FinanceLab Magazine 9

MAGAZINE 9 - ISSUE SEPTEMBER 2014

The biggest IPO’s of 2014 Page 18

The largest mergers of 2014 Page 22

The significance of high-frequency trading in global markets Page 32

www.financelab.dk

FINANCELAB MAGAZINE

CONTENTS EDITOR’S LETTER

8

Abenomics - how the economy fares?

10

Credit derivatives - where do we go from here?

12 14 16

Determinants of Capital Structure

Draghi’s QE

Emerging Markets Outlook

18

The biggest IPO’s of 2014

22 24

The largest mergers 2014

Noise traders in financial markets - do they matter?

26 28

The significance of high-frequency trading in global markets

Significant PE deals 2013-2014

Summer internship in investment banking - what’s all the buzz about?

30 32

The Economics of FIFA - what’s in it for Brazil The significance of highfrequency trading in global markets

FINANCELAB • ISSUE SEPTEMBER 2014

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32

The biggest IPO’s of 2014

18

Noise traders in financial markets - do they matter?

24

Summer internship in investment banking - what’s all the buzz about?

38

EVENT CALENDAR

28

Who is FinanceLab? FinanceLab is a non-profit, voluntary interest organisation covering all major universities and colleges in Denmark with 1,900 registered members.

We are the prime point of contact between the financial industry and the academic world.

Thanks to Jacob Graubæk Houlberg Waleed Bashri Nina Olesen Ulrik Stig Hansen Edward Enoch Sosman Jacob Christensen Christian Smedegaard Andersen

Christian Nielsen Martin Lynge Rasmussen Iva Rakocevic Julie Helm Trige Starklit Maria Ilyas Katrine Jensen Monica Wong

Layouter

Editor

Frederik Ploug Søgaard

Jens Brøchner Grosbøl Poul Kotiah Hansen

Oskar Harmsen Morten L. Siggaard Emil Ignatzi Reinholdt Kristin Horn Anni Fong Daniel Fleischer S. Nadine Raida Bo Laursen

FINANCELAB • ISSUE SEPTEMBER 2014

Contributors

03

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07

ABENOMICS How the economy fares?

By Jacob Graubæk Houlberg and Waleed Bashri

A

FINANCELAB • ISSUE SEPTEMBER 2014

fter Shinzo Abe’s election, the land of the rising sun seemed poised to rise again – ready to break out of 20 years of stagnation.

The stock market rose nearly 35 percent after his first four months in office, businesses in Japan were considering expansion for the first time in years and Tokyo’s property market started to resuscitate as well. This was all part of Abe’s bold break with the failed policies of the past.

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still that the GDP of Japan has reverted from a negative growth of -0.5% in 2011 to a positive growth of 1.5% for the year 2013 indicating at least a somewhat brighter future.

Through Abenomics, the aim is to resuscitate the Japanese economy with “three arrows”: a massive fiscal stimulus, more aggressive monetary easing from the Bank of Japan, and structural reforms to boost Japan’s competitiveness. Along the way enthusiasm went missing. The stock market dropped sharply and consumer confidence fell. Some blamed the uncertainty over the election for Japan’s Upper House in the following July 2013. Abe’s political party Liberal Democratic Party has since won the election and all political power came into Abe’s favor, after which the market rose above its previous levels, and thereafter stagnated.

Another part of the quantitative easing was an intention to kick start the Japanese economy via several means, one of which would be a decline in unemployment rate. This would once again be achieved by the use of quantitative easing as a rise in inflation usually leads to a lower unemployment rate. However while unemployment has marginally risen from 4.00% in December, 2012 to 4.40% in May, 2014 the inflation has risen from 0.39% in the beginning of 2013 to an average inflation of 2.33% in 2014. A probably reason for the lack of effect on unemployment rate is the ultimatum presented by Abe, as he famously announced that the quantitative easing will continue until Japan reaches a suitable level of inflation. The result of this is an expected inflation, due to the promise of an ever-increasing monetary base, which has a smaller bearing on the unemployment rate.

Dominant macro economic theory suggests that exports are negatively correlated with exchange rate. This notion is one of the driving factors behind the reasoning for such a massive quantitative easing that Abenomics is a proponent for, as the quantitative easing is supposed to create inflation and devaluate the Japanese Yen. While the money base has gradually risen from ¥132tn ($1.3tn) to ¥224tn ($2.2tn) since the introduction of Abenomics in December 2012, the export has actually decreased by 15 percent. While this gives an ambiguous picture of how the Japanese economy fares, the bottom line is

Nontheless the effect of the quantitative easing is reflected in the Japanese stock market. A stock market is not necessarily always a good indicator of the stability and growth of a country’s economy, but it still projects the overall predictions from an investor’s perspective. A sharp rise in a stock market is however not without risks as markets which rises quickly are prone to creating speculative bubbles. So even if Abenomics manages to be the lifebuoy that lifts the Japanese economy out of the two lost decades it still comes with the possibility of creating massive instability if an asset bubble were to occur

and if this bubble would not be deflated in a timely and orderly fashion.

Japanese Prime Minister Shinzo Abe has unveiled his long-awaited structural reforms or the so-called “third arrow”. A preliminary version of the plan, announced last summer, was met with disappointment in international financial markets. The new version covers more of the issues Japan faces. Fresh proposals include a review of the massive government-run pension system’s investment strategy to direct more of the money into Japanese stocks. Among the most important of the reform measures is a cut to the corporate tax closer to the OECD average of 25% from the current level of over 35% from next year, 2015. To counter the country’s labour shortages due to the aging population and low birthrate, it also includes an easing of the immigration policy to promote greater use of foreign policy and measures to promote greater gender equality in the workforce.

Lastly, another possible cause for the poor response on some fronts from Abenomics could be due to a lag that is often present when introducing new policies. The rise in the Japanese stock market and the overall growth in GDP could however prelude an increase in other factors as well, such as employment rate and export.

There do however lie other challenges ahead for the Japanese economy besides breaking out of the stagflation that overshadowed the last two decades, namely its changing demographics. There are two inherently problems with the changing demographic of Japan, it is shrinking while simultaneously growing old. This poses several long-term problems that may dwarf even the stagflation of the past.

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09

CREDIT DERIVATIVES Where do we go from here?

By Nina Olesen and Ulrik Stig Hansen Since its inception in the beginning of the 1990’s, the market for credit derivatives has had a remarkable journey. Not only has the notional amount of debt underlying cred-

it derivatives ballooned until its collapse in 2008, but so has the complexity of the credit derivative products. During the latest financial crisis, the collapse of the

credit derivative market has been identified as one of the main reasons leading to this worldwide turmoil.

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n the early 2000’s, credit derivatives were very popular and in 2006, the market peaked with a global issuance amounting to more than $500 billion. During this period, because of the great popularity of the CDOs build on mortgage-backed securities, the supply began to dry out. This created an incentive to develop synthetic-CDO’s, which weren’t

restricted by the number of actual mortgages. Several investments banks came to prefer synthetic-CDOs, because they were more cost efficient to construct. In 2008, the credit derivatives market crashed following the emerging subprime mortgage crisis, and the market has not been close to reach the same level since.

There is an on-going debate as to

what caused the market to crash and how it came to grow so large, and while there might be many identifiable causes for the collapse in the credit derivatives market, the methods used in pricing them have been under accusation of being one of the primary culprits.

It is easy to get puzzled by the fact that the market for credit derivatives was able to grow so large with only few people finding cause for alarm.

Following the global financial crisis, it has become evident that the models used to price complex financial products, such as credit derivatives, have failed miserably in providing an accurate measure of the underlying value in these types of products, causing a severe mispricing of risk. It is widely agreed that the fallacies of these models have caused the market for these products to grow larger than it otherwise would have.

So how are these pricing models constructed? The common feature in all credit derivatives pricing models is that they in some way assess the statistical probability of default. This is a daunting task, since such calculations are based on information that can be difficult to obtain and that the credit derivatives market is highly opaque, making it difficult to monitor the price of the underlying credit obligation. The task is complicated further by the difficulties in quantifying credit worthiness, lack of empirical data and that readily obtainable data is often corrupted.

One of the most widely used methodologies in pricing is the Gaussian copula, which almost became industry standard prior to the financial crisis, and subsequently ended up taking a big part of the blame for the disastrous meltdown of the credit derivatives market. In a world growing ever more complex, the method offers relative simplicity, lax data requirements and a way to deal with default correlation in complex instruments – key tenets of its success. For two securities A and B, only three parameters are needed: the probability of default of A and B and the default correlation between them. That is, given a statistical probability of default of A and B, what is the probability that they will both default given specific default correlation. Now, using a Gaussian copula, historical default data is not required and it is possible to make use of historical market pricing data of credit default swaps (“CDS”) instead. This follows the reasoning that if the price

Yet another, and perhaps the most toxic assumption of the Gaussian copula, is that the huge number of loans that could make up one pool had only a single default correlation parameter, flattening information on thousands of pairwise correlation parameters into just one. For example, if a pool of loans is made of three tranches, the top-tranche being the pool of loans with the highest credit worthiness and thus lowest statistical probability of default, the middle tranche with the second-highest and the bottom tranche with the highest, they would share the same default correlation. This leads to a misrepresentation of the probability of the occurrence of extreme events, such as the 2008 financial meltdown, and the possibility that the whole pool of loans might turn out to be worthless following a credit event.

too heavy concentration and speculation on real estate, flawed accounting rules and too heavy reliance on rating agencies. Despite the market being on its knees for the last few years, a comeback might lure around the corner. In a world of cheap credit that does not seem to end in the near future, the market could be heading for a strong comeback.

In hindsight, these assumptions were optimistic. However, quantitative analysts has been aware of the limitations and inherent shortfalls of the method, both now and before the crisis – and despite the “bad press” it has gotten following the crisis, it is still the most widely used method to price credit derivatives and cannot be blamed solely for the recent crisis.

Where are we heading?

Credit derivatives have become an important financial instrument in the global financial system, as they have given the opportunity for cheaper credit and improved the efficiency of capital allocation. The idea of pulling together loans into tranches made it possible to invest in a desired level of risk – however, as people started to speculate in defaulting loans, it put pressure on the financial system and made it unstable.

With regards to the 2008 meltdown, credit derivatives are solely responsible for the crisis. There were also issues with lack of liquidity and reserve policies (especially in central banks),

FINANCELAB • ISSUE SEPTEMBER 2014

Default is king

of a CDS increases, so does the risk of default. This implies imposing an assumption that the market is able to price risk correctly, using pricing data rather than actual default data.

11

Determinants of Capital Structure

By Edward Enoch Sosman and Jacob Christensen

Introduction When forming an opinion on the market value of a company, investors are often basing this on some form of corporate valuation. This can be approached in several different ways, but most common are methods based on present value models. Therefore, part of com-

pany management is about optimizing the parameters that the present value models use to estimate value of the company. One of the most important parameters is the company WACC, which is the weighted average of debt and equity cost of capital.

The purpose of this article is to investigate the factors that affect the capital structure choices of Danish publicly traded companies and discuss which other factors might be relevant for managements to take into consideration.

Study finds that capital structure is not significant for many Danish companies

FINANCELAB • ISSUE SEPTEMBER 2014

Despite the importance of capital structure for the value of a company, a study from 2012 by the DIRF (The Danish Investor Relations Association) found that only 65% of the investigated companies have an actual capital structure policy1. Furthermore, a study from 2007 by FIH Erhvervsbank found that even large corporations such as A.P. Møller A/S, H. Lundbeck A/S and Novo Nordisk A/S did not have a target capital

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structure2. These findings give rise to the question of why managements in publicly traded Danish companies do not emphasize capital structure policy more when it is a factor of great importance to the value of the company.

According to the DIRF study, a possible explanation is that other drivers than the traditional theoretical factors are more important when deci-

sions are made about how to finance an investment. In fact, by far the most important driver is the degree of financial flexibility, which 79% of the companies in the study regarded as very important. More traditional factors such as the tax shield of taking on debt, bankruptcy cost, and informational asymmetry are only of minor interest when decisions are made regarding capital structure, according to the study.

Many of the traditional drivers of capital structure are affecting corporations in Denmark Despite the results from DIRF, it is possible that the traditional factors are affecting the capital structure decision to a certain extent. To further examine whether this is the case, thorough research was conducted on 18 publicly traded Danish companies in two very different branches; the shipping industry and the pharmaceutical industry. Following the 1. Borberg & Motzfeldt 2. PFA Pension, 2007, s. slide 6

seminal paper of Titman & Wessel (1981), the particular importance of six factors was examined. These factors are volatility, asset composition, profitability, product uniqueness, growth potential, and company size, which are all predicted by theory to influence capital structure decisions.

When testing for the significance of

these factors in the period of 20022012, it turns out that earnings volatility, asset composition, profitability and company size are indeed influential. However, product uniqueness and growth potential are not significant, which is contradictory to theory.

This result is somewhat surprising, given earlier research by Qio & La (2010) and Frank & Goyal (2009)

showing that companies that sell unique products are not using the tax advantage provided by debt in to same extent as other companies, at least on the American and Australian market.

Regarding how companies’ growth

potential affects capital structure, Qio & La (2010) and Fama & French (2002) research show that there is a negative relation between the ratio of debt and growth potential. Thus, companies with many investment opportunities will often have a lower debt ratio.

Based on the trade-off theory and the pecking order we will in the following explain, why Danish companies should consider product uniqueness and growth potential when choosing their capital structure.

According to theory product uniqueness and growth potential should affect companies’ capital structure

According to the trade-off theory, high profitability and high earnings volatility affect the capital structure in two different directions. High profitability affects the debt-equity ratio positively and high earnings volatility affects the debt-equity ratio negatively. Thus, according to the tradeoff theory it is ambiguous how prod-

uct uniqueness should affect capital structure.

If it is assumed that companies that mainly sell unique products, also are profitable then these companies will, according to the pecking order theory, mainly use internal cash when making investments and thereby have a low debt-equity ratio.

High growth potential is valuable for companies; however, when companies go bankrupt it is not possible to convert growth potential into cash, which increases the indirect distress costs. Thus, according to the tradeoff theory, growth companies should have low debt-equity ratios. In contrast, the pecking order theory predicts a positive relation between the

debt ratio and growth opportunities.

Companies that make many investments often need debt financing in order to finance their projects. Thus, the pecking order theory predicts growth companies to have a high debt-equity ratio.

Our analysis shows that the conclusions of the trade-off and the pecking order theory are contradicting when determining how product uniqueness and growth potential should affect companies’ capital structure. The missing consensus in theory may be a reason for why managers disregard these factors when determining their companies’ capital structure.

Conclusion Although DIRF’s study found that managers find factors such as financial flexibility more important than the traditional theoretical factors when determining capital structure, our research shows that most of the traditional factors do affect compa-

nies’ capital structure. Furthermore, our research finds that factors such as product uniqueness and growth potential do not affect capital structure, although these factors according to theory and earlier research should affect capital structure. There-

fore, it might be the case that Danish managers do not regard these factors when determining their firm’s capital structure and thereby they might not fully optimize the market value of their firm.

FINANCELAB • ISSUE SEPTEMBER 2014

Unique products are often sold at high margins instead of high turnover rates. Therefore, companies that are selling unique products are often profitable and have high earnings volatility, since revenue drops when a product goes out of fashion or becomes obsolete. However, exceptions exist e.g. some design objects have long lifecycles and low earnings volatility.

13

DRAGHI’S QE

By Christian Smedegaard Andersen & Christian Nielsen

FINANCELAB • ISSUE SEPTEMBER 2014

The European recovery got off to a disappointing start in the first half of 2014 as GDP rose by just 0.2% across the 18 euro-states. The forecast for the future looks better, but the recovery remains fragile. To support the recovery, the European Central Bank has been undertaking various initiatives to stimulate the economy. With the use of LTRO and most recently the introduction TLTRO’s Draghi is sticking to his commitment of doing whatever it may take to save the European economy from a prolonged recession, stagnation or deflation. At this point though, scepticism about TLTRO’s and their effectiveness has already arisen. The uptake of TLTRO’s among European banks seems to be far below Draghi’s initial expectation of 1trn euro. This indicates that the ECB might need to take more drastic measures: Quantitative Easing (QE).

14

Draghi’s plan The ECB cuts its reserve-deposit rate for banks from zero to -0.1% to increase the money supply of the banks, as well as cutting its benchmark interest rate from 0.25% to 0.15% by making open-market operations.

This is done to inject liquidity into financial markets and thereby encourage banks to lend to businesses.

The hope is for an increase in investments, which can help the economy back to its potential output level.

There are obvious limits to this policy. As people have the option of holding money rather than loaning it out, the nominal interest rate can never fall below zero. Due to this, additional increases in the money supply cannot reduce the rate further, rendering conventional monetary policy ineffective. This is often referred to as a liquidity trap.

Draghi’ plan of increased consumption and investments has more or less failed, as private consumption only exhibited marginal growth in the first half of 2014.

When the Central Bank has pushed the interest rate close to zero, a different strategy has to be deployed: the QE.

Quantitative easing from a theoretic perspective Quantitative easing has been a widely used term since the global financial crisis hit in 2008.

Central banks pursuing QE buy assets

– typically government bonds – using “printed” money. The institutions’ increased money supply from the sales of bonds are used to invest. Due to the increased demand in government bonds, they become a weaker investment. Consequently, institutions use the proceeds to invest in other companies or lend to individuals.

Typically, QE convinces the market of the fact that the central banks are willing to fight deflation or increased unemployment. The raised confidence in the economy boosts economic activity further. However, there are certain risks that one should be aware of. Listing the pros and cons, it becomes evident that central banks have to strike a balance in order to gain optimally from QE. As mentioned above, a benefit of QE is that it can encourage lending and borrowing, and thereby increase spending. There are also other benefits in terms of job creation, and the Fed has argued that QE can be used to create jobs since businesses should end up with more cash on hand to finance new hiring.

The abovementioned reasons for pursuing QE makes sense in theory. Nonetheless, the benefits have been criticised for only providing short-term gains. In the longer term, economists fear that QE can lead to inflation. High inflation happens as

the economic situation is a well-discussed topic, dividing economists into groups due to the complexity of defining the success parameters.

Another risk concerns the value of the local currency. As this – practically speaking – is printed money that is used to buy goods abroad, foreign countries begin to devalue the currency. There have been examples where countries regret to recognize the importer’s currency, because it is regarded as a printed piece of paper.

Estimates from macroeconomic models elaborated by the Fed and the Bank of England show that, compared with scenarios where no such action has been done, the QE programs in the US and UK have improved GDP by between 1 and 3 percent, reduced the unemployment rate by about 1 percentage point, and prevented deflation.

Finally, QE encourages large portions of debt because of the large money supply and the low interest rates.

Some debt stimulates the economy, however, excessive amounts of debt can further aggravate an already weak one. When the central bank stops printing money, the economic recovery can be put on standby, in spite of the hopes that increased consumer confidence will trigger a true recovery. The consequence is evident in the equities markets, which tend to dive when signals of ending QE are present.

Effectiveness of the QE-program Whether previous QE-programs have shown to be an advantage for

Furthermore, the policies have increased household wealth held in fixed income in the United States by up to $5.6 trillion due to the ultra-low interest rates.

This meant that central bank action helped to stabilize the financial system and heal the wounds from the financial crises.

On the other hand, lower rates have reduced interest payments for borrowers but have diminished the interest income of savers. This fact has caused a large distributional effect.

By the end of 2012, households in the UK and US had lost $630 billing in net interest income while the governments have benefited.

On top of this, many banks have experienced continued erosion in their profitability, putting many of them

under financial pressure. In the long run, this may affect bank consumers.

There is greater uncertainty combined with the QE-programs, as the success is contingent on a variety of factors. A reduction in the interest rate will, for example, have a greater impact if the market participants believe it will be held for some time.

Furthermore, there are issues regarding price stability and level of financial leverage of the banks.

It seems reasonable that central bank actions in the form of QE helped to stabilize the financial system and dampen the recession. Whether it is going to work in the Eurozone depends on the ECB and Draghi’s ability of communicating a credible forward guidance combined with an increased trust in the financial system.

Of course, the TLTRO’s also remain an important factor for determining whether QE is needed. For now though a broad based asset purchase programme cannot be ruled out.

Quite contrary, it seems as though it may very well be needed.

FINANCELAB • ISSUE SEPTEMBER 2014

money supply in the economy is increased, and because the supply of goods is constant, prices rise, which leads to inflation.

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Emerging Markets Outlook

By Martin Lynge Rasmussen & Iva Rakocevic

Emerging markets are currently experiencing continued net inflows of capital after having experienced significant outflows in mid-2013. In June 2013, tapering of quantitative easing (QE) in the US led to outflows from emerging markets, which increased the likelihood of US rate hikes.

tainable credit expansion, credit expansion declined to its lowest level in eight years. Despite positives, China’s finance minister recently stated that a growth rate of 7.5% is not a floor, providing a reminder that worries about underperforming Chinese growth are still real.

When the US government increases interest rates, even if done before expected, such change would result in a smoother change of money flow than seen in 2013, according to Steven Englander of Citigroup. Currently, US rates are not expected to increase until mid- to late 2015, leaving plenty of time for EM to recover. As previously, investors worldwide turn to emerging markets in search for higher returns as developed markets suffer low growth and rates. This article aims to explore current issues in EM equities, but is neither an attempt to cover all countries nor themes.

Chinese equities have significantly underperformed in the past few years, yet is starting to receive increased attention due to low valuations and a stabilizing outlook. The MSCI China Index is currently trading at 10 times earnings, and is forecasted to trade at 9.8 times for 2014, in contrast to a 10-year average of 13.8.

According to our research, influential investors have started having a more positive look on China.

FINANCELAB • ISSUE SEPTEMBER 2014

With emerging market growth - predicted at 4.9% for 2014 by IMF - outstripping the expected developed market growth of 2.2%, companies and governments have a strong foundation to improve fundamentals from. Although a general slowdown and structural issues in EM growth are valid concerns, fundamentals in EM are nonetheless more attractive than in developed markets.

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China In July Chinese production activity hit its highest level in 18 months, suggesting that actions such as expansionary monetary policy and infrastructure investments has allowed China to avoid a hard landing.

Despite the economic growth, China saw its real estate prices decline by 29% year-over-year in the second quarter, easing fears of a real-estate bubble. Regarding fears of unsus-

Reasons for optimism include that valuations have been depressed due to lack of market confidence. Confidence in the market could be changing as the government carries out significant reforms of capital markets along with privatization of stateowned enterprises.

India India recently welcomed a new prime minister, Narendra Modi. Modi has been positively received for his ability to deliver results throughout his political career, although certain critics say that current reforms contain little change from previous policy. Despite the fact that Modi’s promise is yet to be fulfilled, his investor-friendly attitude rightfully spurs cautious optimism.

Indian equities jumped more than 20% in the first half of 2014, and inflows surged from $354 million in the first two months of the year to $8.9 billion between March and June. Despite long-waited triumph about India’s outlook, investors are starting

to reconsider further investments.

One major reason cited is that investors would like to see more specific details of how Modi will turn the inefficient, inflation-ladden economy back on track. While it is unlikely that new policies will lead to quick fixes, long-term investors might place faith in Modi’s ability to move India closer to its potential.

ASEAN As for ASEAN (The Association of Southeast Asian Nations), current optimism is based on the initiation of the ASEAN Economic Community in 2015, which will allow for further integration of markets and economies.

In May, Thailand experienced a military coup, something that has been well received by investors, as the coup is expected to increase stability.

The MSCI Thailand index is already up by 12.9% since its low in May. Despite initial short-term optimism and stability, it has been questioned whether the military overthrow will result in longer-term stability and development. Although Thailand’s economic outlook have improved recently, it could still be questioned to what extent stocks are adequately discounted for risks associated with longer-term political development.

Indonesia is currently in an uncertain stage as Prabowo, who initially lost the presidential election, has contested the win of new president Joko Widodo. Furthermore, Indonesian stocks are surprisingly expensive given its uncertain outlook and poor returns for equities. The price-book ratio of the MSCI Indonesia Index is currently 2.23 times higher than the MSCI Emerging Markets Index, a high valuation given that the index has decreased by 11.42% in the past year.

In the Philippines stock prices continue to rise amid a credit rating upgrade

Eastern Europe In Eastern Europe a tense geopolitical situation caused by Russian aggression has increased risks of sanctions, despite subsiding risk of military action. Actions against Russia carries significant risk of spillover effects for emerging Eastern Europe, one reason being the reliance of Eastern European countries on Russian energy.

Emerging Eastern Europe (Czech Republic, Hungary, Poland and Russia) is currently valued at a low expected price earnings ratio of 7.2 for 2014, compared to emerging markets overall, which is at 13.7. One reason for the low valuation is the current geopolitical environment, where there is substantial probability of risks being realized. While this author finds the current environment discouraging, certain investments could remain attractive. Value investors could consider companies that derive a majority of earnings from countries shielded from current geopolitical issues - it could be interesting to explore whether such companies have been unduly discounted due to current risks.

MENA In the Middle East, Qatar and UAE are expected to see net capital inflows increase as they were upgraded from frontier market to emerging market status by MSCI. The upgrade provides a quality stamp for the two markets, likely leading them to be seen as more attractive by investors.

Another Golf-country that will receive

increased attention is Saudi Arabia, whose stock market will be opened to foreign investors in early 2015.

For Turkey, this author argues that the increased reliance on trade with the Middle East has developed into a vulnerability given renewed tension in places such as Syria, Iraq and Israel/Palestine. Elsewhere, South Africa has seen a downgrade in its credit rating by both Fitch and Standard & Poor’s, citing an expected inability of the newly elected government to undertake labor and economic reforms.

In MENA, non-Gulf countries are expected to perform less well than their Gulf counterparts as they are undergoing a series of challenges and issues. Gulf-countries are expected to perform well due to strong oil prices, generous government spending, and for some, a healthy private sector.

For Gulf-countries, non-oil GDP is expected to rise by 5.5% for 2014, half a percentage point higher than for 2013, suggesting healthy fundamentals that are diversified beyond oil.

The upgrade is expected to result in inflows of emerging market allocations from passive funds, although analysts have pointed to volatility.

Analysts have argued that similar upgrades have caused equities to outperform in the 12 months after being announced, but underperform in the 12 months following the upgrade being made effective. One reason mentioned for such market behavior is that weaknesses surface due to increased attention.

Latin America Latin America is currently undergoing a harsh period, with current predictions putting growth for 2014 at its lowest level since 2009. In addition to overall unimpressive fundamentals, Argentina defaulted on August 1.

Despite focus from the 2014 Football World Cup, investors do not favor Brazil. Brazil is experiencing stagflation consisting of a 1.1% growth rate (... and inflation of 5.9%) in 2013 and is expected to achieve a growth rate of no more than 1% in 2014. Reasons for the weak growth include that low investments in basic services is preventing significant productivity increases. Although Brazilian funda-

mentals are not encouraging, valuations are low – it is the cheapest market in Latin America. In more specific terms, Brazil’s 12-month forward P/E is 3.8% below that of emerging markets as a whole, and its P/BV is 8.5% below emerging markets overall.

While valuations reflect fundamentals, investors willing to search for companies with long-term potential might find bargains.

Meanwhile, Mexico is increasingly seen as a top Latin American destination for investment, based on its ability to carry out strong reforms and increasing economic growth.

Despite Mexican growth amounting to only 1.1% in 2013, reforms should allow growth to rebound from 2014 onwards. While Mexico’s reforms are bold and should improve long-term performance, the 12-month forward price-earnings ratio for the MSCI Mexico Index is currently 68% above that of the MSCI Emerging Market Index. Despite being a compelling reform-story, prospective investors might question to what extent current valuations are warranted.

Conclusion While the early 00’s saw many investors attracted to emerging markets based on rising commodity prices, falling interest rates and promise of future potential, deep structural issues are receiving increasing attention. This author argues that emerging markets going forward will be assessed less on their promise and more on ability to improve fundamentals.

2014 so far has seen China avoid a hard landing and multiple elections.

While overall sentiment towards new political leadership has been positive, the coming period will show whether politicians are able to execute structural reforms.

This author argues that investors able to stomach volatility should search for companies strong enough to withstand medium-term austerity as governments undertake reforms.

While such companies could still be subject to volatile market sentiment, economic moat could allow such investments to deliver over time.

FINANCELAB • ISSUE SEPTEMBER 2014

by both Moody’s and S&P, something considered a major driver behind stock prices. Since 2010 the country has seen a new president, Benigno Aquino, drive forward substantial reforms, most recently with a relaxation of foreign direct investment in late July. One worry for prospective investors is whether the market is overvalued. The MSCI Philippines Index has the highest TTM PE-ratio in Southeast Asia at 24.6, compared to 15.6 for the MSCI Southeast Asia index, encouraging investors to reexamine fundamentals.

17

The biggest IPOs of 2014

By Julie Helm Trige Starklit and Maria Ilyas

FINANCELAB • ISSUE SEPTEMBER 2014

2014 opened successfully and continued to recover to end the first half of the year strongly. The highest amount of capital was raised since 2007. A total of 588 deals raised around USD 118 billion, which is an increase of more than 60% on the same period in 2013. The strong recovery is expected to continue in the second half of 2014.

18

The biggest IPOs of 2014 – Asia takes the bulk Japan Display Inc. went public on Tokyo Stock Exchange in March 2014 with an offer size of USD 3.13 billion, making it the biggest IPO in the first

half of 2014. Japan Display, a worldwide manufacturer of small and medium sized LCD displays, was established through the merger of Sony Mobile, Toshiba Mobile and Hitachi’s LCD display divisions. The offering is the biggest in Tokyo since drink giant Suntory’s food-and-beverage unit raised USD 3.9 billion in 2013. However, the share plunged on its Tokyo debut and has since dropped by 30%.

Issue Month

Issuer

Issuer Origin

Sector

Business Description

Offer Size (USD bn)

Exchange

March

Japan Display Inc.

Japan

Industrials

Manufacturer of smartphone and tablet screens.

3:13

Tokyo

January

HK Electric Investments Ltd.

Hong Kong

Utilities

Investment trust and supplier 3:11 of electricity.

Hong Kong

July

NN Group NV

Netherlands

Financials

Insurance and investment management.

Euronext Amsterdam

June

AA Ltd.

Britain

Diversified

Car insurance and road assis- 2:33 tance.

London

May

JD.com Inc.

China

Communications

Consumer focused online retailer.

NASDAQ New York

2:42

2:05

Source: Bloomberg, ThomsonOne, Company websites – July 2014.

The IPO of HK Electric Investments comes in second with an offer size of USD 3.11 billion. However, the share has performed better compared to Japan Display, trading at -3.85% offer to date.

The IPO of NN Group NV, the biggest Dutch financial services company, is the largest flotation in Europe and the third largest globally with an offer size of USD 2.42 billion.

AA Ltd., a car insurance and road assistance company, had the fourth big-

gest IPO in the first half 2014. The offer size of USD 2.33 billion resulted in the exit of its private equity owners.

The share price has almost remained unchanged since the offering.

JD.com Inc. is a leading consumer fo-

cused online retailer in China, which got listed in the US. The company is the fifth biggest IPO and the largest Chinese IPO in the US since 2003 with an offer size of USD 2.05 billion. With a return of 44.11% offer to date its

share is the best performing among the five biggest IPOs. Also, the company belongs in the communications sector, which is the best performing sector in the first half 2014.

Furthermore, China-based Alibaba Group Holding Ltd., plans to list its shares on the New York Stock Exchange. With an estimated value of about USD 168 billion, Alibaba could be the largest-ever IPO in the U.S.

IPO performance

45% 35% 25% 15% 5% -5% Japan Display Inc

HK Electric Ally Financial Inc NN Group NV Investments & HK E

AA Ltd

JD.com Inc

-15% -25% -35%

Asia-Pacific leads by deal volume Asia-Pacific saw more IPOs in the first half of 2014 than any other region.

Four of the 20 largest IPOs in the period took place on Asian stock exchanges — three IPOs on the Hong Kong Stock Exchange and one on the Tokyo Stock Exchange. While the reopening of the Chinese IPO market in January 2014 contributed to the strength in the region, the market was shut down again since several Chinese companies that started trading were halted after gains exceeded limits set by the exchange. In addition, some companies postponed their listings after the China Securities Regulatory Commission (CSRC) stated concerns on high offering prices and high percentages of sales of secondary shares. Thus, Mainland China exchanges remained closed to new listings for much of the second quarter. During this period, a number of Chinese companies got listed overseas, such as e-commerce

company JD.com. The CSRC restarted the Chinese IPO market once again in June after some key amendments to the new listing rules. Ten companies were allowed to list on the Shanghai and Shenzhen stock exchanges. The reopening of the Chinese IPO market and the very strong pipeline of companies ready to go public bodes well for Asian IPOs in the remainder of 2014. With a further 100 Chinese companies now expected to be listed in this year and deal activity across a range of markets in the region, including Hong Kong, Japan and Australia, the mood is one of optimism for the second half of the year.

Financial sponsors a key driver behind activity across multiple sectors A look at the sector allocation of the first half of the year reveals that

different industries are represented. Also, the top five biggest deals are all from different sectors. While this highlights investors’ willingness to consider opportunities regardless of sector, it also underlines the key role of private equity (PE) and venture capital (VC). Financial sponsor-backed exits have been a critical factor in the recovery of IPO activity.

In EMEIA, the effect accounts for 25% of deals by volume and 51% of capital raised. In the US, the effect is even more noticeable: PE- and VC-backed listings accounted for 64% of IPOs by volume and 81% of proceeds, including nine out of ten of the largest listings in the period.

FINANCELAB • ISSUE SEPTEMBER 2014

Performance offer-to-date, Source: Bloomberg, July 2014.

19

Sector allocation

30% 25% 20% 15% 10% 5%

Market share

FINANCELAB • ISSUE SEPTEMBER 2014

The Consumer sectors comprise the biggest number of IPOs, while Communications, Materials and Energy comprise the best performing ones.

Also, there is an indication of a negative correlation between the number of IPOs and performance of these.

An explanation might be that the environment allows companies in some sectors to charge a higher price when entering the market, which decreases the chance of a strong performance following the issuance. Contrary, some sectors seem to be lower valued, which increases the possibility of large rises in the share price. High IPO prices are attractive for the previous owners of a company, while

20

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low IPO prices are attractive for the investors.

Future outlook is bright The second half of 2014 is likely to be characterized by a period of normalization for the global IPO market.

Stock indices around the world are trending higher, levels of volatility are low, and economic indicators are encouraging. Investor confidence has been further bolstered by the predominantly solid aftermarket performance of companies that have

gone public and the robust pipeline of IPO-ready businesses, indicating that there will be no shortage of opportunities in the remainder of 2014.

All the indicators are that the upward trend in activity is sustainable. However, despite the increase in deals, pricing has come under pressure, suggesting that investors are displaying a savvy and commendable level of caution. They are not prepared to invest in deals that are overvalued, which means that now more than ever those companies that come to market at the right time with the right growth story will attract investor interest only if they are prepared to ask the right price.

Become an active member of FinanceLab It’s not the money.

It’s the magic.

21

The largest mergers of 2014

By Katrine Jensen and Monica Wong

W

ith the favourable conditions of low interest rates and positions of high cash levels, boardrooms finally regained confidence and as a result the first half of 2014 witnessed the long-waited boom in M&A activity. With deals summing to $1.6bn for the first half-year, M&A activity has reached pre-crisis levels and is again marked by larger deal sizes. As of June 2014, 18 megadeals were announced.

FINANCELAB • ISSUE SEPTEMBER 2014

Consolidation in the technology, media and telecommunications (TMT) industry

22

The largest deal this year and the third largest deal ever in the media industry was announced in February 2014, when Time Warner Cable accepted Comcast’s offer of a friendly takeover stock-for-stock transaction of $45.2bn. This corresponds to an 18% premium and a transaction value of $68.4bn. The announcement came after Time Warner Cable’s rejection of the offer from the competitor Charter Communications, who had pursued the takeover for months, but lost the bidding war with a $37.8bn bid, deemed a ‘low ball offer’ by the target’s board of directors.

The deal complements Comcast’s $16.7bn acquisition of the remaining half of NBCUniversal last year and the company is now approaching a market share of one third both within its pay-TV and Internet businesses.

In late April, Comcast further announced a three part, tax-free deal with an estimated value of $20bn with Charter Communications. This deal consists of selling, swapping and spinning out a total of 3.9m of Comcast’s subscribers as a part of

their plan to divest some of their subscribers in order to get the merger approved more quickly. A US market share of 30% is the horizontal ownership cap that has been vacated twice by the courts. The deal is expected to be completed at the end of the year with the approval from the FCC being the last hurdle.

As a direct response to this merger, AT&T and DirectTV announced in May 2014, that AT&T will acquire DirectTV for $48.5bn in equity value as an attempt to keep its competitiveness in the telecom industry. The deal is yet to be approved by the FCC, who will have to consider the strength of the new company’s position as a content distribution leader across mobile, video and broadband platforms. In general, the megadeals in the TMT industry are connected to higher valuations of the companies that could end up as the new bubble.

Global Pharma, Medical & Biotech (PMB) are back in the game Companies in the PMB industry are pressured in terms of increasing scale, differentiating and getting more efficient. In the US, this pressure primarily stems from implementation of disruptive healthcare policy reforms, consumer demand for product scope and domestic tax disadvantages. The pressure has led to a boom in PMB M&A activity, which reached the highest level since 2001 with total transactions worth $260.2bn in the first half of 2014. This value is higher than the annual value for the last eight years and is primarily driven by six megadeals announced so far.

The latest and largest deal is AbbVie’s unsolicited acquisition of Shire in a

deal valued at £31.9bn. The media considers it a prime example of an acquisition driven by tax inversion.

Tax inversion refers to shifting or “inverting” the domicile of the company outside the US in order to gain tax efficiencies. Further, there has been speculation that this motive is a significant driver of the fierce increase in deals, as companies sprint to land cross-regional deals while they can amid fear of the window closing due to heightened political scrutiny of foreign acquisitions. AbbVie’s financial advisor, J.P. Morgan Chase, also worked with Pfizer in their failed bid to acquire AstraZeneca, which was also motivated by tax-efficiencies.

While tax efficiencies can also be attributed to the third largest PMB deal: Medtronic’s $46.2bn acquisition of Covidien, the main drivers of the deal were the need for scale and product span in dealing with margins under pressure from changes in the US healthcare system. The deal will combine the world’s largest standalone maker of medical devices with a maker of surgical devices and create a close rival to the market leader, Johnson & Johnson.

Others are on the move too Construction and Tobacco Megadeals have also been announced outside the TMT and PMB industries with the most significant being the Swiss construction company Holcim’s acquisition of the French construction company Lafarge. The all-stock deal worth EUR 27.3bn was announced in April. The new company will have the number one position globally across cement, concrete and aggregates. In order to gain approval

for the acquisition, both groups will therefore be auctioning off assets totalling EUR 5bn. These divestments will be mainly in Europe, which currently suffers from overcapacity, and in areas where the companies’ businesses are overlapping such as Canada, Mauritius and Brazil.

42 percent equity stake in the firm.

However, the deal is precarious as it is under regulatory scrutiny and as the cigarette and tobacco market is maturing. With smoking rates declining 3 percent per year focus on achieving profit growth in terms of price is inevitable.

In July, the tobacco company Reynolds American announced their acquisition of Lorillard in a cash-andstock transaction valued at $26.7bn.

Reynolds American plans to keep the Camel and Pall Mall brands as well as Newport, the second-most popular brand in the US. The other brands in the Lorillard portfolio will be spun-off to Imperial in a $7.1bn deal. The merger provides Reynolds American’s largest shareholder British American Tobacco (BAT) with a solid position in the $90bn US tobacco industry. As Reynolds American increased their portfolio of brands, BAT invested $4.7bn in Reynolds American in order to maintain their

What to look for – Autumn 2014 and 2015 The M&A market has bounced back with a vengeance recognizing that cost-cutting and organic growth is not enough to deliver in the challenging world of today. The timing of the rebound is supported by increased confidence in the boardrooms, enabling conditions of low-cost financing and access to debt and disruptive changes in certain industries such as policy reforms. As Robert Rankin, co-

Largest Deals in Q1 and Q2 of 2014

head of corporate banking and securities at Deutsche Bank said, “A lot of these transactions have been considered for a long time, but the courage to execute them has only returned in the last 12 months”. That corporate governance issues and regulatory interferences troubles the acquisition process is a common sight, however, we find it intriguing to see whether the announced megadeals will be approved by the authorities. The Comcast-Time Warner Cable deal is especially interesting as it will significantly change the competitive environment of the TMT industry in the US. While it can be expected that M&A activity in the PMB industry will slow down for the second half of the year following the boom in the first half, we find that the TMT industry is still something to look out for in the near future, as the speed at which new innovative technologies are developed are bound to disrupt the market.

Rank

Announced

Bidder company

Target company

Target dominant sector

Seller Company

Announced Total Deal value (US$bn)

Target Dominant Geopraphy

Financial Advisers (B)

Financial Advisers (T)

1

2/13/2014

Comcast Corporation

Time Warner Cable Inc.

TMT

-

68.4

USA

J.P. Morgan Chase, Paul J. Taubman and Barclays

Morgan Stanley, Allen & Company, Citigroup and Centerview Partners

2

5/18/2014

AT&T Inc.

DirecTV

TMT

-

66.0

USA

Extensive internal M&A team, Lazard

Goldman Sachs and Bank of America Merrill Lynch

3

7/8/2014

AbbVie Inc.

Shire PLC

PMB

-

54.7

Ireland

J.P. Morgan Chase

Evercore Partners, Morgan Stanley, Citigroup, Goldman Sachs and Deutsche Bank

4

4/22/2014

Valeant Pharmaceuticals International Inc.

Allergan Inc. (90.29%) stake

PMB

-

54.2

USA

Barclays, Morgan Stanley, RBC Capital Markets

Goldman Sachs and Bank of America Merrill Lynch

5

6/15/2014

Medtronic Inc.

Covidien Plc

PMB

-

46.2

Ireland

Perella Weinberg Partners LP

Goldman Sachs

6

4/7/2014

Holcim Ltd

Lafarge SA

Construc-tion

-

37.5

France

Goldman Sachs

BNP Paribas SA, Morgan Stanley, Rotchchild, Zaoui & Co

7

7/15/2014

Reynolds American Inc.

Lorillard Inc.

Tobacco

-

26.7

USA

Lazard and J.P. Morgan Securities LLC

Centerview Partners and Barclays

8

2/18/2014

Actavis Inc.

Forest Laboratories Inc.

PMB

-

20.8

USA

Greenhill & Co., Bank of America Merrill Lynch1 and Mizuho Financial Group2

J.P. Morgan Chase & Co.

9

3/14/2014

Altice SA

SFR SA

TMT

Vivendi SA

18.8

France

J.P. Morgan Chase, Morgan Stanley and Barclays

Citigroup and Lazard

10

2/19/2014

18,0

USA

Allen & Company

Morgan Stanley

Facebook WhatsApp TMT Sequoia Inc. Inc. Capital Source: Mergermarketgroup and Bloomberg, based on accounted deals

1) Bridge loan commitments 2) Pending execution of final financing

FINANCELAB • ISSUE SEPTEMBER 2014

Blue = Recent announcement Red = Hostile

23

Noise traders in financial markets - do they matter?

By Oskar Harmsen

I

FINANCELAB • ISSUE SEPTEMBER 2014

t does not take many finance classes to make you sceptical about following your uncles’ stock picking advice. The same goes for investment advice in the popular press, from your bank (which is probably crafted by your student analyst friends anyway) and many other sources. Without trading based on such ’noise’, however, stock markets might not exist at all. This article will explain how economists often think about noise traders and the role they play in financial markets.

24

The typical household investor will probably give you an odd look if you mention mean-variance optimization or market portfolios. Despite him not having chewed through countless volumes of finance textbooks, he certainly won’t be lacking inputs on where to let his money grow. Investment advice comes from everywhere, both in the press, on internet forums and via the occasional ’insider newsletter’ from the local bank. Many financial economists will think of such investors as ’noise traders’, trading on random information that is in fact

just ’noise’. While there is (as usual) some disagreement among economists, as to the role played by noise traders, one thing is for certain; they are a large part of financial markets.

Evidently, household investors hold nearly sixty percent of all outstanding US equities.

Are you smart enough to trade?

Even though noise traders may seem to be nothing but ’happy fools’ in the eyes of economists, they play a crucial role - without noise traders, financial markets might not function at all. In a 1982 paper, Milgrom and Stokey showed that in a speculative market of fully rational agents (that is, no noise traders), there will be no trading in equilibrium, even in the presence of asymmetric information, as long as prior beliefs are identical.

Picture the situation like this: If you have inside information about an asset and think you will become better off from trading, you will realize

that the person at the other end of the trade likewise will believe she will become better off - do you then still want to make the trade? Not if you expect the other party to be rational. In theory, most of trading ought to derive from differences in beliefs, and in fact a new paper by researchers Li and Li from the Federal Reserve show that stock turnover increases in periods of large belief dispersion between households.

You better hope the counterparty is acting on noise Obviously, there are trading reasons such as hedging, diversification or liquidity needs that would create trading demand, even in the case of rational, similar beliefs, but as Fisher Black argues in his ’Noise’ paper from 1986, financial markets generally see a turnover that is hardly explainable from these sources. Instead, he says, noise traders will act on random

noise as if it was real information and will be willing to trade even though they might objectively be better off from not trading. The effect of noise traders will then be dual. Firstly, rational investors will be more confident in trading on their information, since they know their counterparts may be noise traders. Secondly, the ability to trade on information will make it valuable for rational investors to seek out costly information.

As such, noise traders provide the crucial liquidity that makes financial markets go around, or as Black puts it; “noise creates the opportunity to trade profitably, but at the same time makes it difficult to [do so]”.

Noise trading and market efficiency Can markets be efficient when noise traders are around? This is where economists’ beliefs start to diverge since there seems to be agreement on the role of noise traders, the discussion really becomes one of whether markets are efficient.

On the efficiency side, the classical argument is that noise traders are met in the market by rational arbitrageurs, who constantly trade on superior information and thereby drive prices towards fundamental values. This is also the argument that professional trading on average is stabilizing markets, rather than causing speculative bubbles. Friedman writes this in his 1953 paper as the

argument “that speculation is [...] destabilizing [...] is largely equivalent to saying that speculators lose money, since speculation can be destabilizing in general only if speculators on [...] average sell [...] low [...] and buy [...] high”. On average then, noise traders as a group will lose money to rational investors. The more they push prices from fundamentals, the more aggressively they will be traded against.

Other economists argue that this mechanism might be severely limited in reality. For example fund managers (who we might be inclined to perceive as rational investors) will usually have short horizons because of biannual earnings reports, and may be risk averse. Will he be more concerned about differences between a current asset’s price and its fundamental value, or about the price at which he may later liquidate or register the asset? Larry Summers and others presented a model in which investors with finite horizons were reluctant to take large bets against mispriced assets because of the risk that they would be even more mispriced in the future. This limited the arbitrage mechanism, and, even in the absence of fundamental risk (e.g. about the value of the company in the case of a stock), markets were inefficient. With Andrei Shleifer, a Chicago economist, he argued that noise traders should take the place as a ’paradigm’ instead of the efficient markets hypothesis, and that we may attribute much of the anomalies discovered by behavioral finance to noise traders.

Weighing the arguments What side is right? As always, it is difficult to tell. The concept of noise traders allows explanation of a number of stock market anomalies, but stand against massive evidence on efficient markets, suggesting they may not affect prices at all. Also, in a methodological sense, the theory of noise traders may be difficult to falsify, which would lead some advocating caution in using it to explain anything at all. In my view, the core of the disagreement is on whether noise trader risk is diversifiable. For the risk not to be, there has to be room for noise trader ’sentiment’, such that large groups of investors can be bullish or bearish at the same time. Given the existence of bubbles (which is itself a disputed subject), this does not seem to be completely off, but evidence goes to both sides.

Where does that leave the discussion around the family table, when investment advice starts flying around? If nothing else, you can comfortably lean back, ignore the noise, and know that there will be a counterparty to your trades on the day where you want to act on your own insightful analyses. Just hope they’re not based on noise.

Black, Fischer. “Noise.” The journal of finance 41.3 (1986): 529-543.

De Long, J. Bradford, et al. “Noise trader risk in financial markets.” Journal of political Economy (1990): 703-738.

Friedman, Milton. “The case for flexible exchange rates.”

(1953): 157-203.

Li, Dan, and Geng Li, “Are Household Investors Noise Traders? Evidence from Belief Dispersion and Stock Trading Volume.” FEDS, Federal Reserve Board, Washington D.C. (2014).

Milgrom, Paul, and Nancy Stokey. “Information, trade and common knowledge.” Journal of Economic Theory 26.1 (1982): 17-27.

Shleifer, Andrei, and Lawrence H. Summers. “The noise trader approach to finance.” The Journal of Economic Perspectives (1990): 19-33.

FINANCELAB • ISSUE SEPTEMBER 2014

Papers referred to in this article

25

Significant PE deals 2013-2014

By Morten L. Siggaard and Emil Ignatzi Reinholdt

T

FINANCELAB • ISSUE SEPTEMBER 2014

he global private equity industry showed a strong come back in 2013, resulting in the highest aggregate amount of capital raised since 2008. The total global PE capital raised, when the books closed on 2013 reached a level of $454bn. Still, deal making is the heart of private

26

equity, and although the activity was up in value, deal count was down, compared to the previous three years. This article aims to shed light on two significant PE deals. The end, for one of the biggest buy-outs in history - TXU a Texan utility, and the beginning for another, the takeover of

the US consumer giant Heinz in one of the food industry’s biggest deals.

However, the PE market trend moving into 2014 is experiencing increasing optimism and with several interesting deals, the investor appetite for private equity in 2014 remains high.

The death of largest leveraged buy-out Q2 2014 witnessed the filing for bankruptcy for TXU, also known as Energy Future Hold-ings Corp., which remains as one of the biggest private equity deals in history represent-ing a deal value of $44.37 billion in 2007.

Back then a trio of top private equity firms, in-cluding Kohlberg Kravis Roberts & Co., TPG Capital and Goldman Sachs Capital Partners, acquired the Texas power utility leaving TXU more than $40 billion in debt, or conversely 8.2 times the company’s adjusted EBITDA. When the company on April 29, 2014 filed for bankruptcy, the unanswered question remained, what caused this to happen? The an-swer

may be a combination of several unforseen incidents. As the financial crisis hit shortly after the closing of the deal, it seemed that the buy-out was facing a race against the odds. Steven Kaplan, professor at the University of Chicago Booth School of Business comments on the timing of the deal and the over-optimism shared by the majority of the industry;

“Energy Future is emblematic of the peak of the buyout boom, when firms did very high-priced, over-leveraged deals that left little room for error. When you buy into a cyclical industry at the peak and you get the bet wrong, bad things happen.”

Takeover of an elephant In 2013 the biggest takeover in the

history of the food industry took place as Warren Buf-fet’s Berkshire Hathaway teamed up with Brazilian private equity firm 3G Capital to acquire industry giant H J Heinz Company, famously known for its food products such as Heinz Ketchup and Heinz Beans. This mega-deal of GBP 18bn was realized in collabora-tion with US banks J.P. Morgan and Wells Fargo who both provided capital for the takeo-ver. On the advisory side, Bank of America advised Heinz on the deal while Lazard ad-vised the acquiring side.

Since the takeover analysts have argued that America’s most well-known investor, Mr. Buffet has once again invested in a sound business with substantial growth potential. Analysts have thus argued that despite the somewhat fragile recovery in many Western economies Heinz has the potential to becoming a dominant player in fast growing re-gions like Asia. Especially the business’ strong brand is highlighted as a key competitive advantage that will help the company attain growth through market entries and consoli-dations.

In fact one of the key elements in the rise of the stock price before the takeover was former CEO William R. Johnsons strategy of pushing Heinz

15 largest brands into emerging market economies. Asia has proved an especially sound investment for Heinz and this strategy is expected to be maintained under the new management.

Another strategy of value creation introduced by the new owners is emphasis on cutting costs. Since 3G Capital and Berkshire Hathaway took over they have replaced former CEO Mr. William R. Johnson with former Burger King CEO Mr. Bernardo Hees who has cut away 600 office positions in Canada and US to ‘simplify the organization’ as a Heinz spokesperson put it. The cuts will help the Heinz Company to introduce more accounta-bility and enable faster decision making within the organization.

The strategy of cost cutting was expected as Bernardo Hees managed to reduce costs by about 30 pct. at his former employer Burger King, which was also acquired and owned by 3G Capital until they took the company public in 2012.

FINANCELAB • ISSUE SEPTEMBER 2014

The period just before the TXU deal in 2007 was characterised by a booming economy with the result of a rise in the demand for electricity. This was all good signs prior to the buy-out, but following a period of falling natural gas prices shortly after combined with an increased competition, especially from companies offering supplements such as ex-tracting natural gas from shale, the buy-out suddenly went down in value. Consequently, the Energy Future deal could be seen from the outside as not only a strategy of backing the wrong horse, but also a gamble that natural gas prices would rise and act as competitive advantage. Instead, natural gas prices fell sharply. The inevitable result of this was sizable financial losses coupled with the upcoming maturity of a significant debt load followed by the tempting conclusion that this bankruptcy in the end might have arisen from a failure of energy pricing predictions combined with unforseen macroeconomic changes from the financial crisis.

27

Summer internship in investment banking – what’s all the buzz about?

By Kristin Horn and Anni Fong

FINANCELAB • ISSUE SEPTEMBER 2014

From the perspective of the students

28

As an undergraduate, graduate or MBA student you find tons of available summer internships offered by both small investment banks you have barely ever heard of, and the big financial institutions you have always dreamed of working for. Basically, you get an internship in investment banking for two reasons: firstly, to learn and secondly, to land a full-time offer. A summer internship in investment banking is typically an intensive eight to ten-week introduction to the firm and the industry.

Every year there is a fierce competition in getting a spot at a summer

internship program to the different investment banks. At Goldman Sachs there was an acceptance ratio of 2% last summer, where they had 17.000 applicants. This year there was an even more fierce competition at another investment bank, Morgan Stanley, where there were 90.000 applicants for their summer program.

Despite the financial crisis, the big investment banks don’t seem to have any problem in attracting student applicants. So why is there such a huge motivation among the students in applying for the summer internships?

The path of getting the internship Before landing a summer internship, you must go through a thorough recruitment process. Normally, the

process begins in September and ends no later than January depending on which bank the student apply to. The recruitment process starts by sending in CV and cover letter. After submitting your files you will be asked to complete numerous online tests. It is only after passing the online tests the bank will even look at you application. It is needless to say that your CV and application need to be outstanding to be invited to the next stage: the interview stage. The interview process typically consists of first rounds telephone interviews, followed by a assessment centre and case studies that the student completes at the bank’s office. There are several ways to prepare for the recruitment process. Many students use AskIvy or Vault, which are websites that consist of, among other, career advice, interview guides, modelling tests that are designed to help

The summer internship The beginning of the internship consists of an introductory part, where the student gets to learn more about the company and has several types of courses. The rest of the internship involves different projects the student has to participate in. During the internship you will get practical experience, which is a tremendous advantage when applying for a full time job later on. Additionally, the summer analyst gets to network with fellow students, which can possibly be fellow colleagues in the near future.

Further, this gives the student the time to decide if this is really something he/she or not. This minimizes risk the possibility to choose a wrong fulltime job later on.

After the summer internship, what’s next?

When the internship is over, there are several advantages. First of all your CV will be strengthened significantly. Having completed the internship you will have a major advantage relative to other students who did not complete an internship in getting

a full time offer. Should you decide banking is not for you there is still an advantage when applying to other firms. Remember, firms always prefer students that have had internships over students that have not.

From the perspective of the banks

way to attract talent at an early point while branding themselves as the best employers. By the looks of it, the financial crisis has not diminished the popularity of summer internships, if anything the opposite could be true as even more attention has been cast on investment banks.

Why are summer internships so important to all the banks? They offer this over and over, so what are the pros by doing this? It is not surprising that the competition between investment banks is tough and a talented base of employees is one of the most valuable assets for the bank. From this point of view it is crucial to recruit the most talented people in order to outperform competitors. To recruit most talented people for fulltime positions, summer internships or internships in general is a good non-committed way for the banks to test young ambitious students and whether they fit into investment banking and the company. This is why the recruiting process for summer internships is as comprehensive as applying for a full-time position in investment banking. In spite of the extensive recruitment process the responsibilities given to summer analysts are similar to that of a full-time analyst. According to Goldman Sachs, which is the best-ranked bank within M&A in 2013 by Thomson Reuters, a very significant portion of their fulltime Analyst and Associate classes comes from their summer internships.

But not only is it about getting the most suited people for investment banking, but from the perspective of the banks it is important to make an effort in offering the best and most attractive internships. The banks are selective in choosing the best students, but the students are also selective and targeted in choosing which internships to apply for.

To sum up, summer internships are invaluable for both students and banks. For students it is the best way to enter the one of the most prestigious and sought after careers in finance. For banks it remains the best

FINANCELAB • ISSUE SEPTEMBER 2014

the student for a career in investment banking and other areas in finance.

Having done a fair share of networking before the recruitment season is a significant advantage. This can consist of informal meetings during the summer and/or weekend trips near recruitment season. A weekend trip is a 2-3 days trip to a financial centre (New York, London or Hong Kong), where the student typically book 5-10 meetings per day, which are informal interviews. By doing the networking before hand, the student get a significant advantage as the bankers will remember who you are if the informal interviews are successful. As there is so much preparation to be done, the whole recruitment process will provide a huge learning curve. So even though if you do not get an offer, you will still have learned so much, which makes the application process itself a motivation in applying.

29

Economics of FIFA The

– what’s in it for Brazil?

By Daniel Fleischer & S. Nadine Raida

E

very time FIFA has to find a host for the World Cup there is always great competition to have the honour. But why do countries fight over who gets to spend a ton of money on hosting this massive event?

FINANCELAB • ISSUE SEPTEMBER 2014

World’s biggest soccer party This summer we have all been witnessing the 32-day event in Brazil amalgamating cultures around the globe. But what impact does such a significant event have on the host’s economy?

Every fourth year when the World Cup is held, visitors from around the world can be amazed of the many great facilities that have been built for the event. You may have wondered why these countries would be willing to spend billions on stadiums for a giant sporting event. Obviously

30 1) Numbers from the world bank

there must be a very good reason for Brazil to spend this much money on a sports event, so what’s in it for them?

There are many reasons for a country to host this kind of event, one of which is tourism. Brazil was expected to attract 600.000 tourists for the event, and with calculations based on average spending of the tourists at past tournaments from the Economic Research Institute Foundation they project visitor spending for the 2014 World Cup to approximate $11.1 billion in total. Although this seems like a very large gain from the World Cup, it’s actually just a tiny gain in the trillion-dollar economy of Brazil. From this perspective the gains from tourism shouldn’t be enough for Brazil to want to host the event.

An additional gain from hosting is international branding of your country, which might improve Brazil’s international standing and attract investments and people to Brazil. This could be a powerful booster for the

Brazilian economy. However, the World Cup appears to be is a very large investment in something that is not guaranteed at all. Looking at South Africa’s economy since 2010, shows that it had a minor upturn in 2011, but since then the GDP growth has decreased by almost 50%points1.

Hence, we see a pattern of shortterm hype, but no lasting effects on the economic growth. Analyst Barbara Mattos also expressed how the “event will provide short-lived sales increases that are unlikely to materially affect earnings and disruptions associated with traffic, crowding and lost work days will take a toll on business.”

In spite of this, Brazil’s tourism Minister Vinicius Lages says: “The Cup is not an economic panacea but a catalyst for Brazilian development. [...] It was a key factor behind Brazil finally overhauling its infrastructure.”

He predicted that the 32-day event would add about $13.6 billion this

This reflects one of the main reasons many developing countries choose to host this massive event. It is a great way to get things done. It creates a deadline for some modernisation processes especially in infrastructure.

This can be very important for a country like Brazil, which is known for having difficulty implementing economic legislations of reformation. Maybe

this is also a reason for Brazil’s failure to exploit this opportunity to invest in the country’s long-term growth. Brazil is a country with massive inequality, a Gini-coefficient of 0.59, and a fairly high level of corruption. This is how some people explain, why the Brazilian government has mostly focussed on investing in grand and very inaccessible stadiums, and not solving some of the very serious problems in infrastructure. You could also point out that maybe infrastructure should not be the first priority, but that with a haltering educational system creating further inequality, this should be Rousseff’s (Dilma Rousseff, the Brazillian president) main area of attention. According to Paw Research Center the Brazilians agree with 61% thinking that the World Cup is bad for their country, and histories of communities being evicted to make way for stadiums and houses for athletes makes it hard to disagree completely with this view.

Taking all this into account it still

does not seem clear why the Brazilian government would choose to host the World Cup, against the will of the people and not with any clear or guaranteed economic benefits.

This might not be explained by economics, but by something even more irrational... namely politics.

Coinciding with the World Cup is the presidential election in Brazil, and with the World Cup it might have been possible for Rousseff to win the election on the feel-good-buzz of the event. Now though it seems as if a bulletproof plan is failing, because what the World Cup really has done is highlight the extreme inequality of the nation, and the need for modernisation. One way the World Cup has surely created a gain for Brazil is that it has pushed the people to their limits and out onto the streets. From here they might even be heard and start the change that the government promised the World Cup would bring.

FINANCELAB • ISSUE SEPTEMBER 2014

year to the Brazilian Economy. And additionally, the event will add longterm value for the economy. Ernst and Young made a report with the Brazillian economic institute, Getulio Vargas Foundation, concluding that the cup will produce a surprising cascading effect on investments. In addition, the report measured the impact of both FIFA World Cup and the 2016 Olympics to add 4 percentage points a year to economic growth through 2019 as well as creating no less than 3.6 million jobs, and with a population of about 32 million people living in poverty this will have great meaning for Brazil.

31

The significance of high-frequency trading in global markets

By Bo Laursen

FINANCELAB • ISSUE SEPTEMBER 2014

What is high-frequency trading?

32

H

FT is characterized by a higher number of trades and a lower average gain per trade compared to traditional fundamental investments. Typically HFT firms engage in multiple intra-daily trades and close the positions so only a few, if any, are carried overnight.

It has been found that returns based on high-frequency intra-day trading have a very little correlation with returns based on traditional long term investment strategies. In terms of the classical CAPM terminology this means that HFT portfolios are

High-frequency trading (HFT) has been one of the most discussed topics within the financial industry over the past decade. But what is high-frequency trading really? There is no official definition of HFT and therefore it is often confused with phrases such

as algorithmic trading, electronic trading, black box trading, quantitative trading, automatic trading etc. In academic literature HFT is often specified by systematic trading using an algorithmic execution method at very high speed.

Systematic trading

Refers to a computer driven system that makes portfolio allocation decisions, decisions about when to buy/sell or decisions about which specific assets to buy/sell.

Algorithmic execution

Refers to the computerized execution of a trade. That is, when a trade has been decided, a computer may determine how to process the order given current market conditions, whether to execute a trade aggressively/passively, or whether to execute the order in one trade or in several smaller trades.

zero-beta and may therefore serve as valuable diversification tools for long-term portfolios.

The most obvious aspect of competition for firms engaging in HFT is speed. Whoever is able to act first upon a profitable trading opportunity capture the biggest profit. The firms need to collect data, run their models and execute the trades as fast as possible. To gain speed on the collection of data HFT firms spends millions each year to place their trading models on computers geographically close to the exchanges in so-called co-location centres. The speed at

which the HFT firms compete is milliseconds (1/1000 sec.).

HFT has been intensely debated in the past decade. Advocates of HFT argue that it improves liquidity and thereby shrinks the bid-ask spread making it cheaper to trade for everyone. On the other hand opponents argue that HFT destabilize the market and introduces the possibility of so-called flash crashes i.e. crashes where the market returns to its initial position in a short period of time.

More information about co-location, flash crashes, regulation, technologi-

“

I’m so fast that last night I turned off the switch in my hotel room and was in bed before the room was dark.

Muhammed Ali

Statistics of high-frequency trading Most HFT firms are based in New York, London, Singapore or Chicago.

Since speed matters in HFT the companies utilize strategies that depend on their geographic location. For instance, several Chicago based HFT

Asset classes traded by HFT-companies

companies exploit their proximity to the Chicago Mercantile Exchange to develop faster trading strategies for futures, options and commodities.

On the other hand New York based firms tend to have preferences for U.S. equities. Some HFT companies in London take advantage of the European time zones. London may therefore have a larger proportion of firms trading foreign exchange compared to the rest of the world. The Singapore based firms specializes in the Asian markets.

Examples of large companies in the financial sector practicing HFT are Getco, Renaissance Technologies,

D.E. Shaw, Millennium and Worldqaunt.

Of all asset classes equity remains the major asset for HFT companies. Of all companies specializing solely in HFT 83% of them trade equities, while the number is only 26% for foreign exchange. This pattern may be partly explained by the fact that the majority of the equity, futures, and option trades are executed algorithmically (a prerequisite for HFT). On the other hand a lot of the trades in the fixed income and foreign exchange markets are made over-the-counter.

Equities

Futures

FINANCELAB • ISSUE SEPTEMBER 2014

cal developments and HFT in general see the “Algorithms and high-frequency trading” section in Financelab Magazine 8.

Options

Bonds

FX

0% 10% Figure 1

20%

30%

40%

50%

60%

70%

80%

90%

33

High-frequency trading, share of equity trading 2012

Figure 2

Considering equity alone as the major asset class figure 2 shows the prevalence of HFT in different parts of the world. The most striking result is that more than half of all the equity trades in the US can be considered being of high-frequency. The rest of the world is far behind America with Europe at a second place with 35% of the trades.

Share of equity trading (20052014) Figure 3 shows the evolution of HFT in the equity market for America and Europe. It is obvious that there has been a tremendous increase in the market.

In the years before 2000 the market share of HFT in equity was less than 1% in both US and EU. Technological improvements and large profits for the companies involved dramatically increased the popularity of HFT. The US market peaked in 2009 with a market share of 61%, while the EU market peaked in 2010/2011 with 39% of the equity trades being of high-frequency.

Figure 3

70%

60%

50%

40% EU US

30%

20%

10%

0% 8

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

FINANCELAB • ISSUE SEPTEMBER 2014

Figure 4

34

Revenue for HFT-companies trading US equity ($bn) In the most recent years HFT has been on a decline. Figure 4 shows the revenue for US HFT companies during the period 2009-2014. Revenues and profits from trading US equities have fallen dramatically since the volatility needed to foster ideal conditions for HFT have declined from what it was at the height of the global financial crisis.

7

6

5

4

3

2

1

0 2009

2010

2011

2012

2013

2014

US trading companies by type US trading companies by type The last figure shows that while HFT accounts for a very large part of the trading volume in the US market, the number of companies specializing solely in HFT constitutes only 2% of the total market.

To conclude, HFT makes up a very large part of global trading volumes, at least for equities, futures and options. As HFT specialized firms compete for increased speeds and the best strategies there is little doubt that HFT will remain significant and most likely will increase in significance going forward. As this race occurs and HFT spreads across all asset classes, we could be witnessing what is the future for all trading. But only time can tell us the answer to that.

HFT Companies 2%

Figure 5

Mutual Funds 33%

Hedge Funds 42%

Broker-dealers 23%

FINANCELAB • ISSUE SEPTEMBER 2014

- THE END -

35

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Computerne er klar og parate. Det samme er de 15 deltagere, der har kvalificeret sig til turneringen Nordic Trading Competition. Fordelt på fem hold skal deltagerne se, hvem der i løbet af dagen kan få 100 millioner virtuelle kroner til at yngle mest. Bag konkurrencen står Financelab, der er en studenterorganisation, som er bygget op omkring medlemmernes fælles interesse for at handle med aktier.

Deltagerne i konkurrencen er dog ikke medlemmer af foreningen, men derimod studerende fra CBS. Fire en halv times aktiehandel skal nu afgøre, hvem der har bedst styr på dagens kursudvikling. Frederik Ploug

Søgaard er formand for Financelab og er en af initiativtagerne til konkurrencen. Han byder velkommen til deltagerne og giver dem en kort ”market briefing”. Det vil sige en orientering om begivenheder, der kan få betydning for udviklingen på dagens marked. ”Konkurrencen er dog bevidst lagt på en dag uden de helt store begivenheder i finansmarkedet. Det er gjort, så det er de deltagere, der er bedst til at bruge de analytiske redskaber, der vinder”, fortæller Frederik. ”Release the bulls” råber han ud til forsamlingen. Konkurrencen er nu i gang. Deltagerne i dag har alle deltaget i de tradingkur-

ser, der blev holdt i foråret. Vinderne ved af disse kurser er de 15, der er her i dag, o er dermed de bedste af de 200 oprindelig deltagere.

Skal finde de bedste af de bedste ”Today is about finding the very best of th best”, som Wayne Walker siger. Han er un viser på trading-kurserne og har flere års e ring med aktiemarkedet efter at have arbe som trader tidligere i sin karriere.

Han har store forventninger til deltager kunnen, og sammen med sin kollega Ole Quistgaard er han dommer ved konkurren

AF SAJEEV SHANKAR / FOTO CASPER BALSLEV

Qualify for the next

Nordic Trading Competition FOTO CASPER BALSLEV

37

The events we’re hosting SEPTEMBER 2014 11

NORDNET - OPTIMIZE YOUR RETURN

18

17:00 - 20:00, Århus Event Type: Education

FINANCELAB AT CBS STUDENT SOCIETY DAY All Day, Copenhagen Business School, Solbjerg Plads 3 Event Type: Career

19 - 28

FINANCELAB STUDY TRIP

A full week, London Event Type: Career

OCTOBER 2014 1

6

FINANCELAB • ISSUE SEPTEMBER 2014

38

9

9

INVESTMENT PANEL - APPLICATION 08:00, Århus Event Type: Career

SPRING INSIGHT PROGRAMMES WITH DEUTSCHE BANK Time and place TBA, Copenhagen Event Type: Career

FINANCELAB QUANT EVENT ON CVA 18:00 - 22:00, Place TBA Event Type: Education, Social WOMAN IN FINANCE 16:00 - 21:00, HOW601, Howitzvej 60, 2000 Frederiksberg Event Type: Social

9

NORDEA - RISK MANAGEMENT 16:00 - 19:00, Århus Event Type: Education, Career

10 - 11

28

30

30

31

INVESTMENT STRATEGY CHALLENGE 2014 14:00 - 17:00, Nordre Ringgade 1, 6000 Århus, Danmark Event Type: Education, Career, Social

INSIGHT INTO DEUTSCHE BANK CB&S: MARKETS 18:00 - 22:00 Copenhagen Business School, Fuhu-lounge, Porcelænshaven 26, 3. tr. 2000 Frederiksberg Event Type: Education, Social

FINANCELAB QUANT EVENT ON STRUCTURING 18:00 - 22:00 Copenhagen Business School, Fuhu-lounge, Porcelænshaven 26, 3. tr. 2000 Frederiksberg Event Type: Education, Social

CLEARWATER INTERNATIONAL - M&A COURSE Time & place TBA, Århus Event Type: Education

INVESTMENT CAMP 2014 All Day, Copenhagen Event Type: Education, Career, Social

NOVEMBER 2014

2-3

BASIC TRADING COURSE 08:00 - 16:00, Århus Event Type: Education

4

BLACKROCK - THE WORLD OF ISHARES 16:00 - 19:00, Aarhus Event Type: Education

FINANCELAB • ISSUE SEPTEMBER 2014

DECEMBER 2014

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