is, next year gets a little fuzzy in terms of forecasting. We are worried about the durability of the recovery: it could hit a wall due to factors such as rising tax rates, the withdrawal of fiscal stimulus, the continued rise of commodity prices and increasing mortgage rates.”

A questioning of old truths

Amid fears of a muted recovery, many companies and financial institutions are also concerned about their future viability. Over half of respondents believe that corporate profit margins and returns on capital will not return to pre-crisis levels for at least five years. The proportion is even higher among European companies. When executives talk about the end of the recession, more than 80% qualify it by saying that subsequent growth will be “below-trend” or negligible rather than a rising tide that lifts everyone. Such confusion can cause paralysis. How can investors determine whether they are making a sound investment? Rekha Sharma, a global strategist at JPMorgan

Just as the patient with a chronic illness may come to reject the conventional medical techniques that have failed him, so market participants have started to question the beliefs that have underpinned capital markets for many decades. Distorted by asset bubbles, pummelled by macroeconomic shocks and drained of liquidity when it is most needed, markets appear to have become dysfunctional. This is of more than academic interest: when institutions and participants are trusted, prices are easily set and transactions flourish. When trust wanes, prices are questioned and transactions suffer. The chart on the next page shows how some of the consensus beliefs around financial markets have changed. For each statement, respondents were asked whether they agreed, disagreed or had no opinion. Those who had no opinion are not shown in the chart.

Inflation is the bigger threat

Deflation is the bigger threat

Investors Borrowers Western Europe North America Asia-Pacific 50%

Raising Capital in a New Era

40%

30%

20%

10%

0

10%

20%

30%

40%

50%

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Capital markets participants are Title sceptical and pessimistic Copy

Disagree

Agree

Tenets of academic finance (CAPM, EMH, option pricing, portfolio theory) should be re-evaluated

Higher correlations are making diversification less useful in mitigating risk

Banks must find new operating models to survive

The U.S. Federal Reserve is becoming less independent

Financial policymakers will successfully respond to the credit crisis over the next two years

The actions of the U.S. government are the most serious source of systemic financial risk

During the next five years, the U.S. dollar will lose its reserve currency status

-50%

8

0%

50%

Raising Capital in a New Era

Tenets of academic finance should be re-evaluated

Banks must find new operating models to survive

Until Graham and Dodd came along in the 1930s, finance was a collection of observations and rules of thumb, more akin to folklore than science. But with the coming of Harry Markowitz, Eugene Fama, Merton Miller, Fischer Black, Myron Scholes and Robert Merton – all associated at some point in their careers with the University of Chicago – a body of theory came into being that, starting in the 1960s, guided billions of dollars in transactions. Several generations of business school students have now been weaned on the efficient markets hypothesis, the capital asset pricing model, portfolio theory and other tenets of modern finance.

The financial crisis has brought about a fundamental rethinking of how banks should operate. The conviction is growing that banks can no longer operate profitably as conventional intermediaries. Just over half (56%) of executives agree that new operating models are a necessity, and only 35% disagree. New operating models might include: • The disaggregated bank. Bankers are rethinking which parts of the bank should be retained and which should become part of the supply chain. Small or medium-sized banks may not have sufficient scale to operate the back office efficiently, and may choose to outsource or co-operate with a group of peers. • Splitting origination and distribution. Just as the asset management industry has split into manufacturers and distributors, banks may split into those specializing in gathering deposits and those good at capturing yield and managing risk. • Turning fixed costs into variable costs. Instead of ramping up capacity in big steps as volume grows – then coping with unused capacity and high costs when volume drops – banks are trying to change costs incrementally. They sacrifice operating margin at the top of the cycle, but reduce business risk dramatically at the bottom.

Now 65% of survey respondents doubt these concepts (and only 22% accept them without question). And they are not alone. “Initially confined to academia, the battle between efficient markets hypothesis disciples and behavioralists has spilled over to central bankers, regulators and politicians,” says Andrew Lo, a professor at the MIT Sloan School of Management, interviewed in August 2009.

Higher correlations among markets are making diversification less useful in mitigating risk More than half (59%) of survey respondents question the value of diversification in portfolios, one of the basic tenets of modern portfolio theory. This figure rises to 67% among investors. The problem is not with the theory: Mr Markowitz won a Nobel Prize for proving that a portfolio of less-than-perfectly-correlated assets reduces risk for a given level of return. Instead, the problems are that asset correlations change, correlations among prices in far-flung markets increase as markets globalise, assets are impossible to value when liquidity vanishes, and correlations move towards one in a panic.

Raising Capital in a New Era

Doubts about policymakers and their effectiveness Executives voice strong doubts about the ability of regulators – especially U.S. regulators – to cope effectively with the crisis. A plurality of respondents believe that the Federal Reserve is losing its independence and that actions of the U.S. government are the biggest source of systemic risk in the financial markets. These sentiments reinforce an underlying source of the crisis: distorted trade and capital flows and inconsistent policies. They also suggest widespread distrust of the U.S. government’s ability to apply rationally the levers of fiscal and monetary policy.

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The tipping point The U.S. and China, the world’s two most important economies, are key to understanding the crisis and shaping a solution. It is a truism that the world’s centre of economic gravity is shifting towards the emerging markets, particularly China. With its undervalued exchange rate, massive exports, high savings rate and limited currency convertibility, China has gathered 30% of the world’s foreign-currency reserves (mostly in dollars), providing the U.S. with sufficient liquidity to keep its interest rates low. Despite a 40% drop in the second-quarter trade surplus, China will still accumulate dollars at a rate of about $155bn per year, according to Economist Intelligence Unit forecasts. As China becomes more prosperous, its focus will shift towards domestic consumption rather than exports. This will provide an incentive to float its currency, like other economic powers, and allow the renminbi to strengthen. China has already started to move in this direction: it ended its fixed exchange rate to the U.S. dollar in July 2005 and more recently set up renminbi swap arrangements with Brazil, Argentina and several African countries. A stronger renminbi will reduce the growth of exports and reserves, and should lead to more balanced capital flows. None of this escaped survey participants. They see the future, and it lies to the east. In particular: • Asked which country is the most stable and offers the best growth potential over the next two years, respondents selected China above any other country or region. China is seen as both a hub of growth and as the financial market of the future. • Just over 40% of borrowers say that they will try to strengthen relationships with financial institutions based on the “soundness of the lender’s home economy and the degree to which it has been affected by the financial crisis,” and 30% will consider the “capital surplus or deficit of the institution’s home region” when selecting a partner. • Nearly one-third of respondents think the dollar will lose its reserve currency status over the next five years.

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Federico Bazzoni, head of international equity sales at Citic Securities, China’s largest brokerage firm, says the credit crisis has had only a marginal impact to date on the Chinese market. He argues that the market has already emerged from any problems it was experiencing and the economy is expanding at a pace Western economies cannot hope to match. “Western investors and companies are still in wait-and-see mode,” Mr Bazzoni says. “Here, everyone is talking about expansion, the property market, and equities. There is lots of liquidity and the Shanghai stock exchange is seeing record volumes.” And the shift is not just to Asia, but to other geographical areas that can attract and distribute large amounts of liquidity. So it is conceivable that the Middle East could also become a centre of financial power, despite recent weakness in equity markets and real estate in the region. Francis Beddington, head of research at Insparo Asset Management, which advises an Africa- and Middle Eastfocused hedge fund, says, “Financial markets always follow the money. There are large pools of wealth in the Middle East, so financial markets will continue to develop there.” Many Western companies have already raised money in the Middle East, including a number of banks, and this trend is likely to persist, particularly if the price of oil continues to recover from its lows at the beginning of 2009. Enbridge, an energy transport company, is starting to reach out to up-and-coming financial regions. Its investor base already includes the sovereign wealth funds of Singapore, Kuwait and Norway, and it is conducting awareness-raising events next year among investors in Hong Kong, Japan, Singapore and, possibly, China. Vern Yu, VP Investor Relations & Enterprise Risk, says, “We are aiming to tap large pools of capital and we want investors to be interested in our story.”

Raising Capital in a New Era

Real U.S. Interest Rates Overnight Fed funds rate minus year-on-year change in U.S. CPI 6% 4% 2% 0% -2% -4% 1999

2001

2003

2005

2007

2009

Current-account balances 1990–2008 $900 $600

China, Japan and Germany United States

USD billions

$300 $0 -$300 -$600 -$900 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 US$

Source: Economist Intelligence Unit

Raising Capital in a New Era

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The implications for capital raisers Although parts of the corporate world are beginning to sense a recovery, any nascent upturn has yet to feed through to the bottom line and companies across the world are scrambling to secure financing. Some 60% of the issuers in the survey say they are looking to raise capital over the next two years. Just 27% say they will be able to continue operations at the same level from current cashflow, without fresh financing. In other words, for most companies, access to capital markets will be more critical than ever. Unfortunately, such access may not be forthcoming. Although most executives surveyed expect financing activity to grow from its low levels in the first half of 2009, a substantial minority expects the pace of transactions to slow. Much of the urgency to secure financing stems from fears that credit may become scarcer. Gerald Ashley, a banking consultant and former central banker at the Bank for

International Settlements, says, “Many large corporates have borrowed money they don’t really need in case their lines of credit are withdrawn. Corporate treasurers have changed their attitudes towards liquidity and are gathering war-chests of cash.” One problem is that bank borrowing has become more expensive. Market pressures forced Bombardier, one of the world’s four big aircraft makers, to pay higher fees for a C$600m credit facility it agreed to with a syndicate of North American banks in July 2009. Andrew Baranowsky, senior director in Bombardier’s Corporate Treasury, says, “Although our risk profile has improved over the last two to three years, the cost to secure bank lines has increased. It now costs us tens of millions more in bank fees.” The funding now sought by many companies is the kind of flexible, long-term capital that provides security amidst volatility and represents a shift away from a historical reliance on banks.

Where transaction volume is headed % of respondents who think volume will decline over the next year

% of respondents who think volume will rise over the next year

Initial public offerings Securitisation/asset-backed securities Private equity High-yield debt Secondary equity offerings Syndicated loans Investment-grade debt Commercial paper Convertible debt M&A activity Preferred equity 40% 30% 20% 10% 0% 10% 20% 30% 40% 50% 60%

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Raising Capital in a New Era

High-profile companies once had a good deal of influence over the cost of funding. Now firms have less power to set prices that will allow them to raise as much capital as they need as quickly as possible. Ulf Quellmann, treasurer of Rio Tinto, the diversified global mining group that launched a number of equity and bond issues this year in a bid to reduce net debt, says, “In June of last year, it was all about price from the borrowers’ point of view; now it is all about access to liquidity.” Many companies are also looking to the non-public markets, according to the survey. Nearly one-half of issuer companies surveyed (44%) say they plan to raise capital via private equity in the next two years. This figure rises to 55% for larger companies. In contrast, only 15% of companies expect to launch an initial public offerings in the next two years, rising to 33% for the larger companies in the survey. And even this minority of companies may be disappointed. Globally, the $220.3bn in new equity issuance in the first six months of 2009 was the weakest start to a year since 2005, according to Dealogic. And at just $6.7bn, the volume of IPO is the lowest six-month total on record. Pierre-Marie Boury, a capital markets specialist at international law firm Cleary Gottlieb Steen & Hamilton, says, “The IPO market will not return until next year, and possibly not until the second half of it.” Funding will be more expensive, especially for companies using bank loans. More than half of respondents believe banks will charge higher fees for commitments and drawdowns of loans over the next two years. This partly explains why 58% of respondents believe that their weighted average cost of capital will rise. This figure increases 64% in the view of investors – and they may be in a better position to tell, since their appetite for risk will largely determine what borrowers pay. When asked why the cost of capital will rise, respondents point to both higher financing costs and a capital structure more heavily weighted towards equity and long-term debt.

Raising Capital in a New Era

Power shifts to investors In every economic to downturn, investors become more demanding and issuers must put in more effort to obtain financing. One-third of companies in the survey say that it is necessary to improve relations with current investors to raise new money, and in this downturn the need to court investors extends even to brand-name investment-grade companies. Rio Tinto, which has launched a series of equity and bond issues this year to bolster its balance sheet, says improving relationships with investors has reaped benefits. Mr Quellmann was surprised about the positive reaction of investors to a road show undertaken among bond investors. “Equity road shows are common,” says Mr Quellmann. “But it is less common to do them for fixed income investors. However, we have come to appreciate the virtue of them and non-deal road shows have become a part of best practice at our company.” The implementation of these best-practice principles led to Rio Tinto receiving $15bn of expressed interest from investors in a bond that was expected to raise $2bn earlier this year. The company decided to increase the issue to $3.5bn as a result and was able to achieve better pricing in the process. The embrace of capital markets investors will be counterbalanced by a move away from banks. The disintermediation of banks, which has been a feature of the North American market for decades, is appearing in continental Europe. Mr Boury believes a lack of available capital at European banks, which have always dominated the European corporate sector, will force more companies to raise funds in the markets. This belief is reinforced by the sheer number of companies seeking funding in Europe – while 60% of companies worldwide will seek capital in the next two years, this figure rises to 69% in Europe. Mr Boury says, “This shift is new to Europe, which will move closer to the U.S. model.”

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Liquidity in reserve: Enbridge’s best practices for raising capital In a chaotic financial environment, even companies with steady cashflows and strong balance sheets can find it difficult to raise capital. Enbridge, a Canadian energy transport company with 2008 revenues of C$13.76bn, takes this possibility seriously; despite a stable business model based on long-term contracts with large, well-capitalized oil companies, it is concerned about access to the capital markets after the current bond frenzy has abated. Vern Yu, VP Investor Relations & Enterprise Risk, says, “We want to make sure we have 12 to 18 months of dry powder in case the capital markets get worse.”

Enbridge appears to have no shortage of “dry powder”, having issued C$300m of bonds in November 2008, a further C$400m in May 2009 and C$600m in September 2009. But it has had to work harder than ever before to make sure investors are convinced of the business case. “Investors are very demanding of investee balance sheets now,” says Mr Yu. “They have more fixed-income analysts now than has historically been the case, and they are doing more due diligence and relying less on ratings agencies. We have to be at the top of our game.”

The Enbridge’s capital-raising best practices are particularly relevant in the post-crisis capital markets. The four principles are:

1. Plan ahead for capital market outages. Never assume that funds will be available at the moment they are required. Enbridge looks 18 months ahead for funding and keeps in place several multi-year bank facilities so it can pick and choose the best environment to issue debt in terms of accessibility and low coupons. As a result, it was able to price its three recent bond issues at levels “compatible with historical norms.”

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2. Actively market the company. Senior management conducts 400 separate investor meetings a year, the majority with equity investors. They also attend energy conferences to network with investors and key issues such as revenues, earnings, cashflow and debt levels are widely understood.

3. Size offerings to satisfy all market sectors. Enbridge’s issuance is generally large enough to provide a reasonable “fill” for loyal investors, but it also aims to leave some demand on the table, so appetite remains for subsequent issues.

4. Set aside enough resources to capital-raising, leaving nothing to chance. Enbridge employs a full-time team dedicated to monitoring markets. The team is in daily contact with a syndicate of seven investment banks. These banks are retained to gauge market demand for bonds and equities and to collect other market intelligence.

Raising Capital in a New Era

Open-source credit models: An alternative to rating agencies? Rating agencies are under attack from all sides: regulators, investors, issuers and the press. In the survey, one-third of respondents also highlighted a market-driven alternative to ratings: “open source” credit models, characterized by public algorithms, consistent data sets and track records open to public scrutiny. The idea of open-source credit modelling is borrowed from open-source projects in software (Linux), reference documents (Wikipedia) and education (MIT’s OpenCourseWare). “You want to open up the process [of modelling credit risk] to smart people with different experiences, approaches and incentives,” says Aaron Brown, chief risk officer at the quantitative hedge fund AQR Capital Management. “The people in the Netflix company made names for themselves by coming up with a better movie-rating algorithm. In the same way, there are a lot of capable people who would welcome the chance to join a competition to develop a superior credit rating model.” In an era when the credibility of black-box forecasters is in short supply, the idea may appeal to regulators and investors as well. Even if prognosticators wanted to promote an opaque model, their customers might not let them. And open-source modelling, while rare among financial institutions, has a long tradition in academia. The original Altman Z-score model is freely available, open to scrutiny and widely used. The business models of research organizations have changed as well: many practitioners give a basic model away for free while offering enhanced services or consulting at a premium.

This is not quite true. Even the most sophisticated parser is likely to choke on footnotes. The significance of a footnote may lie in what is said or what is omitted, and its goal can be obfuscation as well as clarity. But even footnotes can be quantified to some extent. First, under pressure from regulators, some footnotes – management disclosure of options, for instance – are more structured than they used to be. Second, disclosures are often binary: either a company deducts option costs from earnings or it does not. Finally, according to Toby Segaran, a founder of the open-source finance project Freerisk, “Besides sharing quantitative models, the idea is to have more highly annotated data to feed them with. To the extent that people can annotate and add their own variables to footnotes, they can be read by machines and incorporated into the modelling process.” The New Zealand-born Mr Segaran and his partner, Jesper Andersen, are attempting to create a repository of data drawn from original financial statements, as well as a distributed modelling API intended to allow anyone to build, host and allow others to run a model. The Netflix-style leaderboard system, which allows credit and other financial models to be back-tested, is due for release by year-end. Over time it is hoped that the most useful models will rise to the top. The creators will gain credibility and can then start to work on monetizing their reputations. “The idea is to open the doors to do-it-yourself grass-roots models,” says Mr Brown. “Who knows? Maybe there’s an anthropologist out there with the right insights to create a better credit model.”

One obstacle to comparing the results of credit models is the inconsistency of the underlying data. Rating agencies publish voluminous information about methodology and the companies that they rate. What’s lacking, however, is a consistent, accepted and accessible set of data. “Every time you see a model it comes with its own data,” says Mr Brown. “Open-source sharing of financial data has to happen. The SEC wants it. Investors want it. The technology to parse financial statements, capture a consistent set of data and highlight inconsistencies is here. There’s no reason for it not to happen.”

Raising Capital in a New Era

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The implications for investors On the investor side, there is more selectivity about where to place funds. Nearly three-quarters (69%) of investors say they assign more weight to the financial strength of a company than they did two years ago. Says Curtis Arledge, co-head of U.S. Fixed Income for BlackRock’s Fixed Income Portfolio Management Group: “In the past, the strength of a company’s balance sheet was less critical as long as the economy was doing reasonably well. However, in today’s turbulent markets, examining a company’s balance sheet and relative position in an industry is extremely important.” Although investors will demand high risk premiums, investment-grade companies may be able to tap the fixed-income and private equity markets. Mr Arledge says the bonds of a number of companies represent a rare investment opportunity. “Many investment-grade corporations made significant progress in strengthening their balance-sheet positions during the period when credit was cheap and easily accessible, making them stronger companies and their bonds relatively attractive,” he says. The survey results supports Mr Arledge’s statements. Nearly half of the surveyed investors say that they will buy investment-grade debt, the most popular asset class. This compares to just 23% that say they will invest in high-yield debt.

Pension funds search their souls Prominent among investors that suffered the greatest losses are pension funds − major investors in long-term securities. According to research from International Financial Services London (IFSL), pension funds worldwide manage $25trn in assets, the vast majority of which is invested in equities and bonds. A loss of confidence among pension funds could have a significant impact on the companies in which they (indirectly, through hired asset managers) invest. And there is good reason to believe that pension funds will reconsider their portfolios. The value of pension fund assets fell 18% in 2008, according to IFSL, and the two largest pension funds in the U.S. lost considerably more than the worldwide average: the value of CALPERS’ assets fell 23% for the year to June 30, from $237.1bn to $180.9bn, while over the same period the assets of the California State Teachers’ Retirement System (CalSTRS) fell 27%, from $162.2bn to $118.8 bn. Even the most sophisticated and diversified pension funds could not fend off the impact of the economic shock. 1 “Pension funds pare stocks, ignoring economic rebound,” Alexis Xydias and Adam Haigh, August 17, 2009, Bloomberg News

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The survey shows that investors have consequently taken a cautious view of their performance prospects. About a one-third believe that pre-crisis levels of returns will never be seen again, and there is no consensus that global equity markets will recover even two years from now. Indeed, an August 2009 survey of the world’s ten largest pension funds shows four cutting equity allocations and five holding the share of equities steady (the remaining fund has no equity allocation target).1 As pension funds shift their strategies away from developed market equities, the staple of their portfolios for many decades, companies will be forced to look elsewhere.

Raising Capital in a New Era

Nearly a one-third of investors surveyed will allocate more to private equity over the next two years. However, some private equity executives warn that the asset class is unlikely to be able to split infinitive replace traditional forms of lending. George Anson, managing director at HarbourVest, which has raised $30 bn from investors and allocated it to private equity funds, says, “There is a lot of capital around that has been pre-committed for investment. But private equity is not a panacea. It has grown a lot but it is still just a pimple on the whole capital market system.” According to the publication Private Equity Intelligence, private equity funds raised $554bn worldwide in 2008, which represents about 1.4% of the capitalisation of the world’s public companies. The brightest spot is M&A, where nearly a third of investors surveyed (31%) expect the volume of transactions to rise. However, many of these transactions may involve distressed companies or industries that were already consolidating: the market for bankruptcyrelated deals reached record highs in the first half of 2009, according to figures from Dealogic. Only the second half of last year was busier globally.

Moving beyond traditional investments: The case of ABP ABP is a Dutch pension fund for government employees with €173bn in assets, slightly more than the largest U.S. pension fund, CALPERS. ABP was shocked by an unprecedented negative 20% return in its portfolio last year and is now revamping of its investment strategy. Harry Borghouts, interim chairman of the board of governors of ABP from March to August 1 of 2009, says: “ABP’s assets shrank and its liabilities grew – in common with many other pension funds.” In fact, ABP’s financial position deteriorated to such an extent that, by the end of the year, the ratio of its assets to liabilities had fallen to 90%, below the required minimum of about 105%. “The board of governors took the painful decision not to apply indexation to the pensions,” Mr Borghouts adds, referring to the inflation-linked increase in benefits that most pension funds apply annually. It is a rare occurrence for a well-run pension fund such as ABP to fail to index its benefits. The Dutch fund has since submitted a recovery plan to the regulator. The details of the plan should make every company seeking funding sit up and take notice, for ABP is looking partly to private equity and hedge funds in a bid to make good the losses. Fixed-income and developed-market equities will be scaled back, since ABP believes these will produce insufficient future returns. It is this aspect that could send a shiver down the spine of CFOs. If pension funds and the money managers they hire reduce investments in companies headquartered in developed economies, the pool of available finance will continue to shrink.

Raising Capital in a New Era

17

Conclusion Bubble, crisis, contraction, recovery – everyone knows the stages of the business cycle and its cousin, the credit cycle. If the events of the past year were part of a typical cycle, the capital-raising lessons would be straightforward: strengthen the balance sheet, embrace greater investor scrutiny, accept higher financing costs and stricter conditions, and be ready to act quickly when a market window opens. These are the time-worn lessons of the conventional wisdom, and they hold as true today as they did in 1982, 1991 and 2001. But this time is different, and the 2008–09 crisis offers several less intuitive implications as well. To survive and prosper, investors and issuers need to look beyond the obvious and embrace the longer-term trends that will prevail well after this downturn has ended. For instance:

2 “Off the charts: Around the world, stock markets fell and rose, together” Floyd Norris, The New York Times, September 12, 2009, page B1

• A  s the scepticism around the applicability of portfolio theory to the real world suggests, investors may be less willing to pay a premium for securities that offer conventional sorts of diversification benefits. “Whatever else you might want to say about the virtues of international diversification,” wrote Floyd Norris in The New York Times, “in this cycle it has done little to balance the risks of investing in any one market.”2 • On the other hand, the experience of ABP holds out the prospect of investors leapfrogging traditional fixed-income and equity in favour of more volatile and less highly-correlated asset classes (hedge funds, private equity). As pension funds and other institutional investors adopt more creative asset allocation strategies, new opportunities will arise for some borrowers, while others will suffer. • One-third of survey respondents predict growing experimentation with open-source credit modelling – an example of how a crisis of confidence can shake loose long-standing arrangements and drive new market-oriented approaches. As Aaron Brown of AQR Capital Management observes, if you give credit analysts a way to prove themselves, they will figure out how to monetize their reputation on their own. • As Francis Beddington of Insparo Asset Management suggests, financial markets follow the money, and the U.S. and U.K. may no longer be the world’s largest pools of liquidity. Moreover, survey respondents are far more pessimistic about the future growth and stability of the U.S. and U.K. financial markets than those of China, India or even Brazil. Enbridge’s decision to reach out to sovereign wealth funds throughout the world is only the beginning. The great shift is under way.

The details may be murky, but the broad outlines are clear. Capital-raising has become a contact sport. Companies will have to look farther, dig deeper and work harder to lock in the long-term capital that fuels growth. The lessons of previous downturns are still valid. Investors require balance-sheet strength and access to liquidity; borrowers need to lower expectations and accept higher costs. At the same time, a world in flux can be a world of opportunity. Creative approaches to capital raising are abound. It’s up to you to go find them.

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Raising Capital in a New Era

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