Capital InsightsHelping businesses raise, invest, preserve and optimize capital

Q2

2013

on new products, strong partnerships and

capital prudence

Fighting

Intellectual property: wise ideas

The distressed debt debate

The Nordics: northern star

Capital Insights from the Transaction Advisory Services practice at Ernst & Young

For Ernst & YoungMarketing Director: Leor Franks (lfranks@uk.ey.com) Program Director: Nathaniel Hass (nhass@uk.ey.com) Consultant Editor: Richard Hall Compliance Editors: Natalie Effemey, Jwala PoovakattCreative Manager: Marisa Doberman Digital Manager: Laura Hodges Digital Executive: Jess Cowley Design Consultants: David Hale, Christophe Menard Deployment Executive: Angela Singgih

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Capital Insights is published on behalf of Ernst & Young by Remark, the publishing and events division of Mergermarket Ltd, 80 Strand, London, WC2R 0RL UK.

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Ernst & Young Assurance | Tax | Transactions | Advisory

About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 167,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential.

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About Ernst & Young’s Transaction Advisory Services How organizations manage their capital agenda

tomorrow. We work with our clients to help them make better and more informed decisions about how they strategically manage capital and transactions in a changing world. Whether you’re preserving, optimizing, raising or investing capital, Ernst & Young’s Transaction Advisory Services bring together a unique combination of skills, insight and experience to deliver tailored advice attuned to your needs – helping you drive competitive advantage and increased shareholder returns through improved decision-making across all aspects of your capital agenda.

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ED 0713

ContributorsCapital Insights would like to thank the following business leaders for their contribution to this issue

Stijn Claessens

Assistant Director International Monetary Fund

Mark Hutchinson

Head of Alternative Credit

Frank D’Amelio

Dagmar Kent Kershaw

Head of Credit Fund Management

Erik Gerding

Associate Professor University of Colorado Law School

Joseph Hadzima

Senior Lecturer Massachusetts Institute of Technology

Josh Lerner

Jacob H. Schiff Professor of Investment Banking Harvard Business School

Anna Faelten

Deputy Director M&A Research Centre Cass Business School

Petri Parvinen

Professor of Sales Management Aalto University

Kristoffer Melinder

Managing Partner Nordic Capital

John Trainer

Vice President Corporate Business Development MedImmune

Brian Pearce

Chief Economist International Air Transport Association

Helping businesses raise, invest, preserve and optimize capital

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Capital Insights from the Transaction Advisory Services practice at Ernst & Young

For more insights, visit www.capitalinsights.info where you can find our latest thought leadership including our market-leading Capital Confidence Barometer.

Joachim Spill

Transaction Advisory Services Leader, EMEIA (Europe, Middle East, India and Africa) at Ernst & Young

If you have any feedback or questions, please email joachim@capitalinsights.info

In spite of better news on the M&A front — the total value of Q1 2013 mega-deals (those worth more than US$10b) was up 21.8% compared with Q1 2012, according to Mergermarket data — it is clear we are still living in demanding times.

Recent data from the European Union’s statistical agency, Eurostat, bears this out. The Eurozone area sank further into recession in Q4 2012, it says. Meanwhile, OECD data has revealed that India slowed to its lowest economic growth rate in a decade over the same three-month period. With this in mind, corporates need to start looking for innovative approaches when it comes to their own capital agenda. In this issue of Capital Insights, we explore how you can use inventive and creative ideas to find new sources of capital and help grow your business.

Raise your game: With banks still retrenching, corporates need to look for new sources of funding. We investigate whether alternative financing can fill the gap left by banks (page 35). In the Capital Insights debate (page 24), we examine the rise in distressed debt funds across Europe with four notable members of the industry. We also explore how companies can value their intellectual property and use it to raise capital (page 32). Meanwhile, we discover how the four largest Nordic countries have stayed ahead of their European neighbors (page 28).

United front: In times of uncertainty, collaborations can give businesses a clear advantage. In an in-depth and exclusive interview on page 14, Pfizer CFO Frank D’Amelio talks to us about the power of partnerships and creative business deals. Our feature on joint ventures on page 10 examines how these alliances can help you invest capital, mitigate risk and enter new markets. And on page 20, we look at how airlines are teaming up to overcome challenges in the industry.

While the recovery in M&A lifts the spirits, significant challenges still lie ahead. For those looking to raise, preserve, invest or optimize capital, an open-minded approach is more important than ever. I hope this issue of Capital Insights provides you with much food for thought.

Differentstrokes

www.capitalinsights.info | Issue 6 | Q2 2013 | 3

Features10 Bridging the gap

In the bid for fresh capital, companies are looking to enter new markets. And sharing knowledge and risk via a joint venture could

14 Cover story: Capital

Insights how creative business deals, positive partnerships and a return to core values are keeping the pharma giant in robust health.

20 Flight planRegulation, fuel prices and economic strife

how the industry has been responding via alliances, mergers and cross-border deals.

24 The big debate: distressed investing

traditional sources of capital. But debt funds

experts discuss the distressed debt market.

28 Northern lights

stability, creativity and prosperity and see how it is providing companies with opportunities to expand or consolidate their businesses.

32 Capturing the imaginationIntellectual property is becoming increasingly important for companies looking to raise or invest capital. But how do you put a value on the intangible?

35 Shopping aroundAs traditional sources of lending become harder for companies to access, we investigate

20Aviation

14Pfizer

WINNER 2012

Ernst & Young is proud to be the Financial Times/

Mergermarket European Accountancy Firm of The Year

#1 Ernst & Young – recognized by Mergermarket as top of the European league tables for accountancy advice on transactions in calendar year 2012**As run on 7 January 2013

©Ito

Insights Q2

2013

Capital Insights from the Transaction Advisory Services practice at Ernst & Young

Regulars06 HeadlinesThe latest news in the world of

for your business.

07 Deal dynamicsErnst & Young’s Pär-Ola Hansson

08 Transaction insights

equity (PE) exits. How and where are

27 The PE perspectiveErnst & Young’s Sachin Date on why PE’s built-in focus and experience

38 Moeller’s corner

39 Further insightsA look at how Ernst & Young’s regular

your business the edge.

32Intellectual property

Nordics28

Alternative financing35

On the web or on the move?Capital Insights is available online and on your mobile device. To access extra content and download the app, visit www.capitalinsights.info

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www.capitalinsights.info | Issue 6 | Q2 2013 | 5

HeadlinesAfrica on the riseM&A activity and values in Africa are showing a resurgence. After a quiet first half in 2012 brought 92 deals, the second half saw 105 deals. And while deal numbers in 2013 have been muted, with 29 in Q1, values have sky-rocketed. The US$18.3b recorded in Q1 is the highest quarterly value since Q1 2010. South Africa continues to be the continent’s M&A hub, contributing just under half (14) of Africa’s deals in the first three months of 2013. Corporates are also gaining confidence. Mergermarket’s Deal Drivers Africa report revealed that 75% of those surveyed expected M&A to increase in 2013.

Divest with cautionThe desire to divest is rising according to Ernst & Young’s Global corporate divestment study. It found that 77% of executives plan to accelerate divestment plans over the next two years. However, the survey also discovered that corporates’ rationale for embarking on a divest-ment is not always strategic. The key factor determining whether a business stays within a company portfolio, for almost six out of 10 respondents, is whether an asset dilutes or en-hances earnings per share and how it performs against financial benchmarks such as return on capital employed. Despite this, the survey points out that businesses that adopt strategic practices will extract greater value from a sale.

Media on the moveLarge-scale media M&A deals are on the way back. The first quarter of 2013 saw 111 deals in the sector worth US$48.9b — a figure more than double Q4 2012’s US$16.1b. Major deals an-nounced so far this year include the US$21.9b acquisition of the UK’s Virgin Media by Liberty Global, and Ukrainian investment company Group DF’s US$2.5b buyout of U.A. Inter Media Group. Indeed, the opening quarter of this year has seen a number of transformational deals announced across a variety of sectors. This is a sign that corporates could be looking to start spending the cash that is on their balance sheets. Those looking to divest businesses, par-ticularly in the media sector, should take note.

Completion times risingCorporates are playing a waiting game when it comes to finalizing takeovers. Ernst & Young’s latest M&A Tracker shows that deal completion times rose to an average of 58 days in the final quarter of 2012, up from 53 days in the previous quarter and 48 days year on year. One factor that is behind this rise is more time-consuming regulation procedures, which are slowing down the dealmaking process. This has been borne out in India where, in February, the executives of drinks giants Diageo and United Spirits met officials of the country’s fair trade regulatory body, the Competition Commission of India. This was to discuss clearance for the companies’ proposed US$2b tie-up, announced in November 2012. For more on regulation in deals, visit www.capitalinsights.info.cl

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Engage the activistsActivist investors are set to play a big part in the corporate world again this year after coming to greater prominence in 2012. Last year, activists launched 219 campaigns against US companies they deemed undervalued, according to research from FactSet Research Systems. This is the highest figure since 2008, and shareholders have assumed more power in 2013. In March, the result of a referendum in Switzerland saw voters back curbs on corporate wages. These measures included giving shareholders a binding say on corporate pay and having annual re-elections for directors. With this in mind, corporates should be well prepared when in conversation with company stakeholders. For more on getting the M&A message right, see Deal dynamics, page 7.

Japanese IPO boomJapan is topping the charts in terms of Asian IPOs. Companies who have listed there so far this year have raised a combined total of US$1.9b — more than in Singapore, Hong Kong and Australia together, according to Bloomberg. Data provider Dealogic now ranks Japan second in the world in terms of funds raised, a position it has not occupied since 2006. The outlook for the rest of the year is also positive. Japanese equity underwriter, Nomura, said in January that it believes the country will see the highest number of IPOs for six years. In the bid to raise fresh capital, corporates should consider looking east when deciding on the options of where and if to float. For more on Japan and IPOs, visit www.capitalinsights.info.

Capital Insights from the Transaction Advisory Services practice at Ernst & Young

Even the best story falls flat if you tell it incorrectly. The same is true for M&A deals. On top of this, the audience to whom you’ll be selling

the deal is broad, diverse and, sometimes, hostile. From shareholders to regulators — via the markets and the media (both social and traditional) — there are many willing to shoot down a deal if it isn’t explained well.

Some deals have even collapsed due to corporates not getting the right message across to the right stakeholders. This is particularly true in a time of growing investor activism — a 2013 report from US firm Cornerstone Research found that lawsuits on behalf of shareholders were filed in 96% of M&A deals valued at more than US$500m.

When companies experience uncertain times, preserving capital takes precedence over investing it. Even though corporates have an estimated US$7.8t on their balance sheets, M&A volumes fell by 12% in 2012 year on year, and the corresponding total of announced deal values fell by 9%, according to figures from Ernst & Young’s M&A Tracker. With figures such as these in mind, selling the deal to key stakeholders upfront becomes all-important.

So, how can corporates master their M&A message?

Companies must clearly explain the deal’s purpose — be that geographic growth, gaining new technology or adding product lines. Showing the strategic rationale builds a spirit of trust and lets stakeholders see how the deal could benefit them in terms of total returns.

deal to stakeholders has never been more importantWhen German software company SAP

bought US cloud-computing firm Ariba for US$4.3b in May last year, the company’s Co-CEOs Bill McDermott and Jim Hagemann Snabe were clear about the deal’s strategy. “Cloud-based collaboration is redefining business network innovation, and we are catching this wave early,” they said. “The addition of Ariba will deliver immediate value to our customers and provide another solid engine for driving SAP’s growth in the cloud.”

In addition, corporates need to be transparent with stakeholders about what is coming before it happens. A September 2012 report from law firm Schulte, Roth & Zabel (SRZ) found that 50% of corporate respondents believed that active dialogue with shareholders was the most effective tactic to combat activism. Corporates and shareholders alike also agree that staying out of the media is best for both parties. In the same SRZ report, 78% of survey respondents thought that, most of the time, activists and corporates worked co-operatively without receiving media attention. Disputes that appear in the media can often badly affect the company’s value.

Finally, corporates need to control the message — particularly in a world of 24-hour news. Keeping a tight deal team is vital. A 2013 report from Cass Business School found that for the 2010—2012 period, 88% of deals complete when there is no evidence of a leak — 8% more than when a leak has been suspected.

When corporates are selling their deals they need to look to the three Ts — trust, transparency and teamwork.

Deal dynamics

Pär-Ola Hansson

Pär-Ola Hansson is EMEIA Markets Leader, Transaction Advisory Services, Ernst & Young.

For further insight, please email par-ola@capitalinsights.info

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Total number of exits by year, 2007—2012

Capital Insights

Exit strategyA breakdown of PE exits reveals that, while the proportions of some exit-types such as SBOs are rising, PE is still having trouble selling its businesses by any method. IPO exits, for instance, fell from 136 to 118 year on year in 2012, reducing their proportion of all exits to just 7.6%. IPOs are still suffering in 2013, as Q1 figures show only 15 public exits, the lowest number since Q1 2009. Trade sales, by contrast, still remain the most popular exit method, occupying 64.3% of the exit market for 2012 and 67.8% in Q1 2013. However, the number of trade sales in Q1 — 219 — was the lowest recorded for two years. SBOs accounted for 27.6% of exits in Q1 2013, increasing from its 26.1% share in Q4 2012. However, like trade sales, the actual number of SBOs — 89 — is the lowest seen since Q1 2010.

While it has been a relatively slow start to 2013, time will tell whether exits pick up as the year progresses. Undoubtedly, this is a tough period for exits meaning corporates under PE control will need to work harder than before to achieve an IPO. And although SBOs in particular are gaining more of the share of PE exits, they and trade sales need similar corporate diligence to succeed. 0 300 600 900 1,200 1,500

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Top three trade sale growth areas in 2012 by percentage increase (10 deals or more)

Trade salesCorporates looking to buy from PE houses should not be disheartened by the fall in trade sales (see graph above). A closer look at geographic splits reveals that, while trade sale volumes in the top four markets — the US, UK, France and Germany — are down 12.9% year on year, the BRIC economies are seeing a boom in exits to cash-rich corporate buyers, with a 28% rise on 2011’s numbers. India is the standout performer, having seen year on year corporate exits worldwide nearly treble from 7 to 19.

It isn’t just emerging economies where acquisitive corporates should be looking for PE deals — more developed areas can provide platforms, too. For example, the main countries in the Nordic region — Sweden, Denmark, Norway and Finland — contain opportunities. After hitting a trade sale low of 36 four years ago, 2012 saw the region’s exit market recover with 54 deals. Norway in particular performed well, adding a third more deals to its total in 2012 compared with 2011. For more on Nordic PE and the area’s M&A market in general, see Northern lights on page 28.

Exits per year by type, 2007—2012

www.capitalinsights.info | Issue 6 | Q2 2013 | 9

A s the search for new streams of revenue continues for corporates, be that by creating new products or entering new markets, many are finding that the best way to solve a problem

is, in fact, to share it. This type of partnership is often considered by

companies looking to expand their geographical footprint. For example, pharmaceutical giant AstraZeneca knew that cracking the biologics market in the world’s most populous country, China, was a critical component of its long-term growth plan. The Chinese pharmaceutical market grew from US$10b in 2004 to US$41b in 2010 and is projected to grow to over US$100b by 2014, according to IMS Health.

After considering the options for market entry, MedImmune, the global biologics arm of the pharmaceutical giant, entered into a joint venture (JV) with China’s WuXi AppTec, a research and development outsourcing company. The goal of the partnership was to develop and commercialize MEDI5117, a novel biologic for autoimmune and inflammatory diseases.

What made this the best option? “A joint venture is easier when both parties are bringing something relatively equal to the table,” explains John Trainer, Vice President, Business Development at MedImmune. “WuXi had local market know-how and facilities on the ground. AstraZeneca-MedImmune has products and global, as well as local, know-how. It was a good balance, and the quality of investment from both sides makes a difference for a successful long-term partnership.”

JVs can also help to provide a balanced approach to growth by diversifying companies’ business strategies. This is certainly the case with Paradigm Oil & Gas. The

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Key insightsFor many sectors, joint ventures (JVs) are the only practical way into new markets.JVs can help corporates mitigate risk and are a good way to optimize capital — particularly pertinent in the currently unstable economic environment.A successful JV will depend on a number of factors, including transparent governance, choosing the right partner, a shared purpose and adaptability to changing market conditions.

For companies looking to enter a new industry or geographic market, sharing knowledge and risk via a joint venture can be the way forward

thegapBridging

American company agreed a joint JV with its counterpart Energy Revenue America (ERA) in February. In the 50/50 deal, Paradigm brought 5,000 acres of land to the table available for rework, while in return, ERA will introduce Paradigm to leases in Oklahoma, as well as ERA’s expertise in natural gas. As Paradigm president Vince Vellardita put it at the time: “Having the opportunity in natural gas through the new venture and Paradigm Oil & Gas being in traditional oil production, we are now set up for three revenue streams for a win-win situation.”

Sticking togetherJVs can also improve balance sheets. This year, for instance, the International Air Transport Association’s CEO Tony Tyler has estimated industry profits will increase 40% on 2012, citing “joint ventures on long-haul routes” as one of the factors behind this. Elsewhere, Irish agri-services group Origin’s profits attributed to associates and JVs grew by 53.8%, helping it to a 2.5% annualized increase in group operating profit. JV deal values are also rising — in the US, they climbed from US$9.5b in 2008 to over US$12b in 2012, according to Thomson Reuters data.

For David Scourfield, M&A Partner at Ernst & Young, risk mitigation is also a key

factor in the appeal of JVs: “On balance, JVs are a more popular structure for market entry at the moment,” he says. “A number of people have tried to go it alone and have been burned, so there is increasing recognition that it is better to be in a risk-sharing environment.

“In the pharmaceuticals sector, for example, people were historically very protective of their intellectual property. But now we are seeing that, where they are producing drugs for a particular therapy area and there is common ground in terms of research, there should be a mechanism for sharing that.”

Despite these, some believe JVs’ appearance as complex deals means they aren’t getting the press they deserve. “I am bemused when I read about JVs,” says Paul Beamish, Professor of General Management at the University of Western Ontario’s Richard Ivey School of Business. “There is an implicit assumption that somehow JVs are going to be more complicated or less profitable than wholly owned greenfield subsidiaries.

“But when we analyzed the performance of more than 27,000 Japanese owned foreign JVs, we found that survival rates are indistinguishable from wholly owned subsidiaries.

“One of the reasons JVs get bad press is that you have an external partner to blame if there is a problem, whereas with a wholly owned subsidiary, there is a tendency to avoid criticizing oneself or one’s colleagues.”

Optimizing

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People have tried to go it alone in the past and have been burned. There is increasing recognition that it is better to be in a risk-sharing environment

11

12bValue of JV deals in the US in 2012

1

Merge to emergeIn many jurisdictions, particularly in emerging markets, a JV is the only way a multinational can gain access to the high-growth prospects on offer. Last year, for example, Chinese authorities relaxed foreign ownership rules for JVs involved in securities underwriting, but the foreign partner is still only allowed to own 49% of the venture, compared with just 33% previously.

“It is a prerequisite for certain markets because of regulations, but going into an emerging market where you have no knowledge without a local partner would be a pretty foolish thing to do,” says Scourfield.

“In theory, you can go in on your own. And some companies, particularly consumer products-type companies where it is about sales and marketing rather than local manufacturing, can get away with it. But as a strategy, that is probably not advisable. People are more comfortable with developing an organic or a bigger presence when they have already been in a market for a while.”

It isn’t just China that is a target for corporate JVs. “Investors are looking to Africa, Latin America and, to a lesser extent, Russia for their growth opportunities,” says Scourfield. “Asia has been a traditional destination, but it looks fully valued at present and the required investment in understanding the cultural richness of the region has often been underestimated.”

Italian helicopter manufacturer AgustaWestland is one of the companies following this trend. In February

this year, it agreed to establish a JV with Brazilian aircraft maker Embraer. AgustaWestland CEO Bruno Spagnolini said after the announcement that the move would “help us to further grow our business in one of the world’s fastest-growing markets.”

Sharing the riskAs well as opening doors for opportunities, JVs can also provide a form of protection from risk. This kind of mitigation is particularly salient in today’s unstable financing environment.

The recent JV between Canada’s Constantine Metals and Japan’s Dowa Metals & Mining highlights this point. Constantine required capital for a project in Alaska, and for its vice-president of exploration, Darwin Green, the Dowa deal made sense. “It’s a scenario that lets us avoid the risk and vulnerability of trying to finance the hundreds of millions required to develop a project alone — a situation wherein many juniors with quality assets run into problems

even when they have positive feasibility studies in hand,” he said in February.

Capital efficiencyCollaborating via a JV can also be a good way to optimize capital. In this vein, MedImmune is extremely proud of its collaborative approach to drug development. “If you rely on doing everything yourself, then you are probably not being as efficient with your capital and people as you could be,” says Trainer.

This advice has been heeded by Spanish broadcaster Telemundo and Warner Music Latina, who agreed a JV in February this year to sign, promote and market Latin music artists. While Warner will provide its knowledge of the music industry and production, Telemundo will offer promotional expertise through its various broadcast platforms. Here, both parties bring what they each do best to the table, to deliver a common goal and shared revenues. For more JV insights, see our interview with Pfizer CFO Frank D’Amelio on page 14.

Steps to successJVs can be complex transactions. Getting it right at the outset is the key to a successful partnership. There are four keys to a happy and productive relationship.

Get the governance rightYou need to be clear about the composition of the board and who is going to make decisions on a day-to-day basis. No matter how compelling the strategic logic, if the detail about who has responsibility for what is not clear, the venture is doomed from the outset. Governance standards need to be as robust as for any business venture. JVs should be treated as any other business line and having focused goals is the key to success.

“If you anticipate that the relationship with the external partner is going to be very broad, very strategic and you will have to co-ordinate it through a lot of joint activities and have a lot of competitive

US$

Capital Insights from the Transaction Advisory Services practice at Ernst & Young

If you do everything yourself, you are probably not being as

people as you should beJohn Trainer, VP Business Development, MedImmune

On the webFor information on how JVs can help overcome cultural differences in M&A deals, visit www.capitalinsights.info/jointventures

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Professor Laurence Capron from INSEAD talks about the benefits of joint ventures

A balanced approach to growth is vital for a long-term business strategy. Yet just one-third of companies in the ICT sector use a balance of alliances, acquisitions and internal development.

Companies using many modes to obtain new resources are 46% more likely to be in business five years later than those who solely focus on alliances; 26% more likely than those using M&A; and 12% more likely than companies using only internal development.

For many, alliances and JVs are forgotten business development modes. They focus on organic development, and it is only when they are lagging behind their competitors or in crisis mode that they jump into an expansive acquisition to catch up.

The main benefit of a JV is that it gives you a more flexible and less expensive option when compared with an acquisition. If you are in a fast-moving business environment with lots of emerging technology, but you don’t know which one will win, a JV can be a good way to start and cover off all potential developments.

JVs can offer a de-risked entry strategy when going into unfamiliar jurisdictions or sectors. When French food giant Danone wanted to enter the organic yoghurt segment in the US, it formed a strategic alliance with Stonyfield that saw it take a 40% stake in the business. The JV performed well, with annual revenue growth of 24.3%. Two years later, Danone purchased the remaining non-employee-owned shares in the business, taking its stake to 85%.

Viewpoint

Laurence Capron is the Paul Desmarais Chaired Professor of Partnership & Active Ownership at INSEAD

A joint venture gives

overlap, then the JV is likely to fail,” says Laurence Capron, the Paul Desmarais Chaired Professor of Partnership & Active Ownership at French business school INSEAD. “Companies need to identify the conditions under which a JV is the right option. If the venture is strategic and core to their business and they are certain of that strategic value, then an acquisition might be a better option. But if it is focused and the partners’ objectives are clearly aligned, then a JV is the way forward.”

Find the right partnerThis step is crucial. To do this, you need to engage in thorough due diligence. It is not enough for the two directors to meet and get on. You need independent due diligence and would be well advised to use your own employees who are working on the ground to provide commentary on what they think of the JV partner.

“It is vitally important to get real agreement on how you are going to measure success and what potential contingencies you will take in response to changing market conditions,” says Beamish. “You need to be upfront about the relationship because no one can predict what will happen over the next three to five years. With more discussion at the start, you will have a better idea about whether you have a partner that will be on the same page as things evolve.”

Know what you wantGoal alignment is crucial, and comes down to knowledge of what your partner wants from a relationship. Open communication and trust are important, and goals need to be kept under constant watch. If, over time, learning opportunities become unbalanced and one side is getting more out of the relationship than the other, the venture can turn sour.

For instance, the long-standing JV between Indian car manufacturer Hero and Japanese giant Honda — which started in 1984 — began to break down after Hero felt Honda was not sharing information. In 2004, following a liberalization of Indian markets, Honda announced plans to set up a manufacturing subsidiary in India that would compete with Hero-Honda. Honda downgraded the relationship from strategic to operational and the two parties began to separate. Honda began to divest its stake in 2011.

Plan for changeJVs can be an efficient structure in fast-changing markets. “When you set up a JV, you have to be willing to compromise and be flexible,” says Trainer. “You can set up

a great JV, but something can happen in two years’ time that you didn’t anticipate. You have to have the mindset that allows you to work with your partner and adapt to survive and prosper.” As well as being clear on the life cycle of the venture, partners need to work out how they will react to changing market conditions.

As in any walk of life, JVs and partnerships require commitment from both sides and a clear vision of what is to be achieved. But putting in the necessary work on such a project could help your business expand into exciting new markets.

For further insight, please email editor@capitalinsights.info

www.capitalinsights.info | Issue 6 | Q2 2013 | 13

fitFighting

While the pharmaceutical sector faces tough tests in 2013 and beyond, Capital Insights

and mastering his capital agenda

Pharmaceutical companies are currently suffering

hitting the industry all at once.

This problem is especially acute in austerity-hit countries

Closing the gap?most troubling of all, the ongoing pain of patent expirations

Up and about

Capital Insights

D’Amelio is certainly no stranger to challenges. When he joined the company in 2007, Pfizer was faced with the upcoming patent expiration of the company’s biggest-selling drug Lipitor (which was set to expire in late 2011 in the US). In response, he helped architect the US$68b acquisition of rival Wyeth in 2009. It was hoped that the deal would make up for the loss of Lipitor and would bring in a new, diversified pipeline of drugs, vaccines and other products. The CFO believes the strategy has worked.

“We acquired Wyeth to help address the Lipitor cliff,” he says. “When we bought Wyeth, we did something I don’t like doing — we provided earnings guidance three years out. We wanted to show our owners that using US$68b of their capital could solve the Lipitor cliff. In 2012, the first full fiscal year after the Lipitor loss, our stock price went up significantly.”

Staying activeHowever, the CFO is not one to rely on past victories. His focus now is on working with his Pfizer colleagues to deliver the four strategic imperatives laid out by CEO Ian Read when he took over in December 2010.

“The first of these is to fix the innovative core of the business; second, we must continue to allocate capital prudently; third, we want to be respected by society; and finally, we want our culture and our people to be a competitive advantage,” he says.

Clinical with capitalAfter buying Wyeth, Pfizer’s leadership team had to manage costs to deliver the promised synergies to shareholders.

One crucial area in which the company has been able to reduce costs while still maintaining a strong pipeline of products is R&D.

“If you look at R&D spending in 2008, before we bought Wyeth, the combined spending of the two companies was US$11b,” says D’Amelio. “In 2012 and for 2013, it will be about US$7b, which is less than Pfizer’s stand-alone R&D spend before the Wyeth acquisition. Our focused approach to R&D has led to improved R&D productivity.”

The reason for the greater focus is that Pfizer employs three key tests when considering R&D spend.

an area where there is a large unmet medical need?”

assets we have? Being an also-ran product is not going to create value.”

acquire to win? Can we do things with capital and structuring to play the game so we can win?”

This more targeted approach has proved successful. Pfizer had five products approved in 2012 — including arthritis pill Xeljanz and anticoagulant Eliquis — both of which are expected to generate significant future revenue, according to the CFO.

The company has also achieved cost reductions, in part, by rationalizing the combined workforce but, more importantly, by working on two key areas — enabling functions and manufacturing costs.

In terms of enabling functions such as finance, business technology and real estate, Pfizer was able to reduce costs dramatically by analyzing the two companies and then centralizing and restructuring certain areas. “In fact, corporate center spend today, in absolute terms, is lower than Pfizer’s stand-alone enabling functions in 2008,” says D’Amelio.

As for optimizing manufacturing spending, the company has implemented a four-point plan.

“First, we try to optimize the overall manufacturing footprint, in a similar way to a telecoms network. We ask whether plants are necessary and whether they are located properly. From there, we use lean manufacturing and other models to optimize every plant within the network.

“Then we look very closely at procurement. Manufacturing is a massive spending area, so we make sure we have the right suppliers with the right terms. And finally, we focus on non-factory manufacturing costs. We have done a good job of optimizing all of these areas in a very efficient way.”

Healthy returnsWhen it comes to allocating capital at Pfizer, there is one factor that the CFO prioritizes above all others.

“We always look at what will generate the best after-tax returns to our shareholders,” he says. “One of the privileges of working for Pfizer is that we generate significant operating cash — US$17b last year. This affords us the ability to do many things.

“In each of the last two years, for example, we’ve returned about US$15b of capital to our shareholders, through dividends and share buybacks. We spent approximately US$1.5b on capital expenditures. We’ve done bolt-on acquisitions. We run all the metrics, but the main compass is always how we maximize total after-tax shareholder return.”

With roughly US$15b spent on dividends and buybacks, the CFO believes that repurchases are the “case to beat.”

“Given the certain return that share repurchases provide, other uses of capital need to clearly exceed the hurdle for the return on repurchases.”

Preserving

Investing

Optimizing

Raising

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Working capital harderOn the day-to-day level of improving working capital, D’Amelio has made this a high priority and, for the CFO, it is very much a team effort — fitting in well with the strategic imperative of making Pfizer’s people a crucial competitive advantage.

“We’ve set up several financial impact teams (FITs) that deal with every major aspect of working capital. For example, we have a receivables team, an inventory team and a payables team,” he says. “We negotiate with each of them on how much cash they will deliver and then it is their job to deliver it.”

According to the CFO, it is not glamorous work, but it is imperative for the smooth

running of the business. “Working capital management is about blocking and tackling — for example, we look at specific regions and ask questions such as ‘how long does it take to pay bills?’ and ‘if we’re paying faster than we’re collecting, why are we doing so?’.

“We also look carefully at inventory across the company and at payables. We’ve been taking this

rigorous approach for five years and it’s working well.”However, noting the importance of working capital

improvement within the business, D’Amelio is now looking to take it to the next level. “After five years, we need to re-energize our efforts and make sure that things don’t get stale — in the future this will mean more aggressive targets and more frequent performance meetings,” he says.

Perfecting the portfolioPrudently deploying and managing capital is very much the remit of the CFO and his team, so he is also very involved in rationalizing Pfizer’s business portfolio.

With this in mind, Pfizer has recently executed two well-publicized and highly successful major carve-outs. The first saw the non-core infant nutrition business sold to Nestlé for US$11.85b in December last year. And in January, Pfizer offered a 19.8% ownership stake in its animal health business, Zoetis, through the largest US IPO since Facebook, raising US$2.6b from investors.

But what criteria did Pfizer apply when looking to spin-off these businesses? “Our compass is always maximizing total after-tax shareholder return,” he says. “Now the animal health business is a great business, but it’s all about unlocking trapped value. In the IPO deal, we got a multiple of 20 plus. Our current multiple is 12. The business is dwarfed inside Pfizer. The same was true with the nutrition business. It may seem counterintuitive — getting smaller to create value — but it’s about unlocking trapped value.”

This approach fits in well with recent findings from Ernst & Young’s Global corporate divestment survey, in

2000 20032002 2004

Pfizer invests US$5.1b in R&D. During the same year, the company also becomes the first US pharmaceutical company and first top 10 company on the New York Stock Exchange to join the UN Global Compact

Pfizer acquires competitor Warner-Lambert for US$90b in stock, creating a pharmaceutical giant with over 85,000 employees

Pfizer merges with Pharmacia Corporation, giving the combined entity an R&D budget of US$7.1b. This makes Pfizer the world’s leading research-based pharmaceutical company

Pfizer founds Pfizer Venture Investments (PVI), the

company’s venture capital arm

The CFO

Frank D’AmelioAge: 55

Appointed CFO at Pfizer: 2007

Educated: St John’s University, New York and St Peter’s College, New Jersey

Previous positions: Before joining Pfizer as CFO, Frank was senior executive vice president of Alcatel-Lucent, where he oversaw the merger of Alcatel and Lucent Technologies. Prior to this, he was COO and CFO of Lucent Technologies. He began his working career with AT&T in 1979 at Bell Labs, holding numerous financial and management positions.

Pfizer Founded: 1849

Employees: 91,500

Countries: 150

Market capitalization: US$209.2b (as of 5 April 2013)

which 59% of respondents stated that enhancing or diluting earnings per share was the key factor in determining whether a business should be in the company portfolio.

Creativity is the cureWhile the company is carving out certain businesses, that doesn’t mean Pfizer is steering clear of acquisitions. But, according to the CFO, the focus is now on bolt-ons and structured business development deals — with partnerships and emerging markets playing a key role in growth plans.

“We never say never to any acquisition, but bolt-ons are the main targets,” he says. “We’re looking at therapeutic areas where we have the opportunity to achieve sufficient returns on capital such as inflammation and immunology, oncology and neuroscience.

“Another focus area is emerging markets. The business last year grew 12%. In BRIC–MT (Brazil, Russia, India, China — Mexico, Turkey) markets, we grew 16%. There are opportunities here not just for acquisitions but for well-structured collaborations.”

Two such deals are already well under way in rapid-growth markets. At the end of 2010, Pfizer acquired a US$250m, 40% stake in Brazilian drug company Teuto to expand its portfolio of generic drugs. Meanwhile, in September last year, the company launched a US$295m JV with Chinese company Hisun.

D’Amelio explains that, while Pfizer may take 100% ownership of Teuto in 2014, the deal had been carefully and creatively structured to ensure that the Brazilian company would only receive additional payments if certain financial targets were met.

“We structured the deal so that Teuto would get more money if they delivered,” he says. “For us, it was a win-win situation. We’re happy to pay them more money, but only if the business is performing.”

However, despite the continued growth, this increased focus on emerging markets could potentially throw up a raft

17

2005 2006 2006 2007

Pfizer wins approval to allow drugs wholesaler UniChem to become its exclusive distributor in the UK

Pfizer buys US-based Rinat Neuroscience, a drugs company, to move further into biotechnology

Pfizer acquires anti-infective drug developer Vicuron Pharmaceuticals for US$1.9b. In the same year, it also acquires Idun Pharmaceuticals for an undisclosed amount, and bio-pharma firm AngioSyn for US$527m

Pfizer sells its consumer products division to Johnson & Johnson for US$16.6b

Lessons learned

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Capital Insights his tenets for professional and personal success in business

There is no decision you should make based on just one metric. You should evaluate all aspects of the business with multiple metrics.

When it comes to external communications, we under-commit and over-deliver. If you take a hit by under-committing, that’s fine. Take your hits once and be determined to over-deliver.

A rule of thumb on business development deals, such as JVs and partnerships, is that one plus one has to equal more than two. When someone proposes an acquisition or partnership that doesn’t include substantial synergies, ask why we are doing the deal.

I like structured business deals. I don’t like paying today for growth that may be delivered tomorrow. Pay for growth when your partner delivers it.

Operational cause equals financial effect. If we execute with excellence, the financials — and stock price — will take care of themselves over time.

One of the things I like about the consumer business is that assets can have long lives. If you manage the brands and invest in them correctly, they can live forever. So it’s easier to get a return on capital.

When I first came to Pfizer, I made sure I listened to everyone and learned what they did before giving my opinion on what I thought needed to be done. You have to go slow to go fast.

Don’t be embarrassed to ask questions. Every industry has its own language — don’t be embarrassed to ask about acronyms, for example. Be humble and learn from people.

Work with the team and build relationships throughout the organization. The higher up you go, the more you become dependent on others.

of risks that are not present in more developed economies. D’Amelio is quick to rebuff the argument.

“We are not just entering these markets. We’ve been in them for decades. We have significant infrastructure and distribution capabilities. We are viewed as a local company,” he says. “In terms of mitigating risk, it’s the same approach we take everywhere. We have a rigorous control environment. The operational people are there every day and they are a major part of the solution.”

In addition, D’Amelio believes that one of the keys to competing in these markets is building alliances with strong local companies — as has been the case with Hisun and Teuto.

“Teuto, for example, is a company that has a good local reach into segments of the market that our field force doesn’t reach. Together, we are doing things that we each couldn’t do on our own.”

Power partnershipsPfizer is also applying these principles to partnerships with other big pharma players. One innovative deal was

a JV with GlaxoSmithKline (GSK) in 2009. This saw the creation of ViiV Healthcare, a company specializing in therapies for HIV. D’Amelio believes that the deal benefited both companies.

“GSK had a robust commercial portfolio and Pfizer had a robust pipeline. By combining

each company’s assets and capabilities, we were so much stronger together than either company could have been on its own. In terms of our ownership percentage, this can swing depending on pipeline results. If our pipeline plays out well, we will have greater ownership.”

Another demonstration of the power of Pfizer’s collaborative abilities came in August last year, when

the company signed a US$250m deal with UK company AstraZeneca for the global over-the-counter (OTC) rights to Nexium, a drug used to treat the symptoms of acid reflux. For D’Amelio, the deal made complete sense. Once again, it played to the strengths of both companies.

“We believe there was significant upside for this deal because it leverages AstraZeneca’s leadership in the gastrointestinal therapeutic area and Pfizer Consumer Healthcare’s expertise in the sales and marketing of consumer health products.”

In the same month, Pfizer also announced a collaboration with US generic drug company Mylan to deliver some of its products in Japan. Again, this was a case of combining forces to produce better results.

“Mylan has a strong generic product portfolio in Japan and we have really good channel capability there. The country represents 11% of our sales,” he says. “The two of us will come off better together than apart.”

2009 2010 2012201 1

Pfizer, along with four other pharmaceutical giants, provides venture funding to Ablexis for its antibody drug discovery technology

Pfizer sells its Capsugel pill manufacturing unit to private equity

firm KKR for US$2.4b

Pfizer acquires rival firm Wyeth for US$68b — the largest merger in the pharmaceutical industry since Pfizer’s own tie-up with Warner-Lambert

Pfizer sells its infant food unit to Swiss firm Nestlé for US$11.85b

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Deals like these have helped Pfizer earn the reputation of being a good partner, something D’Amelio is proud of. “Some of the most attractive assets can only be accessed through collaboration, so being a partner of choice is important.”

People give you the edgeThe idea of being a good partner fits in well with Pfizer’s two other strategic imperatives: being respected by society and using the company’s culture — specifically its people — to provide a competitive advantage.

“We do good things for society, but we are not always well received,” says D’Amelio. “People are now living longer and in better health than in previous generations. This is, in part, due to the pharmaceutical industry. For us to keep on delivering on this, we need to continue to conduct our

clinical trials in the best possible way and be as transparent as possible to our stakeholders.”

Particularly as it relates

to investors, transparency is very much “a perpetual improvement game.”

“The more transparent we are, the better it is for everyone,” he says. “We always want to be improving in this area.”

However, in the final analysis, whether it is deploying capital, promoting partnerships or completing creative business deals, D’Amelio is clear that it is Pfizer’s people that are giving the company its competitive edge. As CFO for more than five years, he has seen how this has evolved.

“As an example, when I first got here, we didn’t have a good relationship with the Street. It was difficult. However, over the years, the management team has become respected by them,” he says. “The team is

accessible; we answer questions directly, and we continually improve our transparency.”

He also feels that this ethos of teamwork and transparency has helped Pfizer to improve its relationship with its shareholders. “We have an excellent investor relations team. We meet with investors frequently. I feel that the only way to really know them is to spend time with them,” he says. “I enjoy investor meetings. I’m in a room full of very bright people. I always come away with useful nuggets from every meeting.”

While the health of the pharmaceutical industry may be variable at present, D’Amelio is looking forward to the challenges and sees very real opportunities on the horizon.

“There will be continued focus on cost reduction, productivity improvements and capital deployment in the coming years, but I am most excited about our newly approved products,” he says. “We need to launch these effectively. We may have significant launch costs, but these new products can have a huge impact — both on the business and society in general.”

Some of the most attractive assets can only be accessed by collaboration

19

2012 2012 20132013

Pfizer launches JV with Chinese firm Zhejiang Hisun Pharmaceuticals

Pfizer acquires the global rights for an OTC version of acid reflux drug Nexium, for US$250m

Pfizer lists 19.8% of its animal health business, Zoetis, on the New York

Stock Exchange. It raises US$2.6b in its IPO

Pfizer announces collaboration with CDRD Ventures. The project is aimed at commercializing several Canadian health technologies

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Capital Insights explores how airlines are consolidating via joint ventures, equity investments and cross-border takeovers to win the battle for capital in the skies

R ising fuel costs, the Eurozone crisis and threats of tougher regulation have given airlines a rough ride of late.

However, despite this three-pronged bout of turbulence, the sector held up well in 2012. The International Air Transport Association (IATA) upgraded the industry’s profit estimates to US$6.7b over the course of the year — well above its previous 2012 projection of US$4.1b.

However, the underlying numbers are less encouraging. Globally, profit margins came in at around 1% but there was a huge amount of regional variation in performance. In North America, airlines are expected to post a combined profit of US$2.4b. However, IATA projected a loss of US$1.2b in Europe. IATA’s projections were underlined by evidence from individual operators. In July 2012, the UK airport operator Heathrow Airport

Holdings noted a year-on-year downturn in flights between Heathrow and recession-hit European countries such as Greece (-11.3%), Italy (-9.0%) and Portugal (-11.4%).

“One of the key threats facing aviation in Europe is that the sources of growth are shifting from the West to the emerging markets,” says Toby Stokes, EMEIA Leader for Aviation at Ernst & Young. “China, India and Brazil together contributed over 50% of global GDP growth from 2008 to 2011 while the Eurozone contributed just 4%.”

This directly links to the airline sector, Stokes adds. “Domestic Chinese traffic will surpass domestic US traffic and Asia Pacific will lead in world traffic by 2031, with 32% share of the global aviation market. Growth in the aviation business is linked directly to GDP growth and global economic output. The shift of economic growth toward the East has started to affect the global aviation

Flightplan

Key insightsEmerging markets are offering strong investment opportunities but airlines from developed markets are increasingly in competition with their rivals in rapid-growth economies.Joint ventures (JVs) are a valuable method, not only to address cost issues, but also to enter key new markets. A key to a successful JV is both parties fitting well together on a cultural level.In some cases, mergers may present a better option than JVs because they can offer far greater synergies.In terms of mergers, one method of overcoming regulatory issues is to seek deals within your own jurisdiction.

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Capital Insights from the Transaction Advisory Services practice at Ernst & Young

market significantly, including increasing the challenges for airlines operating in Europe.”

This shift in growth eastwards is seen with the investment by Middle Eastern carriers where, in late 2011, Abu Dhabi’s Etihad Airways bought 12 Boeing jets for US$2.8b (on top of the 150 jets they ordered at the Farnborough International Airshow in 2008) and Emirates ordered 50 Boeing 777 jetliners, costing US$18b, as well as 60 A380s and 50 A350s.

Airlines worldwide have also been hit by rising fuel costs. In its 2013 outlook, IATA predicted that jet fuel is expected to average US$130 a barrel for the year (up from US$124 a barrel projected in December). Fuel now amounts to around a third of airline costs compared with 13% a decade earlier.

Flight patternsAgainst this background, consolidation in the airline industry is increasing through M&A activity. Indeed, deal values in

the first quarter of 2013 totaled US$5.6b, more than the combined value of deals in all of 2012. Airlines are also using alliances and JVs either to reduce their own costs or to realign them to a world where economic power is shifting.

“Airlines are increasingly looking at partnerships through different mechanisms like code shares, JVs, global alliance alignments, as well as equity investments where regulation permits,” says Stokes. “This is to ensure they capitalize on feeder markets and optimize their combined networks to create mutual benefits.”

IATA’s Chief Economist Brian Pearce points out that cross-border mergers outside Open Aviation Areas, such as Europe, are barred by foreign ownership rules. “What we’ve seen instead of cross-border mergers is a range of alternative measures such as alliances,” says Pearce.

Allied forcesStar Alliance, SkyTeam and Oneworld are the three dominant alliances in the airline industry today. Between them, they provide around 80% of capacity across the Atlantic and Pacific, and between Europe and Asia.

Alliances allow airlines to increase the number of global destinations they can offer to passengers by working with partners to provide seamless connections. The key to this is

Investing

Raising

Top three announced aviation deals since April 2012

Announced Target Buyer Deal valueFEB

2013US Airways Group (US)

AMR (US) US$4.9b

SEPT

2012Landmark Aviation (US)

Carlyle Partners (US)

US$625m

SEPT

2012Virgin Atlantic Airways (UK)*

Delta Air Lines (US)

US$360m

Source: Mergermarket *49% stake

code sharing, under which ticketing codes are pooled to allow passengers to book connecting flights through an integrated system.

According to Anna Faelten of Cass Business School’s M&A Research Centre, the alliance model has parallels in other industries — such as telecoms or transport — where the business model is based around networks. It can provide a means to cut costs and expand reach while offering seamless service. “Airlines move people around, but you can apply the same principles to data or transported goods,” she says.

Combination locksJVs create an even closer relationship between partners. “This is a relatively recent development,” says Pearce. “Under a JV agreement, networks and schedules are co-ordinated on selected routes, providing passengers with a much better service but also generating economies of scale for the airline partners.”

A JV or strategic alliance may also involve building equity stake investments. For instance, Virgin Atlantic and Delta have entered into an alliance that will see the two partners share routes across the Atlantic. Announced in December 2012, the arrangement was prefaced by a US$360m deal in which Delta bought a 49% stake in Virgin.

This illustrates a key benefit of a JV in this industry: partners can take advantage of each other’s landing slots, which are normally hugely expensive to buy at major airports. Virgin’s slots at Heathrow will enable the airlines to fly 304 flights per week in and out of London’s major airport.

JVs of this type can go a long way to addressing regulatory restrictions and cost and profitability issues. A partnership on a specific route can help to solve the problem of two carriers that are competing directly, but flying half-empty planes. However, they are typically not JVs in the traditional sense of having their own separate management structure.

Alliances allow airlines to increase the number of global destinations they can offer passengers

Preserving

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Shifting gearsJoint ventures and alliances are also allowing airlines to make inroads into emerging

markets. According to Ernst & Young’s recent Growing Beyond report, the number of people in the global middle class will increase from 1.8b to 4.9b by 2030 — with the majority of those in Asia and other high-growth markets.

Scott McCubbin, Ernst & Young UK and Ireland Aviation Transaction Support Partner, believes that airlines are responding to this global shift in economic power. “GDP growth is now in emerging markets rather than Europe or North America, and that is driving deal activity in the airline sector,” he says.

Australian carrier Qantas announced in January this year that it would form a partnership with Emirates, which would see the carriers fly to Dubai from Australia 14 times a day.

Overseas tripsHowever, JVs and alliances are not without their own obstacles. They are by no means regulation-free and any deal requires governments to grant anti-trust immunity (ATI). Airlines can enter into alliances without ATI but, typically, they will be prevented from discussing issues such as pricing with their partners.

And immunity can be hard to obtain. For instance, US regulators will not grant ATI to an overseas airline unless an “open skies” agreement is in place between Washington and the relevant government.

Risks are also attached to alliances. “You have to find a partner that has the same strategic approach,” says Faelten. “And after that, you have to be aware that the

partner will be delivering services on your behalf.” In other words, mistakes made by one party will reflect on the brand of the other.

For these reasons, a merger or a takeover may present a better long-term solution. And according to Jens Rothert-Schnell, Ernst & Young Germany Aviation Transaction Support Partner and GSA (Germany, Switzerland and Austria) Transportation and Logistics Sector Leader, it’s also a question of creating a single decision-making structure.

“You don’t really get all the synergies unless you have a full merger,” he says. “In a JV or alliance structure, you will have at least two sets of top management and stakeholders, different cultures and environments which make change management much more difficult.”

Across Europe, numerous airlines have been active in cross-border mergers in the past few years. One of the largest of these came in 2010 when British Airways (BA) and Spain’s Iberia merged under the umbrella of the International Airlines Group (IAG) creating a company with £6.1b (US$8.5b) of value on its stock market debut in January 2011.

IAG CEO Willie Walsh and chairman Antonio Vázquez said that the rationale behind the deal was to create an airline with a much bigger combined network than the two parts. “BA and Iberia will retain their strong brands and have complementary networks that operate from two of the biggest hubs in Europe,” Walsh said at the time of the deal.

In the US, consolidation has been widespread, with tie-ups between airlines such as United Airlines and Continental Airlines (2010), Delta and NorthWest (2010), and SouthWest and AirTran (2011). Meanwhile, in February this year, American Airlines and US Airways entered into a

merger agreement.These tie-ups brought benefits for the airlines —

though each deal has its own nuances, says Stokes.“Domestic mergers such as United and Continental

and the recently announced US$11b tie-up between American Airlines and US Airways have produced significant cost synergies, and efficiencies, through a single resultant brand,” says Stokes. “Cross-border European mergers tend to keep the individual identity of both carriers (for example, Air France and KLM) while searching for both commercial and operational efficiencies and savings.”

Staking your claimOwnership rules remain an obstacle for several airlines. The 2007 Open Skies agreement between the US and

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Aviation M&A deals (volume and value) 2007—2012

US$5.6bDeal value in the airlines sector in the first three months of 2013

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Abdulgader Bajubair of Saudi Airlines on breaking into the European market and partnering to achieve growth

Europe is an extremely attractive destination for Saudi Airlines (SV) as it is a high-yield market. We will get more returns from there, due to the rise in demand. It is extremely popular among

travelers and the increasing movement of air transport through the seasons and throughout the year is aiding this. For Saudis, it’s a focal spot for tourism. IATA data shows that revenue passenger kilometers (RPK), a measure of the volume of passengers carried by an airline, increased by 5.3% in Europe from 2011 to 2012. And although this is a smaller rate of growth than in other areas, Europe still generates over a third of the global RPKs, making it the biggest market. For us, this makes it relatively risk-free.

Although risk might not be high, there are some obstacles to overcome. Since the inclusion of international aviation in the EU Emissions Trading System (ETS), regulation is a critical issue. The ETS caps the level of CO2 emissions from flights each year. This is restricting SV’s expansion. From our side, CO2 emissions have to be predicted in order to know the number of certificates needed to combat such instances. To do this, we must have upfront planning, addressing the specific requirements regarding the methods of dealing with such regulatory issues.

The Sky Team Alliance, which we joined in May 2012, complements SV’s network and will assist in the dawn of a new era in our expansion plan. We gain key advantages from this partnership, namely improved service, lower fares and a wider range of schedules.

Viewpoint

Abdulgader Bajubair is the General Manager for Treasury at Saudi Airlines

The alliance The acomplements our complnetwork and will assist a new era in in our expansion planlan

Europe was intended to liberalize the air travel market, yet there is still a 49% foreign ownership cap in Europe and a 25% ceiling in the US.

“Airlines are faced with less regulatory issues in the case of mergers and acquisitions within their own jurisdiction,” says Rothert-Schnell. “In such cases, regulatory issues are mostly limited to approvals needed from the competition authorities.”

One example of a company using this kind of model is India’s Jet. It has expanded by taking on board local partners including Air Sahara, which it bought in 2007 for US$340m and renamed JetLite.

Business classEach deal will have its own strategic goals. For example, the Middle East’s fast-growing and highly competitive airline players are pursuing a strategy that sees their countries becoming hubs for passenger and cargo travel between Europe and Asia, according to Rothert-Schnell.

“They don’t necessarily need to take majority stakes, but they do want to ensure that the airlines they invest in will fly into their hubs and combine their flight networks,” he says. For more on Middle East airlines targeting Europe, see Viewpoint, right.

In addition, mergers can help airlines that are looking to preserve capital in the long term in the two following ways:

Savings behind the scenesWhile a merger may not mean that two airlines will unite under one brand, there are real opportunities to pool resources. For instance, airlines can leave the customer-facing operations branded in the old colors while merging processes such as baggage handling, booking, scheduling and customer service. In the case of IAG, a rationalization of sales and management teams, plus the integration of engineering and property services, contributed to savings of £112m (US$168m) up to 2012.

Subsidiary savingsThere can be further savings by using a subsidiary to alter the cost structures of part of the business. Rothert-Schnell cites the example of Lufthansa’s low-cost carrier Germanwings.

“Flag carriers tend to have very high staffing costs because of their history,” he says. “Lufthansa has been moving some of its routes to Germanwings, which has a much lower cost base.” In addition, Rothert-Schnell explains that this move comes as a reaction to price pressure and aggressive competition from

low-cost carriers. Lufthansa will transfer its short-haul business to Germanwings, adjust its product and service level to the offerings of their competitors and fly under that name, and thus protect its own Lufthansa brand.

It is a tough time for airlines. But the industry has responded to tighter regulation, high fuel costs and the ongoing financial crisis by developing an innovative range of ownership strategies. Other sectors would do well to look to the skies for inspiration.

For further insight, please email editor@capitalinsights.info

www.capitalinsights.info | Issue 6 | Q2 2013 | 23

The Capital Insights debate:

Distressedinvesting

are drying up and corporates are turning to a new breed of alternative funds for support. Ernst & Young’s Keith McGregor discusses this change of direction with some of

A t the turn of the millennium, distressed debt investors were already established players in the US. However, more recently, Europe has become a target market.

Banks have had to constrain lending. As a result, businesses already facing falling profits in weak Eurozone economies may also be looking into a funding hole. Growing numbers of alternative investment and distressed debt funds are moving in fast to fill that gap. Ten years ago, few funds chased European distressed debt — yet now, Bloomberg estimates that as much as US$74b is available for this market. The once unconventional band of distressed debt investors are stepping firmly into the mainstream.

KM: Today’s distressed debt funds feel very different to those operating during the last downturn in the early 2000s. What has changed?

JD: Last time around, hedge funds and distressed debt funds made very good returns from effectively trading in and out of debt. They traded in below par, the environment improved, the debt returned to par and they made their money.

If you look at the wider economic picture now, we will have very sluggish economic conditions for a number of years, whereas last time we were in and out of recession relatively quickly. The challenges are very different.

What that means for the debt fund community is that its business model has to be different from the one that it used last time. Now they have to find ways to restructure and turn around the businesses in which they take debt positions. That is a different mindset.

JC: I agree. Last time, there was a lot of opportunity to buy in cheap and make a return a few months later with little true value creation. Now, there is a need to add value. This means that not only is the skill set different, but a much broader array of skills is required — sourcing and origination, structuring (and restructuring) and, perhaps most importantly, operational restructuring skills. It’s no

Key insightsDebt funds have emerged in Europe over the last decade to fill a void left by more traditional providers.These funds have changed the way they work and are now looking at restructuring and turning round the business in which they take debt positions.Corporates looking to divest, especially those that are underperforming, could look to these debt funds.

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longer the case that a smart guy with a mobile phone and a checkbook can execute this from a small office in central London. Success now requires a broadly based team with extensive experience.

MW: Yes, investing in debt is by no means straightforward. For all the reasons outlined by John, you can’t just buy cheap and sell a little later for a profit. As you think about the loan-to-own opportunity set (situations where investors seek to take ownership of struggling businesses by buying into their debt), it starts to look very different.

If you want to become involved in a debt-for-equity swap, for example, you know that it is going to involve disenfranchising multiple stakeholders. That is something we at GSO prefer to avoid, if possible. So one approach is to look at what we can do with the resources we have. We have scale and we have drawdown capital so we can provide a longer-term capital structure. That allows us to provide a credit-led solution to companies with a stressed balance sheet — a solution that does not disenfranchise stakeholders.

KM: I feel that funds really relish working alongside management and other advisors with a common purpose. A whole range of skills can be introduced from across a wide range of resources. In particular, a focus on the operational restructuring of the business, with the involvement of a chief restructuring officer, can really support management and be instrumental in change. We have found that an initial focus on getting short-term cash sorted and establishing stability can expand into a longer-term, more strategic role over the period of restructuring, looking at structural issues, supply chain and more.

JC: It is fair to say that the market is much more mature today. Distressed investors often all get seen as the same — but there are different types of investors within the community. Some will provide new capital into the right capital structure. Others are interested in buying non-core assets, often

severely underperforming ones, because they are interested in the scope for turning these around. There are pools of capital available for all kinds of situations. A broader array of skill sets and objectives are being brought to bear on the more mature opportunity set presented by today’s market and that can only be a good thing.

Our investment in Klöckner Pentaplast, a resins and packaging business with revenues above €1b (US$1.3b), is a good example. This was a high-quality business that was heavily constrained by its legacy capital structure. We were able to work with the business to restructure the balance sheet and address some operational deficiencies head-on, in a way that has enabled it to react well to current market developments. As a result, earnings have grown dramatically since the restructuring closed.

JD: For sure, the more diverse experience you have around a company, the better your chances of finding a solution. Management should not take it all on their own shoulders.

KM: So what do you think has made Europe so attractive to the funds?

JC: Traditional providers are more reluctant to service some parts of the corporate economy. Small and mid-sized businesses are clearly struggling to access lending in a way that they used to. The debt funds have emerged to fill the void.

From our perspective, there seems to be a new fund marketing its new direct lending capability almost every month or two in Europe right now. A lot of these guys have suddenly arrived looking to build a book of business over the course of the next 18 to 24 months.

I think we will see more and more capital provided by alternative lenders. What is going to be interesting is the cost of that capital — I think it is already becoming very competitive.

MW: Historically, commercial banks have been the primary provider of debt capital in Europe. The collateralized loan obligation (CLO) community, which invests in syndicated loans from larger corporate and leveraged buyout borrowers, also have grown to be a meaningful provider. Between them, those two have historically provided 75% to 80% of the senior debt to companies.

But going forward, if you think about the funding pressures that European banks are under, the banking system is going to provide less capital to corporates. These banks are faced with, among other issues, capital pressures from Basel III and a reduction in wholesale funding.

CEOs, CFOs and boards of directors have to look at ways to diversify their sources of funding — debt funds offer that.

KM: Alongside the changing approach of the funds, it’s pretty clear that the traditional strategy of banks toward restructuring has also evolved. The stakeholder spectrum is so much broader and more complex and it’s no longer possible for banks to control direction in the way they perhaps once did. Nor, with economic pressure and varying provisioning policies around Europe, is it as easy for banks to agree courses of action among themselves.

On the webFor more information about debt and corporate divestment, read Ernst & Young’s Global corporate divestment study at www.capitalinsights.info/divest

At the tableKeith McGregor (KM)Head, EMEIA Capital Transformation and Restructuring practice at Ernst & Young

Jason Clarke (JC)Managing Director, Strategic Value Partners

John Davison (JD)Head of the Strategic Investment Group, RBS

Michael Whitman (MW)Senior Managing Director, GSO Capital Partners

www.capitalinsights.info | Issue 6 | Q2 2013 | 25

JD: Banks as a group have a very wide range of approaches to restructuring, and there are often some very different objectives and priorities. Some banks want to exit and move on, while some are prepared to be patient and want to try to work through the business’s problems to return it to strength and, as a result, deliver a longer-term financial return.

We also have to understand that it has taken time for banks to work through what has been a very large leverage loan portfolio. The market only had a limited amount of capacity to deal with all these restructurings and, to a certain extent, it should not be surprising that some things took two or three rounds of restructuring to sort out.

We have seen businesses with top lines that are dropping dramatically even within a year. That is a shock to the system for any management team, and it is not something many have contemplated with any degree of rigor. So it is reasonable to give them time to think how to react to a situation and then come back and have a sensible discussion.

It is also worth remembering that we have situations where there are a large number of stakeholders. We have banks holding debt at par, debt funds that have bought in below par and there are international banks with differing policies on restructuring.

As a result, it takes time to reach a solution that enough of the stakeholders are willing to support. There are situations where you would hope to come to a quicker solution, but the practicalities of the stakeholder group mean that that is often quite difficult.

MW: The banks have taken their time for sure. There was an expectation that the banks would be aggressive sellers

US$74bThe amount funds have available to invest in distressed debt

The shape of things to comeA 2012 survey of 100 European hedge fund managers, long-term investors and proprietary desk traders by research firm Debtwire suggests an optimistic outlook for the industry

early on, but that has generally not materialized. Banks are reluctant to take the capital hit and just sell.

KM: So what does having so many stakeholders mean for corporates? How should they approach banks and funds, and best influence stakeholders, to work together to preserve value?

JD: Talk to stakeholders and talk to them early; give them accurate information; don’t give them false hope. Try to be realistic, because trust is important in these situations. Try to understand the process a stakeholder needs to go through, whether it is a bank or distressed debt fund, so nothing comes as a surprise.

The other thing I would say is that corporates should think about cash. Most of the businesses we deal with have a cash issue not an “earnings” or EBITDA issue.

Management should share the problem, and getting good support can only help — the restructuring of a business can be a horribly lonely place to be as a CEO.

MW: I would say, come in and start a conversation. Headline leverage in these situations is higher than anyone would like and that can lead to a lack of comfort around the credit story. A sector can be out of favor, or existing lenders may assign negligible value to a large base of installed assets that have a lot of intrinsic value.

A credit committee inside a financial institution typically adheres to very traditional credit metrics; a debt fund can deviate from that, given the nature of its capital, and we can devise something more bespoke.

The capital structure need not suffocate a business. Too often, we find management teams spending too much time managing their lenders and not enough time managing their business. The end objective for us is to allow CEOs to go back to managing their businesses.

KM: And that objective is particularly relevant given that the market is more complex than I’ve ever seen it. Longer term, a permanent reclassification of the debt capital markets is taking shape, which will have a profound impact on the restructuring landscape. It’s clear that these funds have established their space across Europe and they can certainly be a force for good in the world of corporate turnaround.

For further insight, please email keith@capitalinsights.info

66%services sector would have

investors — the highest-ranked sector in the survey

58%feel most restructuring

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57%believe raising money will be easier in 2013

45%are actively raising funds for distressed debt, up from 20%

in 2011

43%will increase distressed

allocation in 2013

Capital Insights from the Transaction Advisory Services practice at Ernst & Young

The PE perspective

Sachin Date

Learningcurve

Icrisis, many commentators predicted

the myth that PE-backed companies do not

Sachin Date

sachin@capitalinsights.info

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W hile much of Europe is still in the grip of financial turmoil, the four largest Nordic countries are holding up well. The region is home to half of all the countries that still

enjoy AAA status from ratings agencies, and M&A volumes are on the rise. In Q1 2013, the 41 deals done in the Nordics with non-Nordic buyers represented a 24.2% increase on the 33 deals in Q1 2012.

Small region, big thinkingOne possible reason for the success of Nordic corporates is that they see themselves as global businesses, not national ones. Jesper Almström, Transaction Advisory Services Leader at Ernst & Young in Stockholm, explains that an international approach is ingrained in the Nordic corporate culture. “This region is small,” he says. “We need to be international. We need to look offshore, outsource and automate things.”

With this approach, many Nordic businesses are open to investing internationally and accessing international capital. Fortunately, the region has few barriers to investment. “The Nordic region is one of the easier areas to invest in because our corporate culture is very transparent,” says Almström. “The numbers are reliable. You get a lot of information and the information is of good quality.”

Business attraction is even stronger due to the countries’ commitment to robust corporate governance. All four Nordic nations were in the top seven in the Corruption Index, produced by anti-corruption NGO Transparency International, in 2012.

In addition, all four countries feature in the top 30 in Ernst & Young’s M&A Maturity index.

We explore how the Nordics’ stability, creativity and innovative spirit offers much for corporates looking to acquire and divest

However, the region is not without its challenges.“We tend to have more complex rules on employment, tax and pensions,” says Almström. “Those requirements vary between Nordic countries and this means you do need local guidance.”

In addition to inbound opportunities in the region, Nordic corporates and PE firms and funds are interested in investments, both within the region and globally. For example, Danish pension funds are keen to make infrastructure investments. The funds already have strong exposure to the renewable energy sector.

According to Almström, Nordic acquisitions are likely to be carefully targeted. “Corporates are looking at niches where there are opportunities to buy the technologies and capabilities they need to improve their businesses,” he says.

And while it is tempting to view the Nordics as a bloc, each country provides different opportunities and challenges for those looking to invest capital — and the countries are each looking at separate activities when it comes to outbound deals.

Sweden: Nordic leaderSweden had more M&A activity than any of its neighbors in 2012, with 244 deals worth

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Key insightsThe Nordic region has a very transparent corporate culture, making it one of the easiest areas in which to do business.Corporates need to be wary of treating the Nordics as a bloc; each country is unique with specific strengths and different investment opportunities.Challenges in the region that corporates need to overcome include complex tax and employment rules, and variations in each country’s takeover codes.Private equity is a major deal-driver in the Nordics, particularly in Sweden.

over US$18.5b. This is continuing into 2013, with Q1 seeing Sweden home to 40 deals worth a total of US$6.3b — the joint most deals by number (with Denmark) and by far the highest in terms of value.

Start-ups and servicesAs well as being the home to major multinationals such as H&M and Ericsson, Sweden is also a hub for some of the world’s fastest-growing digital businesses, including Skype, which was bought by Microsoft in 2011 for US$8.5b.

Swedish start-ups are some of the most successful in Europe at attracting investment. According to the European Private Equity and Venture Capital Association, in the first three quarters of 2012, the country took nearly a fifth of all venture capital invested in the EU.

In addition to start-ups, Swedish industrial services companies have attracted interest from PE investors. These firms have accounted for over 25% of all PE deals in Sweden since the beginning of 2012. One of the largest deals came in April last year when Swedish investment company EQT VI acquired Anticimex, a pest control and food safety company, for SK2.7b (US$421m).

However, according to the World Bank’s Doing Business 2013 index, Sweden is the least easy country in the Nordics in which to do business. Factors holding back its ranking were the comparative difficulties in starting

a business and tax system complexities — though it is still above the global average. There is also uncertainty about the future of taxation of PE-carried interest, and the tax authority is investigating whether PE investors are properly reporting their tax liabilities. While this has caused some anxiety, it is having little practical impact on activity, reports Almström. “At the end of the day, no investment is made based on the tax position,” he says.

Indeed, many see recent tax changes as good news for businesses. “The corporation tax rate has come down to 22% for this year. Sweden is becoming a sort of tax haven,” says Almström. This is the lowest corporation tax rate of the four countries, and is lower than the global average of 24%.

Norway: power and privatization Norway’s economy has fared well compared with its other European counterparts and has experienced a significant recent lift in M&A activity. Ernst & Young’s Transaction Trends: Norwegian transaction market update 2013 reports that, in Q4 2012, the 500 largest Norwegian companies announced 32 deals, up from 22 in the previous quarter. This is the highest level of activity since the third quarter of 2011. Additionally, cross-border deals constituted 56% of transactions in Q4, up from 36% in Q3.

“Norway has a strong economy and a stable political environment,” says Nils Kristian Bø, Transaction Advisory Services Partner at Ernst & Young in Oslo. “We have elections coming up, where we could see a change to a conservative government. This may open up opportunities with publicly owned assets and public private collaborations may rise.” Should a new government wish to, it would have a long list of attractive publicly owned assets to sell — the public sector accounts for 52% of Norway’s GDP.

www.capitalinsights.info | Issue 6 | Q2 2013 | 29

FinlandPopulation 5.3m (2013)*

FDI US$84.3b (2012)

GDP US$247.2b (2012)

Source: CIA World Factbook; World Bank

*Estimates forJuly 2013

NorwayPopulation 4.7m (2013)*

FDI US$192.5b (2012)

GDP US$500b (2012)

Source: CIA World Factbook; World Bank

DenmarkPopulation 5.6m (2013)*

FDI US$120.7b (2012)

GDP US$309.2b (2012)

Source: CIA World Factbook; World Bank

SwedenPopulation 9.1m (2013)*

FDI US$356.5b (2012)

GDP US$520.3b (2012)

Source: CIA World Factbook; World Bank

Powering upEnergy is Norway’s key strength, with the sector’s output constituting 23% of GDP in 2011. And Norwegian energy companies are diversifying internationally and into non-traditional assets. Oil and gas company Statoil has major shale gas assets in the US and Australia, and is engaged in joint venture oil extraction projects in Brazil and Africa. It is also investing in renewables.

In October 2012, Statoil teamed up with state-owned energy company, Statkraft, to buy the Dudgeon Offshore Wind Farm project in the UK. Statoil’s Senior Vice President of Renewable Energy Siri E. Kindem said: “The acquisition is in line with Statoil's strategy to seek new business opportunities in offshore wind as part of the development of our renewable energy portfolio.”

Bø expects the recent high level of deal activity to be maintained, with both inbound and outbound deals.

“Many Nordic companies have a growth agenda, and to achieve and to expand that they have to go abroad because the domestic markets are small,” he explains. “In addition, their balance sheets are fairly strong, so they can concentrate on their growth strategies.”

One example of this is Norwegian chemical company Yara’s US$750m acquisition of US agribusiness Bunge’s

Brazil-based fertilizer arm in December 2012. Those corporates in growth industries that are looking to divest would do well to keep an eye on Norwegian investors.

Finland: picking up the paceFinnish M&A is small, but exciting developments are taking place. Deals for Finnish companies were up 24% in Q1 2013 compared with Q1 2012, according to Mergermarket data.

However, according to Petri Parvinen, Professor of Sales Management at the Aalto University School of Economics, there is currently a lot of medium-sized M&A taking place domestically. Indeed, Mergermarket data reveals that over 58% of all Finnish M&A deals in 2012 were domestic ones.

Tech watchTechnology is key to Finnish development. Notable technology deals in 2012 include Digita, a digital provider, which was bought by asset management company Colonial

On the webFor more information about Norwegian M&A, read Ernst & Young’s Transactions Trends at www.capitalinsights.info/norway

What’s in the stars for PE?

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1We examine the state of the Nordics’ PE marketPE-historic. Kristoffer Melinder, managing partner of Nordic Capital, says that PE activity is strong. Indeed, Mergermarket data shows that 16% of all deals in these four countries since 2012 have featured a PE bidder. “The Nordic region has one of the oldest and most active PE markets in the world,” he says. Despite some more challenging times in the exit market, Nordic Capital has been able to attract strategic and other premium buyers for recent highly successful exits, such as Nycomed, Point and Falck. “There are many fairly large PE funds in Sweden,” Ernst & Young’s Almström says. “Four or five multi-billion euro funds have headquarters here, which is unusual for such a small country.” One

is Ratos, which recently acquired energy services firm Aibel for €1.2b (US$1.6b) along with other investors.

Looking for exits. Almström believes that many PE holdings have reached maturity and there will now be some “significant PE exits, which will create deal opportunities.” This process has already started, with London-based Smedvig Capital selling self-storage company Selstor to Pelican Self Storage. “I think 2013 will be an active year,” adds Melinder. “The global economic unrest has led to a situation where some owners of attractive businesses, particularly those off the radar of larger buyers, are now willing to sell at low entry multiples. In addition, the exit pipeline is strong, a number of exits are likely.” According to Ernst & Young’s Bø: “Many PE firms have mature portfolios,

so the sell-side activity is expected to be high. There has also been a significant amount of fund-raising in the last year and Norwegian PE firms have a lot of dry powder.”

Domestic focus. Lots of PE activity at a smaller level is inward-looking. “There will be a lot of these activities this year,” says Bø. “Among these larger deals, you will see pan-European PE companies coming in. With the smaller deals, it is other Nordic PE firms that are buying.”

8.4bTotal M&A deal value in the Nordic countries in Q1 2013

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First State Australia from French broadcasting company TDF. The deal was reportedly worth €400m (US$536m). Finland is established as a pioneer in digital technologies, making its emerging companies worth monitoring. Parvinen sees opportunities for global deals that bring strengths to rectify the weaknesses of companies whose focus is on Finland.

“There are opportunities to buy good technology and engineering companies and leverage existing international sales channels,” explains Parvinen. “PE companies from Sweden that specialize in small and medium-sized companies have been re-engineering acquired Finnish companies’ sales and marketing operations, and creating lots of value.”

A recent example comes from telecoms giant Nokia, which sold its luxury mobile brand Vertu to Swedish PE fund EQT VI in October 2012, for €200m (US$265m).

However, there are drawbacks for outsiders looking for opportunities. And even financially generous offers may be refused. Parvinen adds: “A lot of Finnish boards see no need to grow. They are concerned about stability, corporate social responsibility and local impact. Finnish companies often value these factors more highly than their international competitors.” To get Finnish companies on board, a bidder is likely to have to stress a shared commitment to ethical values and to the retention of operations in their traditional locality.

In addition, like much of the Nordics, Finland has fairly high costs compared with other regions. “To combat this, there is always a focus on technological development and automation. There is always a need to be ahead of the pack,” says Parvinen. For instance, telecoms giant Nokia runs the Nokia Research Center, which has links with nine leading global universities through its Open Innovation scheme.

Outside investors would be wise not only to look at how Finnish businesses are exploiting emerging technologies, but also to maintain a close watch on research being conducted by respected academic institutions, such as Aalto University.

Denmark: consolidating to recover Of the Nordics, Denmark has been worst hit by the financial crisis, with its banking sector damaged by over-exposure to inflated property lending. Its GDP grew by 0.8% in Q3 2012, before falling by 0.9% in Q3, according to figures from Trading Economics. This performance is mirrored by M&A volumes, which fell to 40 deals in Q1 2013 compared with 46 in Q4

2012. The largest recent inbound deal was the purchase of Dako by Agilent Technologies in June 2012 for US$2.2b.

Coming togetherDenmark’s financial problems create opportunities for potential investors in the country, with some banks looking to offload properties at reduced prices.

This consolidation across Danish industries brings opportunities for corporates, both foreign and domestic. Bø says: “I see opportunities in Denmark in the property and construction sectors. You will see a consolidation of construction companies.”

Sometimes, this can come from foreign sources. For instance, French manufacturer Poujoulat bought Danish steelmaker VL Staal for an undisclosed fee in January.

Significant M&A activity is also taking place in other sectors, particularly where restructuring and international consolidation can yield synergies. Online bookmaker Sportingbet bought Danish betting companies Danbrook and Scandic in 2011 for £8.5m (US$12.8m). Sportingbet is now in the process of being acquired by betting chain William Hill.

Despite the turbulence, Denmark has considerable inherent strengths, including biotechnology. Denmark is recognized by the European Commission as being in the top four EU countries for biotech performance. The Nordics generate 10% of EU biotech businesses, with successful Danish businesses including Novo Nordisk and Novozymes. Novo Nordisk, in particular, has posted strong 2012 results, with its share price increasing by over 100% since 2010, becoming the most highly valued company in the region.

It isn’t just conglomerates where Denmark has the edge in biotech. Aarhus, Denmark’s second-largest city, is in the top 10 EU biotech clusters. The sector’s lobbying agency, Dansk Biotek, reports that there are more than 150 Danish biotech companies now developing innovative industrial products.

The World Bank’s Doing Business 2013 index lists the country as the easiest in Europe in which to do business and the fifth easiest in the world. On top of this, it is still one of the world’s leaders in further reducing regulatory burdens.

For further insight, please email editor@capitalinsights.info

www.capitalinsights.info | Issue 6 | Q2 2013 | 31

Top three completed Nordic outbound deals since April 2012

Completion Target Buyer Deal valueDEC

2012Inoxum (Germany)

Outokumpu Oyj (Finland)

US$3.1b

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2012BSN Medical (Germany)

EQT Partners (Sweden)

US$2.3b

JUL

2012 EMEA tissue business (US)

Svenska Cellulosa Aktiebolaget (Sweden)

US$1.8b

Source: Mergermarket

Top three completed Nordic inbound deals since April 2012

Completion Target Buyer Deal value

JUN

2012Statoil Fuel & Retail (Norway)

Alimentation Couche-Tard (Canada)

US$3.7b

MAY

2012Ahlsell Sverige (Sweden)

CVC (UK) US$2.4b

JUN

2012 Dako (Denmark)Agilent Technologies (US)

US$2.2b

Source: Mergermarket

As intellectual property becomes an important source of wealth, how do companies value it and use it to raise and optimize capital?

Capturingthe

imagination

I n troubled economic times, the focus often turns to keeping the balance sheet healthy rather than fostering innovation. But why can’t these two apparently divergent paths be combined?

Thousands of companies could be sitting on a source of capital they don’t exploit and, in some cases, don’t even realize they own: their intellectual property (IP). Simon Pearson, a Lead Advisory Partner, Technology, Media and Telecoms at Ernst & Young, says that large corporates quite often lose track of the IP in the business. “We’ve seen cases where as much as 65% of the IP is not being used,” he says.

Substantial IP portfolios are being sold. For instance, Nortel Networks entered creditor protection proceedings in North America and Europe in 2009, and subsequently carved out and sold its six global trading businesses. Following the disposals, Nortel was able to market and sell its residual patent portfolio as a separate transaction, achieving US$4.5b in sale value.

And there is further activity in the market. In April 2012, Microsoft bought 800 patents from AOL for more than US$1b. A month later, Google acquired Motorola Mobility — with its 17,000 patents — for US$12.5b in a move to protect its Android mobile operating systems from competitors.

“I see IP becoming a more important driver for businesses,” says Josh Lerner, Jacob H. Schiff Professor of Investment Banking at Harvard Business School. “We’ve seen a lot more emphasis on aggregating, litigating and filing patents in the last few years.”

Not just high tech The potential to monetize IP isn’t just linked to high-tech firms with a grip on standard essential patents (SEPs), which protect inventions that must be used to comply with a technical standard. IP has potent, but sometimes unrealized, power in a whole range of industries from big pharmaceuticals, through to leisure and entertainment.

For example, licensing and merchandising of copyright material has the potential to drive multi-billion dollar revenues. “Disney’s 2011 output of licensed product sales garnered US$37b in retail sales,” points out Tom Phillips, editor of Intellectual Property Magazine. “Disney is a well-known powerful protector of its own copyright.” World Bank data put the global balance of payments for royalties and license fees at US$212b in 2011. But many companies are missing out. And that’s despite the number of filings rising to record levels, topping two million for the first time in 2011.

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Capital Insights from the Transaction Advisory Services practice at Ernst & Young

Key insightsCompanies could be sitting on a key source of unexploited capital — their intellectual property (IP).New ways of using IP as a source of capital include putting it up as security for financing or for bridging a gap in a pension fund.Valuing IP can be a tricky process — three key approaches for doing so are the cost-based, market-based and income-based methods.

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Companies that are the most effective at exploiting their patent portfolios are more likely to have a successful IPO or be acquired in an M&A deal, according to research. “We found that companies with the strongest patent portfolios were the ones that went public or were acquired at a higher rate than those that didn’t have strong portfolios,” says Joseph Hadzima, Senior Lecturer at the Martin Trust Center for MIT Entrepreneurship. “Six out of seven of the companies that scored highest in our ratings of IP had gone public or been acquired. We were astounded it was that high.”

IP sourceEven companies that have traditionally exploited their IP effectively may be missing out on some new ways of using IP as a source of capital. These include putting it up as security for financing or for bridging a gap in a pension fund.

Alcatel-Lucent, the French global telecoms equipment company, used the first of these approaches in December last year to partly secure a €2.1b (US$2.7b) refinancing package. The IP used in the refinancing included, among others, the company’s interests in some of its US subsidiary Bell Labs assets’ patents.

Travel group TUI Travel filled a £411m (US$621m) gap in its pension fund by separating its Thomson and First Choice brands into pension funding partnerships. These were essentially special purpose vehicles used as security for the fund. It leases the right to use the brands back to the company for an annual fee of £16.5m (US$25m) for 15 years.

But the ways in which IP can be used as capital seem limited only by the imagination of financiers and the rules of regulators. For example, Pearson mentions a food processing business that has discovered a way to extract organic materials, and is now exploring how to license the technology to other sectors.

Upping your IP game Where do you start when monetizing IP? “When a company wants to gain more commercial benefits from its IP, it needs to put a systematic process in place that identifies what and where its IP is,” says Lerner.

“When you look at a lot of firms that haven’t traditionally focused on IP, they don’t really have a clear mechanism for identifying what’s promising IP, potential patent filings, trade secrets and the like. So a first step is to identify the stuff.”

He adds: “A second strategy is to figure out how to view IP as an asset like any other so that it can be used strategically. For that, you have to think through all the issues around what is going to be licensed, what is going to be used internally, what the litigation strategy is, and so on. In short, this is an asset where there are a lot of aspects of strategic management.”

However, for corporates looking at their IP portfolio, uncertainty may arise when it comes to putting a concrete value on the intangible. There has been a step-change in IP values in recent years, stimulated in part by the globalization of patent registrations, the increasing realization of the potential value of IP and reform in the legislative landscape. The America Invents Act, which is coming into force this year, introduces the “first to file” rather than “first to invent” principle in patent protection in the US.

Hadzima says: “When I’m asked to consider how much a patent or portfolio of IP is worth, I think of it as three components. First, how good is the underlying invention? Is it a cure for cancer or merely an incremental improvement? Second, if it’s an important invention, is the patent legal document well constructed and has it captured the value of that invention? Does it protect it? Third, how do I get the value of it out?”

Alay Patel, Valuation and Business Modeling Partner at Ernst & Young, says that there are three main ways in which a company can determine the value of its IP.

The cost-based methodThis calculates the cost of replicating the invention. “This may be relevant where the IP is not protected, and providing you can replicate the technology without any limitations, encumbrances or restrictions,” he says.

The rise of China: top three patent offices by number of filings

Source: World Intellectual Property Organization (WIPO)

14,000The number of patent applications made using the international Patent Cooperation Treaty in 2012

2011

China 526,412

USA 503,582

Japan 342,610

2010

USA 490,226

China 391,177

Japan 344,598

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The market-based methodThis involves looking at reference points in the market as a means of gaining a view of the value. Essentially, this is like using the sale price of the house next door to value your own home. But that’s only possible if the house next door is sold.

The income-based method“Look at the income stream that you can generate from the IP,” says Patel. Variants of this approach are increasingly being used. These include calculating the hypothetical royalty stream that could be generated, the residual profit that would be created, litigation revenue that would come from pursuing infringements and what Patel calls “value at risk”. “This looks not so much at the value created by owning the IP, but what value might be lost by not owning particular IP,” he explains.

Following leadsPearson cites semiconductor company Qualcomm as an exemplar for valuing and exploiting IP effectively. “The company took a strategic decision, more than 12 years ago, to maximize the value from what it invents without trying to own the entire infrastructure to produce the products,” he says. Instead, licensing inventions and technologies now count for over 35% of revenue.

Patel says companies that exploit their IP effectively have learnt “to look at the world through an IP lens.” He warns: “Most

people look at the world through a balance sheet lens, or a profit-and-loss lens, or a

marketing lens.” Companies with the wrong focus could miss out on making IP a new driver for their business.

The key is to take a step back. “Reassess some of the parts of your business model to align better with an IP world,” he says.

Hadzima adds: “It’s important to audit IP against the firm’s strategy. You can see what can be sold, licensed or exploited in a joint venture.”

Cashing in on IPCompanies looking to monetize IP face five options, says Simon Edel, Restructuring Director in Transaction Advisory Services at Ernst & Young, all of which have advantages, as well as drawbacks.

Selling the IP. Transactions such as the aforementioned AOL deal show that it can harvest substantial sums. But this means that the seller loses the IP for the future.

Licensing the IP. This generates a continuing revenue stream but may result in the IP reaching rival companies that could then be better placed to compete.

Packaging it into a separate firm to exploit its value. This may generate both revenue streams and capital, but will require upfront financial investment and management time.

Litigate to win damages from infringers. However, this poses the risk of becoming a target for counterclaims by rival companies. It can also prove expensive.

Using IP as security for loans. This makes the IP work for its living as an asset, but may result in an effective loss of operational control while it is securitized.

“There are many ways that companies can use IP as a source of capital. But whichever lever they use to get the capital in, they need to be aware of the impact and how that fits in with their business strategy,” adds Edel.

Global encouragement for companies to optimize their IP more widely is rising. The European Commission’s Europe 2020 strategy proposes an “innovation union” that aims to establish a single EU patent and patent court, designed partly to help small- to medium-sized enterprises protect their IP. Meanwhile, China’s State Intellectual Property Office has developed a “national plan” that targets tech companies as an area for IP growth.

In the IP world, it won’t be surprising if some are unsure of their next move. “It’s often difficult for a business to demonstrate the value of its IP to others when it’s trying to make an informed decision about what to do,” says Pearson. “An external perspective can help you form an objective view about how IP may be valued and exploited.”

For further insight, please email editor@capitalinsights.info

IP in numbers

Source: WIPO 2.1m The number of patent

applications filed in 2011

16%Growth rate in trademark

applications between 2010 and 2011

7.8%Growth rate in global patent applications

between 2010 and 2011

Capital Insights from the Transaction Advisory Services practice at Ernst & Young

An external perspective can help you form an objective view about how IP may be valued

As traditional sources of lending become harder for companies to access, Capital Insights investigates the alternative lending sector

W ith bank de-risking leading to less liquidity, alternative financing routes have grown. The Financial Stability Board (FSB) puts the size of the global “shadow banking”

market — loosely defined by the FSB as credit intermediation “outside the regular banking system” — at US$67t. In 2002, it was worth US$26t. The FSB figures, released in November 2012, show that the US leads the way with US$23t, followed by the Eurozone with assets held by non-bank financial intermediaries (NBFIs) worth US$22t.

“The growth of alternative financing has been partly the result of traditional banks deleveraging, but also the effect of investors looking for higher rates of return,” explains Erik Gerding, Associate Professor, University of Colorado Law School. “That search leads them to more illiquid and less transparent markets.”

Regulatory response Regulators concede that non-bank funding is important. For instance, in its 2012 monitoring report, the FSB notes “the importance of finance companies in providing credit to the real economy, especially to fill credit voids that are not covered by other financial institutions.”

However, they worry that some activities may cause further financial shocks if left entirely unregulated. “The

regulators are attempting to reduce the spillover risks from the “shadow banking” system to the main banking sector by regulating the traditional lenders differently,” explains Stijn Claessens, Assistant Director in the Research Department at the International Monetary Fund (IMF). “Besides this indirect approach to reduce the spillovers, there is also an agenda of strengthening the shadow banking system directly. So, for example, measures being looked at by the FSB include putting a floor on the margins and haircuts being used in collateral transactions — although this is difficult to do in practice.”

There are concerns that uncertainty remains over the form of future regulation. In the US, the Securities and Exchange Commission and the Financial Stability Oversight Council are considering tighter rules in areas such as the US$4.1t money market — a short-term borrowing sector whose securities include commercial paper and certificates of deposit.

“If more drastic action is taken in US money market reform, it could dramatically reduce the attractiveness of investing there,” says Gerding. “With over-the-counter derivatives, if US regulators set margin requirements high,

Key insightsThe growth of alternative financing should be good news for companies looking to diversify their sources of capital.Many boards need to change their perception of non-traditional funding if they are to find alternatives to bank-based lending.Companies need to take steps to attract alternative finance, including being open-minded, establishing a long-term strategy, being well prepared and getting the right advice.

Shoppingaround

US$67tSize of the global “shadow banking” market

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Raising

it lowers corporate incentives to use these instruments for hedging or investment. There’s a lot at stake.”

Despite these concerns, good regulation of the non-bank financial market could be helpful for investors and corporates alike. “If the regulation is designed effectively, then investors benefit from a stable market,” says Gerding. “For corporates, there is the long-term benefit of knowing that the market won’t go haywire.”

Opportunity knocksThe growth of NBFIs challenges regulators. But this should be good news for those companies looking for capital from sources such as hedge funds, credit funds and other forms of private finance — such as private placements, in which companies source funds directly outside the public markets.

Canada’s Forum Uranium Corp is just one company taking advantage of liquidity in the US private placement market, raising US$2.6m in its four tranches by March this year. The company is far from alone. Mark Hutchinson, Head of Alternative Credit at M&G Investments, estimates that UK companies raised US$10b in the US private placements market last year alone.

In October 2012, the IMF said that European banks could shed between US$2.3t and US$4.5t of assets over the coming years. Without the involvement of new players in the credit markets, that leaves a substantial capital shortfall. This is combined with a loss of confidence among some business leaders about the suitability of public markets for fund-raising. Xstrata’s outgoing chief executive Mick Davies, said in January: “If I’m going to go forward in a way where I’m going to be involved in the business community and build a business again, I will go to the people who are going to deliver capital to me in the most effective and efficient way. And right now, I don’t think the public markets are demonstrating that.”

One issue, however, is that accessing non-traditional forms of lending can require a change of mindset among boards. “In many instances, we see that there is a perception issue with many of these forms of finance,” explains Chris Lowe, Partner in Ernst & Young’s UK Capital and Debt Advisory Group. “It doesn’t help that they are often lumped under the term shadow banking, which invariably has negative connotations.”

There are also concerns about the motives of some credit providers. “There are clearly some funds that

sometimes follow a ‘loan-to-own’ strategy,” says Luke Reeve, also a Partner in Ernst & Young’s Capital and Debt Advisory Group. “Yet even the more speculative alternative debt providers, such as funds set up by the PE and hedge funds, will look at higher-quality businesses as well as the higher-yielding opportunities.

“And that isn’t the whole story. You’ve got a number of blue-chip insurers that are developing products to fill the funding shortfall and these will look at the higher end of the credit quality spectrum.”

Legal & General, for example, entered the property lending market last year with a £121m (US$182m) loan to student housing developer Unite, and storage company Big Yellow Group tapped Aviva last year for £100m (US$151m).

And many believe this trend is set to continue. Over half of those surveyed (55%) in the 2012 Ernst & Young European real estate assets investment indicator believe that insurers are likely to become more active providers of debt financing for real estate assets.

Perceptions are changing as more corporates are forced to look for alternatives, says Lowe. In the UK, government initiatives may also help shift perceptions. Established last year, the UK’s Business Finance Partnership is an attempt to push capital through non-bank channels. With £1.2b (US$1.8b) to invest, this fund has so far allocated £600m

(US$906m) in a first tranche to players such as M&G Investments’ M&G UK Companies Financing Fund 2, which offers corporate loans to mid-sized UK companies. The second tranche will be released in the first half of 2013, with a commitment already to Intermediate Capital Group (ICG), which manages mezzanine, equity and credit funds.

Yet even without government help, the proliferation of new funds is likely to continue. The last couple of years have seen the creation of credit funds by PE groups including Partners Group, Gulf Capital, Summit Partners and CVC Private Equity Partners. While many of these operations may have been set up to help finance a firm’s own PE deals, the trend now is for credit arms to operate independently, sourcing their own deals.

On top of investor demand for higher-yielding opportunities, part of the driver for this growth is the expiry

The banks that want to stay in the market now have considerably lower hold levels. Where once they might have lent €100m, now it’s €25m

The top three areas for alternative finance

USUS$23t

EurozoneUS$22t

UKUS$9t

Capital Insights from the Transaction Advisory Services practice at Ernst & Young

of the €120b (US$155b) of collateralized loan obligation funds raised in 2006 and 2007.

“When these investment periods end over the next few years, that capacity will be removed from the market,” says Dagmar Kent Kershaw, Head of Credit Fund Management at ICG. “The banks that want to stay in the market now have considerably lower hold levels. Where once they might have lent €100m (US$129m) to a company, now they can only go to €25m (US$32m) — and so they need to bring in new lenders. I know of between 10 and 15 funds that are setting up in direct lending, hoping to capitalize on this shortfall.”

One of the biggest areas of new non-bank lending is infrastructure. Allianz Global Investors has been raising debt capital across the UK and the Eurozone to finance schools,

On the webFor more information on the global banking sector, read Ernst & Young’s Making the right moves at www.capitalinsights.info/banking

hospitals, roads and other infrastructure projects. Macquarie Funds Group launched a debt infrastructure fund at the end of 2012 and asset managers BlackRock also announced it was establishing an infrastructure debt team in Europe.

With banks retreating and alternatives appearing, companies need to at least assess their options. Not exploring alternatives could see corporates left behind by more proactive competitors. As Lowe says: “More non-bank funding is now being secured. And many are finding that they can get the right capital for their business. This is an exciting development for companies and financial sponsors operating in this space.”

For further insight, please email editor@capitalinsights.info

Making the right choice

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1Be open-minded. Businesses in all sectors need to be considering alternative methods of financing. “There are clear benefits to diversifying your funding options,” says Ernst & Young’s Lowe. “This de-risks your core relationships and takes the pressure from your more traditional lines of funding. But it also enables you as a borrower to attract finance that is fit for purpose, because you can often negotiate flexible structures that suit your strategy. In addition, looking at alternatives injects competition into the mix, which clearly helps your negotiating position.”

Pick and mix. Many banks may welcome the participation of other types of funder. Both M&G’s Hutchinson and ICG’s Kent Kershaw say that, while banks will often lend as a precursor to selling other products, such as M&A advice, funds are only interested in the lending business. As a result, incumbent banks don’t see their entry as a threat to possible future ancillary business.

Establish a long-term strategy. “Corporates need to be more organized than ever,” says Lowe. “They need to be more disciplined about their credit considerations, where previously they have focused purely on equity. Getting to this point requires businesses to identify their credit drivers and what their strategy will be over the next five years. Once they have understood this, they need to look at what their options are and get a clear idea of what kinds of terms they can expect.”

Get independent advice. Outside help can ensure that you get the funding package structured correctly to suit your business. In this new world of finance, these external contributors can help navigate corporates through the market. “One of the best ways that corporates can prepare for attracting alternative sources of finance is to get the right advice,” says Hutchinson. “One of the issues with the last 15 to 20 years is that corporates became dependent on getting advice from banks. It’s understandable, as bank finance has been the norm and corporates know it well. But if they really want to explore alternatives, there may be others, such as debt advisors, better placed to help them. Clearly, there may be a cost for this, but the result could be more suitable and diverse types of finance for a company’s strategy.”

Be well prepared. Have detailed information readily available for prospective funders. “The better prepared a company is and the more information it can give us, the more realistic our pricing will be,” says Kent Kershaw. “It really helps if there is high-quality management reporting. It’s also better if companies can report in English. We have language capabilities across Europe, but not all our competitors do.”

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The time between signing the deal and merging the assets is a period that corporates often forget. So, how can they ensure a steady transition?

During the due diligence process, delays, revisions or even cancellations can occur if an acquirer decides the takeover is no longer in its best interests. For instance, in September last year, PE firm Bain Capital withdrew its offer for surfwear maker Billabong after due diligence.

Additionally, the fact that a deal is announced can change the perception of the companies involved — and with that, bring new challenges. The current proposed merger of commodities giant Glencore and mining firm Xstrata is a key indicator of how an announcement will affect concerned parties and shape their actions. In this case, despite a deal being agreed in February 2012, several outside factors have contributed to delays. These include insistences by Xstrata shareholder Qatar Holding to improve some terms of the deal. A revised offer was made in September, but continued regulatory wrangling and rewrites of personnel structure mean that the deal will have taken over a year to complete.

What can acquiring companies do to prepare for such eventualities?

First, flexibility within the deal should be built into the process. This can take many forms: the ability to walk away from a deal, pursue others or even just extend time frames. For instance, in December last year, US consumer electronics company BestBuy extended the period it gave to majority shareholder Richard Schulze to buy out the rest of the investors. This

allowed him more time to raise capital and conduct due diligence.

Putting the effort into preparing properly for regulatory and due diligence hurdles can help preserve a deal’s value in the long run. These should be incorporated early into the planning process, and even when considering which target to pursue. For instance, Ireland’s National Asset Management Agency paid almost €40m (US$52m) in legal fees in its first two and a half years of existence. However, this expenditure on due diligence helped to save it €477m (US$616m) on loans acquired, according to the agency.

Cost-effective due diligence applies to other areas, too. Nearly half of respondents to a survey for Ernst & Young’s 2011 report, IT as a driver of M&A success, said that, in retrospect, more detailed IT due diligence could have prevented value erosion.

Finally, if a company acquires regularly, it should learn from each deal. As Paul Johnstone, HR M&A and Benefits Manager at GE, puts it: “Each M&A deal has a different flavor. The more we do, the more knowledge we can bring to the next deal.” Applying this knowledge the next time is of paramount importance.

If corporates look to prevent rather than cure their ills, they can save themselves trouble in their deals in the long run.

For further insight, please email scott@capitalinsights.info

In Dutch philosopher Desiderius Erasmus’s collection of ancient proverbs, Adagia, it is said that “prevention is better than cure”.

This is still true for corporates — especially when it comes to avoiding pitfalls that can stop a deal in its tracks. Of course, post-completion issues can harm any transaction. But buyouts face more pressing risks after their announcement. These must be addressed first.

Regulatory issues can prove difficult obstacles. They can derail a deal or propose onerous remedies, making the transaction an irrational proposition. For example, logistics company UPS’s planned takeover of Dutch shipping agent TNT Express ended in January this year after the European Commission indicated that it would block the deal on competition grounds.

Insight, hindsightnot

Professor Scott Moeller is Director of the M&A Research

Centre at Cass Business School. He also teaches Mergers & Acquisitions

on the MBA and MSc programs.

Moeller’s corner

Prof. Scott Moeller

Capital Insights from the Transaction Advisory Services practice at Ernst & Young

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