The new normal implications of sovereign debt and the competition for capital

The New “Normal”
Implications of Sovereign Debt and the Competition for Capital

A survey and report created with


Printed June 2010

Table of Contents
About the survey
Introduction
+ Key survey findings
CPP – The IPO markets re-open
Sovereign debt: crisis and change
+ Investor appetite for sovereign debt
+ Longer-term prospects
+ Changing perceptions of risk
Postponing the inevitable: An interview with Carmen Reinhart
The reserve currency of choice
Sophos exploits the thawing of the private equity market
The outlook for corporates
+ Cash and other alternatives
+ Regulation and credit availability
Nord Stream: From three banks to 26
Conclusion

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4
5
7
8

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9
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11
12
13
14
16
17
19
20

About RBC Capital Markets
RBC Capital Markets is A Premier Investment Bank. Our strengths in providing focused expertise, superior execution and
­insightful thinking have consistently ranked us among the top 20 global investment banks. With over 3,000 employees,
we provide our capital markets products and services from 75 offices in 15 countries and work with clients through operations
in Asia and Australasia, the U.K. and Europe and in every major North American city.
We are part of a global financial institution, Royal Bank of Canada (RBC). RBC has been providing financial services for
over 140 years. We are a top 10 global bank by market capitalization and have one of the highest credit ratings of any financial
institution: Moody’s Aaa and Standard & Poor’s AA-.

About The Economist Intelligence Unit
The Economist Intelligence Unit is the business information and research arm of The Economist Group, publisher of
The Economist. Through its global network of 650 analysts, it continuously assesses and forecasts political, economic
and business conditions in more than 200 countries. As the world’s leading provider of country intelligence, it helps
executives make better business decisions by providing timely, reliable and impartial analysis on worldwide market trends
and business strategies.


Foreword

Our clients are operating in unprecedented times – what many are calling “the new normal”. This environment of high frequency change and
evolution is challenging institutional investors and corporate executives to understand, as never before, the derivative implications of complex
global economic issues when making important capital allocation decisions for their organizations. At RBC Capital Markets, we strive to provide
our clients with relevant information and a unique perspective to help them make the best decisions possible.
With this goal in mind, we partnered with the Economist Intelligence Unit to embark on our second poll of over 400 capital markets participants
to specifically address sovereign risk and the outlook for global investors and corporates. We launched our survey on April 28, 2010 – concurrent
with the beginning of the most volatile month of the European debt crisis – and received responses through the end of May.
This white paper is the result of the survey work conducted in the midst of this crisis. It reveals interesting insights regarding the impact of recent
financial, economic and fiscal events on future financing and investing decisions of corporate and institutional leaders.
Some of the themes addressed in the report include:
• Guarded optimism about industrialised North American and Asian economies over the next 12 months
• Decoupling of European prospects for currency, fiscal solidarity and economic growth from global peers
• Long-term capital availability concerns for sovereigns and a cautionary approach from corporates in light of risk reorientation
Paul Abberley, Chief Executive, Aviva Investors
Paul Corcoran, Financial Director, Nord Stream
James Douglas, Head of Debt Advisory, Deloitte
Teddy Moynihan, Partner, Oliver Wyman
Steve Munford, Chief Executive Officer, Sophos
Shaun Parker, Chief Financial Officer, CPP
Carmen Reinhart, Co-Author of This Time Is Different
Robin Stalker, Chief Financial Officer, Adidas
Ian Winham, Chief Financial Officer, Ricoh Europe
Theo Zemek, Global Head of Fixed Income, AXA Investment Managers
We hope you will find the report insightful.

Marc Harris
Co-Head of Global Research
RBC Capital Markets

Richard Talbot

Co-Head of Global Research
RBC Capital Markets


About the survey
•Respondents were almost evenly split

between financial institutions (229 or
52%) and non-financial corporations
(211 or 48%).
•Among the financial institutions,

27% were commercial banks, 20%
investment banks, 19% asset
managers, 16% private equity firms,
10% hedge funds and 8% pension
funds, sovereign wealth funds or other
institutional investors. About one-third
had over $150bn in assets, while
60% had over $10bn.1
•The corporates came from a wide

range of industries, with six sectors
accounting for 61%: healthcare
and pharma, professional services,
manufacturing, technology, energy and
natural resources, and retail. Threequarters had over $500m in annual
revenues and about a third had over
$5bn.

As part of this research program, RBC Capital Markets commissioned the
Economist Intelligence Unit to survey 440 capital markets participants
on the effects of the recent financial, economic and fiscal events on borrowers
and investors. The online survey was done over a period of four weeks,
from April 28 to May 25, 2010, a time of massive market volatility and constant
headlines on a potential Greek default (see below).

Headlines over the time period

Greece
readies
austerity
measures,
markets
steady

April 30

•The largest group of respondents,

ECB dashes
rescue hopes

EU, IMF stitch
together
€750bn
emergency
fund; IMF to
disburse
€5.5bn now

Greece gets
€14.5bn
loan from EU

IMF chief
economist
says
Greek aid
package
doubts
remain

May 7

May 10

May 18

May 25

41%, was from Europe, followed by
North America (34%) and Asia-Pacific
(16%). The remaining 9% were
from Latin America, the Middle East
or Africa.
a senior group, with 38% at the
C-level and 61% at or above
the VP or director level. The rest
were heads of business lines,

departmental heads or managers.

Cumulative Responses

•The executives polled were

1 All $ figures are USD$ unless
otherwise noted.

2

The New “Normal”


Market activity during the survey window
The timing of the survey coincided with a period of extreme volatility visible in most market indicators.
$ per Euro

VIX Index

1.5

50

40

1.4
30

1.3

20

1.2

10

Jun 1

Aug 1

Oct 1

Dec 1

Feb 1

Apr 1

Jun 1

Jun 1

Aug 1

S&P500

FTSE-100

1,250

6,000

Oct 1

Dec 1

Feb 1

Apr 1

Jun 1

1,200

5,500

1,150
1,100

5,000

1,050
1,000

4,500

950
900
850
Jun 1

4,000
Aug 1

Oct 1

Dec 1

Feb 1

Apr 1

Jun 1

Jun 1

Aug 1

Greek sovereign CDS spreads

WTI crude oil

1000

90

Oct 1

Dec 1

Feb 1

Apr 1

Jun 1

900
85

800
700

80

600
500

75

400
70

300
200

65

100
0
Jun 1

60

Aug 1

Oct 1

Dec 1

Feb 1

Apr 1

Jun 1

Jun 1

Aug 1

Oct 1

Dec 1

Feb 1

Apr 1

Jun 1

Source: Bloomberg

The New “Normal”

5


Introduction
“The lesson of history,
then, is that even
as institutions
and policy-makers
improve, there
will always be a
temptation to stretch
the limits. Just as
an individual can go
bankrupt no
matter how rich she
starts out, a financial
system can collapse
under the pressure
of greed, politics and
profits no matter
how well regulated
it seems to be.”
This Time Is Different,
Carmen Reinhart
and Kenneth Rogoff

As one crisis leads to another – first financial, then economic, now fiscal –

market participants struggle to discern the shape of the next big wave.
Investment-grade capital providers and borrowers have plenty of cash and
the ability to get more. But in terms of perceptions and performance, the
gap between high-quality borrowers and others – companies, sovereigns or
even entire industries – has seldom been wider. And capital providers
need to remain vigilant in light of continuing writedowns and regulatory
challenges that could reduce their financial flexibility.
Demand for funding is low today, but competition may well grow more acute.
The scale of debt issuance required by governments and financial institutions
over the next few years will be almost without precedent. As demand grows, any
institution seeking to raise capital will face more selective and critical investors.
The euro is not likely to recover soon; sovereigns in developed nations will need
years to repair the fiscal damage. To succeed in this environment, borrowers will
require strong, long-term relationships and the ability to construct a convincing
argument for their prospects in a volatile environment.
At the end of 2009, the global economy was showing strong signs of recovery.
Major economies had emerged from recession, equity markets had enjoyed
a sustained boom, trade was flowing again, and corporate profitability had
returned after companies had slashed costs. Even the major investment banks
at the epicentre of the crisis enjoyed a strong rebound and posted significant
increases in revenues and profitability.
But despite a growing sense that the worst is over, serious problems continue
to bubble up. The economic recovery is uneven, with emerging markets leading
the way and industrialised countries constrained by damage to the financial
sector. Banks are in better shape than at the start of 2009 but continue to
be severely impaired, particularly in Europe. And unemployment remains
stubbornly high in many OECD countries, constraining consumption and
prompting further fears of defaults on loans.
But perhaps the most severe challenge is the indebtedness of many
industrialised countries. The massive transfer of debt from the private sector

to the public sector, along with an unprecedented fiscal and monetary
stimulus from the world’s major industrialised economies, has led to a
dramatic deterioration in public finances. As the OECD notes: “Many countries
are facing very unfavorable government debt dynamics, as rising indebtedness
raises risk premia, which adds to the debt burden while holding back growth,
which has further adverse consequences on debt sustainability.” 2

2 OECD Economic Outlook
No. 87, May 2010

4

The New “Normal”


Key survey findings
TOPIC

FINDINGS

Financial institutions and corporates are
guardedly optimistic about the prospects
for economic growth

>Respondents expect growth-friendly monetary
(if not fiscal) policies over the next three years
>Despite strength in the emerging markets, growth in the
developed nations will remain below historic norms
>Respondents expect the prospects for industrialised
Asia and North America to improve over the next

12 months

The economic prospects for Europe appear
to have decoupled from those of other
industrialised regions

>A strong consensus exists that Europe’s prospects
are negative
>There is little confidence in the euro; most respondents
expect it to continue its slide in value
>Almost half of respondents think there is a greater
than a 50/50 chance of one or more countries leaving
the eurozone in the next three years
>One-third see at least a 25% chance of a complete
break-up of the eurozone over the same period
>Problems facing the euro have reinforced the position
of the dollar as the international reserve currency of
choice

The European sovereign debt crisis has
caused a reorientation of risk

>There are concerns that governments of developed
countries will not have sufficient credit capacity
for the massive intervention required to kick-start
their economies in the event of another financial crisis
>Sovereign debt is not alone in being perceived as more
risky: respondents think all asset classes have become
riskier as a result of the financial crisis
>A small majority of respondents expect yields on

bonds from the most creditworthy corporates to fall
below those of sovereign benchmarks over the next
three years – corporates, suggest these respondents,
are the new sovereigns

Economic uncertainty is deterring corporates
from raising capital

>Just one-third of corporates say that they plan to raise
capital over the next 12 months
>For companies that do plan to raise capital,
investment-grade debt and private equity are the most
popular categories
>There is a mismatch between expectations of financial
services and corporate respondents; the former are
more optimistic about the outlook for transaction
volumes than the latter
>More than half of companies have restructured their
business operations to improve access to capital

The New “Normal”

5


Although the actions of policy-makers around the world have been effective in
dealing with the short-term problems of the financial crisis, many commentators
continue to worry that the underlying problems remain unresolved. “Policy-makers
essentially took a private sector debt overhang and nationalised it,” says Paul
Abberley, Chief Executive of Aviva Investors. “The response to the financial crisis

has delayed a reckoning rather than solving the problem and getting us back
to normal.”
While corporates and investors expect a return to growth, the adverse economic
headwinds continue to weigh heavily on their minds. Among the survey
respondents, 87% think that economic growth will be positive over the next two
years, but only 5% expect it to exceed levels seen in 2003 to 2007. There is a
strong consensus that growth will be driven by policy intervention rather than an
improvement in the economic fundamentals. The number of respondents who
agree that central banks will continue to prop up the economy and financial sector
rather than fight inflation exceeds the number who disagree by 44% (see Chart 1).
Respondents also foresee a divergence between developed and undeveloped
markets. Many more respondents agree than disagree with the assertion that
economic growth and consumer demand in developed countries will remain well
below the post-war norm (see Chart 1). We find similar levels of agreement with the
statement that faster-growing nations such as China and India will replace the U.S.
as a source of import demand driving global growth.3 To use a phrase borrowed from
Mohamed El-Erian, CEO of PIMCO, this is the “new normal” of “muted growth overall,
a protracted need for balance sheet rehabilitation, accelerated migration of growth
and wealth dynamics to systemically important emerging economies and relatively
weak global governance”.4

Chart 1: Positive albeit modest growth prospects
Demand and growth over next 3 years (agree minus disagree)
Central banks will continue to prop
up the economy and financial sector
rather than fight inflation
Even after income, credit
and confidence return,
U.S. consumers will not spend at
historic peak levels

Economic growth and consumer
demand in developed
economies will remain well below the
post-war norm

3 For instance, China’s spending on
imports rose 48% year-on-year in
May and India’s imports 43% in April
4 PIMCO Secular Outlook, May 2010

6

Faster-growing nations will replace
the U.S. as a source of import
demand driving global growth
0%

10%

20%

30%

40%

50%

Respondents were given choices of agree, disagree, neutral or don't know/no opinion. The chart shows the percentage
choosing "agree" less those choosing "disagree." It does not show those choosing "neutral" or "don't know/no opinion."

The New “Normal”


But although growth prospects are
polarised between industrialised
and emerging economies, there are
important nuances. While respondents
undoubtedly see Asia as having the
best economic prospects over the next
12 months, North America is close
behind in terms of levels of optimism.
The outlier is Europe, which many
more respondents think has a negative
outlook than a positive one (see Chart 2).
Essentially, survey participants’
perceptions of Europe’s economic
outlook appear to have decoupled
from their perceptions of the rest of the
industralised world.

Chart 2: E
 urope’s lack of expected growth contrasts
with the rest of the world
Economic prospects over next 12 months by region
(better minus worse)
India
Other developed Asia (Hong Kong,
Singapore, South Korea)
China
North America

Russia
Middle East
Africa
Japan
Europe
-40%

-20%

0%

20%

40%

60%

80%

Respondents were given choices of better economic prospects, worse economic prospects, no change or don’t know/no
opinion. The chart shows the percentage choosing “better prospects” less those choosing “worse prospects.” It does
not show those choosing “neutral” or “don’t know/no opinion.”

CPP – The IPO markets re-open
In the first quarter of 2010, there were 100 IPO deals
globally, making it the best quarter for issuance since
the end of 2007. CPP, an insurance company providing
protection against credit card and identity theft, was one
beneficiary of this trend. In March 2010, it raised £150m
(US$220m) on the London Stock Exchange through an IPO

that valued the company at £396m (US$581m). Although
the shares were priced at the lower end of the expected
range, the IPO is a sign of growing investor appetite to
participate in new offerings.
The IPO took place before the eruption of sovereign debt
problems, but there was still considerable volatility. “As we
went into the process there were good weeks and bad weeks
in the financial markets,” says Shaun Parker, Chief Financial

The New “Normal”

Officer of CPP. “At some points things looked bad and then
all of a sudden the market would firm up again. So it was a
period of considerable volatility but still within a reasonable
boundary that led us to feel comfortable about the timing.”
A number of other companies cancelled offerings due to
market volatility or lack of demand. The key to success,
according to Mr Parker, is to ensure that the company has
strong financial fundamentals before going to market.
“We’re a business with a growth story and we’ve proven
that over a relatively long period of time,” he explains. “We
also generate cash, which means we can pay out a pretty
strong dividend. I believe that if the fundamentals are
there and investors have money to invest, then they will be
willing to get involved.”

7


Sovereign debt: crisis and change

Although few industrialised countries can boast a positive
fiscal outlook, the problems have become most acute on the
periphery of the eurozone. In December 2009, Greece’s credit
rating was downgraded to the lowest in the eurozone as a
result of concerns over its ballooning debt. Despite promises of
“austerity measures” comprising public spending cuts and tax
increases, Greek bond yields jumped to unprecedented levels.
Fears grew that other indebted members of the eurozone –
Portugal, Spain, Italy, Ireland, even France – faced problems on
a similar scale. Despite a €750bn rescue package announced
in late May by eurozone finance ministers, concerns about a
potential Greek default, and indeed for the future of the entire
eurozone, persist. “The bail-out failed to reassure the markets,
but I think it would have been impossible at an institutional
level to move any faster than the governments actually did,”
says Mr Abberley.
The problems facing the eurozone have raised questions as to
whether the euro can survive the crisis. Almost half of survey
respondents think there is a greater than 50/50 chance of one
or more countries leaving the eurozone in the next three years
(see Chart 3). More worryingly, about one-third see at least a
25% chance of a complete break-up of the eurozone over the
same period (see Chart 4).

Part of the problem has been that peripheral countries have
built up fiscal deficits that massively breach the eurozone’s
targets of 3% of GDP. But a deeper problem has been a
monetary union achieved without fiscal or political union.
“I genuinely cannot see how in the longer term the euro can
last in the form that it is in, unless there is greater fiscal and

political centralisation in Brussels,” says Theo Zemek, Global
Head of Fixed Income at AXA. “And the implications of that are
so onerous that I do not believe it will ever happen.”

Investor appetite for sovereign debt
In 2009, sovereign debt issuance surged to record levels in
the U.S., U.K. and eurozone as crisis-related interventions
led to a dramatic increase in borrowing requirements. This
huge transfer of debt from the private to public sector raises
the question of whether institutional investors will have the
capacity or willingness to absorb the supply of new sovereign
debt issuance.
Among the survey respondents, significantly more agree
than disagree with the assertion that the credit capacity of
developed countries will diminish significantly compared
with capacity today (see Chart 5). Respondents agree
even more strongly that developed countries will not stop

Chart 3: Survey respondents estimate the odds of one or more countries leaving the
eurozone in the next three years
14%

46% of respondents say the
probability is 50% or more

12%

% of respondents

10%

8%

6%

4%

2%

0%
Probability of at least one country leaving Eurozone in next 3 years

8

The New “Normal”


Chart 4: Survey respondents estimate the odds of the eurozone breaking up in
the next three years

75–100%
Probability

36% of respondents
believe there is at least
a 25% probability

50–74%
Probability

7%
11%

25–49%
Probability

18%

increasing their levels of indebtedness until investors force
them to scale back on debt purchases (see Chart 5). In
short, even supposedly “safe” sovereigns could experience
a shock if they do not restore fiscal discipline and bring
down deficits.
For now there is sufficient appetite for sovereign debt
issuance, even if the conditions may not be to everyone’s
liking. “Everything can be digested under certain scenarios
– it is just that some are more pleasant than others,” says
Professor Reinhart. “There will be costs. You cannot take
current interest rates as a given in this kind of scenario
because the issuance by the major parties is so huge.”

64%
of respondents
0–24%
Probability

A persistent risk aversion among investors also suggests
higher allocations to bonds despite a reassessment of
sovereign debt. “In one form or another, pension funds and
other large investors are increasing their exposure to bonds

at the expense of equities,” says Ms Zemek. “But given
the choice, we are buying shorter-dated bonds and we are
buying ones with inflation protection.”
Changing demographics, particularly in the developed
world, also benefit bonds. “The demographics of
the wealthy world suggest that there will be more aging
and this will require a greater shift towards age-related
products, of which bonds are certainly one,” says
Ms Zemek.

Longer-term prospects
Despite price volatility, sovereign assets have a good deal
going for them over the long term. Banks are likely to hold more
sovereign debt to meet new rules on capital adequacy and
liquidity. Basel III will heavily weight government bonds on the
asset side, leading to higher demand for sovereigns. Moreover,
banks have learned the importance of holding assets that can
be sold quickly and easily. As the most liquid asset class by far,
government bonds will always hold strong appeal.

The New “Normal”

Changing perceptions of risk
But while banks and other investors will continue to place
great emphasis on sovereign debt as an asset class, they will
increasingly take the view that not all government bonds are
created equal. Before the crisis, there was an assumption that
all sovereign debt had similar risk and that spreads between
countries were minimal. Investors are now more discriminating
– and this discrimination is reflected in bond prices.

9


Chart 5: Financial executives say that the sovereign crisis is far from over
Opinions of sovereign credit over next 3 years (agree minus disagree)
Developed countries will not stop increasing their levels of indebtedness
until investors force them to by scaling back on debt purchases
In the aftermath of another financial crisis, governments will not have sufficient
credit capacity for the massive intervention required to re-start the economy
The credit capacity of developed economies will diminish significantly
compared to capacity today
Corporate bonds from the most creditworthy companies will yield less than their
sovereign benchmarks

Respondents were given choices of agree, disagree, neutral or don't know/no opinion. The chart shows the percentage choosing "agree" less those choosing "disagree." It does not show those
choosing "neutral" or "don't know/no opinion."

This reassessment of risk raises questions about how fixed
income products should be priced in the future. “If the
government bond you own is no longer a risk-free rate, then
you have a re-orientation of the corporate bond market,”
continues Mr Abberley. “Rather than saying a bond is 112
basis points over you have to go back to the days when you
say: the yield is 7%. But is that the right number?”
Of course, sovereign debt is not the only asset class that is
perceived as riskier as a result of the financial crisis. Asked
how their risk perceptions had changed over the past year,
more respondents said that risks were higher than lower for
every single asset class (see Chart 6). Indeed, currencies and

equities were perceived to have become even more risky than
sovereign debt.
At the same time, a significant minority of respondents
said that certain asset classes had become less risky. The
top three were classic inflation hedges: real estate (both
residential and commercial) and commodities. And indeed,
a majority of both corporate and financial services executives
said that they had begun to fear the impact of inflation
more than deflation. This stands in contrast to the survey
that preceded this one – done in August of 2009 – in which
executives split close to 50-50 on expectations for the
impact of inflation versus deflation.

Chart 6: Financial services respondents perceive all asset classes as becoming more risky
over the past year
Less risky
More risky
Currencies
Commercial real estate in my country
Equities
Corporate debt in my market
Sovereign debt of my country, if not U.S.
Residential real estate in my country
U.S. Treasuries
Private equity
Hedge funds
Commodities

% of respondents

10

The New “Normal”


Postponing the inevitable:
An interview with Carmen Reinhart
In May, the European Central Bank and IMF
announced a €750bn aid package to stem the
panic over Greek sovereign debt. After a brief
rally, the euro plunged to a new low and investors
fled to U.S. Treasury bills.

there’s going to be a restructuring, which is a
partial default so it’s a matter of semantics at
that stage,” she says. “We don’t have many tools
available to deal with this crisis so one can’t rule
out restructuring.”

For Carmen Reinhart, professor of economics at the
University of Maryland and co-author with Kenneth
Rogoff of This Time Is Different, the reaction was
typical. In her book, she traces the history of financial
crises across 800 years and finds patterns in how
they unfold. Financial crises are often followed by
sovereign debt crises as governments face falling tax
revenues and the cost of bailouts. This, in turn, often
leads to defaults on sovereign debt.

But delay is good: it provides time to reduce
positions in an orderly fashion and reduces the
risk of contagion. The element of surprise is one
of three factors that Professor Reinhart calls
“the unholy trinity of financial contagion,” along
with an abrupt reversal in capital inflows and a
leveraged common creditor. “Episodes that turn
out to have fast and furious contagion tend to
be characterised by surprise and high leverage,”
she says. “And an immediate default by Greece
would have had both of those elements. So
postponement plays a useful role in giving Europe
time to adjust to this.”

Professor Reinhart foresees a similar cycle in
the sovereign debt problems of the eurozone.
“Although the situation in many of the more
troubled European countries is different, the
collective exposure has led to a fundamental risk
reassessment of those countries,” she explains.
“And that, coupled with worrisome growth
prospects, makes for more non-performing loans.
In turn, that leads to more banking problems and
further fiscal strain.”
The troubles on Europe’s periphery have echoes of
sovereign debt crises such as Mexico in 1994-1995
or Turkey in 2000. But the problems facing Greece
are particularly severe. “Both Mexico and Turkey
had far stronger fundamentals and were able to
devalue their currency, which is not an option for

Greece,” she says.
Professor Reinhart believes that the ECB and IMF
bailout will only delay Greece’s default. “I think

The New “Normal”

Holdings by European banks of troubled sovereign
bonds raise the spectre of banking crisis. “Even if
the ripple effects are not on the gloom-and-doom
panic mode for European banks, they are on the
downside and that means that growth prospects
are further dampened,” says Professor Reinhart.
“The combination of higher risk in lending and
lower growth prospects tends to end badly for
banks. When they end badly for banks, they end
badly for governments, too.”
Many survey respondents predict that countries will
drop out of the eurozone. “I think the efforts will
be enormous to try to avoid that,” says Professor
Reinhart. “I’m not saying that particular scenario
will not play out, just that this will be something
that countries will work very hard to avoid.”

11


The reserve currency of choice
The cloud hanging over the euro has reduced the likelihood of a shift away from the dollar. “The fact that the whole coalition
surrounding the euro has seemed rather weaker than one would have hoped has undermined its position as a solid and tested
reserve currency,” says Ms Zemek. “It’s just not clear how a politically and fiscally diverse entity such as the E.U. would perform

over the long term according to a number of different scenarios.”
But this says less about the dollar than it does about a lack of real alternatives. “If you are an investor looking for a reserve
currency, that is a pretty unpalatable choice,” says Mr Abberley. “None of [the currencies] have anything to commend them at the
moment. Almost by default, the dollar remains the reserve currency at the present time. But I don’t think people will talk about
dollar reserves with any great relish because they’ll also be aware that, to a degree, the dollar story can only be maintained as
long as everyone else believes it.”
The vast majority of respondents (80%) expect the dollar to remain the reserve currency of choice in three years’ time, while 57%
expect it to retain its role in five years’ time (see Chart 7). Over the five-year horizon, respondents are more likely to expect the
Chinese renminbi to take over than the euro – despite the low likelihood of this occurring. Ultimately, this finding says more
about the poor perception of the euro than it does about the potential of the renminbi.
While the weakness of the euro may postpone its chances of becoming a more widely used reserve currency, its decline is good
news from an economic perspective because it may help the region export its way out of the crisis. Although a credible currency
is important, so is an exchange rate that stimulates growth.

Chart 7: There is no substitute for the dollar in the intermediate term
What will be the world’s dominant reserve currency in three years? In five years?

Dollar

Euro

3 years
Special drawing rights
5 years
Renminbi

Don’t know

% of respondents

12

The New “Normal”


Sophos exploits the thawing
of the private equity market
The financial crisis devastated the private equity
industry. According to Ernst & Young, the number
of acquisitions fell by 38% in 2009 while total deal
values fell by 56% to US$95.5bn. But this drop
conceals a more nuanced picture. While highly
leveraged transactions may still be difficult to
conduct, there continues to be a market for equity in
fast-growing companies with strong balance sheets.
One such company is Sophos, an IT security and
data protection firm with headquarters in the U.S.
and U.K. In May 2010, Sophos announced that
it had reached an agreement to sell a majority
interest to Apax Partners, a global private equity
house. The transaction would value Sophos at
US$830m.
Unlike many private equity deals prior to the crisis,
the transaction between Sophos and Apax relies
on low levels of leverage. In return for a US$400m
equity investment, Apax will take ownership of
70% of the company. The remaining 30% will be
financed with debt.
“We were not keen to enter into a highly leveraged
deal,” says Steve Munford, Chief Executive Officer

of Sophos. “The goal was to support the company
through its next stage of growth. You can’t do
that in a technology company if you’re highly
leveraged. We need to retain a degree of agility
to take advantage of acquisitions or investment
opportunities as they arise.”
The agreement occurred during a period of
rising concern about sovereign debt from Greece
and other peripheral eurozone countries. But

The New “Normal”

according to Mr Munford, this had no material
impact on the economics or willingness of either
party to complete the deal. “We wanted a partner
that would take a longer-term view, beyond what’s
happening in the markets in this quarter and the
next,” he explains. “And when you have a four- to
five-year investment horizon, a short-term change
in the markets may cause some discomfort, but it
certainly doesn’t change the long-term merits of
the investment.”
Mr Munford felt that the longer-term perspective
could not be achieved through a public listing. In
2007, Sophos embarked on the early stages of an
IPO but cancelled its plans because of concerns
about the emerging financial crisis. At that time
“it was tough to get the right demand at the right
valuation,” says Mr Munford. The financial markets
may have since stabilised, but a public listing

would still not have been appropriate. “Although
the public markets were open, they were certainly
going to be choppy and what we didn’t want to
do is have the conditions of the public markets
affecting our ability to provide liquidity and raise
capital,” says Mr Munford.
This does not preclude a public offering in the
future. Mr Munford views the current deal with
Apax as a stepping-stone to a public listing once
the company has grown. “We see private equity as
a viable alternative to delaying an IPO and giving
our company the benefits of raising capital but
allowing us to continue to invest in the future,”
says Mr Munford. “Our goal is to continue our
growth trajectory and enable us to have more skill
and staying power in the market.”

13


The outlook for corporates
A gradual recovery in the global economy encourages corporates to shift their focus to strategies for growth, rather than
cost-cutting and strengthening their balance sheets. Although volumes remain small by pre-crisis standards, there is a gradual
return of M&A activity, private equity deals, project financings and IPOs.
But despite the return of strategic activity, the number of companies that expect to raise capital remains surprisingly low. Just 38%
of respondents say that they expect to issue new debt or equity capital in the next two years (see Chart 8). This suggests that many
companies harbour doubts about the strength of the economic recovery and are shelving major strategic growth projects for the
foreseeable future.

Chart 8: Corporates have scaled back funding plans

Does your firm expect to raise new capital in the next two years?
Yes, significant amounts of capital

Yes, moderate amounts of capital

No, we will finance the current level of operations from cash flow and retained earnings

No, we will finance a scaled-down level of operations from cash flow and retained earnings

May 2010
Aug 2009

No, we are unable to access the capital markets

Don’t know

% of respondents

Further evidence of this pervasive caution can be seen in the mismatch between the expectations of financial services
respondents and those from the corporate world. When asked about the outlook for transaction volumes in their country or
region over the next 12 months, respondents from financial institutions are, without exception, more optimistic than
corporate executives (see Chart 9). Overall, respondents see M&A activity as the area where an increase in transaction volumes
is most likely, with 61% of financial services respondents expecting an increase, compared with 52% of corporates.
Although higher equity prices in 2009 stimulated optimism on a return to M&A activity, this seems to have faded. “It’s going to
be quite a while before there’s sufficient liquidity in the market to support a return to an M&A boom,” says Teddy Moynihan, a
Partner in the Corporate and Institutional Banking practice at Oliver Wyman in EMEA. “When deals do happen, there will be a focus
on transactions that are not highly leveraged, that have very good cash flows and can service debt easily without a lot of risk.”
Which group’s forecast of transaction volume has more credibility? Ultimately it is the corporations that are closest to their own
capital-raising decisions. The most creditworthy may have already filled up on funding, while the less creditworthy have fewer
funding opportunities and lower expectations. The respondents from the financial institutions are specialists in their markets.

But the scope for originating assets backed by financial portfolios is limited, and it will be difficult to create transactions when
corporations have little interest in them.

14

The New “Normal”


Chart 9: Corporates have scaled back funding plans
Outlook for transaction volumes over next
12 months vs. last 12 months
M&A activity
Secondary
equity offerings
Initial public
offerings
Investment-grade
debt
Private equity

High-yield debt

Convertible debt

Syndicated loans
Financial institutions
Corporates

Commercial paper

Preferred equity
0%

10%

20%

30%

40%

50%

60%

70%

% predicting an increase in transaction volume over next 12 months

Uncertainty about future growth is leading corporates to postpone major
fundraising plans. According to the Bank for International Settlements,
borrowers from developed economies reduced their issuance by 38% in the final
quarter of 2009, although those from emerging markets raised 19% more funds
in the international market than in the third quarter.5 The crisis in the eurozone,
combined with the unexpected unilateral decision by the German government
to ban naked short-selling, has unsettled the markets. “People are postponing
bond issuance while the environment is so uncertain,” says James Douglas,
Head of Debt Advisory at Deloitte. “It was unexpected but it is having a pretty
significant knock-on effect on companies who have had to shelve capital raising
plans as a result of the sovereign turmoil.”

But not all corporates think that the sovereign debt problems will affect their
capital raising activities. “What is happening at the moment is of concern in
terms of the value of the currencies but not in terms of raising capital,” says
Robin Stalker, Chief Financial Officer of Adidas. “It is a worry but won’t in the
short-term or long-term affect our ability to raise capital.”

The New “Normal”

5 BIS Quarterly Review, March 2010

15


This sudden drop in bond issuance
follows a period in which unprecedented
numbers of corporates came to the
capital markets. By August 2009, global
corporate bond issuance had broken
through the US$1tr threshold for the
first time in a single year. The inability to
borrow from banks encouraged smaller
and medium-sized companies, who
would previously have relied on bank
lending, to tap capital markets for the
first time. “The severe shortage of credit
supply in the banking sector means
that the capital markets will have to
step in and pick up the slack in terms
of supplying leverage into the economy
to support growth,” says Mr Moynihan.

This has been particularly true in
Europe, a region that has traditionally
been more closely associated with bank
finance. In the U.K., for example, the
average size of bond issues has halved
from the market peak in 2007, according
to Dealogic.
Institutional investors such as AXA
regard this trend as a positive one
overall. “It has been a good thing
that the capital markets have been
open and ready for business because
this has kept a significant number
of businesses afloat in some fairly
difficult times,” says Ms Zemek. “This
has also been a positive development
for us because we can get access
to assets of a good quality and this
enables us to diversify more than we
have been able to for a while.”
With credit constraints diverting
companies from bank lenders
to the capital markets directly,
investor relations teams have been
growing accustomed to a new type
of stakeholder: the bondholder.
Prior to the crisis, few CFOs held
investor roadshows for bondholders,
but this is becoming increasingly
commonplace. “CFOs have to get a lot

16

Chart 10: Market participants expect more regulation
To what extent do you agree with these predictions about the
next three years? (agree minus disagree)

Global capital movements will
be regulated to a greater extent
than they are today as countries
seek to protect themselves from
disruptive inflows and outflows

As derivatives and other
transactions become more
tightly regulated,
activity will increasingly
be pushed into less regulated
offshore venues

0%

20 %

40 %

60 %

Respondents were given choices of agree, disagree, neutral or don't know/no opinion. The chart shows the
percentage choosing "agree" less those choosing "disagree." It does not show those choosing "neutral" or

"don't know/no opinion."

more match fit in terms of how they
present information to lenders,” says
Mr Douglas of Deloitte. “There’s a
lot more emphasis on the numerical
data and CFOs are finding that they
must make a real effort to make their
companies look more attractive to the
lending community.”

Cash and other alternatives
It used to be that investors frowned
on companies hoarding cash. Now
they recognise the benefits of a war
chest. “I’ve certainly put a message
into the business that while I’m
looking to invest and take advantage
of opportunities, I need everyone
to focus on building up the cash
reserves,” says Ian Winham, Chief
Financial Officer of Ricoh Europe. “In
my discussions with funders, the fact
that we are able to bring an element

of self-funding and equity to the table
is a real positive.”
Ricoh also recognises that its smalland medium-sized customers may
have trouble getting financing. To
this end, the company has worked

with providers of lease financing to
ensure that its customers get access to
funds they need to make investments.
“The willingness of lease finance
companies to support our customer
base is absolutely essential,” says Mr
Winham. “We have been taking great
care to understand their decisionmaking process. Just by being very
engaged with these providers of
finance, you can start to get a real
sense of how they arrive at decisions.”
Taking advantage of its strong position
in terms of raising capital, Ricoh has

The New “Normal”


even started to disintermediate the external providers of capital and disburse
funds directly to its customers. “The lease finance companies haven’t necessarily
got the history with the customers,” says Mr Winham. “Whereas from our
perspective we’re close to them, we can see their history and, as a manufacturer,
we have greater flexibility on how the product works with them as well. This
means that we’re moving into a different funding requirement where it’s internally
driven and I’ve got to raise the funds to support that capital requirement.”

Regulation and credit availability
The regulatory agenda focuses on reducing systemic risk. Although
harmonisation of regulatory oversight across countries is seen as the most
effective way of reducing systemic risk, respondents do not consider this
particularly likely. They also doubt that regulators will be able to agree on

an approach to central clearing of over-the-counter derivatives. More likely,
according to respondents, is closer supervision of banks by the same regulators
– in most jurisdictions this is already happening – and the upcoming Basel III
rules on capital and liquidity.
Stricter capital and liquidity buffers, a potential global tax on transactions
and attempts to reduce leverage in the system will all help to improve the
stability of the financial sector, but they could also have a profound impact on
the profitability of the banking sector. According to a recent report from Oliver
Wyman, a punitive response from regulators could reduce the return on equity
in the investment banking sector by as much as 8%.6 The survey results and
interviews confirm that market participants are very concerned about the impact
of new regulations. Mr Abberley worries that the regulatory agenda will reduce
not just bank profitability, but economic growth as well. Regulators keen to
clamp down on capital markets and the banking sector will constrain the ability
of financial institutions to lend and leave corporates with limited options for
raising capital. “If you restrict both the banking system and the capital markets
from a regulatory perspective, then logically you have to accept that GDP will
potentially be lower than it would otherwise have been – albeit less volatile.
Corporates have got to be able to borrow from somewhere.”
The uncertain regulatory outlook is affecting corporate borrowers. “Uncertainty
about what regulators will allow you to do in capital markets is creating risk
aversion and potentially raising the cost for borrowers,” says Mr Abberley.
“It might also impact the maturities over which they can borrow because
committing to longer-term investments could be dangerous in the context of a
changing regulatory environment.”
Unilateral regulatory decisions taken by some governments have the potential
to muddy the waters even further. Take the decision by the German government
to ban naked short-selling, which exacerbated fears about liquidity in the bond
markets. “The actions in Germany are the thin end of the wedge which, if you
follow it along its shape, gets to the point where it may be that you are simply

not allowed as an investor to sell a government bond,” says Mr Abberley. “So
liquidity risk suddenly goes through the roof.”

The New “Normal”

6 O utlook for Global Wholesale and
Investment Banking, March 2010

17


Chart 11: Investors, and to a lesser extent issuers, see regulation as a threat

ISSUERS

INVESTORS

What is the single biggest threat to your ability to finance
your business?

What is the single biggest threat to the value of
your portfolio?

Rank
1
2
3
4
5
6

7
8

Issue
Regulation/government actions
Weak demand
Defaults
Inflation
Higher risk
Risky debt
Sovereign credits
Pricing of risk

Issue
Weak demand
Tight credit
High cost of finance
Crisis/Volatility
High operating costs
Debt availability
Risk appetite of lenders
Regulation/government actions

Frequency
15%
13%
9%
7%
6%
5%

5%
4%

Frequency
13%
9%
8%
7%
5%
4%
3%
3%

Chart 11 categorises the answers to write-in questions posed to issuers and investors. In the comments section, some investors
were merciless in their condemnation of impending regulatory changes. Typical write-ins included:
> Regulatory overshoot
> Government interference
> Ill-conceived legislation
> Intrusive and burdensome regulation
> Top-heavy governments in developed countries
> Abrupt asset price changes driven by inconsistent/indecisive governments
> Liquidity rules forcing poor capital allocation

18

The New “Normal”


Nord Stream:
From three banks to 26

When it comes to large financings, persistence
and flexibility can win the game even in difficult
market conditions. In March 2010, Nord Stream
successfully raised €3.9bn of project finance to
fund the first phase of a 1,200-km underwater gas
pipeline linking Russia and the European Union.
With Europe expected to import 70% of its energy
supplies by 2030, the pipeline is vital to the
continent’s energy security and a sign of stronger
relations between Europe and Russia.
Nord Stream is a joint venture between the
Russian energy giant Gazprom, which owns a
controlling stake, BASF Wintershall, E.ON Ruhrgas
and Gasunie of the Netherlands. For the Phase 1
financing, the consortium partners provided 30%
of the funds in line with their shareholding, while
the remaining 70% was raised from a syndicate of
participating banks.
Although the funding was ultimately oversubscribed,
it was difficult to secure. When the project first
launched in 2005, offers from banks were such that
only three or four would have been required. In the
end, 26 participated. “The whole environment had
changed,” says Paul Corcoran, Financial Director of
Nord Stream. “Many of those banks who were key
relationship banks with our shareholders and
who were keen on the project were just not in a
position to be able to go ahead. They just didn’t
have the liquidity.”
To finance the project, Nord Stream had to

increase the coverage ratio to give investors
more protection. “We worked very hard with the
partners in the financing to improve the covered
to uncovered ratio, and indeed we improved it to

The New “Normal”

80/20. This opened up the liquidity that we needed
to cover the commercial tranche and ultimately led
to successful financing.”
Mr Corcoran says that project financings have been
affected less by credit constraints than other areas
of debt finance. “With project finance, the underlying
credit is the project itself so as long as it is solid,
then investors are less influenced by macroeconomic
factors,” he says. “In terms of our project, I think all
the fundamentals mean a low-risk offering to banks.”
But with credit committees scrutinising every
investment, clear documentation and planning
are essential. “You don’t give them any excuses to
block the deal,” says Mr Corcoran. “You need as
much interest in the project as you can generate in
order to end up with a good clearing price.”
It may seem surprising that Nord Stream did not
tap the capital markets directly. “We did consider
whether we’d go to the bond market, but at the
time that we were looking to make our decision,
it was in a very poor state,” says Mr Corcoran.
“When you decide to go for bond markets, you
need to know that they’re going to be there when

you want them.”
With the first phase of financing now over,
Nord Stream has begun construction and expects
it to be complete by 2012. A second fundraising
phase is expected to close by the end of 2010.
“We have a solid package, a project that everyone
is familiar with and thorough documentation
established in Phase One,” says Mr Corcoran.
“Just by the nature of this process, that puts us
in a very strong position for the next stage.”

19


Conclusion
Six months can be a long time in the financial markets. In the first half of 2010, each week
brought the shock of the new, with old verities crumbling and fresh ones taking shape.
The survey and interviews conducted for this research confirmed the outline of certain aspects
of this new world.
First, there is a new dichotomy between developed and emerging markets. Countries such as
China, India and Brazil have little debt and huge capacity. The U.S., Europe and Japan have
a great deal of debt and capacity approaching its limits. The old notion of safety in the center
and danger on the frontier is eroding. Or perhaps the center is simply shifting: the developed
world is seen as a legacy economy while the former periphery becomes a vibrant center of
growth and opportunity.
As this shift occurs, survey participants see every asset class as riskier. This is especially true for
currencies – and not just the euro. There are no good choices among currencies. A significant
minority of executives sees the euro shrinking at the very least and potentially disappearing. The
dollar is king by default, but few believe in its long-term viability. The renminbi is too controlled;
the SDR, too abstract. In a world of high volatility and no-win choices, every holding will be

scrutinized and every investor will re-evaluate the trade-off between liquidity and risk.
This new level of scrutiny will bring about a new era of competition for capital. It’s true that
corporate demand for debt and equity financing is down. It’s also true that investment-grade
borrowers, both corporate and sovereign, can choose their investors and almost name their
prices. Nevertheless, over the next few years there will be stiff competition for increasingly scarce
capital. The financial, economic and fiscal crises all carry high price tags as governments seek
to simultaneously rescue their financial institutions, stimulate their economies and address tax
shortfalls. Beyond the cyclical expenditures lie structural outlays related to the aging population,
the deteriorating infrastructure and impending energy and climate crises. All will compete for
funds in increasingly crowded capital markets. With banks looking to rebuild balance sheets
in a more stringent regulatory environment, sovereigns seeking to restore public finances to
health and corporates looking to finance – at the very least – day-to-day needs, this competition
presents a highly challenging overall environment for raising capital.
Capacity may not be the problem. Instead, it could be willingness on the part of investors to
commit funds in an uncertain and problematic environment. The key, for any entity seeking to
raise capital, is to ensure that strong fundamentals are in place. For sovereigns, this means
taking the necessary steps towards fiscal discipline. For corporates, it means building strong,
long-term relationships with both equity investors and lenders, and ensuring that the company’s
prospects are clearly articulated and understood. Regardless of how the next wave plays out,
the keys to navigating the crowded capital markets of the future will be a strong balance sheet,
a flexible approach and a recognition that borrowers will have to work harder for their capital
than ever before.

20

The New “Normal”



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