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About the author

Article written in June 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, i>Grande Ecole – Master in Management, 2019-2023).

Examples of companies issuing bonds

June 14, 2021 by Rodolphe CHOLLAT-NAMY

Examples of companies issuing bonds

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) provides you with examples of companies issuing bonds.

In order to better understand corporate bonds, it is appropriate to look at recent issues to see their different characteristics: Veolia, Essilorluxottica and LVMH.

Véolia: EUR 700 million 6-year bond issuance with negative interest rate

The company

Veolia is a French multinational utility company. It markets water, waste and energy management services for local authorities and companies.

It employs more than 163,000 employees and had revenues of €27 billion in 2019.

The company recently made headlines in the financial news with its takeover bid for Suez. After months of financial, political and media battle, the French giants finally agreed on a merger. The new group is expected to have a 5% share of the world market with 230,000 employees.

The bond issuance

On Monday, January 11, 2021, Veolia issued €700 million of bonds maturing in January 2027 at a negative rate of -0.021%.

This is the first time that a BBB-rated issuer has obtained a negative rate for this maturity. This was due to strong demand from investors who welcomed the transaction. As a result, the order book reached up to 2 billion euros, which allowed for a negative yield. This reflects the very positive perception of Veolia, as well as the credibility of its proposed merger with Suez.

This example is quite symptomatic of the low-rate period we are currently in. Indeed, we see here that a company can take on debt at negative rates.

Essilorluxottica: €3 billion bond issuance

The company

EssilorLuxottica is a Franco-Italian multinational company, resulting from the 2018 merger of the French company Essilor and the Italian company Luxottica. It is one of the leading groups in the design, production and marketing of ophthalmic lenses, optical equipment, prescription glasses and sunglasses.

The group employs more than 153,000 people and had sales of EUR 14 billion in 2002.

The bond issuance

On Thursday, May 28, 2020, EssilorLuxottica issued €3 billion of bonds. The bonds have maturities of 3.6 years, 5.6 years and 8 years, with rates of 0.25%, 0.375% and 0.5% respectively.

Demand was very high as the order book reached almost 11 billion euros, reflecting investors’ confidence in EssilorLuxottica’s model.

This example allows us to notice that during an issue, bonds of different maturities can be issued at the same time. This allows us to respond adequately to financing needs by allowing us to play on the maturity and therefore on the rates. Here, the rates increase with time. In fact, outside of recessionary periods, this correlation is observed because the risks for investors increase with time. In the same way, their money is immobilized for a longer period of time and therefore must be remunerated for that.

LVMH: 9.3-billion-euro bond issuance

The company

LVMH is a French group of companies, today a world leader in the luxury goods industry. The firm has a portfolio of seventy brands including Moët, Hennessy, Louis Vuitton, Dior, Céline, …

The group employs more than 163,000 employees and had a turnover of 53 billion euros in 2019.

Announced in November 2019, then canceled because of Covid-19, the takeover of Tiffany finally took place in January 2021 for a total amount of $ 15.8 billion.

The bond issuance

On February 6, 2020, LVMH issued €9.3 billion in bonds, denominated in euros and pounds sterling. This was the largest bond issue in Europe since AB inBev in 2016. The maturities of the bonds issued range up to 11 years with a yield of 0.45%. Some tranches, including the four-year euro tranche, have a negative yield. The overall cost of this financing is estimated at 0.05%.

The purpose of this issue was to refinance the acquisition of Tiffany. It received strong interest from investors with an order book of nearly 23 billion euros. In addition, LVMH benefited from very favorable market conditions. Indeed, January had been rather weak in terms of the volume of issues by companies in the investment grade category and had been dominated by those in the high yield category. Thus, investors had a lot of liquidity to invest in more secure investments. Finally, LVMH issues few bonds even though the group is highly rated. Investors were therefore looking to acquire its debt.

This example allows us to understand the conditions of a record issue. Moreover, it also allows us to underline that it is possible to resort to borrowing to finance new projects, current expenses or, in this case, an acquisition.

Useful resources

Rating agencies

▶ Rodolphe CHOLLAT-NAMY Bond valuation

▶ Rodolphe CHOLLAT-NAMY Bond risks

▶ Rodolphe CHOLLAT-NAMY Bond markets

▶ Bijal GANDHI Credit Rating

▶ Jayati WALIA Credit risk

About the author

Article written in June 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

The rise in corporate debt

June 14, 2021 by Rodolphe CHOLLAT-NAMY

The rise in corporate debt

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) analyzes the rise in corporate debt.

Since the financial crisis of 2007-2008, the level of debt in the world has increased significantly. Global debt, which includes the debt of (non-financial) corporations, financial institutions, governments and households, has risen from 292% of global GDP in 2008 to 318% in 2018. This increase in global debt is primarily driven by the growth of non-financial corporate debt after the subprime crisis. Indeed, the debt of non-financial companies rose from 78% to 92% of GDP between 2008 and 2018. What are the reasons for this increase? How did the coronavirus crisis impact debt levels? What are the consequences of rising debt levels?

Growth in corporate debt through the bond markets, mainly driven by emerging countries

An increase linked to an increase in bond issues

Until the 2008 crisis, the banking sector was the fastest growing corporate financing tool, notably through international banks. Since the 2008 crisis, there has been a shift. Companies then began to take on more debt on the financial markets (bonds) than from banks (credit). Thus, the increase in corporate debt since the 2008 crisis has been mainly through the bond markets. The main driver of this increase is the accommodating monetary policies pursued by the developed economies.

An increase driven by developing countries

Moreover, the rise in non-financial corporate debt has not been uniform across the world. It has actually been concentrated in emerging economies. Between 2008 and 2018, this type of debt in emerging economies grew from $9 trillion to $28 trillion. This growth is much faster than the growth of the GDP of these countries. Indeed, over the same period, the debt of non-financial companies has increased from 56% to 96% of GDP. At the same time, the debt of non-financial corporations has grown at the same rate as GDP since 2008 in the developed economies (with the exception of China).

The growing share of bond markets, in the case of emerging economies, is noteworthy. Indeed, between 2008 and 2018, the share of bonds in the total debt of non-financial companies in emerging economies rose from 19% to 32%, effectively increasing by 13 percentage points.

A rise in non-financial private sector debt with the Covid-19 pandemic

The exceptional measures taken by governments around the world eased financial conditions to support the economy of their own country. This response to the pandemic helped maintain the flow of credit to households and businesses, facilitated the recovery and contained financial risks. Nevertheless, this support has increased private non-financial sector indebtedness in both advanced and emerging economies.

While we saw above that the debt-to-GDP ratio of firms in developed countries was constant between 2008 and 2018, it worsened with the Covid-19 pandemic. The debt of private non-financial firms in developed countries rose from 149% of GDP in Q3 2019 for the US to 160% in Q3 2020. Similarly, debt of private non-financial firm in the Eurozone rose from 120% to 129% over the same period. Debt levels are not uniformly high as it depends on the size of the company and its sector of activity.

Companies have had massive recourse to borrowing first of all to cope with their cash flow difficulties, between a fall in activity and marked tensions in terms of payment. In addition to this, there is also a precautionary attitude which is pushing companies to use their borrowing capacity to the maximum in order to build up an extra cash cushion. Finally, large companies will also take advantage of borrowing facilities for other purposes. In particular, they will use debt to conduct share buyback programs and pay dividends.

What are the consequences of increased debt?

The growth in debt financing can have a number of positive aspects. It may indicate that firms are less constrained in their financing, allowing them to raise more funds to pursue profitable investment projects and expand. Similarly, it may mean that firms are obtaining new financing outside the traditional banking system, which helps them grow by diversifying their sources of funding.

However, it also poses a number of risks. In the aftermath of the Covid-19 crisis, corporate debt reached a worrying level. The question is: how will companies manage the repayment of their debt?

The accumulation of high levels of debt in a period of weak economic growth and declining corporate profits has been accompanied by increased default risks.

In addition, refinancing risks may have increased, as the fastest growth in corporate debt has been through bond financing, which is more difficult to refinance.

Finally, the post-covid recovery is likely to be asynchronous and divergent across countries. Financial conditions are likely to tighten in developed country markets, making it more difficult to finance companies in emerging economies.

Useful resources

Rating agencies

About the author

Article written in June 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

Credit analyst

June 14, 2021 by Rodolphe CHOLLAT-NAMY

Credit analyst

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) introduces you to the job of credit analyst.

Within an investment bank, several jobs are directly linked to bonds. Among them is that of credit analyst. What does a credit analyst do? What are the qualities required to be a credit analyst?

The missions of a credit analyst

Within a bank, the role of the credit analyst is to study in depth the financial situation of companies (risk assessment, analysis of strengths and weaknesses, analysis of financial accounts, etc.) in order to determine their solvency.

More concretely, analysts have three main tasks:

Firstly, as mentioned above, analysts conduct in-depth analyses of the financial statements and credit applications of the companies under their responsibility. They keep abreast of their current situation and closely monitor any developments that may affect their debt capacity.

Secondly, analysts provide recommendations related to the analysis and evaluation of the credit risk. If they think that the company is solid, they can for example propose to buy bonds of this company, which would thus constitute a safe investment. On the other hand, if they believe that the risk of default is increasing, they will propose to sell.

Finally, a significant part of analysts’ job is to present their results. This may take the form of a daily summary publication, or a more in-depth quarterly or annual publication. In addition, analysts may have to meet with the bank’s clients, mainly investors, to present their recommendations.

In addition, there may be ancillary tasks. For example, analysts may seek to develop new mathematical and statistical models to improve their understanding of bond risks.

What is the day-to-day life of a credit analyst like?

Analysts’ day starts early, before the financial markets open, so that he has time to brief investors on the latest bond news in the sectors they follow.

After that, their day depends very much on the calendar of the companies he or she follow. During the quarterly publications of these companies, they will spend time reading them and collecting the information contained in them. Similarly, they will attend the various conferences organized by these companies to explain the published results. The rest of the time, they will analyze this information, update their projection models and update their recommendations.

As the end of the semester or the year approaches, credit analysts’ days can become longer because they have to produce a semiannual or annual publication in which their recall the economic context and their recommendations. Following the publication of this, they will often make a tour of their clients to present it. This is known as a roadshow.

The qualities required to be a good credit analyst

Several qualities are necessary to be a good credit analyst.

First of all, credit analysts have strong corporate finance skills. In particular, they have a good understanding of corporate debt and liquidity ratios. The main ratios are: the debt-to-equity ratio which informs on the financial structure of the company, the interest coverage ratio which measures the capacity of a company to pay its interests and the debt-to-EBITDA ratio which measures the capacity of the company to repay its debt with the money generated by its activity.

Secondly, it is imperative to be very rigorous. Indeed, the quality of the analyses depends on the data collected. Analysts cannot afford to make mistakes in the figures they report. To this end, they have recourse to several sources of information: companies’ annual reports, press releases, financial statements, as well as market analyses produced by other players. It is important to note that all this information is public. Indeed, for legal reasons, to avoid insider trading, analysts have limited access to the information.

In addition, analysts must have strong synthesis skills. It is their analysis that investors will buy. It must therefore be as relevant as possible in order to present the best possible guidance. Moreover, the format of these analyses must also be carefully designed. They must be easily understandable by its readers. Analysts must therefore have presentation skills in order to sell them. It is important to take care of the content and the form.

Finally, analysts improve over time. They usually cover a particular sector. For example, he or she will be a specialist in the automotive sector. The better their knowledge of the sector, the more relevant their analysis. To do this, they must be familiar with the general environment of the sector they are following in order to identify future trends. Secondly, they must build up a database of the companies they follow. The more accurate and long-standing the database, the better they will be able to put the new information they collect into perspective.

Useful resources

Rating agencies

About the author

Article written in June 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

Why do companies issue debt?

June 14, 2021 by Rodolphe CHOLLAT-NAMY

Why do companies issue debt?

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) provides insights into why companies issue bonds.

A company can finance its activities in different ways: by internal financing (self-financing) and by external financing comprising debt and equity. Often, internal funds are not sufficient. The company must therefore make a choice between raising debt and raising equity. So, it is necessary to ask what might lead a company to prefer one over the other.

The advantages of debt over equity for a company

Debt is often preferred to equity because it is structurally less costly for the following reasons:

– The interest on the debt is tax deductible. The debt therefore costs the interest minus the tax savings (assuming that the company makes profit and pays taxes…).

– Investing in stocks is riskier than investing in bonds because of a number of factors. For instance, the stock market has a higher volatility of returns than the bond market, capital gains are not a guarantee, dividends are discretionary, stockholders have a lower claim on company assets in case of company default. Therefore, investor expect higher returns to compensate it for the additional risk. Thus, for the company, financing itself through debt will be less expensive than through equity.

– The remuneration of the debt is not strictly proportional to the increase of the risk taken by the company, because there are multiple ways for lenders to take guarantees: leasing, mortgage….

Debt has other advantages over equity:

Debt can be used to gain leverage. It provides a leverage effect for shareholders who contribute only part of the sums mobilized in the investment. This effect is all the more important when the interest rate at which the debt is subscribed is low and the economic profitability of the investment is high.

Raising equity dilutes ownership of existing stockholders. When a company sells equity, it gives up ownership of its business. This has both financial and day-to-day operational implications for the business. Debt does not imply such a dilution effect.

There is a practical benefit for using debt. Issuing debt is easier than issuing equity in practice.

Finally, the terms of repayment of principal and interest payments are known in advance. This allows companies to anticipate future expenses.

The disadvantages of debt over equity

First, unlike equity, debt must be repaid at some point. This is because equity financing is like taking a share in the company in exchange for cash. Thus, where cash outflows are required to pay interest on debt and repay principal, this is not useful for equity.

Moreover, in equity financing, the risk is carried by the stockholders. If the company fails, they will lose their stake in the company. In contrast, in debt financing, creditors often require assets to be secured. Thus, if the company goes bankrupt, they can take the collateral.

Finally, the debt capacity of a company is limited. Indeed, the more debt a company takes on, the higher the risk of default. Thus, creditors will ask an already highly leveraged company for higher interest rates to compensate for the risk they are taking. Conversely, equity financing allows companies to improve their capital structure, and thus present better debt ratios to investors.

Useful resources

Rating agencies

▶ All posts about Professional experiences

About the author

Article written in June 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

Expeditionary experience in a Chinese investment banking boutique

June 1, 2021 by Suyue MA

Expeditionary experience in a Chinese investment banking boutique

In this article, Suyue MA (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021) shares his experience as an intern at InvesTarget, an investment banking boutique in China focusing on capital raising and M&A.

About myself

I have been interested in finance ever since I started my study at ESSEC Business School in 2017. By acknowledging more about finance, during my 2nd year of study, I decided to build up my career in corporate finance, focusing on the primary market. By sending around 400 resumes to different companies and banks, I finally received my first internship offer in a top 10 securities company doing Real Estate Investment Trusts (REITs) and Commercial Mortgage-Backed Securities (CMBS) projects in China. Until now, I have finished 4 internships in the field of corporate finance, private equity, capital-raising advisory, and Mergers and acquisitions (M&A).

In this article, I would like to share with you about my internship in a capital-raising advisory team of a Chinese new-type investment banking boutique. This company mainly focuses on M&A and fundraising advisory; some of those companies will also play a role as venture capital if they have their own money to invest or they find some profitable projects.

My mission

In this internship, my primary exposure covered in Technology & Industrial sector, including Industrial Drone, Intelligence Vehicle, and Advanced Materials.

Main tasks

As an intern, my main tasks were mainly as followed:

Perform pro forma financing consequences, capitalization table, Discounted Cash Flows (DCF) analysis, and accretion/dilution analysis
Perform in-depth financial, accounting, and operation due diligence, which includes financial analysis, team’s background, and technology support on client companies
Prepare materials for internal business plan, business proposal, and financial advisory presentation
Conduct reports of industry research and company analysis on Telecom Media and Technology (TMT) specific sectors.

Details of a deal

Since a round of fundraising process is normally around six months, I had a chance to close two live deals. Let me take one of the deals as an example: we had a client company that is a top intelligent driving-technology startup with valuation around US$250m. The company was looking for US$30m Series B round funding (round of growth stage financing). Our role as a fundraising advisor was to screen potential investors (normally they are Venture Capitals (VCs), since B round is still in growth stage) who are interested in such field at first. We also helped and guided the client company to prepare the material needed for the fundraising, such as business plan, business contract, and company’s financial analysis. Subsequently, if VCs are interested, we will assist VCs to do the due diligence on the client company. It usually includes financial, accounting, law, and compliance documents. After the valuation of VCs, if they agree to invest in company’s shares, both VCs and client company will sign a Term Sheet and finish the transaction within a period mentioned by the contract.

Preparatory work

We also need to do industry and company research report in Technology and Industrial sector, in which industry research report should include the industry’s definition, category, history, political trends, market analysis, competition status, core technology, industry development trend, capital market research, etc. For the company research report, we should present the company’s background information, capitalization table, business category and products, team, financing history, cooperation relationship, etc.

Takeaway from my internship

Thus, by doing such work, as an intern, I could have a deep understanding regarding specific sectors and build up relationship with some top VCs and Private Equity (PE) firms. This is quite important for the students who want to work in the investment field of primary market.

Financial concepts

Venture Capital

Venture capital (VC) is a form of private equity and a type of financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. Venture capital generally comes from well-off investors, investment banks, and any other financial institutions. However, it does not always take a monetary form; it can also be provided in the form of technical or managerial expertise. Venture capital is typically allocated to small companies with exceptional growth potential, or to companies that have grown quickly and appear poised to continue to expand.

Though it can be risky for investors who put up funds, the potential for above-average returns is an attractive payoff. For new companies or ventures that have a limited operating history (under two years), venture capital funding is increasingly becoming a popular – even essential – source for raising capital, especially if they lack access to capital markets, bank loans, or other debt instruments. The main downside is that the investors usually get equity in the company, and, thus, a say in company decisions.

Capital funding

Capital funding is the money that debt and equity holders provide to a business for daily and long-term needs. A company’s capital funding consists of both debt (bonds and loans) and equity (stock). The business uses this money for both capital expenditures (Capex) and operating expenditures (Opex). The debt and equity holders expect to earn a return on their investment. The form of returns is interests for debt holders, and dividends and capital gains for equity holders. However, in my internship, since the company is still a startup at growth stage, so it only includes equity financing, which means that the investors will directly own the company’s share rights by investment money.

Discounted Cash Flow (DCF)

The discounted cash flow (DCF) method is a valuation method used to estimate the value of an investment based on its expected future cash flows. DCF analysis attempts to figure out the value of an investment today (present value) based on projections of how much money it will generate in the future. This applies to investment decisions of investors in companies, such as acquiring a company, investing in a technology startup, or buying stocks in the secondary market. For business, owners and managers are looking to make capital budgeting or operating expenditures decisions such as opening a new factory, purchasing or leasing new equipment.

The DCF formula is shown below:

Present value of a series of cash flows

where PV is the present value of the investment, CF the series of cash flows generated by the investment (CF₁ is for year 1, CF₂ is for year 2, …, CF_T is for the last year T) and r the discount rate.

Relevance to the SimTrade certificate

The experience shared above is strongly related to the SimTrade Certificate. The primary market is where securities are created, while the secondary market is where those securities are traded by investors. The boundary between primary and secondary market is the IPO. Once stocks are traded in public, it comes to secondary market. From my perspective, most parts of the investment analysis and logic are the same, such as fundamental analysis, DCF, P/E ratio, etc. so we can benefit from SimTrade by learning how business factors will affect the company’s stock performance and why and when should we make the right investment.

Useful resources

InvesTarget

Investopedia Venture Capital

Investopedia Private Equity

About the author

Article written in June 2021 by Suyue MA (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021).

Career in finance

May 31, 2021 by Anna BARBERO

Career in finance

In this article, Anna BARBERO (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2020-2021) discusses various aspects of a financial career.

I had the opportunity to talk with Alexis Fontana (ESSEC Alumni and Board member of ESSEC Alumni-Club Finance) who has worked in many fields related to corporate finance (audit, private equity, and mergers and acquisitions, etc.) Alexis currently works at EY as a “Strategy and Transactions” manager.

Interview with Alexis Fontana

Question: First, your curriculum and your engagement at Club ESSEC Finance show a real passion for corporate finance. When did you decide you would take this orientation? And why?

Corporate Finance is indeed a field in which I really enjoy being involved and here are the reasons why:

The analytical aspect of Corporate Finance, as a transaction due diligence professional on a day-to-day basis
The investment side, I was once a private equity professional and continue to work with small and large Private Equity (PE) funds
The theoretical approach, I have just finished my certified accountant thesis. The subject deals with the impacts of the working capital requirements on the value of industrial small medium enterprises (SMEs) in the context of a sell-side process.

When I joined ESSEC in 2012, I initially wanted to work for the Autorité des Marchés Financiers (the French financial regulator). The multiple professional experiences required to fulfil the ESSEC curriculum helped me in the design of my professional career I am still building today.
I think that one of the key encounters that made me discover my passion for corporate finance was Albert Aidan, a Senior Partner at Deloitte, who was once my professor of accounting at ESSEC Business School but also, back then, the treasurer of ESSEC Alumni.

Question: The financial sphere is often criticized for being profit oriented. What would you respond to those critics?

The financial sphere is mandated or has in its very statutory purpose the aim of making sustainable profit. One of the key aspects I learned over the recent years is that no company can be durable without being profitable.

During my curriculum at ESSEC Business School, I have been privileged to work in a pan-European French Private Equity fund, attending each week the investment committee with some of the sharpest investment minds I have had the opportunity to meet so far.

What I understood, is that these professionals work to safeguard the interests of the Limited Partners (LP) of the fund (institutions, family offices, individuals which decide to invest money in an investment fund managed by a General Partner (GP) and its team of investment professionals). To that extent the actions taken are aimed to achieve resilient returns through investments in high potential companies which are, by the way, embarked in value creation journeys which bring (i) new jobs, (ii) economic activity to region, (iii) growth and ambition on a national or international scale.

More recently in the context of the COVID-19 crisis, the financial sphere has been faced with a call for greater purpose that is still being translated in concrete actions: (i) extra-financial reporting measuring impact and Environmental, Social, and Governance (ESG) related metrics, (ii) tighter reporting and communication standards, (iii) stronger compliance. I really do believe that today is a good time to start a career in corporate finance. So many fields and uncharted territories are being addressed by the industry which is in high need of bright minds and pioneers!

Question: You have worked in several finance fields: audit, private equity and more recently even M&A. Which one did you like most? Do you feel that an experience in one field can help in another? For a young professional, which one do you advise to start with?

I am really passionate about my current responsibilities as a transaction due diligence professional, it offers me the opportunity to always be working on the most strategic corporate events (acquisition, divestiture, capital reorganization, refinancing and even restructuring). It gives me also the opportunity to work on daily basis with Chief Executive Officers (CEOs), Chief Financial Officers (CFOs), Private Equity (PE) professionals, Merger and Acquisitions (M&A) bankers, lawyers (corporate, law, tax) on top of a broad ecosystem of experts.

My past experiences gave me the tools to advise my clients on very technical aspects of a deal with the aim of always giving them the more acute advice in a timely manner. What I really like is the negotiation phase of the deals – the final word is to convince the other party to get the deal done. Each deal is unique, and I would even say that cross-border deals are the most fascinating as you add the cultural aspects on top of the already complex deal challenges you must solve.

Should you consider a career in Corporate Finance, I recommend performing an introductory experience in Audit as it gives you all the keys to understand how financial information is sourced, processed and then communicated.

My advice to young professionals is to learn and gather soft skills, but to also bring a broader focus on a domain of expertise. Hard skills are keys in the current business environment we are navigating through and it will become more and more sought after. It can be law, accounting (please do write me directly if this field interest you) and other fields of interest but do be curious and keep learning things even after finalizing your curriculum at ESSEC Business School, you always to remain at the top of the game.

Key concepts

Audit

According to the Dictionary of Cambridge, financial audit is “the process of checking a company’s or organization’s financial statements to make certain they are correct and complete, and then providing this information in an official report”. Financial audits are conducted internally and externally by consulting firms. The major audit experts are called the “Big Four”: Deloitte, EY, KPMG & PwC.

Private Equity

“Private equity is an alternative investment class and consists of capital that is not listed on a public exchange” (Investopedia). There are two types of investors in private equity:

Limited Partners (LP) that generally hold 99% of shares and have limited liability;
General Partners (LP) who hold 1% of shares and have full liability.

Private equity allows companies & startups to gain liquidity without necessarily contracting expensive loans or listing on public markets. Yet, it is more difficult to find & negotiate private equity funds than making a match in the public market order book.

Merger and Acquisitions

According to the CFI (Corporate Finance Institute), “Mergers and acquisitions (M&A) refer to transactions between two companies combining in some form”:

Mergers are the combinations of two companies of comparable size. The largest in history was the merger of American Online & Time Warner Inc. The $360 billion deal was closed in 2000 (Investopedia).
Acquisitions occur when a bigger company acquires a smaller one. Vodafone acquired Mannesman AG for $180.95 billion. However promising, the deal was a failure (Investopedia).

Working in M&A can mean several things: leading the strategy to proceed M&A, advising on the target company, proceeding the financial transaction, examining the legal side, etc. M&A is treated internally in corporations and externally by consulting firms, banks, etc. Morgan Stanley and Goldman Sachs are two famous M&A firm.

Useful resources

Corporate Finance Institution, Mergers & Acquisitions.

Shobit Seth reviewed by Eric Estevez, 2021. The 5 biggest Mergers in History, Investopedia.

Shobit Seth reviewed by David Kindness, 2021. The 5 biggest Acquisitions in History, Investopedia.

About the author

Article written by Anna BARBERO (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2020-2021) .

Credit Rating Agencies

February 3, 2024May 31, 2021 by Raphaël ROERO DE CORTANZE

Credit Rating Agencies

In this article, Raphaël ROERO DE CORTANZE (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) explains how credit rating agencies work.

What are Credit Rating Agencies?

Credit Rating Agencies are private companies whose main activity is to evaluate the capacity of debt issuers to meet their financial commitments. The historical agencies (Moody’s, Standard & Poor’s and Fitch Ratings) hold about 85% of the market. But national competitors have emerged over the years, such as Dagong Global Credit Rating in China. Nonetheless, there is little competition in this market as the barriers to entry are very high. The rating agencies’ business model is based on remuneration paid by the rated entities, consulting activities, and the dissemination of rating-related data.

The rating gives an opinion (in the form of a grade) on the ability of an issuer to meet its obligations to its creditors, or of a security to generate the capital and interest payments in accordance with the planned schedule. The rated entities are therefore potentially all financial or non-financial agents issuing debt: governments, public or semi-public bodies, financial institutions, non-financial companies. The rating may also relate not to an issuer in general, but to a security.

S&P, Moody’s, and Fitch rating scales S&P, Moody's, and Fitch rating scales
Source: internet.

Rating agencies are key players in the markets. Indeed, ratings are widely used in the regulatory framework on the one hand, and also in the strategies of many investors. For instance, to be eligible for central bank refinancing operations, securities must have a minimum rating. Similarly, the management objectives of many investors are based on ratings: for example, a mutual fund may have as one of its objectives to hold 80% of assets issued by issuers rated at least “BBB”. Credit risk monitoring indicators in corporate and investment banks are also based on ratings.

Credit Rating Agencies: judges & parties during the subprime crisis?

Rating agencies played a crucial role in securitization (“titrisation” in French), a financial technique that transforms rather illiquid assets, such as real-estate loans, into easily tradable securities. The agencies rate both the securitized credit packages and the bonds issued as counterparts according to the different risk levels.

The securitization technique appeared in the 70’ in the US, and allowed banks to grant more loans. During the 1990’ and 2000’, banks used securitization as a way to remove from their balance sheet the loans they granted. Indeed, banks would package loans in vehicles labelled as “Asset Backed Securities” (securities which the collateral is an asset). Banks would then sell these securities, or sell the risk associated with these securities. In the case of subprimes, the loans were packaged inside vehicles called “Mortgage Backed Securities”, as these securities had as counterpart the mortgage loans. There was a shift from the previous “originate-to-hold” bank model (where banks originated the loans and kept them in their balance sheet) to the new “originate-to-distribute” model (where banks originated the loans and then took them out of their balance sheet).

Michel Aglietta explains that in the case of securitized loans (such as MBS), the rating agencies rate and are at the same time stakeholders in the securitization. Indeed, the constitution of the product and the rating are completely intertwined. “Without the rating, the security has no existence”. The investment banks that structure and market the product and the agencies work together to determine the specificities of each loan packages or “pools” and obtain the desired rating.

It is now recognized that rating agencies often overrated the securitized packages compared to the intrinsic risk they were carrying. By granting high grades to many securitized packages (the highest being AAA), they have contributed to the formation of a speculative bubble. In addition, when the housing market collapsed, the rating agencies reacted too late and downgraded MBS abruptly, which inevitably worsened the crisis. For example, 93% of the MBS rated AAA marketed in 2006 had their grade scaled down to “junk bond” ratings (BB+/Ba1 and below) later on.

Rating agencies have been accused of conflict of interest, as they are paid by those they rate. The emails revealed by the US Senate Investigations Subcommittee in April 2010 during its work on the Goldman Sachs affair reveal a system in which the marketing teams of structured products of investment banks tended to choose the agency most inclined to give the most favorable rating. Furthermore, the Senate subcommittee found that rating decisions were often subject to concerns about losing market share to competitors.

Key concepts

Mortgage loan

A mortgage loan has the specificity of putting the purchase property (a house for instance) as the counterpart of a loan. In the case of a payment default, the property is seized.

Useful resources

La Finance pour Tous

Aglietta M. (2009) La crise : Pourquoi en est arrivé là ? Michalon Editions.

Ministère de l’Economie et des Finances Quel rôle ont joué les agences de notation dans la crise des subprimes ?

Marian Wang (2010) Banks Pressured Credit Agencies, Then Blamed Them Later on Blog.

About the author

Article written in May 2021 by Raphaël ROERO DE CORTANZE (ESSEC Business School, Master in Management, 2019-2022).

The Internal Rate of Return

May 31, 2021 by Raphaël ROERO DE CORTANZE

The Internal Rate of Return

In this article, Raphaël ROERO DE CORTANZE (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) explains the financial concept of internal rate of return (IRR).

What is the Internal Rate of Return?

The Internal Rate of Return (IRR or “TRI” – “taux de rendement interne” in French) of a sequence of cash flows is the discount rate that makes the Net Present Value (NPV or “VNP” or “VAN” for “valeur nette présente” or “valeur actuelle nette” in French) of this sequence of cash flows equal to zero.

Screenshot 2021-05-31 at 21.59.49

In order to calculate the IRR, two methods can be used. First of all, use the Excel “IRR” formula on the sequence of cash flows, which will automatically display an approximate value for the IRR. Nonetheless, if Excel is not available for performing the IRR calculation, you can use the dichotomy method (which is indeed used by Excel). The dichotomy method uses several iterations to determine an approximation of the IRR. The more iterations are performed, the more accurate the final IRR output is. For each iteration, the table below assesses whether the NPV using the “Average” discount rate is positive or negative. If it is negative (resp. positive), it means the IRR is somewhere in between the “Lower bound” (resp. “Upper bound” and the “Average”) and the next iteration will thus keep the same “Lower bound” (resp. use the “Average” as the new lower bound) and use the “Average” as the new “Upper bound” (resp. keep the same “Upper bound”). After 10 iterations, the table displays an IRR of 18,457%, which is an approximation to the nearest hundredth of the 18,450% IRR calculated with the Excel formula.

The IRR criterion

In the same way as the NPV, the IRR can be used to evaluate the financial performance of:
A tangible investment: the IRR criterion can be used to evaluate which investment project will be the most profitable. For instance, if a firm hesitating between Project A (buying a new machine), Project B (upgrading the existing machine) and Project C (outsourcing a fraction of the production), the firm can calculate the IRR of each project and compare them.
A financial investment: whether it is a bank investment or a private equity investment (purchase of a company) the IRR criterion can be used to sort different projects according to their financial performance.

Disaggregating the IRR

Investors and especially Private Equity firms often rely on the IRR as one measure of a project’s yield. Projects with the highest IRRs are considered the most attractive. The performance of Private Equity funds is also measured through the IRR criterion. In other words, PE firms use the IRR to select the most profitable projects and investors look at the IRR of PE funds when choosing to which PE firms’ fundraising campaign, they will participate in.

Nonetheless, IRR is the most important performance benchmark for PE investments, the IRR does not go into detail. Indeed, disaggregating the IRR can help better understand which are the different components of the IRR:

Unlevered IRR components:
- Baseline return: the cash flows that the acquired business was expected to generate without any improvements after acquisition.
- Business performance: value creation through growth by improving the business performance, margin increase and capital efficiency improvements.
- Strategic repositioning: value creation through by increasing the opportunity for future growth and returns (innovation, market entries etc.).
Leveraged IRR: PE investments heavily rely on high amounts or debt funding (hence the wide use of Leverage Buy-Out or LBO). Debt funding allows to resort to less equity funding, thus mechanically increasing the IRR of the investment.

Each of these components can have different proportions in the IRR. As an example, we can consider two PE funds A and B displaying the same IRR of 30%. After disaggregating each fund’s IRR, we come up with the following table, showing the weight of each IRR component in the total IRR (or “Levered IRR”). From this table, we understand that Fund A and Fund B have very different strategies. Fund A focuses in its PE operations on improving the business performance and carrying out strategic repositioning’s. Only 23% of the total IRR comes from financial engineering. In contrast, Fund B draws most of its performance from financial engineering, while only 23% of the total IRR comes from the unlevered IRR.

Through this example we understand that PE funds and firms can have very different strategies, while disclosing the same IRR. Thus, disaggregating the IRR can reveal the positioning of PE funds. Finally, disaggregating the IRR also allows to assess whether PE funds are true to the strategy they display: for instance, a fund can be specialized in strategic repositioning and business performance improvements on the paper, but drawing most of its value creation through financial engineering.

Useful resources

Prof. Longin’s website Calcul de la VNP et du TRI d’une séquence de flux (in French)

Prof. Longin’s website Méthode de dichotomie pour le calcul du TRI (in French)

McKinsey A better way to understand internal rate of return

About the author

Article written in June 2021 by Raphaël ROERO DE CORTANZE (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

Corporate debt

May 30, 2021 by Rodolphe CHOLLAT-NAMY

Corporate debt

In this article, Rodolphe Chollat-Namy (ESSEC Business School, Grande Ecole – Master in Management, 2019-2023) introduces you to corporate debt.

Investors seek to determine how the different characteristics of a bond can influence its intrinsic value in order to know whether it is a good investment or not. To do this, they will look at the theoretical value of a bond, i.e. its present value. How can this be determined? How to interpret it?

Composition of a company’s debt

The debt of a company is composed of short-term liabilities and of long-term liabilities.

Short-term liabilities: accounts payable, deferred revenues, wages payable, short-term notes, current portion of long-term debt.

Long-term liabilities: Bonds payable, capital leases, long-term loans, pension liabilities, deferred compensation, deferred income taxes.

Let us have a look to the long-term liabilities:

Bonds payable: A bond payable is a form of long-term debt issued by the company.
Capital leases: A capital lease is a contract entitling a renter to the temporary use of an asset.
Long-term loans: A long-term loan involve borrowing money over a specified period with a pre-planned payment schedule.
Pension liabilities: A pension liability is the difference between the total amount due to retirees and the actual amount of money the company has on hand to make those payments.
Deferred compensation: Deferred compensation is an arrangement in which a portion of an employee’s income is paid out at a later date after which the income was earned.
Deferred income taxes: Deferred income taxes result from a difference in income recognition between tax laws and the company’s accounting methods.

When looking at a company’s debt, analysts often look at net debt. It is equal to the sum of the short-term liabilities and of the long-term liabilities minus the cash and the cash equivalents, that are liquid investments with a maturity of 90 days (certificates of deposit, treasury bills, commercial paper, …). It is a metric that measures a company’s ability to bay all its debts if they were due today.

For example, assume that a company has a line of credit of $5,000, a current portion of long-term debt of $25,000, a $60,000 long-term bank loan, and $40,000 in bonds. Moreover it has $10,000 in cash and $5,000 in Treasury bills.

The short-term debt would be equal to $5,000 + $25,000 = $30,000

The long-term debt would be equal to $60,000 + $40,000 = $100,000

And the cash and cash equivalents would be equal to $10,000 + $5,000 = 15,000

So the net debt of the company would be equal to $115,000.

Debt Ratios

Nevertheless, an absolute value will not give us much indication of the health of the company. In order to understand the company’s indebtedness, we need to compare the amount of debt with other metrics. To do this, we will use what are called ratios.

We will focus here on three important ratios: the debt-to-equity ratio, the EBIT-to-interest expenses ratio and the debt-to-EBITDA ratio.

Debt-to-equity ratio (D/E)

The D/E ratio, also known as gearing, is a ratio that measures the level of debt of a company in relation to its equity. Simply put, it tells us about the financial structure of the company.

Changes in long-term liabilities have more influence on the D/E ratio than changes in short-term liabilities. Thus, investors will use other ratios if they want information on short-term liabilities.

The higher the ratio, the more indebted the company is. The risk is therefore higher. Between 0 and 0.1, the ratio is theoretically excellent. Above 1, the ratio is theoretically bad.

Beware, this ratio has its limitations. First of all, the reading of this ratio depends on the industries. Capital intensive industries, such as TMT or oil and gas, will tend to have higher ratios. It is therefore necessary to compare the ratios of companies in the same sector. On the other hand, a low D/E ratio can also mean that a company is afraid to invest. In the long run, this can present a risk of downgrading compared to its competitors.

It is therefore important to keep in mind, and this is also true for other ratios, that it is one indicator among others and that it cannot be perfect. It is important to put it into context and to compare comparable companies.

Interest Coverage ratio (ICR)

The ICR is the ratio of financial expenses to operating income. It measures a company’s ability to pay the interest on its debt.

A low ICR means that less profit is available for interest payments and that the company is more vulnerable to rising interest rates.

Usually, the ICR is considered low when it is below 3. However, it varies according to the type of industry. On the other hand, we can also look at the trends that are emerging. A falling ICR is worrying for investors.

Debt-to-EBIDTA ratio

This ratio measures the company’s ability to repay its debt with the money generated by its activity. It tells us how many years of profit it would take to pay off the entire debt. It is often referred to as leverage.

Analysts often use this ratio, which is easy to calculate. The lower the ratio, the healthier the company. A good ratio is between 2 and 4. However, again, it depends on the industry.

About the author

Article written in May 2021 by Rodolphe Chollat-Namy (ESSEC Business School, Grande Ecole – Master in Management, 2019-2023).

Bond risks

May 30, 2021 by Rodolphe CHOLLAT-NAMY

Bond risks

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) introduces you to bond risks.

Holding bonds exposes you to fluctuations in its price, both up and down. Nevertheless, bonds offer the guarantee of a coupon regularly paid during for a fixed period. Investing in bonds has long been considered one of the safest investments, especially if the securities are held to maturity. Nevertheless, a number of risks exist. What are these risks? How are they defined?

Default risk

Default risk is the risk that a company, local authority or government fails to pay the coupons or repay the face value of the bonds they issued. This risk can be low, moderate or high. It depends on the quality of the issuer.

For a given product, the default risk is mainly measured by rating agencies. Three agencies share 95% of the world’s rating requests. Moody’s and Standard & Poor’s (S&P) each hold 40% of the market, and Fitch Ratings 14%. The highest rated bonds (from Aaa to Baa3 at Moody’s and from AAA to BBB- at S&P and Fitch) are investment-grade bonds. The lowest rated bonds (Ba1 to Caa3 at Moody’s and BB+ to D at S&P and Fitch) are high yield bonds, otherwise known as junk bonds.

It should be noted that the opinions produced by an agency are advisory and indicative. Moreover, some criticisms have emerged. As agencies rate their clients, questions may be asked about their independence and therefore their impartiality. The analysis done aby rating agencies is most of the time paid by the entities that want their product to be rated.

In addition, companies issuing bonds are increasingly using the technique of “debt subordination”. This technique makes it possible to establish an order of priority between the different types of bonds issued by the same company, in the event that the company is unable to honor all its financial commitments. The order of priority is senior, mezzanine and junior debt. The higher the risk is, the higher the return is. It should also be noted that bonds have priority over equity.

To highlight the level of risk of an issuer, one can compare the yield of its bonds to those of a risk-free issuer. This is called the spread. Theoretically, it is the difference between the yield to maturity of a given bond and that of a zero-coupon bond with similar characteristics. The spread is usually measured in basis points (0.01%).

Liquidity risk

Liquidity risk is the degree of easiness in being able to buy or sell bonds in the secondary market quickly and at the desired price (i.e. with a limited price impact). If the market is illiquid, a bondholder who wishes to sell will have to agree to a substantial discount on the expected price in the best case, and will not be able to sell the bonds at all in the worst case.

The risk depends on the size of the issuance and the existence and functioning of the secondary market for the security. The liquidity of the secondary market varies from one currency to another and changes over time. In addition, a rating downgrade may affect the marketability of a security.

On the other hand, it may be an opportunity for investors who want to keep their illiquid bonds. Indeed, they usually get a better return. This is called the “liquidity premium”. It rewards the risk inherent in the investment and the unavailability of funds during this period.

Interest rate risk

The price of a bond fluctuates with interest rates. The price of a bond is inversely correlated to interest rates (the discount rate used to compute its present value). Indeed, the nominal interest rates follow the key rates. Thus, if rates rise, the coupons offered by new bonds will be higher than those offered by older bonds, issued with lower rates. Investors will therefore prefer the new bonds, which offer a better return, which will automatically lower the price of the older ones.

The interest rate risk is increasing with the maturity of the bond (more precisely its duration). The risk is low for bonds with a life of less than 3 years, moderate for bonds with a life of 3 to 5 years and high for bonds with a life of more than 5 years. However, interest rate risk does not impact investors who hold their bonds to maturity.

Inflation risk

Inflation presents a double risk to bondholders. Firstly, if inflation rises, the value of an investment in bonds will necessarily fall. For example, if an investor purchases a 5% fixed-rate bond, and inflation rises to 10% per year, the bondholder will lose money on the investment because the purchasing power of the proceeds has been greatly diminished. Secondly, high inflation can lead central banks to raise rates in order to tackle it, which, as we can see above, will depreciate the value of the bond.

To protect against this, some bonds, floating-rates bonds, are indexed to inflation. They guarantee their holders a daily readjustment of the value of their investment according to the evolution of inflation. However, these bonds have a cost in terms of return.

As with interest rate risk, the risk increases with the maturity of the bond. Also, the risk rises as the coupon decreases. The risk is therefore very high for zero-coupon bonds.

Currency risk

An investor can buy bonds in a currency other than its own. However, as with any investment in a foreign currency, the return on the bond will depend on the rate of that currency relative to the investor’s own currency.

For example, if an investor holds a $100 US bond. If the EUR/USD exchange rate is 1.30, the price of the bond will be €76.9. If the euro appreciates against the dollar and the exchange rate rises to 1.40, the price of the bond will be €71.4. Thus, the investor will lose money.

Useful resources

Rating agencies