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Feeling the pressure: The challenge of enhancing return on equity

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In March 2008, the Economist Intelligence Unit surveyed 373 C-level, or board-level executives, from around the world about their attitudes to improving return on equity in the current business …

In March 2008, the Economist Intelligence Unit surveyed 373 C-level, or board-level executives, from around the world about their attitudes to improving return on equity in the current business environment. The survey and paper were sponsored by The Royal Bank of Scotland.

Respondents represent a range of industries, including financial services, professional services, manufacturing, and information technology. Approximately 50% of respondents represent companies with revenues in excess of US$500m. Around 50% of respondents are chief financial officers, and the remainder are chief executives or other C-level executives.

Our editorial team conducted the survey and wrote the paper. The author was Christopher Watts and the editor was Rob Mitchell. The findings expressed in this paper do not necessarily reflect the views of our sponsors.

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  • 1. Feeling the pressure?The challenge of enhancing return on equity sponsored byAn Economist Intelligence Unit report
  • 2. The Economist Intelligence UnitThe Economist Intelligence Unit is a specialist publisher serving companies establishing and managingoperations across national borders. For 60 years it has been a source of information on business developments,economic and political trends, government regulations and corporate practice worldwide.The Economist Intelligence Unit delivers its information in four ways: through its digital portfolio, where thelatest analysis is updated daily; through printed subscription products ranging from newsletters to annualreference works; through research reports; and by organising seminars and presentations. The firm is a memberof The Economist Group.Copyright© 2008 The Economist Intelligence Unit Limited. All rights reserved. Neither this publication norany part of it may be reproduced, stored in a retrieval system, or transmitted in any form or by any means,electronic, mechanical, photocopying, recording or otherwise, without the prior permissionof The Economist Intelligence Unit Limited.All information in this report is verified to the best of the author’s and the publisher’s ability. However, theEconomist Intelligence Unit does not accept responsibility for any loss arising from reliance on it.
  • 3. Feeling the pressure? The challenge of enhancing return on equity About this research In March 2008, the Economist Intelligence Unit surveyed 373 C-level, or board-level executives, from around the world about their attitudes to improving return on equity in the current business environment. The survey and paper were sponsored by The Royal Bank of Scotland. Respondents represent a range of industries, including financial services, professional services, manufactur- ing, and information technology. Approximately 50% of respondents represent companies with revenues in excess of US$500m. Around 50% of respondents are chief financial officers, and the remainder are chief executives or other C-level executives. Our editorial team conducted the survey and wrote the paper. The author was Christopher Watts and the editor was Rob Mitchell. The findings expressed in this paper do not necessarily reflect the views of our spon- sors. Our thanks go to the survey respondents and interviewees for their time and insight. © The Economist Intelligence Unit 2008 
  • 4. Feeling the pressure? The challenge of enhancing return on equity Executive summary l Return on equity is increasingly at risk. As the l Greater operational efficiency is seen as an effects of the tightened credit environment spread important source of improved return on equity. from the US to the rest of the world, surveyed As companies look to the future, they expect to for this report are finding their ability to deliver increase their reliance on operational efficiency improved return on equity curtailed. Beyond the as a source of enhanced return on equity. This increased cost and reduced availability of finance, could incorporate a range of initiatives, including a number of factors are exacerbating the problem. greater efficiency of business processes, improved Chief among these are dampened business confi- inventory management and a stronger focus on dence, downward pressure on revenues, adverse working capital management. Revenue diversifi- exchange rate movements and rising costs. cation and enhancement, and renewed efforts to cut costs, are also seen as important tactics. l There is growing pressure on companies to increase return on equity. Just at a time when l For some executives, it is a time for disciplined return on equity is under threat, investors and acquisitions. Corporations with solid balance other stakeholders are intensifying pressure on sheets and strong cash flows may find that the management to deliver improved performance on current environment is providing opportunities to this measure. Indeed, six in ten respondents say drive return on equity by means of acquisitions. that they have experienced increased pressure to Many senior executives questioned for this survey boost return on equity since the start of the credit see softening valuations of acquisition targets. In crisis. Although executive management is most part, this is due to uncertain growth prospects and likely to drive initiatives to improve return on diminished competition from private equity oper- equity, shareholders and the general competitive ators, whose access to abundant cash resources environment are also exerting a strong influence. has been cut back. Yet a disciplined approach to acquisitions remains as critical as ever. l Executives are adopting a cautious approach to balance sheet leverage. Senior executives are finding themselves in a corner: where once they would have turned to balance sheet restructur- ing to drive return on equity, today, few have an appetite for this. Instead, many executives are cautiously bracing themselves for the possibility of more difficult times ahead by paying down debt and watching cash more closely. Those that have committed themselves to dividend and share buy- back programmes to increase return on equity plan to keep these on course; cancellation of such pro- grammes to conserve cash is a last-resort option. © The Economist Intelligence Unit 2008
  • 5. Feeling the pressure? The challenge of enhancing return on equityReturn on equity comes under pressureThe financial crisis that had its origins in US sub- 2009. Growth in Europe, too, is expected to slowprime loans has developed into one of the largest this year, again largely as a consequence of thefinancial shocks in living memory. Since August credit crisis.2007, the so-called credit crisis has been char- The ultimate impact of the credit crisis on theacterised by a widespread tightening of lending global economy remains unclear. What is plain,and accompanied by sinking stock markets. Add however, is that anxiety among many corporatein the effects of record-breaking prices for oil and executives across the world is running high. While,other commodities, a declining dollar, plus mixed for the time being, the impact in some regions mayeconomic indicators, and there appears to be little have yet to be fully felt, many corporations are an-reason for optimism among investors or company ticipating worsening economic conditions. Amongexecutives alike. senior executives of companies surveyed for this It comes as little surprise, then, that the rapid report, declining business confidence and difficultyglobal expansion of recent years is losing mo- increasing return on equity are among the mostmentum. The slowdown has been most evident in widely reported effects of the current environment.developed economies, particularly the US, which Just under half of respondents report an adverseis now almost certain to dip into a recession this impact on business confidence, while 37% report ayear, with, at best, a gradual recovery expected for similar effect on their ability to improve return onHow significant has the adverse impact of the credit crisis been on the following aspects of your business?Please rate on a scale from 1 to 5, where 1=Very significant and 5=Not significant.(% respondents) 1 Very significant 2 3 4 5 Not significant Don’t know/Not applicableShare price 15 17 15 8 18 27Cost of borrowing 15 33 16 12 18 6Availability of bank credit 12 28 19 15 21 5Availability of capital markets debt 11 23 21 13 12 21Value of assets 9 20 23 18 26 5Capital expenditure plans 10 22 23 22 21 2Business confidence 15 30 28 14 13 1Ability to execute strategy 8 25 24 23 19 1Ability to increase return on equity 11 26 27 19 15 2Strength of balance sheet 7 19 28 18 25 2Ability to fund pension liabilities 4 10 18 15 26 27 11 © The Economist Intelligence Unit 2008 11 
  • 6. Feeling the pressure? The challenge of enhancing return on equity equity. For those companies that carry debt on their has kept its interest rate steady due to inflation balance sheets, the growing cost and shrinking concerns. The resulting strength of the euro versus availability of bank credit and capital markets debt other currencies, such as the dollar and sterling, are also perceived as a problem. is likely to put downward pressure on European Herman Agneessens, of KBC, an integrated ban- exporters’ revenues. The French automotive com- cassurance group based in Belgium, says that he has pany Renault, for example, reported in April that already felt the impact of this changed environment. unfavourable exchange rates had dampened the In December 2006, KBC communicated to investors revenues of its carmaking division by 2.1% in the and analysts its average return on equity target of first three months of this year. 18.5%. But since then, the worsening environment It is not only revenues that are hit by the crisis has increased the challenge of meeting this meas- – costs are, too. “The main effect of the current ure. “The targets we set at the end of 2006 will be crisis is on our [cost of borrowing],” says Patrick more difficult to achieve in the environment that we Claude. He points out that, for Renault’s short- see around us today,” he says. term commercial paper, the spread over European For KBC, and many other companies like it, down- overnight rates had widened from six basis points ward pressure on revenues is hampering executives’ (bp, hundredths of a percentage point) to 60 bp efforts to deliver targeted return on equity. With a between the start of the credit crisis and April; for significant proportion of capital markets activity on its European medium-term programme, spreads hold, the company’s investment banking operations had widened from 40 bp over EURIBOR to 140 bp; face a difficult environment; and in its retail asset and for its Japanese public debt, from 30 bp over management operations, slower customer growth LIBOR to 120 bp. The difference in interest expense is also set to weigh on revenues. One bright spot, (assuming Renault renewed at April 2008 rates the however, is its exposure to central and eastern average debt it had outstanding under these pro- Europe, which have been less affected by the credit grammes in 2007) is equivalent to almost €50m an- crisis than western Europe, and therefore help to nually – a cost burden of around 0.2% of Renault’s stabilise revenues. end-2007 equity. (The group’s return on equity in Companies are facing less direct revenue effects, 2007 was 12.7%, according to Bloomberg data). too. For example, while central banks in the US At the same time as return on equity is coming and UK have loosened monetary policy in response under strain, pressure on company management to the credit crisis, the European Central Bank to increase returns is intensifying. Six out of every ten executives say that they have seen heightened What change has there been to overall levels of pressure since pressure to improve return on equity since the the credit crisis began in August 2007? credit crisis first emerged, with 13% reporting that (% respondents) the increase is “significant”. In some cases, this Significant increase 13 pressure is from inside the company, for example Slight increase from owner-managers and from supervisory and 45 No change executive management boards. In other cases, the 34 pressure is from external parties, including institu- Slight decrease 6 tional shareholders and activist investors, such as Significant decrease hedge funds. 1 © The Economist Intelligence Unit 2008
  • 7. Feeling the pressure? The challenge of enhancing return on equityWhich of the following are currently exerting pressure on your Which of the following have exerted pressure on your company tocompany to boost its return on equity? boost its return on equity in the past three years?Please select all that apply. Please select all that apply.(% respondents) (% respondents)Executive management Executive management 61 53Competitive pressure Shareholders (institutional) 37 40Shareholders (institutional) Competitive pressure 31 36Non-executive management Shareholders (activist) 25 22Shareholders (activist) Non-executive management 22 17Private equity suitors Private equity suitors 13 13Other, please specify Other, please specify 3 3 Under intensifying pressure to deliver higherreturns on equity, CFOs and other senior executivesare increasingly finding themselves in a corner.Textbook methods for driving return on equityinclude taking on extra financial risk by means ofaggressive balance sheet restructuring – increasingleverage, buying back shares, and paying specialdividends. “But who wants to do that in this envi-ronment?” asks Peter Clokey, head of the valuationpractice at PricewaterhouseCoopers in London. © The Economist Intelligence Unit 2008 
  • 8. Feeling the pressure? The challenge of enhancing return on equity A cautious approach to balance sheet manoeuvres In the wake of the galloping global economic or anticipate a reduced likelihood of takeover by a growth, low interest rates, abundant capital, private equity operator, which may itself ease the strong corporate earnings and rising stock mar- pressure they perceive to increase leverage. Cer- kets that characterised much of this decade, many tainly, an increased debt to equity ratio is not gen- corporate balance sheets are in robust health. As erally seen as a favoured way of improving return on a result, some finance executives have come under equity over the next three years – just 15% say that pressure to drive returns by leveraging the bal- this will be an important approach for them. ance sheet. This was certainly the experience of A more widespread response in the current Mr Agneessens of KBC. “If you read analyst reports conditions is to reduce levels of net debt. Four in from 15 months ago, you will find that we were ten respondents say that they plan to adopt this heavily criticised for under-leveraging our bal- approach in an attempt to trim their exposure to ance sheet, for carrying excess capital, for being further increases in the cost of borrowing. In a too conservative and for not having sufficient risk similar vein, some executives – albeit a minority appetite,” he says. – are scaling back capital expenditure and acquisi- But now, such demands appear to be easing. tion plans. And around one-third of respondents Among respondents to our survey, 28% say that indicate that they have put plans to optimise their they have already noticed diminished pressure from capital structure on hold until there is greater activist investors, such as hedge funds and private clarity about how the current market downturn equity investors, to increase levels of leverage. A will develop. further 43% anticipate this effect. In a related find- But while a significant proportion of companies ing, almost three-quarters of executives have felt will adjust their balance sheet according to the prevailing conditions, some prefer a consistent Over the next year, which of the following steps do you expect approach to ride out the cycles. “We have stuck to your company to take in response to the credit crisis? Select all that apply. our [financing] strategy through the previous cycles (% respondents) and we have no intention of changing it,” says Mr Reduce levels of debt Agneessens of KBC. “I think that right now that 38 strategy has been vindicated.” Cancel, scale back or postpone capital expenditure plans 34 Caution is also the watchword as far as the bal- Refinance debt or bank credit 26 ance sheet cash goes. “If the markets are uncer- Cancel or postpone acquisition plans tain, there is nothing like having cash in the bank,” 25 Cancel, scale back or postpone debt issuance plans says Vijaya Sampath, Group General Counsel and 13 Company Secretary of Bharti Enterprises, an indus- Cancel, scale back or postpone equity issuance plans 12 trial conglomerate based in India. Indeed, when Cancel or postpone sale or divestiture plans deciding how much cash to hold on the balance 12 None of the above sheet, the most widespread motivation cited by 23 © The Economist Intelligence Unit 2008
  • 9. Feeling the pressure? The challenge of enhancing return on equityIn deciding how much cash to hold on the balance sheet, which Our survey indicates that 62% of respondents haveof the following are the most important considerations? kept down equity by paying out regular dividendsPlease select up to three.(% respondents) in the past three years, while a slightly smaller proportion of 55% intend to continue the paymentHolding a "war chest" to protect against future downturns of dividends in the next three years. 42Uncertainty about future investment opportunities Sonic Healthcare, a medical diagnostics company 31 based in Australia, is an example of a company thatThe cost of raising additional funds 25 is seeking to maintain, or grow, its dividends. SinceInterest rate considerations 24 the company made its first payment 12 years ago,The time it takes to raise funds dividends have grown every year, and have remained 23Ability to return cash to shareholders at a high rate of 70% of net earnings. “If the debt 23 markets get really tough, we could consider cuttingPreference of shareholders 20 that – but we would be loath to do it,” says ChrisTax considerations Wilks, CFO at the company. 17Regulatory considerations Much the same applies to companies’ existing 11 share buyback programmes. “In the past two and aPotential liabilities (eg, possible litigation exposures in the future) 10 half years, we have bought back roughly one third ofsenior corporate executives is to hold a “war chest” our equity,” says Mr Rigolle of SES. Buying back andin case of possible future downturns. Despite these cancelling shares has helped push the group’s returnfindings, there is little evidence that current condi- on equity from 10.3% to 17.7% since 2004, accord-tions have pushed senior executives into hoarding ing to Bloomberg data. Despite the more difficultexcessive amounts of cash: 63% say that they have economic environment, Mr Rigolle remains confidentabout the right level of cash on their balance sheet in the visibility and robustness of his company’sand just think that they have too. revenue streams and cash flows. Nevertheless, he These results suggest that few executives have lost has a last-resort option if economic conditions weresight of the cost of holding cash, despite the more to become tougher for the company. “We can alwaysdifficult operating environment. This is a view that is delay the increase in our leverage – slow down ourechoed by Sampath. “Holding too much cash means share buyback programme for instance, throttle backthat it is not being put to proper use,” he says. a bit the cash-out, and wait until sanity returns to What has changed, however, is that companies the market,” he says.are increasing the scrutiny of their cash balances to Senior executives questioned for our survey clearlyensure that funds are being employed effectively. face a dilemma. On the one hand, their ability to“[The current environment] is making us use our What is your view of the amount of cash that you currently holdcash much more carefully and is making us restrict on the balance sheet? (% respondents)the utilisation of cash more stringently than we usedto do before,” adds Sampath. Too much 17 For many companies, dividend growth is a key About right 63element of a financing strategy to drive return on Too littleequity. These plans so far appear to remain reasona- 21bly intact, despite the tightened credit environment. © The Economist Intelligence Unit 2008 
  • 10. Feeling the pressure? The challenge of enhancing return on equity CFOs turn to the bottom line improve return on equity has been hampered by the service areas, or by rolling out existing products credit crisis, which has placed revenues under threat and services into new geographical markets that and increased interest expense. On the other, many are perhaps less affected by the current economic report intensifying pressure to deliver improved climate. For other companies, a less risky and less return on equity. In the current environment, few capital-intensive route to revenue enhancement may companies are willing to restructure the balance lie in making greater use of long-term after-sales sheet to resolve this dilemma. And while there is service contracts with customers, or in concentrat- no magic bullet to solve this problem, our research ing greater sales and marketing effort onto their shows that, increasingly, CFOs and other executives most important clients in order to attract a greater are turning to the bottom line as a way of squaring share of budgets. this circle. Still, when comparing approaches taken over the In turning to the bottom line to drive return on past three years with those that executives plan to equity, the first option for executives – although take in the next three, it is interesting to note that, it is by no means easy to achieve – is to increase while increasing revenues retains pole position both revenues. Fully 68% of respondents say that they in the past and in the future, increasing operational expect to drive their companies’ return on equity by efficiency gains in importance over this period. Just pushing top-line growth over the next three years. less than four in ten respondents say that they fa- But with acquisition-led strategies increasingly voured this approach in the past three years, while under pressure, executives need another approach. 59% intend to focus on it in the next three. “That is where the emphasis has to be,” says Mr For many of these senior finance executives, Agneessens of KBC. increasing operational efficiency includes trim- Some executives are considering diversifying ming costs from the income statement. For most, their revenues by expanding into new product and internal services such as IT can be streamlined Which of the following have played an important role in enabling Which of the following do you expect to be important in enabling your company to boost its return on equity in the past three your company to boost its return on equity in the next three years? years? Please select up to three. Please select up to three. (% respondents) (% respondents) Increasing revenues Increasing revenues 66 68 Reducing costs Increasing operational efficiency (eg, working capital) 51 59 Increasing operational efficiency (eg, working capital) Reducing costs 38 56 Refinancing assets Divestment 16 17 Increasing ratio of debt to equity Increasing ratio of debt to equity 15 15 Divestment Refinancing assets 15 14 © The Economist Intelligence Unit 2008
  • 11. Feeling the pressure? The challenge of enhancing return on equitywithout having any potential longer-term effects expand, and more mature organisations, which mayon the company; and shared service centres offer a have less potential to grow.chance to drive efficiency in areas such as finance As part of its mid-term strategy to drive earningsand procurement. However, in those cases where growth, Renault has put clear targets for cost controlCFOs are re-thinking budgets in areas such as sales in place – a programme that has become all the moreand marketing, and research and development, they significant in the current climate. Measures includeare doing so with caution, for fear of harming their reducing procurement costs by 14% by the end ofcompanies’ medium and long-term revenue and this year (using the 2005 level as a base); cuttingearnings prospects. manufacturing costs by 12% by the end of 2009; The larger companies in the survey – those with and making savings in logistics of 9% by the end ofrevenues greater than US$1bn a year – are par- next year. Furthermore, general and administrativeticularly likely to focus on cost-cutting as a means expenses are to be brought below 4% of revenues,to increase return on equity; those with revenues down from 4.8% in 2007.below that threshold are more likely to cite revenue Increasing operational efficiency goes beyondgrowth as their preferred course of action. This cost-cutting, of course. Many CFOs are looking tofinding is likely to reflect the difference between drive operational efficiency by squeezing more outsmaller, growing companies, that are looking to of existing balance sheet assets. For most, this Case study return on equity by taking on greater debt and handing more cash to shareholders via share buybacks and SES: Investment grade mantra dividends. Mr Rigolle set a target debt level of 3.5 times EBITDA (versus around 2.2 times at the end of 2004). “At Not all senior finance executives are paying down debt that level, we would still probably have one [credit rating] or putting plans for balance sheet restructuring on hold. notch between us and [sub-]investment grade,” he says. Indeed, only around four in ten executives questioned At the end of 2007, SES closed its books with net debt for our survey say that they plan to cut back debt in response to the credit crisis. For those that do not plan of €3.2bn, equivalent to just under three times EBITDA. to pay down debt, some are continuing with existing SES has bought back around one third of its equity in the plans to invest capital or return cash to shareholders. past three years, according to Mr Rigolle. In 2007 alone, In many cases, these are companies with solid balance the group ploughed €1.6bn into share repurchases and sheets and strong cash flow generation. dividends. Return on equity soared to 17.7% in 2007, Luxembourg-based satellite operator SES is one such from 10.3% back in 2004, according to Bloomberg data. company. When Mark Rigolle arrived as CFO in August And over the same time-frame, the SES share price has 2004, he found a corporation deleveraging after having more than doubled. swallowed a big cash-and-stock acquisition three years Despite SES’s strong financial position, Mr Rigolle previously. He also found a business with a very long remained more than aware that sentiment on the credit operating cycle, including lead times of up to five years market could worsen. Keeping an investment-grade in capital expenditure and ten-year customer contracts. credit rating has been the company’s mantra when it This meant that cash flows in and out of the company comes to determining the right level of leverage. “We were little affected by short-term, or perhaps even mid- take a very conservative view that as long as we remain term, factors. investment grade, come credit crunch or whatever, Bolstered by this long-term visibility in revenues, at least we will be less exposed to erratic market earnings and cash flows, the group decided to boost sentiment,” he says. © The Economist Intelligence Unit 2008 
  • 12. Feeling the pressure? The challenge of enhancing return on equity includes working capital and tightening the use of cash to lower the interest expense. For CFOs in asset- light businesses, driving operational efficiency may mean better co-ordination of employees around the world, to facilitate transfer of best practice, to unify processes, and to co-ordinate output; for those in asset-intensive industries, it may include allocating capital expenditure to spruce up. In the case of EC Harris, Mr Morling reports that his company, too, is planning to sharpen its focus on costs. First, the firm is tightening its cash management in order to keep interest expense to a minimum. A second area of focus is asset utilisation. “We are getting far stronger on asset utilisation, to make sure there isn’t an under-utilised resource in one area, that can be deployed elsewhere,” he explains. And third, he says, “we will be taking a far more critical view on performance on a location-by- location basis.” Mr Agneessens of KBC also plans a renewed push for efficiency. “We have a very strong reputation for cost control but we will look at our expenses even more closely than before to see whether we can do even more,” he says. “It is a combination of setting ambitious targets throughout the organi- sation and monitoring the results very carefully and frequently.”10 © The Economist Intelligence Unit 2008
  • 13. Feeling the pressure? The challenge of enhancing return on equityA time for disciplined acquisitionsWhile some senior executives are cautiously bracing When Sonic Healthcare considered acquisitionthemselves for a possible worsening of economic targets in the course of 2007 – the company closedconditions ahead, others see opportunities in the around US$1bn of deals during the year – Mr Wilkscurrent environment. In one of the clearest-cut says that it came up against private equity operatorsindications from executives polled for this report, bidding top prices. Bolstered by debt, some firms82% of executives say that they are feeling – or were bidding up to 13 times the target company’sare expecting to feel – the positive impact from EBITDA, while Sonic was reluctant to bid highermore attractive valuations of acquisition targets. than ten times EBITDA, despite its greater potentialIn a related finding, 51% of respondents say that to drive returns through synergies. Today, privatethe current credit crisis has made conditions more equity firms’ restricted access to debt may put afavourable for the strategic acquisition of assets, more reasonable ceiling on valuations. “We mightdespite tightening credit conditions. Only 12% disa- now see private equity start to suffer as the industrygree with this statement. “We have noticed some competes for new assets,” he says.reduction in the competition from private equity Needless to say, the companies that are now bestfirms,” says David Pace, CFO of Unicorn Investment positioned to make acquisitions are those that canBank, a Bahrain-based Islamic investment bank, finance deals with minimal recourse to externalwhich has been making acquisitions not only in its debt – for example those with strong operating cashcore banking business at group level, but also as an flow. Our research suggests that few companiesactive private equity investor. are likely significantly to increase debt in pursuit In some cases, valuations are under pressure of acquisitions. An increase of borrowing costs,because of an increasingly negative – or, at the very reduced flexibility, and the difficulty of servicingleast, uncertain – revenue and earnings outlook. But debt in a downturn were most commonly cited byanother significant factor weighing on the valuation senior executives as drawbacks of taking on greaterof assets is reduced competition from private equity levels of debt. “We are presently very comfortablefirms, according to executives. Around three-quarters in terms of leverage,” says Mr Sampath of Bhartiof respondents are feeling – or are anticipating feeling Enterprises. “But if we have to take a big debt on a– this effect. foreign acquisition, one [drawback] would be thatHas the current credit crisis had a positive impact for your company in any of the following ways?Please select all that apply.(% respondents) Impact already felt Anticipating this impactLess competition from private equity firms for assets 26 49Less pressure from private equity/activist hedge funds to increase levels of leverage 28 43More attractive valuations of assets for acquisition 37 45Reduced likelihood of takeover by private equity 28 45 © The Economist Intelligence Unit 200811
  • 14. Feeling the pressure? The challenge of enhancing return on equity you have to earn a return on that debt. We need to see that the internal rate of return that we make on A note of caution the acquisition is good enough.” Peter Clokey, head of the valuation practice at To be sure, acquisitions in the current environ- PricewaterhouseCoopers in the UK, is all too aware ment will be scrutinised more closely by investors, of the effect of the credit crisis on asset valuations. lenders and supervisory boards alike – increasing the “Before the credit crunch, we were living in a world pressure on executives to pursue only those deals where valuations were driven in many sectors by that make a clear contribution to strategic, opera- the private equity community, especially in the US tional and financial goals. Again, discipline is key. and Europe,” he says. “There was a mass of money and easy access to bank financing.” Auctions for Sonic Healthcare’s strategy includes driving return assets were increasingly being won by private equity on equity by folding small and mid-sized acquisitions houses, where ordinarily a trade buyer with potential into its infrastructure worldwide. “We try to be disci- for synergies would hope to win such a contest. With plined in terms of return on equity, to drive value for large proportions of cheap debt in their financing shareholders. We would like to think return on equity packages, though, private equity houses were able will grow within 12 months of completing a strategic to pay high prices and still expect a decent return on acquisition,” says CFO Mr Wilks. their investment. So what effect is the worsening credit environment This is no longer the case. With the tightening of having? “Perhaps we are becoming a little choosier,” the credit environment since August last year, asset says Mr Wilks. “Of five acquisitions that we would values have been under pressure. First, an uncertain have been completed previously, perhaps now we may future outlook for revenues and earnings is weighing only buy the three most synergistic ones.” on valuations; and second, the investment activities of many private equity houses have been curtailed. “A bit of froth has come out of the valuation,” points out Mr Clokey. “There’s now a return to trying to understand where the value lies.” While the time may be ripe for trade buyers to make selective acquisitions, Mr Clokey sounds a note of caution. For one thing, he says, valuation has become more difficult. “The one-year multiple [such as a multiple of EBITDA] becomes a blunter tool at a time when valuations are falling and there is a threat to short-term profits.” Moreover, once an investment has been made, it is now more difficult to retreat. “If you make an [ill-advised] investment when the market is hot, you can always exit it to remedy any errors you make – perhaps even at a profit. Now, it’s more difficult to do this.”12 © The Economist Intelligence Unit 2008
  • 15. Feeling the pressure? The challenge of enhancing return on equity Conclusion CFOs in the US and beyond are now beginning to feel – or anticipate – the effects of the credit crisis that started in August 2007. For many executives, delivering improved return on equity is a growing challenge. At the same time, pressure on executives to enhance return on equity is intensifying. But few executives are making significant changes to their long-term financial strategy. For the time being, executives are adopting a cau- tious approach to balance sheet restructuring and leverage, in anticipation of a possible worsening of economic conditions. Rather than using the balance sheet to drive return on equity, executives appear to be turning to the bottom line in an effort to increase returns. For many, driving organic revenue growth – for example by diversification – is key; most executives are also planning cost efficiency measures. For some companies with solid balance sheets and strong cash flow, the current environment is a time of opportunities for acquisitions that may drive returns. Executives report that asset valuations are under pressure, in part due to re- duced competition for assets from private equity operators. Still, discipline is key in ensuring that acquisitions make a valuable contribution to return on equity. © The Economist Intelligence Unit 200813
  • 16. Appendix Feeling the pressure?The challenge of enhancing return on equity Appendix How significant has the adverse impact of the credit crisis been on the following aspects of your business? Please rate on a scale from 1 to 5, where 1=Very significant and 5=Not significant. (% respondents) 1 Very significant 2 3 4 5 Not significant Don’t know/Not applicable Share price 15 17 15 8 18 27 Cost of borrowing 15 33 16 12 18 6 Availability of bank credit 12 28 19 15 21 5 Availability of capital markets debt 11 23 21 13 12 21 Value of assets 9 20 23 18 26 5 Capital expenditure plans 10 22 23 22 21 2 Business confidence 15 30 28 14 13 1 Ability to execute strategy 8 25 24 23 19 1 Ability to increase return on equity 11 26 27 19 15 2 Strength of balance sheet 7 19 28 18 25 2 Ability to fund pension liabilities 4 10 18 15 26 27 11 Over the next year, which of the following steps do you expect your company to take in response to the credit crisis? 11 Select all that apply. (% respondents) Reduce levels of debt 38 Cancel, scale back or postpone capital expenditure plans 34 Refinance debt or bank credit 26 Cancel or postpone acquisition plans 25 Cancel, scale back or postpone debt issuance plans 13 Cancel, scale back or postpone equity issuance plans 12 Cancel or postpone sale or divestiture plans 12 None of the above 2314 © The Economist Intelligence Unit 2008
  • 17. Appendix Feeling the pressure? The challenge of enhancing return on equityHas the current credit crisis had a positive impact for your company in any of the following ways?Please select all that apply.(% respondents) Impact already felt Anticipating this impactLess competition from private equity firms for assets 26 49Less pressure from private equity/activist hedge funds to increase levels of leverage 28 43More attractive valuations of assets for acquisition 37 45Reduced likelihood of takeover by private equity 28 45Which of the following financing structures does your company Which of the following structures have been most successful atintend to use in the next three years? helping your company to achieve its required financingSelect all that apply. objectives?(% respondents) Select up to five. (% respondents)Equity 42 EquityPrivate placement 46 36 Private placementSyndicated loans 31 33 Syndicated loansEquity linked financing 29 21 Securitisation of assetsSecuritisation of assets 17 21 Asset sale and leasebackDerivatives to hedge interest rates 17 17 Equity linked financingAsset sale and leaseback 15 16 Public bondsPublic bonds 13 14 Subordinated debt / hybrid capitalNon-recourse project finance 11 14 Non-recourse project financeSubordinated debt / hybrid capital 11 14 Derivatives to hedge interest ratesDerivatives to hedge commodities 10 8 Derivatives to hedge commoditiesCarbon trading instruments 5 6 Index-linked bondsIndex-linked bonds 3 6 Covered bondsDerivatives to hedge inflation 3 5 Derivatives to hedge inflationEquity derivatives 3 4 Carbon trading instrumentsCovered bonds 3 3 Equity derivatives 3 © The Economist Intelligence Unit 200815
  • 18. Appendix Feeling the pressure?The challenge of enhancing return on equity Please indicate current measures for the following performance ratios. (% respondents) Current ratio (current assets divided by current liabilities) 25 22 16 7 6 4 4 3 3 3 2 1 1 1 1 1 1 1 0 0 0 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0 Cash to debt ratio 25 14 12 11 8 7 5 5 3 2 2 2 1 1 1 1 1 0 0 0 0 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0 What change has there been to these measures over the past year? (% respondents) Significant increase Slight increase No change Slight decrease Significant decrease Current ratio 11 33 42 11 3 Cash to debt ratio 11 24 43 17 6 What is your current debt/equity ratio and what do you expect this to be in one years time? (% respondents) Between 0 and 0.5 Between 0.5 and 1 Between 1 and 2 Between 2 and 5 Between 5 and 10 More than 10 Currently 32 21 22 14 6 4 In one years time 29 23 24 15 6 316 © The Economist Intelligence Unit 2008
  • 19. Appendix Feeling the pressure? The challenge of enhancing return on equityIn the past three years, how has your companys debt to equity What changes have you made to levels of debt and equity in yourratio changed in relation to your industry average? company over the past three years?(% respondents) (% respondents)Increased compared with industry average Increased ratio of debt to equity 20 30No change Increased ratio of equity to debt 38 36Decreased compared with industry average No change 26 34Don’t know 17In deciding how much cash to hold on the balance sheet, which What is your view of the amount of cash that you currently holdof the following are the most important considerations? on the balance sheet?Please select up to three. (% respondents)(% respondents) Too much 17Holding a "war chest" to protect against future downturns About right 42 63Uncertainty about future investment opportunities Too little 31 21The cost of raising additional funds 25Interest rate considerations Which of the following have you used to return cash to 24 shareholders in the past three years?The time it takes to raise funds (% respondents) 23Ability to return cash to shareholders Paid a regular dividend 23 62Preference of shareholders Paid an extraordinary dividend 20 21Tax considerations Repurchased shares 17 26Regulatory considerations 11Potential liabilities (eg, possible litigation exposures in the future) 10Which of the following do you intend to use to return cash toshareholders in the next three years?(% respondents)Paid a regular dividend 55Paid an extraordinary dividend 26Repurchased shares 27 © The Economist Intelligence Unit 200817
  • 20. Appendix Feeling the pressure?The challenge of enhancing return on equity How satisfied are you with the following aspects of your financial management? Please rate on a scale of 1 to 5, where 1=Very satisfied and 5=Not satisfied. (% respondents) 1 Very satisfied 2 3 4 5 Not satisfied Don’t know/Not applicable Overall capital structure 16 42 25 11 5 1 Return on equity 13 32 28 14 11 2 Debt issuance and management 13 30 29 10 3 14 Equity issuance and management 10 26 33 9 2 20 Dividend and share buyback policy 12 27 27 9 4 21 Cash management 15 42 24 12 5 1 Management of assets 16 36 34 11 3 2 Financial risk management 12 35 32 13 6 1 Please indicate whether you agree or disagree with the following statements. (% respondents) Agree Neither agree nor disagree Disagree An asset-light business model is currently attractive to us 39 35 26 The tax advantages of debt are a strong incentive for us to increase leverage 28 42 30 We have put plans to optimise our capital structure on hold until there is greater clarity about how the current market downturn will develop 34 42 23 We would consider partnering with private equity firms to acquire assets 33 32 36 We would welcome an attempt by a sovereign wealth fund to take a stake in our company 24 31 45 The current environment has made conditions more favourable for the strategic acquisition of assets 51 37 12 We have been thwarted in our attempts to acquire assets in the past by private equity firms that use more aggressive balance sheet structures 27 46 27 We believe that our equity is currently undervalued by the market 45 47 8 11 11 11 11 1118 © The Economist Intelligence Unit 2008
  • 21. Appendix Feeling the pressure? The challenge of enhancing return on equityIn deciding how much cash to hold on the balance sheet, which Which of the following are currently exerting pressure on yourof the following are the most important considerations? company to boost its return on equity?Please select up to three. Please select all that apply.(% respondents) (% respondents) Executive managementHolding a "war chest" to protect against future downturns 61 42 Competitive pressureUncertainty about future investment opportunities 37 31 Shareholders (institutional)The cost of raising additional funds 31 25 Non-executive managementInterest rate considerations 25 24 Shareholders (activist)The time it takes to raise funds 22 23 Private equity suitorsAbility to return cash to shareholders 13 23 Other, please specifyPreference of shareholders 3 20Tax considerations 17Regulatory considerations 11Potential liabilities (eg, possible litigation exposures in the future) 10Which of the following have exerted pressure on your company to What change has there been to overall levels of pressure sinceboost its return on equity in the past three years? the credit crisis began in August 2007?Please select all that apply. (% respondents)(% respondents) Significant increaseExecutive management 13 53 Slight increaseShareholders (institutional) 45 40 No changeCompetitive pressure 34 36 Slight decreaseShareholders (activist) 6 22 Significant decreaseNon-executive management 1 17Private equity suitors 13Other, please specify 3 © The Economist Intelligence Unit 200819
  • 22. Appendix Feeling the pressure?The challenge of enhancing return on equity Which of the following have played an important role in enabling If you have increased leverage in the past three years, what have your company to boost its return on equity in the past three been the main objectives for this approach? years? Please select all that apply. Please select up to three. (% respondents) (% respondents) Enabling more capital investments Increasing revenues 32 66 Returning cash to shareholders Reducing costs 16 51 Satisfying activist investors Increasing operational efficiency (eg, working capital) 8 38 Defending against takeover Refinancing assets 7 16 Other, please specify Increasing ratio of debt to equity 7 15 Not applicable; we have not increased leverage Divestment 41 15 Which of the following do you expect to be important in enabling What do you see as the main drawbacks of increasing leverage at your company to boost its return on equity in the next three your company? years? (% respondents) Please select up to three. (% respondents) Increase in borrowing costs 26 Increasing revenues Issuing debt would lead to reduced financial flexibility in the future 68 19 Increasing operational efficiency (eg, working capital) Difficulty servicing debt in the event of a downturn 59 16 Reducing costs Negative impact on companys appeal to investors 56 11 Divestment Potential for lower credit rating 17 11 Increasing ratio of debt to equity Potential for increase in interest rates 15 11 Refinancing assets High transaction costs of issuing debt 14 5 If you intend to increase leverage in the next year, what will be the main objectives for this approach? Please select all that apply. (% respondents) Enabling more capital investments 35 Returning cash to shareholders 18 Satisfying activist investors 10 Defending against takeover 7 Other, please specify 5 Not applicable; we do not expect to increase leverage 3920 © The Economist Intelligence Unit 2008
  • 23. Appendix Feeling the pressure? The challenge of enhancing return on equityAbout the respondentsWhat is your primary industry? In which region are you personally located?(% respondents) (% respondents)Financial services Western Europe 20 31Manufacturing Asia-Pacific 10 31Professional services North America 10 28IT and technology Eastern Europe 8 5Consumer goods Middle East 8 3Construction and real estate Latin America 7 1Energy and natural resources Africa 7 1Entertainment, media and publishing 6Healthcare, pharmaceuticals and biotechnology 5 Which of the following best describes your title?Automotive (% respondents) 4Chemicals Board member 3 7Logistics and distribution CEO/President/Managing director 3 3 24Telecoms COO 2 2 2Transportation CFO/Treasurer/Comptroller/Finance director 2 52Education Other C-level executive 2 15Agriculture and agribusiness 2Aerospace and defence 1Government/public sector 1 What is the ownership structure of your company? (% respondents) Privately owned 53 Publicly listed 38 Private equity owned 9 © The Economist Intelligence Unit 2008 21
  • 24. Appendix Feeling the pressure?The challenge of enhancing return on equity Does your company currently have a credit rating? What are your companys annual global revenues in US dollars? Select all that apply. (% respondents) (% respondents) $500m or less AAA (or equivalent) 49 7 $500m to $1bn AA+ 15 7 $1bn to $5bn AA 17 7 $5bn to $10bn AA- 7 3 $10bn or more A+ 12 2 A 5 A- 3 BBB+ 3 BBB 2 BBB- 1 BB+ 2 BB 1 BB- 1 B+ 1 B 1 B- 0 CCC 0 Not rated 5522 © The Economist Intelligence Unit 2008
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