The new 'Normal': Implications of sovereign debt and the competition for capital

The New “Normal”Implications of Sovereign Debt and the Competition for CapitalA survey and report created with

Printed June 2010Table of ContentsAbout the survey 2Introduction 4 + Key survey findings 5CPP – The IPO markets re-open 7Sovereign debt: crisis and change 8 + Investor appetite for sovereign debt 8 + Longer-term prospects 9 + Changing perceptions of risk 9Postponing the inevitable: An interview with Carmen Reinhart 11The reserve currency of choice 12Sophos exploits the thawing of the private equity market 13The outlook for corporates 14 + Cash and other alternatives 16 + Regulation and credit availability 17Nord Stream: From three banks to 26 19Conclusion 20About RBC Capital MarketsRBC Capital Markets is A Premier Investment Bank. Our strengths in providing focused expertise, superior execution andi nsightful thinking have consistently ranked us among the top 20 global investment banks. With over 3,000 employees,we provide our capital markets products and services from 75 offices in 15 countries and work with clients through operationsin Asia and Australasia, the U.K. and Europe and in every major North American city.We are part of a global financial institution, Royal Bank of Canada (RBC). RBC has been providing financial services forover 140 years. We are a top 10 global bank by market capitalization and have one of the highest credit ratings of any financialinstitution: Moody’s Aaa and Standard & Poor’s AA-.About The Economist Intelligence UnitThe Economist Intelligence Unit is the business information and research arm of The Economist Group, publisher ofThe Economist. Through its global network of 650 analysts, it continuously assesses and forecasts political, economicand business conditions in more than 200 countries. As the world’s leading provider of country intelligence, it helpsexecutives make better business decisions by providing timely, reliable and impartial analysis on worldwide market trendsand business strategies.

ForewordOur clients are operating in unprecedented times – what many are calling “the new normal”. This environment of high frequency change andevolution is challenging institutional investors and corporate executives to understand, as never before, the derivative implications of complexglobal economic issues when making important capital allocation decisions for their organizations. At RBC Capital Markets, we strive to provideour clients with relevant information and a unique perspective to help them make the best decisions possible.With this goal in mind, we partnered with the Economist Intelligence Unit to embark on our second poll of over 400 capital markets participantsto specifically address sovereign risk and the outlook for global investors and corporates. We launched our survey on April 28, 2010 – concurrentwith the beginning of the most volatile month of the European debt crisis – and received responses through the end of May.This white paper is the result of the survey work conducted in the midst of this crisis. It reveals interesting insights regarding the impact of recentfinancial, economic and fiscal events on future financing and investing decisions of corporate and institutional leaders.Some of the themes addressed in the report include: • Guarded optimism about industrialised North American and Asian economies over the next 12 months • Decoupling of European prospects for currency, fiscal solidarity and economic growth from global peers • Long-term capital availability concerns for sovereigns and a cautionary approach from corporates in light of risk reorientationPaul Abberley, Chief Executive, Aviva InvestorsPaul Corcoran, Financial Director, Nord StreamJames Douglas, Head of Debt Advisory, DeloitteTeddy Moynihan, Partner, Oliver WymanSteve Munford, Chief Executive Officer, SophosShaun Parker, Chief Financial Officer, CPPCarmen Reinhart, Co-Author of This Time Is DifferentRobin Stalker, Chief Financial Officer, AdidasIan Winham, Chief Financial Officer, Ricoh EuropeTheo Zemek, Global Head of Fixed Income, AXA Investment ManagersWe hope you will find the report insightful.Marc Harris Richard TalbotCo-Head of Global Research Co-Head of Global ResearchRBC Capital Markets RBC Capital Markets

About the survey• espondents were almost evenly split R As part of this research program, RBC Capital Markets commissioned the between financial institutions (229 or Economist Intelligence Unit to survey 440 capital markets participants 52%) and non-financial corporations on the effects of the recent financial, economic and fiscal events on borrowers (211 or 48%). and investors. The online survey was done over a period of four weeks,• mong the financial institutions, from April 28 to May 25, 2010, a time of massive market volatility and constant A headlines on a potential Greek default (see below). 27% were commercial banks, 20% investment banks, 19% asset managers, 16% private equity firms, 10% hedge funds and 8% pension funds, sovereign wealth funds or other Headlines over the time period institutional investors. About one-third had over $150bn in assets, while 60% had over $10bn.1 EU, IMF stitch IMF chief Greece together economist• he corporates came from a wide T readies €750bn says range of industries, with six sectors austerity emergency Greek aid accounting for 61%: healthcare measures, fund; IMF to Greece gets package markets ECB dashes disburse €14.5bn doubts and pharma, professional services, steady rescue hopes €5.5bn now loan from EU remain manufacturing, technology, energy and natural resources, and retail. Three- quarters had over $500m in annual revenues and about a third had over $5bn. April 30 May 7 May 10 May 18 May 25• he largest group of respondents, T 41%, was from Europe, followed by North America (34%) and Asia-Pacific (16%). The remaining 9% were from Latin America, the Middle East or Africa.• he executives polled were T a senior group, with 38% at the C-level and 61% at or above the VP or director level. The rest Cumulative Responses were heads of business lines, departmental heads or managers. 1 All $ figures are USD$ unless otherwise noted. 2 The New “Normal”

Market activity during the survey windowThe timing of the survey coincided with a period of extreme volatility visible in most market indicators.$ per Euro VIX Index1.5 50 401.4 301.3 201.2 10 Jun 1 Aug 1 Oct 1 Dec 1 Feb 1 Apr 1 Jun 1 Jun 1 Aug 1 Oct 1 Dec 1 Feb 1 Apr 1 Jun 1S&P500 FTSE-1001,250 6,0001,2001,150 5,5001,1001,050 5,0001,000 950 4,500 900 850 4,000 Jun 1 Aug 1 Oct 1 Dec 1 Feb 1 Apr 1 Jun 1 Jun 1 Aug 1 Oct 1 Dec 1 Feb 1 Apr 1 Jun 1Greek sovereign CDS spreads WTI crude oil1000 90 900 85 800 700 80 600 500 75 400 70 300 200 65 100 0 60 Jun 1 Aug 1 Oct 1 Dec 1 Feb 1 Apr 1 Jun 1 Jun 1 Aug 1 Oct 1 Dec 1 Feb 1 Apr 1 Jun 1Source: BloombergThe New “Normal” 5

Introduction “The lesson of history, As one crisis leads to another – first financial, then economic, now fiscal – market participants struggle to discern the shape of the next big wave. then, is that even Investment-grade capital providers and borrowers have plenty of cash and as institutions the ability to get more. But in terms of perceptions and performance, the and policy-makers gap between high-quality borrowers and others – companies, sovereigns or even entire industries – has seldom been wider. And capital providers improve, there need to remain vigilant in light of continuing writedowns and regulatory will always be a challenges that could reduce their financial flexibility. temptation to stretch Demand for funding is low today, but competition may well grow more acute. the limits. Just as The scale of debt issuance required by governments and financial institutions an individual can go over the next few years will be almost without precedent. As demand grows, any bankrupt no institution seeking to raise capital will face more selective and critical investors. The euro is not likely to recover soon; sovereigns in developed nations will need matter how rich she years to repair the fiscal damage. To succeed in this environment, borrowers will starts out, a financial require strong, long-term relationships and the ability to construct a convincing system can collapse argument for their prospects in a volatile environment. under the pressure At the end of 2009, the global economy was showing strong signs of recovery. of greed, politics and Major economies had emerged from recession, equity markets had enjoyed profits no matter a sustained boom, trade was flowing again, and corporate profitability had returned after companies had slashed costs. Even the major investment banks how well regulated at the epicentre of the crisis enjoyed a strong rebound and posted significant it seems to be.” increases in revenues and profitability. But despite a growing sense that the worst is over, serious problems continue This Time Is Different, to bubble up. The economic recovery is uneven, with emerging markets leading Carmen Reinhart the way and industrialised countries constrained by damage to the financial and Kenneth Rogoff sector. Banks are in better shape than at the start of 2009 but continue to be severely impaired, particularly in Europe. And unemployment remains stubbornly high in many OECD countries, constraining consumption and prompting further fears of defaults on loans. But perhaps the most severe challenge is the indebtedness of many industrialised countries. The massive transfer of debt from the private sector to the public sector, along with an unprecedented fiscal and monetary stimulus from the world’s major industrialised economies, has led to a dramatic deterioration in public finances. As the OECD notes: “Many countries are facing very unfavorable government debt dynamics, as rising indebtedness raises risk premia, which adds to the debt burden while holding back growth, which has further adverse consequences on debt sustainability.” 2 2 OECD Economic Outlook No. 87, May 20104 The New “Normal”

Key survey findings TOPIC FINDINGS Financial institutions and corporates are > espondents expect growth-friendly monetary R (if not fiscal) policies over the next three years guardedly optimistic about the prospects > espite strength in the emerging markets, growth in the D for economic growth developed nations will remain below historic norms > espondents expect the prospects for industrialised R Asia and North America to improve over the next 12 months The economic prospects for Europe appear > strong consensus exists that Europe’s prospects A are negative to have decoupled from those of other > here is little confidence in the euro; most respondents T industrialised regions expect it to continue its slide in value > lmost half of respondents think there is a greater A than a 50/50 chance of one or more countries leaving the eurozone in the next three years > ne-third see at least a 25% chance of a complete O break-up of the eurozone over the same period > roblems facing the euro have reinforced the position P of the dollar as the international reserve currency of choice The European sovereign debt crisis has > here are concerns that governments of developed T countries will not have sufficient credit capacity caused a reorientation of risk for the massive intervention required to kick-start their economies in the event of another financial crisis > overeign debt is not alone in being perceived as more S risky: respondents think all asset classes have become riskier as a result of the financial crisis > small majority of respondents expect yields on A bonds from the most creditworthy corporates to fall below those of sovereign benchmarks over the next three years – corporates, suggest these respondents, are the new sovereigns Economic uncertainty is deterring corporates > ust one-third of corporates say that they plan to raise J capital over the next 12 months from raising capital > or companies that do plan to raise capital, F investment-grade debt and private equity are the most popular categories > here is a mismatch between expectations of financial T services and corporate respondents; the former are more optimistic about the outlook for transaction volumes than the latter > ore than half of companies have restructured their M business operations to improve access to capitalThe New “Normal” 5

Although the actions of policy-makers around the world have been effective in dealing with the short-term problems of the financial crisis, many commentators continue to worry that the underlying problems remain unresolved. “Policy-makers essentially took a private sector debt overhang and nationalised it,” says Paul Abberley, Chief Executive of Aviva Investors. “The response to the financial crisis has delayed a reckoning rather than solving the problem and getting us back to normal.” While corporates and investors expect a return to growth, the adverse economic headwinds continue to weigh heavily on their minds. Among the survey respondents, 87% think that economic growth will be positive over the next two years, but only 5% expect it to exceed levels seen in 2003 to 2007. There is a strong consensus that growth will be driven by policy intervention rather than an improvement in the economic fundamentals. The number of respondents who agree that central banks will continue to prop up the economy and financial sector rather than fight inflation exceeds the number who disagree by 44% (see Chart 1). Respondents also foresee a divergence between developed and undeveloped markets. Many more respondents agree than disagree with the assertion that economic growth and consumer demand in developed countries will remain well below the post-war norm (see Chart 1). We find similar levels of agreement with the statement that faster-growing nations such as China and India will replace the U.S. as a source of import demand driving global growth.3 To use a phrase borrowed from Mohamed El-Erian, CEO of PIMCO, this is the “new normal” of “muted growth overall, a protracted need for balance sheet rehabilitation, accelerated migration of growth and wealth dynamics to systemically important emerging economies and relatively weak global governance”.4 Chart 1: Positive albeit modest growth prospects Demand and growth over next 3 years (agree minus disagree) Central banks will continue to prop up the economy and financial sector rather than fight inflation Even after income, credit and confidence return, U.S. consumers will not spend at historic peak levels Economic growth and consumer demand in developed economies will remain well below the post-war norm Faster-growing nations will replace the U.S. as a source of import demand driving global growth 3 For instance, China’s spending on imports rose 48% year-on-year in 0% 10% 20% 30% 40% 50% May and India’s imports 43% in April Respondents were given choices of agree, disagree, neutral or dont know/no opinion. The chart shows the percentage 4 PIMCO Secular Outlook, May 2010 choosing "agree" less those choosing "disagree." It does not show those choosing "neutral" or "dont know/no opinion."6 The New “Normal”

Chart 2: Europe’s lack of expected growth contrasts with the rest of the worldBut although growth prospects arepolarised between industrialised Economic prospects over next 12 months by regionand emerging economies, there are (better minus worse)important nuances. While respondentsundoubtedly see Asia as having the India Other developed Asia (Hong Kong,best economic prospects over the next Singapore, South Korea)12 months, North America is close Chinabehind in terms of levels of optimism. North AmericaThe outlier is Europe, which manymore respondents think has a negative Russiaoutlook than a positive one (see Chart 2). Middle EastEssentially, survey participants’ Africaperceptions of Europe’s economicoutlook appear to have decoupled Japanfrom their perceptions of the rest of the Europeindustralised world. -40% -20% 0% 20% 40% 60% 80% Respondents were given choices of better economic prospects, worse economic prospects, no change or don’t know/no opinion. The chart shows the percentage choosing “better prospects” less those choosing “worse prospects.” It does not show those choosing “neutral” or “don’t know/no opinion.”CPP – The IPO markets re-openIn the first quarter of 2010, there were 100 IPO deals Officer of CPP. “At some points things looked bad and thenglobally, making it the best quarter for issuance since all of a sudden the market would firm up again. So it was athe end of 2007. CPP, an insurance company providing period of considerable volatility but still within a reasonableprotection against credit card and identity theft, was one boundary that led us to feel comfortable about the timing.”beneficiary of this trend. In March 2010, it raised £150m(US$220m) on the London Stock Exchange through an IPO A number of other companies cancelled offerings due tothat valued the company at £396m (US$581m). Although market volatility or lack of demand. The key to success,the shares were priced at the lower end of the expected according to Mr Parker, is to ensure that the company hasrange, the IPO is a sign of growing investor appetite to strong financial fundamentals before going to market.participate in new offerings. “We’re a business with a growth story and we’ve proven that over a relatively long period of time,” he explains. “WeThe IPO took place before the eruption of sovereign debt also generate cash, which means we can pay out a prettyproblems, but there was still considerable volatility. “As we strong dividend. I believe that if the fundamentals arewent into the process there were good weeks and bad weeks there and investors have money to invest, then they will bein the financial markets,” says Shaun Parker, Chief Financial willing to get involved.”The New “Normal” 7

Sovereign debt: crisis and changeAlthough few industrialised countries can boast a positive Part of the problem has been that peripheral countries havefiscal outlook, the problems have become most acute on the built up fiscal deficits that massively breach the eurozone’speriphery of the eurozone. In December 2009, Greece’s credit targets of 3% of GDP. But a deeper problem has been arating was downgraded to the lowest in the eurozone as a monetary union achieved without fiscal or political union.result of concerns over its ballooning debt. Despite promises of “I genuinely cannot see how in the longer term the euro can“austerity measures” comprising public spending cuts and tax last in the form that it is in, unless there is greater fiscal andincreases, Greek bond yields jumped to unprecedented levels. political centralisation in Brussels,” says Theo Zemek, GlobalFears grew that other indebted members of the eurozone – Head of Fixed Income at AXA. “And the implications of that arePortugal, Spain, Italy, Ireland, even France – faced problems on so onerous that I do not believe it will ever happen.”a similar scale. Despite a €750bn rescue package announcedin late May by eurozone finance ministers, concerns about a Investor appetite for sovereign debtpotential Greek default, and indeed for the future of the entire In 2009, sovereign debt issuance surged to record levels ineurozone, persist. “The bail-out failed to reassure the markets, the U.S., U.K. and eurozone as crisis-related interventionsbut I think it would have been impossible at an institutional led to a dramatic increase in borrowing requirements. Thislevel to move any faster than the governments actually did,” huge transfer of debt from the private to public sector raisessays Mr Abberley. the question of whether institutional investors will have the capacity or willingness to absorb the supply of new sovereignThe problems facing the eurozone have raised questions as to debt issuance.whether the euro can survive the crisis. Almost half of surveyrespondents think there is a greater than 50/50 chance of one Among the survey respondents, significantly more agreeor more countries leaving the eurozone in the next three years than disagree with the assertion that the credit capacity of(see Chart 3). More worryingly, about one-third see at least a developed countries will diminish significantly compared25% chance of a complete break-up of the eurozone over the with capacity today (see Chart 5). Respondents agreesame period (see Chart 4). even more strongly that developed countries will not stop Chart 3: urvey respondents estimate the odds of one or more countries leaving the S eurozone in the next three years 14% 46% of respondents say the probability is 50% or more 12% 10% 8% % of respondents 6% 4% 2% 0% Probability of at least one country leaving Eurozone in next 3 years8 The New “Normal”

Chart 4: urvey respondents estimate the odds of the eurozone breaking up in S the next three years 75–100% Probability 36% of respondents 50–74% believe there is at least Probability a 25% probability 7% 11% 64% 25–49% 18% Probability of respondents 0–24% Probabilityincreasing their levels of indebtedness until investors force A persistent risk aversion among investors also suggeststhem to scale back on debt purchases (see Chart 5). In higher allocations to bonds despite a reassessment ofshort, even supposedly “safe” sovereigns could experience sovereign debt. “In one form or another, pension funds anda shock if they do not restore fiscal discipline and bring other large investors are increasing their exposure to bondsdown deficits. at the expense of equities,” says Ms Zemek. “But given the choice, we are buying shorter-dated bonds and we areFor now there is sufficient appetite for sovereign debt buying ones with inflation protection.”issuance, even if the conditions may not be to everyone’sliking. “Everything can be digested under certain scenarios Changing demographics, particularly in the developed– it is just that some are more pleasant than others,” says world, also benefit bonds. “The demographics ofProfessor Reinhart. “There will be costs. You cannot take the wealthy world suggest that there will be more agingcurrent interest rates as a given in this kind of scenario and this will require a greater shift towards age-relatedbecause the issuance by the major parties is so huge.” products, of which bonds are certainly one,” says Ms Zemek.Longer-term prospectsDespite price volatility, sovereign assets have a good deal Changing perceptions of riskgoing for them over the long term. Banks are likely to hold more But while banks and other investors will continue to placesovereign debt to meet new rules on capital adequacy and great emphasis on sovereign debt as an asset class, they willliquidity. Basel III will heavily weight government bonds on the increasingly take the view that not all government bonds areasset side, leading to higher demand for sovereigns. Moreover, created equal. Before the crisis, there was an assumption thatbanks have learned the importance of holding assets that can all sovereign debt had similar risk and that spreads betweenbe sold quickly and easily. As the most liquid asset class by far, countries were minimal. Investors are now more discriminatinggovernment bonds will always hold strong appeal. – and this discrimination is reflected in bond prices.The New “Normal” 9

Chart 5: Financial executives say that the sovereign crisis is far from overOpinions of sovereign credit over next 3 years (agree minus disagree) Developed countries will not stop increasing their levels of indebtedness until investors force them to by scaling back on debt purchases In the aftermath of another financial crisis, governments will not have sufficient credit capacity for the massive intervention required to re-start the economy The credit capacity of developed economies will diminish significantly compared to capacity todayCorporate bonds from the most creditworthy companies will yield less than their sovereign benchmarksRespondents were given choices of agree, disagree, neutral or dont know/no opinion. The chart shows the percentage choosing "agree" less those choosing "disagree." It does not show thosechoosing "neutral" or "dont know/no opinion."This reassessment of risk raises questions about how fixed equities were perceived to have become even more risky thanincome products should be priced in the future. “If the sovereign debt.government bond you own is no longer a risk-free rate, thenyou have a re-orientation of the corporate bond market,” At the same time, a significant minority of respondentscontinues Mr Abberley. “Rather than saying a bond is 112 said that certain asset classes had become less risky. Thebasis points over you have to go back to the days when you top three were classic inflation hedges: real estate (bothsay: the yield is 7%. But is that the right number?” residential and commercial) and commodities. And indeed, a majority of both corporate and financial services executivesOf course, sovereign debt is not the only asset class that is said that they had begun to fear the impact of inflationperceived as riskier as a result of the financial crisis. Asked more than deflation. This stands in contrast to the surveyhow their risk perceptions had changed over the past year, that preceded this one – done in August of 2009 – in whichmore respondents said that risks were higher than lower for executives split close to 50-50 on expectations for theevery single asset class (see Chart 6). Indeed, currencies and impact of inflation versus deflation.Chart 6: inancial services respondents perceive all asset classes as becoming more risky F over the past year Less risky More risky Currencies Commercial real estate in my country Equities Corporate debt in my market Sovereign debt of my country, if not U.S. Residential real estate in my country U.S. Treasuries Private equity Hedge funds Commodities % of respondents10 The New “Normal”

Postponing the inevitable: An interview with Carmen Reinhart In May, the European Central Bank and IMF there’s going to be a restructuring, which is a announced a €750bn aid package to stem the partial default so it’s a matter of semantics at panic over Greek sovereign debt. After a brief that stage,” she says. “We don’t have many tools rally, the euro plunged to a new low and investors available to deal with this crisis so one can’t rule fled to U.S. Treasury bills. out restructuring.” For Carmen Reinhart, professor of economics at the But delay is good: it provides time to reduce University of Maryland and co-author with Kenneth positions in an orderly fashion and reduces the Rogoff of This Time Is Different, the reaction was risk of contagion. The element of surprise is one typical. In her book, she traces the history of financial of three factors that Professor Reinhart calls crises across 800 years and finds patterns in how “the unholy trinity of financial contagion,” along they unfold. Financial crises are often followed by with an abrupt reversal in capital inflows and a sovereign debt crises as governments face falling tax leveraged common creditor. “Episodes that turn revenues and the cost of bailouts. This, in turn, often out to have fast and furious contagion tend to leads to defaults on sovereign debt. be characterised by surprise and high leverage,” she says. “And an immediate default by Greece Professor Reinhart foresees a similar cycle in would have had both of those elements. So the sovereign debt problems of the eurozone. postponement plays a useful role in giving Europe “Although the situation in many of the more time to adjust to this.” troubled European countries is different, the collective exposure has led to a fundamental risk Holdings by European banks of troubled sovereign reassessment of those countries,” she explains. bonds raise the spectre of banking crisis. “Even if “And that, coupled with worrisome growth the ripple effects are not on the gloom-and-doom prospects, makes for more non-performing loans. panic mode for European banks, they are on the In turn, that leads to more banking problems and downside and that means that growth prospects further fiscal strain.” are further dampened,” says Professor Reinhart. “The combination of higher risk in lending and The troubles on Europe’s periphery have echoes of lower growth prospects tends to end badly for sovereign debt crises such as Mexico in 1994-1995 banks. When they end badly for banks, they end or Turkey in 2000. But the problems facing Greece badly for governments, too.” are particularly severe. “Both Mexico and Turkey had far stronger fundamentals and were able to Many survey respondents predict that countries will devalue their currency, which is not an option for drop out of the eurozone. “I think the efforts will Greece,” she says. be enormous to try to avoid that,” says Professor Reinhart. “I’m not saying that particular scenario Professor Reinhart believes that the ECB and IMF will not play out, just that this will be something bailout will only delay Greece’s default. “I think that countries will work very hard to avoid.”The New “Normal” 11

The reserve currency of choiceThe cloud hanging over the euro has reduced the likelihood of a shift away from the dollar. “The fact that the whole coalitionsurrounding the euro has seemed rather weaker than one would have hoped has undermined its position as a solid and testedreserve currency,” says Ms Zemek. “It’s just not clear how a politically and fiscally diverse entity such as the E.U. would performover the long term according to a number of different scenarios.”But this says less about the dollar than it does about a lack of real alternatives. “If you are an investor looking for a reservecurrency, that is a pretty unpalatable choice,” says Mr Abberley. “None of [the currencies] have anything to commend them at themoment. Almost by default, the dollar remains the reserve currency at the present time. But I don’t think people will talk aboutdollar reserves with any great relish because they’ll also be aware that, to a degree, the dollar story can only be maintained aslong as everyone else believes it.”The vast majority of respondents (80%) expect the dollar to remain the reserve currency of choice in three years’ time, while 57%expect it to retain its role in five years’ time (see Chart 7). Over the five-year horizon, respondents are more likely to expect theChinese renminbi to take over than the euro – despite the low likelihood of this occurring. Ultimately, this finding says moreabout the poor perception of the euro than it does about the potential of the renminbi.While the weakness of the euro may postpone its chances of becoming a more widely used reserve currency, its decline is goodnews from an economic perspective because it may help the region export its way out of the crisis. Although a credible currencyis important, so is an exchange rate that stimulates growth.Chart 7: There is no substitute for the dollar in the intermediate termWhat will be the world’s dominant reserve currency in three years? In five years? Dollar Euro 3 yearsSpecial drawing rights 5 years Renminbi Don’t know % of respondents12 The New “Normal”

Sophos exploits the thawing of the private equity market The financial crisis devastated the private equity according to Mr Munford, this had no material industry. According to Ernst & Young, the number impact on the economics or willingness of either of acquisitions fell by 38% in 2009 while total deal party to complete the deal. “We wanted a partner values fell by 56% to US$95.5bn. But this drop that would take a longer-term view, beyond what’s conceals a more nuanced picture. While highly happening in the markets in this quarter and the leveraged transactions may still be difficult to next,” he explains. “And when you have a four- to conduct, there continues to be a market for equity in five-year investment horizon, a short-term change fast-growing companies with strong balance sheets. in the markets may cause some discomfort, but it certainly doesn’t change the long-term merits of One such company is Sophos, an IT security and the investment.” data protection firm with headquarters in the U.S. and U.K. In May 2010, Sophos announced that Mr Munford felt that the longer-term perspective it had reached an agreement to sell a majority could not be achieved through a public listing. In interest to Apax Partners, a global private equity 2007, Sophos embarked on the early stages of an house. The transaction would value Sophos at IPO but cancelled its plans because of concerns US$830m. about the emerging financial crisis. At that time “it was tough to get the right demand at the right Unlike many private equity deals prior to the crisis, valuation,” says Mr Munford. The financial markets the transaction between Sophos and Apax relies may have since stabilised, but a public listing on low levels of leverage. In return for a US$400m would still not have been appropriate. “Although equity investment, Apax will take ownership of the public markets were open, they were certainly 70% of the company. The remaining 30% will be going to be choppy and what we didn’t want to financed with debt. do is have the conditions of the public markets affecting our ability to provide liquidity and raise “We were not keen to enter into a highly leveraged capital,” says Mr Munford. deal,” says Steve Munford, Chief Executive Officer of Sophos. “The goal was to support the company This does not preclude a public offering in the through its next stage of growth. You can’t do future. Mr Munford views the current deal with that in a technology company if you’re highly Apax as a stepping-stone to a public listing once leveraged. We need to retain a degree of agility the company has grown. “We see private equity as to take advantage of acquisitions or investment a viable alternative to delaying an IPO and giving opportunities as they arise.” our company the benefits of raising capital but allowing us to continue to invest in the future,” The agreement occurred during a period of says Mr Munford. “Our goal is to continue our rising concern about sovereign debt from Greece growth trajectory and enable us to have more skill and other peripheral eurozone countries. But and staying power in the market.”The New “Normal” 13

The outlook for corporatesA gradual recovery in the global economy encourages corporates to shift their focus to strategies for growth, rather thancost-cutting and strengthening their balance sheets. Although volumes remain small by pre-crisis standards, there is a gradualreturn of M&A activity, private equity deals, project financings and IPOs.But despite the return of strategic activity, the number of companies that expect to raise capital remains surprisingly low. Just 38%of respondents say that they expect to issue new debt or equity capital in the next two years (see Chart 8). This suggests that manycompanies harbour doubts about the strength of the economic recovery and are shelving major strategic growth projects for theforeseeable future.Chart 8: Corporates have scaled back funding plansDoes your firm expect to raise new capital in the next two years? Yes, significant amounts of capital Yes, moderate amounts of capital No, we will finance the current level of operations from cash flow and retained earningsNo, we will finance a scaled-down level of operations from cash flow and retained earnings May 2010 Aug 2009 No, we are unable to access the capital markets Don’t know % of respondentsFurther evidence of this pervasive caution can be seen in the mismatch between the expectations of financial servicesrespondents and those from the corporate world. When asked about the outlook for transaction volumes in their country orregion over the next 12 months, respondents from financial institutions are, without exception, more optimistic thancorporate executives (see Chart 9). Overall, respondents see M&A activity as the area where an increase in transaction volumesis most likely, with 61% of financial services respondents expecting an increase, compared with 52% of corporates.Although higher equity prices in 2009 stimulated optimism on a return to M&A activity, this seems to have faded. “It’s going tobe quite a while before there’s sufficient liquidity in the market to support a return to an M&A boom,” says Teddy Moynihan, aPartner in the Corporate and Institutional Banking practice at Oliver Wyman in EMEA. “When deals do happen, there will be a focuson transactions that are not highly leveraged, that have very good cash flows and can service debt easily without a lot of risk.”Which group’s forecast of transaction volume has more credibility? Ultimately it is the corporations that are closest to their owncapital-raising decisions. The most creditworthy may have already filled up on funding, while the less creditworthy have fewerfunding opportunities and lower expectations. The respondents from the financial institutions are specialists in their markets.But the scope for originating assets backed by financial portfolios is limited, and it will be difficult to create transactions whencorporations have little interest in them.14 The New “Normal”

Chart 9: Corporates have scaled back funding plansOutlook for transaction volumes over next12 months vs. last 12 months M&A activity Secondary equity offerings Initial public offeringsInvestment-grade debt Private equity High-yield debt Convertible debt Syndicated loans Financial institutionsCommercial paper Corporates Preferred equity 0% 10% 20% 30% 40% 50% 60% 70% % predicting an increase in transaction volume over next 12 monthsUncertainty about future growth is leading corporates to postpone majorfundraising plans. According to the Bank for International Settlements,borrowers from developed economies reduced their issuance by 38% in the finalquarter of 2009, although those from emerging markets raised 19% more fundsin the international market than in the third quarter.5 The crisis in the eurozone,combined with the unexpected unilateral decision by the German governmentto ban naked short-selling, has unsettled the markets. “People are postponingbond issuance while the environment is so uncertain,” says James Douglas,Head of Debt Advisory at Deloitte. “It was unexpected but it is having a prettysignificant knock-on effect on companies who have had to shelve capital raisingplans as a result of the sovereign turmoil.”But not all corporates think that the sovereign debt problems will affect theircapital raising activities. “What is happening at the moment is of concern interms of the value of the currencies but not in terms of raising capital,” saysRobin Stalker, Chief Financial Officer of Adidas. “It is a worry but won’t in theshort-term or long-term affect our ability to raise capital.” 5 BIS Quarterly Review, March 2010The New “Normal” 15

This sudden drop in bond issuance Chart 10: Market participants expect more regulationfollows a period in which unprecedentednumbers of corporates came to the To what extent do you agree with these predictions about thecapital markets. By August 2009, global next three years? (agree minus disagree)corporate bond issuance had brokenthrough the US$1tr threshold for thefirst time in a single year. The inability toborrow from banks encouraged smaller Global capital movements will be regulated to a greater extentand medium-sized companies, who than they are today as countrieswould previously have relied on bank seek to protect themselves fromlending, to tap capital markets for the disruptive inflows and outflowsfirst time. “The severe shortage of creditsupply in the banking sector means As derivatives and otherthat the capital markets will have to transactions become more tightly regulated,step in and pick up the slack in terms activity will increasinglyof supplying leverage into the economy be pushed into less regulated offshore venuesto support growth,” says Mr Moynihan.This has been particularly true inEurope, a region that has traditionallybeen more closely associated with bankfinance. In the U.K., for example, the 0% 20 % 40 % 60 %average size of bond issues has halvedfrom the market peak in 2007, according Respondents were given choices of agree, disagree, neutral or dont know/no opinion. The chart shows theto Dealogic. percentage choosing "agree" less those choosing "disagree." It does not show those choosing "neutral" or "dont know/no opinion."Institutional investors such as AXAregard this trend as a positive oneoverall. “It has been a good thing more match fit in terms of how they of self-funding and equity to the tablethat the capital markets have been present information to lenders,” says is a real positive.”open and ready for business because Mr Douglas of Deloitte. “There’s athis has kept a significant number lot more emphasis on the numerical Ricoh also recognises that its small-of businesses afloat in some fairly data and CFOs are finding that they and medium-sized customers maydifficult times,” says Ms Zemek. “This must make a real effort to make their have trouble getting financing. Tohas also been a positive development companies look more attractive to the this end, the company has workedfor us because we can get access lending community.” with providers of lease financing toto assets of a good quality and this ensure that its customers get access toenables us to diversify more than we Cash and other alternatives funds they need to make investments.have been able to for a while.” It used to be that investors frowned “The willingness of lease finance on companies hoarding cash. Now companies to support our customerWith credit constraints diverting they recognise the benefits of a war base is absolutely essential,” says Mrcompanies from bank lenders chest. “I’ve certainly put a message Winham. “We have been taking greatto the capital markets directly, into the business that while I’m care to understand their decision-investor relations teams have been looking to invest and take advantage making process. Just by being verygrowing accustomed to a new type of opportunities, I need everyone engaged with these providers ofof stakeholder: the bondholder. to focus on building up the cash finance, you can start to get a realPrior to the crisis, few CFOs held reserves,” says Ian Winham, Chief sense of how they arrive at decisions.”investor roadshows for bondholders, Financial Officer of Ricoh Europe. “Inbut this is becoming increasingly my discussions with funders, the fact Taking advantage of its strong positioncommonplace. “CFOs have to get a lot that we are able to bring an element in terms of raising capital, Ricoh has16 The New “Normal”

even started to disintermediate the external providers of capital and disbursefunds directly to its customers. “The lease finance companies haven’t necessarilygot the history with the customers,” says Mr Winham. “Whereas from ourperspective we’re close to them, we can see their history and, as a manufacturer,we have greater flexibility on how the product works with them as well. Thismeans that we’re moving into a different funding requirement where it’s internallydriven and I’ve got to raise the funds to support that capital requirement.”Regulation and credit availabilityThe regulatory agenda focuses on reducing systemic risk. Althoughharmonisation of regulatory oversight across countries is seen as the mosteffective way of reducing systemic risk, respondents do not consider thisparticularly likely. They also doubt that regulators will be able to agree onan approach to central clearing of over-the-counter derivatives. More likely,according to respondents, is closer supervision of banks by the same regulators– in most jurisdictions this is already happening – and the upcoming Basel IIIrules on capital and liquidity.Stricter capital and liquidity buffers, a potential global tax on transactionsand attempts to reduce leverage in the system will all help to improve thestability of the financial sector, but they could also have a profound impact onthe profitability of the banking sector. According to a recent report from OliverWyman, a punitive response from regulators could reduce the return on equityin the investment banking sector by as much as 8%.6 The survey results andinterviews confirm that market participants are very concerned about the impactof new regulations. Mr Abberley worries that the regulatory agenda will reducenot just bank profitability, but economic growth as well. Regulators keen toclamp down on capital markets and the banking sector will constrain the abilityof financial institutions to lend and leave corporates with limited options forraising capital. “If you restrict both the banking system and the capital marketsfrom a regulatory perspective, then logically you have to accept that GDP willpotentially be lower than it would otherwise have been – albeit less volatile.Corporates have got to be able to borrow from somewhere.”The uncertain regulatory outlook is affecting corporate borrowers. “Uncertaintyabout what regulators will allow you to do in capital markets is creating riskaversion and potentially raising the cost for borrowers,” says Mr Abberley.“It might also impact the maturities over which they can borrow becausecommitting to longer-term investments could be dangerous in the context of achanging regulatory environment.”Unilateral regulatory decisions taken by some governments have the potentialto muddy the waters even further. Take the decision by the German governmentto ban naked short-selling, which exacerbated fears about liquidity in the bondmarkets. “The actions in Germany are the thin end of the wedge which, if youfollow it along its shape, gets to the point where it may be that you are simplynot allowed as an investor to sell a government bond,” says Mr Abberley. “Soliquidity risk suddenly goes through the roof.” 6 utlook for Global Wholesale and O Investment Banking, March 2010The New “Normal” 17

Chart 11: Investors, and to a lesser extent issuers, see regulation as a threatISSUERS INVESTORSWhat is the single biggest threat to your ability to finance What is the single biggest threat to the value ofyour business? your portfolio?Rank Issue Frequency Issue Frequency1 Weak demand 15% Regulation/government actions 13%2 Tight credit 13% Weak demand 9%3 High cost of finance 9% Defaults 8%4 Crisis/Volatility 7% Inflation 7%5 High operating costs 6% Higher risk 5%6 Debt availability 5% Risky debt 4%7 Risk appetite of lenders 5% Sovereign credits 3%8 Regulation/government actions 4% Pricing of risk 3%Chart 11 categorises the answers to write-in questions posed to issuers and investors. In the comments section, some investorswere merciless in their condemnation of impending regulatory changes. Typical write-ins included:> Regulatory overshoot> Government interference> Ill-conceived legislation> Intrusive and burdensome regulation> Top-heavy governments in developed countries> Abrupt asset price changes driven by inconsistent/indecisive governments> Liquidity rules forcing poor capital allocation18 The New “Normal”

Nord Stream: From three banks to 26 When it comes to large financings, persistence 80/20. This opened up the liquidity that we needed and flexibility can win the game even in difficult to cover the commercial tranche and ultimately led market conditions. In March 2010, Nord Stream to successful financing.” successfully raised €3.9bn of project finance to fund the first phase of a 1,200-km underwater gas Mr Corcoran says that project financings have been pipeline linking Russia and the European Union. affected less by credit constraints than other areas With Europe expected to import 70% of its energy of debt finance. “With project finance, the underlying supplies by 2030, the pipeline is vital to the credit is the project itself so as long as it is solid, continent’s energy security and a sign of stronger then investors are less influenced by macroeconomic relations between Europe and Russia. factors,” he says. “In terms of our project, I think all the fundamentals mean a low-risk offering to banks.” Nord Stream is a joint venture between the Russian energy giant Gazprom, which owns a But with credit committees scrutinising every controlling stake, BASF Wintershall, E.ON Ruhrgas investment, clear documentation and planning and Gasunie of the Netherlands. For the Phase 1 are essential. “You don’t give them any excuses to financing, the consortium partners provided 30% block the deal,” says Mr Corcoran. “You need as of the funds in line with their shareholding, while much interest in the project as you can generate in the remaining 70% was raised from a syndicate of order to end up with a good clearing price.” participating banks. It may seem surprising that Nord Stream did not Although the funding was ultimately oversubscribed, tap the capital markets directly. “We did consider it was difficult to secure. When the project first whether we’d go to the bond market, but at the launched in 2005, offers from banks were such that time that we were looking to make our decision, only three or four would have been required. In the it was in a very poor state,” says Mr Corcoran. end, 26 participated. “The whole environment had “When you decide to go for bond markets, you changed,” says Paul Corcoran, Financial Director of need to know that they’re going to be there when Nord Stream. “Many of those banks who were key you want them.” relationship banks with our shareholders and who were keen on the project were just not in a With the first phase of financing now over, position to be able to go ahead. They just didn’t Nord Stream has begun construction and expects have the liquidity.” it to be complete by 2012. A second fundraising phase is expected to close by the end of 2010. To finance the project, Nord Stream had to “We have a solid package, a project that everyone increase the coverage ratio to give investors is familiar with and thorough documentation more protection. “We worked very hard with the established in Phase One,” says Mr Corcoran. partners in the financing to improve the covered “Just by the nature of this process, that puts us to uncovered ratio, and indeed we improved it to in a very strong position for the next stage.”The New “Normal” 19

Conclusion Six months can be a long time in the financial markets. In the first half of 2010, each week brought the shock of the new, with old verities crumbling and fresh ones taking shape. The survey and interviews conducted for this research confirmed the outline of certain aspects of this new world. First, there is a new dichotomy between developed and emerging markets. Countries such as China, India and Brazil have little debt and huge capacity. The U.S., Europe and Japan have a great deal of debt and capacity approaching its limits. The old notion of safety in the center and danger on the frontier is eroding. Or perhaps the center is simply shifting: the developed world is seen as a legacy economy while the former periphery becomes a vibrant center of growth and opportunity. As this shift occurs, survey participants see every asset class as riskier. This is especially true for currencies – and not just the euro. There are no good choices among currencies. A significant minority of executives sees the euro shrinking at the very least and potentially disappearing. The dollar is king by default, but few believe in its long-term viability. The renminbi is too controlled; the SDR, too abstract. In a world of high volatility and no-win choices, every holding will be scrutinized and every investor will re-evaluate the trade-off between liquidity and risk. This new level of scrutiny will bring about a new era of competition for capital. It’s true that corporate demand for debt and equity financing is down. It’s also true that investment-grade borrowers, both corporate and sovereign, can choose their investors and almost name their prices. Nevertheless, over the next few years there will be stiff competition for increasingly scarce capital. The financial, economic and fiscal crises all carry high price tags as governments seek to simultaneously rescue their financial institutions, stimulate their economies and address tax shortfalls. Beyond the cyclical expenditures lie structural outlays related to the aging population, the deteriorating infrastructure and impending energy and climate crises. All will compete for funds in increasingly crowded capital markets. With banks looking to rebuild balance sheets in a more stringent regulatory environment, sovereigns seeking to restore public finances to health and corporates looking to finance – at the very least – day-to-day needs, this competition presents a highly challenging overall environment for raising capital. Capacity may not be the problem. Instead, it could be willingness on the part of investors to commit funds in an uncertain and problematic environment. The key, for any entity seeking to raise capital, is to ensure that strong fundamentals are in place. For sovereigns, this means taking the necessary steps towards fiscal discipline. For corporates, it means building strong, long-term relationships with both equity investors and lenders, and ensuring that the company’s prospects are clearly articulated and understood. Regardless of how the next wave plays out, the keys to navigating the crowded capital markets of the future will be a strong balance sheet, a flexible approach and a recognition that borrowers will have to work harder for their capital than ever before.20 The New “Normal”

RBC Capital Markets is the business name used by certain subsidiaries of Royal Bank of Canada, including RBC Dominion Securities Inc., RBC Capital Markets Corporation, Royal Bank of Canada Europe Limited and Royal Bank ofCanada - Sydney Branch. The information contained in this report has been compiled by RBC Capital Markets from sources believed to be reliable, but no representation or warranty, express or implied, is made by Royal Bank of Canada,RBC Capital Markets, its affiliates or any other person as to its accuracy, completeness or correctness. All opinions and estimates contained in this report constitute RBC Capital Markets’ judgement as of the date of this report, aresubject to change without notice and are provided in good faith but without legal responsibility. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice. 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The new 'Normal': Implications of sovereign debt and the competition for capital

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