You are on page 1of 20

Raising Capital in a New Era

A white paper and survey results on the future of capital markets

Created with the

Table of Contents
Introduction 4
+ About the survey 4
Key survey findings 5
The rise of uncertainty 6
+ A questioning of old truths 7
The tipping point 10
The implications for capital raisers 12
+ Power shifts to investors 13
The implications for investors 16
+ Pension funds search their souls 16
Conclusion 18

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.

Client focus is at the root of how we at RBC Capital Markets build relationships and create opportunity. Our clients are operating in
unprecedented times. Therefore, we endeavour to provide them with thought leadership designed to help them navigate what appears to be a
new era in the capital markets.

One of the most noted challenges of the “new era” is raising capital. Together with the Economist Intelligence Unit, we polled more than 700
corporate borrowers and institutional investors from around the globe to gather sentiment and insight about lending and raising capital.

This white paper is the end result of the survey. It reveals some interesting insights about how lenders and borrowers view
current economic conditions and how they have affected capital markets.

Some of the themes addressed in the report include:

• The level of uncertainty at which decision-makers are operating
• Recent and forecasted global economic shifts
• Challenges to some historical tenets of finance theory
• The perspectives of borrowers on raising capital in the current environment
• The perspectives of lenders/investors on investing capital
• The market’s confidence in the success of government and regulatory intervention

We would like to thank the individuals who are quoted in this report for their valuable time and insights:
George Anson, Managing Director, HarbourVest
Curtis Arledge, Co-Head of Fixed Income, BlackRock
Gerald Ashley, formerly of Bank for International Settlements
Andrew Baranowsky, Corporate Treasury, Bombardier
Federico Bazzoni, Head of International Equity Sales, Citic Securities
Francis Beddington, Head of Research, Insparo Asset Management
Harry Borghouts, formerly Board Chairman of ABP
Pierre-Marie Boury, Capital Markets Specialist, Cleary Gottlieb Steen & Hamilton LLP
Aaron Brown, Chief Risk Officer, AQR Capital Management
Andrew Lo, Professor, MIT Sloan School of Management
Ulf Quellmann, Treasurer, Rio Tinto
Toby Segaran, Founder, Freerisk
Rekha Sharma, Global Strategist, JPMorgan Asset Management
Vern Yu, VP Investor Relations & Enterprise Risk, Enbridge

We hope you will find the report insightful.

Doug McGregor Mark Standish

Chairman & Co-CEO President & Co-CEO
RBC Capital Markets RBC Capital Markets

“This time it’s different” are dangerous words, warned Sir John Templeton long ago. The market’s cycle is never
different: it tips from bubble to collapse, enthusiasm to sobriety, spending to saving, the quest for return to
the avoidance of risk. Even so, more than a year after the swiftest and deepest equity market collapse in over
70 years, the question remains: is it possible that this time is different?

For many market participants, the answer appears to be “yes”. This is no ordinary turn of the business cycle.
Economists, accountants and credit rating professionals are under siege. Axioms of financial theory are being
questioned. Many in the financial sector doubt the ability of policymakers to set the economy on a path of
sustainable growth. And unlike crises that stem from cracks in investor psychology, this one is also intertwined
with fundamental structural imbalances that have yet to be addressed: massive and continuing dollar
purchases by the BRICs, Japan and Germany; multi-year periods of negative real interest rates in the U.S.; and
extreme price movements as the unsustainability of these financial flows becomes apparent.

At the institutional level, chief financial officers and chief investment officers need to make daily decisions in an
environment more uncertain than any in recent memory. Amid a massive shift in credit flows, borrowers hope
to strengthen their capital structure with long-term financing; investors, still hurting from last autumn’s market
collapse, seek the highest possible compensation for risk (if they are willing to take on new risk at all). Both sides
will have to act quickly to exploit windows of opportunity, accept higher costs or risks and possibly lower returns,
and potentially rethink the links between their financial and operational strategies.

About the survey

In July and August 2009, on behalf of RBC Capital Markets, the Economist Intelligence Unit surveyed senior
executives at 736 borrowing and investment institutions from around the globe on their outlook for the future
of capital markets. Of the executives, 415 were involved in raising capital and 321 in investing capital. Just over
half of the capital-raisers came from ­non-financial corporations ranging in size from $75m to over $100bn in
annual revenues, with an average size of about $5bn. About 38% (281) came from commercial or investment
banks and 13% (101) were asset managers or asset owners. There were 60 hedge funds, 57 private equity
investors and a handful of central banks. Financial institutions ranged in asset size from below $50bn to over
$1tr, with an average size of about $250bn. Thirty percent were C-level executives and another 20% were at the
SVP or VP level.

4 Raising Capital in a New Era

Key survey findings

The purpose of the survey was to highlight and illuminate the lessons learned by key market participants – both providers
and users of capital – in the months since the financial crisis. The survey covered a range of topics united by the theme
of sourcing and deploying capital. The table below describes the topics in the survey and highlights some of the findings.

Topic Findings

Expectations for the future • Unparalled levels of uncertainty, especially with regards to the timing and ­
of the global economy and durability of the economic recovery, the future direction of prices and the
financial markets, and how prospects for inflation or deflation
the rules of global capital • The expectation of muted transaction volume over the coming year
markets have changed • Re-evaluation of diversification, efficient markets, CAPM and other tenets
of finance theory
• In general, lower levels of return relative to risk

The changing roles of market • Pessimism about ability of governments, central banks or regulators
players – including central banks, to set the economy on a path of sustainable growth
intermediaries and regulators • More regulation, more competition and a persistent credibility gap
for rating agencies

How seekers of capital are • Stockpiling of capital as insurance against funding difficulties
changing financial strategies • For seekers of capital, more equity – especially private equity – and
and plans; how providers long-term debt
are changing the way they • Acceptance of higher cost of capital
evaluate investments • Among investors, stronger focus on financial strength and cash flow
and a shift to a more defensive portfolio strategy

What seekers and providers • For seekers, openness to non-traditional providers of financing, including
of capital are now looking for sovereign wealth funds, private equity funds and hedge funds
in a relationship • Focus on soundness of borrower’s or lender’s home economy and quality
of regulation as a condition for long-term relationships

Which regional capital markets • Little confidence in Russia, Japan or the U.K.
have best prospects for growth • High levels of confidence in China and India
and stability • Split on U.S. and Eurozone, with many expressing optimism and an almost
equal number pessimism

Raising Capital in a New Era 5

The rise of uncertainty

Uncertainty curtails human activity. Uncertain weather stops people from venturing outside their homes,
political uncertainty produces ineffective governments, and an uncertain diagnosis prevents a patient from
taking the first steps on the path to recovery.

So it is with economic activity. The economic crisis caused, and continues to cause, anxiety among issuers and
providers of finance alike. Companies fear that future funding needs may not be met, while providers of financing
worry about their own capital positions and are not confident that they can execute the transactions that are the
lifeblood of their businesses.

A survey conducted by the Economist Intelligence Unit in July and August 2009 reveals just 6% of respondents
expect a sharp economic rebound in the next six months. European companies across all industries are the
least optimistic, with just 4% expecting a rapid recovery, with 8% in North America. Between one-third and
one-half of respondents worldwide do not expect any uptick for a year or longer. Ten percent of respondents
anticipate at least two years of economic weakness; the figure is higher (15%) among Western European
companies and finance providers.

Who is most pessimistic? Most optimistic?

By region By capital raisers and capital providers

Sharp rebound Sharp rebound
No recovery in the next No recovery in the next
for at least six months, for at least six months,
two years, followed by two years, followed by
followed by growth at followed by growth at
neglible growth previous levels neglible growth previous levels


North America

Western Capital
Europe providers

-15% -10% -5% 0% 5% 10% -15% -10% -5% 0% 5% 10%

6 Raising Capital in a New Era

Consider this statistic alone: just 13% of the respondents Asset Management who was interviewed in August 2009,
have a great deal of confidence that they can predict the sums up the difficulties: “You have to be nimble as an investor
direction of prices in capital markets over the next one to two at the moment. You can’t rely on any figures or numbers. In
years. They were not asked to forecast the absolute level the short term, our conviction is that markets will continue to
of prices, just whether they would be higher or lower over perform. The problem is, next year gets a little fuzzy in terms
a fairly long horizon. And yet 36% had little or no confidence of forecasting. We are worried about the durability of the
that they could do so. recovery: it could hit a wall due to factors such as rising tax
rates, the withdrawal of fiscal stimulus, the continued rise of
Another indicator of the level of uncertainty is the close-to- commodity prices and increasing mortgage rates.”
even split among those who fear inflation and those more
concerned about deflation (see chart below). Among those A questioning of old truths
willing to voice an opinion, investors point to inflation as Just as the patient with a chronic illness may come to
a slightly bigger danger, as to respondents in Asia-Pacific reject the conventional medical techniques that have failed
and North America. But the difference between the two him, so market participants have started to question the
viewpoints is small. And there is room for both to be right, beliefs that have underpinned capital markets for many
depending on the time horizon. decades. Distorted by asset bubbles, pummelled by
macroeconomic shocks and drained of liquidity when it
Amid fears of a muted recovery, many companies and financial is most needed, markets appear to have become
institutions are also concerned about their future viability. dysfunctional. This is of more than academic interest:
Over half of respondents believe that corporate profit margins when institutions and participants are trusted, prices are
and returns on capital will not return to pre-crisis levels for at easily set and transactions flourish. When trust wanes,
least five years. The proportion is even higher among European prices are questioned and transactions suffer.
companies. When executives talk about the end of the
recession, more than 80% qualify it by saying that subsequent The chart on the next page shows how some of the
growth will be “below-trend” or negligible rather than a rising consensus beliefs around financial markets have changed.
tide that lifts everyone. Such confusion can cause paralysis. For each statement, respondents were asked whether
How can investors determine whether they are making a sound they agreed, disagreed or had no opinion. Those who had
investment? Rekha Sharma, a global strategist at JPMorgan no opinion are not shown in the chart.

Inflation is the bigger threat Deflation is the bigger threat



Western Europe

North America

50% 40% 30% 20% 10% 0 10% 20% 30% 40% 50%

Raising Capital in a New Era 7

Capital markets participants are
sceptical and pessimistic

Disagree Agree

Tenets of academic finance (CAPM, EMH, option pricing,

portfolio theory) should be re-evaluated

Higher correlations are making diversification less useful

in mitigating risk

Banks must find new operating models to survive

The U.S. Federal Reserve is becoming less independent

Financial policymakers will successfully respond

to the credit crisis over the next two years

The actions of the U.S. government are the most serious

source of systemic financial risk

During the next five years, the U.S. dollar will lose
its reserve currency status
-50% 0% 50%

8 Raising Capital in a New Era

Tenets of academic finance should be re-evaluated Banks must find new operating models to survive
Until Graham and Dodd came along in the 1930s, finance The financial crisis has brought about a fundamental rethinking
was a collection of observations and rules of thumb, of how banks should operate. The conviction is growing
more akin to folklore than science. But with the coming that banks can no longer operate profitably as conventional
of Harry Markowitz, Eugene Fama, Merton Miller, intermediaries. Just over half (56%) of executives agree
Fischer Black, Myron Scholes and Robert Merton – all that new operating models are a necessity, and only 35%
associated at some point in their careers with the disagree. New operating models might include:
University of Chicago – a body of theory came into being • The disaggregated bank. Bankers are rethinking which
that, starting in the 1960s, guided billions of dollars parts of the bank should be retained and which should
in transactions. Several generations of business school become part of the supply chain. Small or medium-sized
students have now been weaned on the efficient markets banks may not have sufficient scale to operate the back
hypothesis, the capital asset pricing model, portfolio office efficiently, and may choose to outsource or co-operate
theory and other tenets of modern finance. with a group of peers.
• Splitting origination and distribution. Just as the asset
Now 65% of survey respondents doubt these concepts management industry has split into manufacturers and
(and only 22% accept them without question). And they are distributors, banks may split into those specializing
not alone. “Initially confined to academia, the battle between in gathering deposits and those good at capturing yield
efficient markets hypothesis disciples and behavioralists and managing risk.
has spilled over to central bankers, regulators and • Turning fixed costs into variable costs. Instead of ramping
politicians,” says Andrew Lo, a professor at the MIT Sloan up capacity in big steps as volume grows – then coping
School of Management, interviewed in August 2009. with unused capacity and high costs when volume drops –
banks are trying to change costs incrementally. They
Higher correlations among markets are making sacrifice operating margin at the top of the cycle, but reduce
diversification less useful in mitigating risk business risk dramatically at the bottom.
More than half (59%) of survey respondents question the
value of diversification in portfolios, one of the basic Doubts about policymakers and their effectiveness
tenets of modern portfolio theory. This figure rises to Executives voice strong doubts about the ability of regulators –
67% among investors. The problem is not with the theory: especially U.S. regulators – to cope effectively with the crisis.
Mr Markowitz won a Nobel Prize for proving that a A plurality of respondents believe that the Federal Reserve is
portfolio of less-than-perfectly-correlated assets reduces losing its independence and that actions of the U.S. government
risk for a given level of return. Instead, the problems are the biggest source of systemic risk in the financial markets.
are that asset correlations change, correlations among These sentiments reinforce an underlying source of the crisis:
prices in far-flung markets increase as markets globalise, distorted trade and capital flows and inconsistent policies. They
assets are impossible to value when liquidity vanishes, also suggest widespread distrust of the U.S. government’s ability
and correlations move towards one in a panic. to apply rationally the levers of fiscal and monetary policy.

Raising Capital in a New Era 9

The tipping point

The U.S. and China, the world’s two most important Federico Bazzoni, head of international equity sales at
economies, are key to understanding the crisis and Citic Securities, China’s largest brokerage firm, says the
shaping a solution. It is a truism that the world’s centre of credit crisis has had only a marginal impact to date on the
economic gravity is shifting towards the emerging markets, Chinese market. He argues that the market has already
particularly China. With its undervalued exchange rate, emerged from any problems it was experiencing and the
massive exports, high savings rate and limited currency economy is expanding at a pace Western economies cannot
convertibility, China has gathered 30% of the world’s hope to match. “Western investors and companies are
foreign-currency reserves (mostly in dollars), providing the still in wait-and-see mode,” Mr Bazzoni says. “Here,
U.S. with sufficient liquidity to keep its interest rates low. everyone is talking about expansion, the property market,
Despite a 40% drop in the second-quarter trade surplus, and equities. There is lots of liquidity and the Shanghai
China will still accumulate dollars at a rate of about $155bn stock exchange is seeing record volumes.”
per year, according to Economist Intelligence Unit forecasts.
And the shift is not just to Asia, but to other geographical
As China becomes more prosperous, its focus will shift areas that can attract and distribute large amounts of
towards domestic consumption rather than exports. This liquidity. So it is conceivable that the Middle East could
will provide an incentive to float its currency, like other also become a centre of financial power, despite recent
economic powers, and allow the renminbi to strengthen. weakness in equity markets and real estate in the region.
China has already started to move in this direction: it ended Francis Beddington, head of research at Insparo Asset
its fixed exchange rate to the U.S. dollar in July 2005 and Management, which advises an Africa- and Middle East-
more recently set up renminbi swap arrangements with focused hedge fund, says, “Financial markets always follow
Brazil, Argentina and several African countries. A stronger the money. There are large pools of wealth in the Middle
renminbi will reduce the growth of exports and reserves, East, so financial markets will continue to develop there.”
and should lead to more balanced capital flows.
Many Western companies have already raised money in the
None of this escaped survey participants. They see the Middle East, including a number of banks, and this trend is
future, and it lies to the east. In particular: likely to persist, particularly if the price of oil continues to
• Asked which country is the most stable and offers recover from its lows at the beginning of 2009. Enbridge,
the best growth potential over the next two years, an energy transport company, is starting to reach out to
respondents selected China above any other country up-and-coming financial regions. Its investor base already
or region. China is seen as both a hub of growth includes the sovereign wealth funds of Singapore, Kuwait
and as the financial market of the future. and Norway, and it is conducting awareness-raising events
• Just over 40% of borrowers say that they will try to next year among investors in Hong Kong, Japan, Singapore
strengthen relationships with financial institutions and, possibly, China. Vern Yu, VP Investor Relations &
based on the “soundness of the lender’s home Enterprise Risk, says, “We are aiming to tap large pools of
economy and the degree to which it has been affected capital and we want investors to be interested in our story.”
by the financial crisis,” and 30% will consider the
“capital surplus or deficit of the institution’s home
region” when selecting a partner.
• Nearly one-third of respondents think the dollar will lose
its reserve currency status over the next five years.

10 Raising Capital in a New Era

Real U.S. Interest Rates
Overnight Fed funds rate minus year-on-year change in U.S. CPI






1999 2001 2003 2005 2007 2009

Current-account balances 1990–2008

China, Japan and Germany

$600 United States

USD billions




1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: Economist Intelligence Unit

Raising Capital in a New Era 11

The implications for capital raisers

Although parts of the corporate world are beginning to sense International Settlements, says, “Many large corporates have
a recovery, any nascent upturn has yet to feed through to the borrowed money they don’t really need in case their lines
bottom line and companies across the world are scrambling of credit are withdrawn. Corporate treasurers have changed
to secure financing. Some 60% of the issuers in the survey their attitudes towards liquidity and are gathering war-chests
say they are looking to raise capital over the next two years. of cash.”
Just 27% say they will be able to continue operations at the
same level from current cashflow, without fresh financing. One problem is that bank borrowing has become more
expensive. Market pressures forced Bombardier, one
In other words, for most companies, access to capital of the world’s four big aircraft makers, to pay higher fees
markets will be more critical than ever. Unfortunately, such for a C$600m credit facility it agreed to with a syndicate
access may not be forthcoming. Although most executives of North American banks in July 2009. Andrew Baranowsky,
surveyed expect financing activity to grow from its low levels senior director in Bombardier’s Corporate Treasury, says,
in the first half of 2009, a substantial minority expects the “Although our risk profile has improved over the last two to
pace of transactions to slow. three years, the cost to secure bank lines has increased. It
now costs us tens of millions more in bank fees.” The funding
Much of the urgency to secure financing stems from fears now sought by many companies is the kind of flexible,
that credit may become scarcer. Gerald Ashley, a banking long-term capital that provides security amidst volatility and
consultant and former central banker at the Bank for represents a shift away from a historical reliance on banks.

Where transaction volume is headed

% of respondents who think volume % of respondents who think volume
will decline over the next year will rise over the next year

Initial public offerings

Securitisation/asset-backed securities
Private equity
High-yield debt
Secondary equity offerings
Syndicated loans
Investment-grade debt
Commercial paper
Convertible debt
M&A activity
Preferred equity
40% 30% 20% 10% 0% 10% 20% 30% 40% 50% 60%

12 Raising Capital in a New Era

High-profile companies once had a good deal of influence Power shifts to investors
over the cost of funding. Now firms have less power to In every economic to downturn, investors become more
set prices that will allow them to raise as much capital as demanding and issuers must put in more effort to obtain
they need as quickly as possible. Ulf Quellmann, treasurer financing. One-third of companies in the survey say that it is
of Rio Tinto, the diversified global mining group that necessary to improve relations with current investors to raise
launched a number of equity and bond issues this year in new money, and in this downturn the need to court investors
a bid to reduce net debt, says, “In June of last year, it extends even to brand-name investment-grade companies.
was all about price from the borrowers’ point of view; now
it is all about access to liquidity.” Rio Tinto, which has launched a series of equity and
bond issues this year to bolster its balance sheet, says
Many companies are also looking to the non-public markets, improving relationships with investors has reaped
according to the survey. Nearly one-half of issuer companies benefits. Mr Quellmann was surprised about the positive
surveyed (44%) say they plan to raise capital via private reaction of investors to a road show undertaken among
equity in the next two years. This figure rises to 55% for bond investors. “Equity road shows are common,” says
larger companies. In contrast, only 15% of companies Mr Quellmann. “But it is less common to do them for fixed
expect to launch an initial public offerings in the next two income investors. However, we have come to appreciate
years, rising to 33% for the larger companies in the survey. the virtue of them and non-deal road shows have become
And even this minority of companies may be disappointed. a part of best practice at our company.”
Globally, the $220.3bn in new equity issuance in the first six
months of 2009 was the weakest start to a year since 2005, The implementation of these best-practice principles led
according to Dealogic. And at just $6.7bn, the volume of IPO to Rio Tinto receiving $15bn of expressed interest from
is the lowest six-month total on record. Pierre-Marie Boury, investors in a bond that was expected to raise $2bn earlier
a capital markets specialist at international law firm Cleary this year. The company decided to increase the issue to
Gottlieb Steen & Hamilton, says, “The IPO market will not $3.5bn as a result and was able to achieve better pricing
return until next year, and possibly not until the second half in the process.
of it.”
The embrace of capital markets investors will be
Funding will be more expensive, especially for companies counterbalanced by a move away from banks. The
using bank loans. More than half of respondents believe disintermediation of banks, which has been a feature of
banks will charge higher fees for commitments and the North American market for decades, is appearing
drawdowns of loans over the next two years. This partly in continental Europe. Mr Boury believes a lack of available
explains why 58% of respondents believe that their weighted capital at European banks, which have always dominated
average cost of capital will rise. This figure increases 64% the European corporate sector, will force more companies
in the view of investors – and they may be in a better position to raise funds in the markets. This belief is reinforced by
to tell, since their appetite for risk will largely determine the sheer number of companies seeking funding in Europe –
what borrowers pay. When asked why the cost of capital while 60% of companies worldwide will seek capital in
will rise, respondents point to both higher financing costs the next two years, this figure rises to 69% in Europe.
and a capital structure more heavily weighted towards equity Mr Boury says, “This shift is new to Europe, which will
and long-term debt. move closer to the U.S. model.”

Raising Capital in a New Era 13

Liquidity in reserve: Enbridge’s best
practices for raising capital
In a chaotic financial environment, even companies with steady Enbridge appears to have no shortage of “dry powder”,
cashflows and strong balance sheets can find it difficult to raise having issued C$300m of bonds in November 2008, a further
capital. Enbridge, a Canadian energy transport company with C$400m in May 2009 and C$600m in September 2009.
2008 revenues of C$13.76bn, takes this possibility seriously; But it has had to work harder than ever before to make sure
despite a stable business model based on long-term contracts investors are convinced of the business case. “Investors are
with large, well-capitalized oil companies, it is concerned about very demanding of investee balance sheets now,” says
access to the capital markets after the current bond frenzy has Mr Yu. “They have more fixed-income analysts now than
abated. Vern Yu, VP Investor Relations & Enterprise Risk, says, has historically been the case, and they are doing more due
“We want to make sure we have 12 to 18 months of dry powder diligence and relying less on ratings agencies. We have to be
in case the capital markets get worse.” at the top of our game.”

The Enbridge’s capital-raising best practices are particularly relevant in the post-crisis capital markets. The four principles are:

1. Plan ahead for capital 2. Actively market 3. Size offerings to satisfy 4. Set aside enough
market outages. the company. all market sectors. resources to
Never assume that Senior management Enbridge’s issuance capital-raising,
funds will be available conducts 400 separate is generally large leaving nothing
at the moment they investor meetings enough to provide to chance.
are required. Enbridge a year, the majority a reasonable “fill” for Enbridge employs
looks 18 months ahead with equity investors. loyal investors, but it a full-time team
for funding and keeps They also attend also aims to leave some dedicated to monitoring
in place several energy conferences demand on the table, markets. The team is
multi-year bank to network with so appetite remains for in daily contact with
facilities so it can investors and key subsequent issues. a syndicate of seven
pick and choose the issues such as investment banks. These
best environment to revenues, earnings, banks are retained to
issue debt in terms cashflow and gauge market demand
of accessibility and debt levels are for bonds and equities
low coupons. As a widely understood. and to collect other
result, it was able to market intelligence.
price its three recent
bond issues at levels
“compatible with
historical norms.”

14 Raising Capital in a New Era

Open-source credit models:
An alternative to rating agencies?
Rating agencies are under attack from all sides: regulators, This is not quite true. Even the most sophisticated parser is
investors, issuers and the press. In the survey, one-third of likely to choke on footnotes. The significance of a footnote
respondents also highlighted a market-driven alternative to may lie in what is said or what is omitted, and its goal can
ratings: “open source” credit models, characterized by public be obfuscation as well as clarity. But even footnotes can
algorithms, consistent data sets and track records open to be quantified to some extent. First, under pressure from
public scrutiny. regulators, some footnotes – management disclosure of
options, for instance – are more structured than they used
The idea of open-source credit modelling is borrowed from to be. Second, disclosures are often binary: either a company
open-source projects in software (Linux), reference documents deducts option costs from earnings or it does not. Finally,
(Wikipedia) and education (MIT’s OpenCourseWare). according to Toby Segaran, a founder of the open-source
“You want to open up the process [of modelling credit risk] finance project Freerisk, “Besides sharing quantitative
to smart people with different experiences, approaches models, the idea is to have more highly annotated data
and incentives,” says Aaron Brown, chief risk officer at the to feed them with. To the extent that people can annotate
quantitative hedge fund AQR Capital Management. and add their own variables to footnotes, they can be read
“The people in the Netflix company made names for by machines and incorporated into the modelling process.”
themselves by coming up with a better movie-rating algorithm.
In the same way, there are a lot of capable people who The New Zealand-born Mr Segaran and his partner, Jesper
would welcome the chance to join a competition to develop Andersen, are attempting to create a repository of data drawn
a superior credit rating model.” from original financial statements, as well as a distributed
modelling API intended to allow anyone to build, host and
In an era when the credibility of black-box forecasters is allow others to run a model. The Netflix-style leaderboard
in short supply, the idea may appeal to regulators and system, which allows credit and other financial models to
investors as well. Even if prognosticators wanted to promote be back-tested, is due for release by year-end. Over time it
an opaque model, their customers might not let them. is hoped that the most useful models will rise to the top.
And open-source modelling, while rare among financial The creators will gain credibility and can then start to work
institutions, has a long tradition in academia. The original on monetizing their reputations.
Altman Z-score model is freely available, open to scrutiny and
widely used. The business models of research organizations “The idea is to open the doors to do-it-yourself grass-roots
have changed as well: many practitioners give a basic model models,” says Mr Brown. “Who knows? Maybe there’s an
away for free while offering enhanced services or consulting anthropologist out there with the right insights to create
at a premium. a better credit model.”

One obstacle to comparing the results of credit models is

the inconsistency of the underlying data. Rating agencies
publish voluminous information about methodology and
the companies that they rate. What’s lacking, however, is a
consistent, accepted and accessible set of data. “Every time
you see a model it comes with its own data,” says Mr Brown.
“Open-source sharing of financial data has to happen. The
SEC wants it. Investors want it. The technology to parse
financial statements, capture a consistent set of data and
highlight inconsistencies is here. There’s no reason for
it not to happen.”

Raising Capital in a New Era 15

The implications
for investors
On the investor side, there is more selectivity about where to place funds. Nearly three-quarters
(69%) of investors say they assign more weight to the financial strength of a company than they
did two years ago. Says Curtis Arledge, co-head of U.S. Fixed Income for BlackRock’s Fixed Income
Portfolio Management Group: “In the past, the strength of a company’s balance sheet was less
critical as long as the economy was doing reasonably well. However, in today’s turbulent markets,
examining a company’s balance sheet and relative position in an industry is extremely important.”

Although investors will demand high risk premiums, investment-grade companies may be able
to tap the fixed-income and private equity markets. Mr Arledge says the bonds of a number of
companies represent a rare investment opportunity. “Many investment-grade corporations made
significant progress in strengthening their balance-sheet positions during the period when credit
was cheap and easily accessible, making them stronger companies and their bonds relatively
attractive,” he says.

The survey results supports Mr Arledge’s statements. Nearly half of the surveyed investors say that
they will buy investment-grade debt, the most popular asset class. This compares to just 23% that
say they will invest in high-yield debt.

Pension funds search their souls

Prominent among investors that suffered the greatest losses are pension funds − major investors
in long-term securities. According to research from International Financial Services London (IFSL),
pension funds worldwide manage $25trn in assets, the vast majority of which is invested in
equities and bonds. A loss of confidence among pension funds could have a significant impact
on the companies in which they (indirectly, through hired asset managers) invest.

And there is good reason to believe that pension funds will reconsider their portfolios. The value
of pension fund assets fell 18% in 2008, according to IFSL, and the two largest pension funds in
the U.S. lost considerably more than the worldwide average: the value of CALPERS’ assets fell
23% for the year to June 30, from $237.1bn to $180.9bn, while over the same period the assets
of the California State Teachers’ Retirement System (CalSTRS) fell 27%, from $162.2bn to
$118.8 bn. Even the most sophisticated and diversified pension funds could not fend off the
impact of the economic shock.

1 “Pension funds pare The survey shows that investors have consequently taken a cautious view of their performance
stocks, ignoring prospects. About a one-third believe that pre-crisis levels of returns will never be seen again, and
economic rebound,” there is no consensus that global equity markets will recover even two years from now. Indeed, an
Alexis Xydias and August 2009 survey of the world’s ten largest pension funds shows four cutting equity allocations
Adam Haigh, and five holding the share of equities steady (the remaining fund has no equity allocation target).1
August 17, 2009, As pension funds shift their strategies away from developed market equities, the staple of their
Bloomberg News portfolios for many decades, companies will be forced to look elsewhere.

16 Raising Capital in a New Era

Moving beyond
Nearly a one-third of investors surveyed
will allocate more to private equity over
the next two years. However, some private
equity executives warn that the asset class is
unlikely to be able to split infinitive replace
The case of ABP
traditional forms of lending. George Anson,
managing director at HarbourVest, which has ABP is a Dutch pension fund for government employees with €173bn
raised $30 bn from investors and allocated it in assets, slightly more than the largest U.S. pension fund, CALPERS.
to private equity funds, says, “There is a lot of ABP was shocked by an unprecedented negative 20% return in its
capital around that has been pre-committed portfolio last year and is now revamping of its investment strategy.
for investment. But private equity is not a
panacea. It has grown a lot but it is still just Harry Borghouts, interim chairman of the board of governors of ABP
a pimple on the whole capital market from March to August 1 of 2009, says: “ABP’s assets shrank and its
system.” According to the publication Private liabilities grew – in common with many other pension funds.” In fact,
Equity Intelligence, private equity funds ABP’s financial position deteriorated to such an extent that, by the
raised $554bn worldwide in 2008, which end of the year, the ratio of its assets to liabilities had fallen to 90%,
represents about 1.4% of the capitalisation below the required minimum of about 105%.
of the world’s public companies.
“The board of governors took the painful decision not to apply
The brightest spot is M&A, where nearly a indexation to the pensions,” Mr Borghouts adds, referring to the
third of investors surveyed (31%) expect the inflation-linked increase in benefits that most pension funds
volume of transactions to rise. However, many apply annually. It is a rare occurrence for a well-run pension fund
of these transactions may involve distressed such as ABP to fail to index its benefits.
companies or industries that were already
consolidating: the market for bankruptcy- The Dutch fund has since submitted a recovery plan to the regulator.
related deals reached record highs in the The details of the plan should make every company seeking funding
first half of 2009, according to figures from sit up and take notice, for ABP is looking partly to private equity and
Dealogic. Only the second half of last year was hedge funds in a bid to make good the losses. Fixed-income and
busier globally. developed-market equities will be scaled back, since ABP believes
these will produce insufficient future returns.

It is this aspect that could send a shiver down the spine of CFOs.
If pension funds and the money managers they hire reduce
investments in companies headquartered in developed economies,
the pool of available finance will continue to shrink.

Raising Capital in a New Era 17


Bubble, crisis, contraction, recovery – everyone knows the stages of the business cycle and its
cousin, the credit cycle. If the events of the past year were part of a typical cycle, the capital-raising
lessons would be straightforward: strengthen the balance sheet, embrace greater investor scrutiny,
accept higher financing costs and stricter conditions, and be ready to act quickly when a market
window opens. These are the time-worn lessons of the conventional wisdom, and they hold as true
today as they did in 1982, 1991 and 2001.

But this time is different, and the 2008–09 crisis offers several less intuitive implications as well.
To survive and prosper, investors and issuers need to look beyond the obvious and embrace the
longer-term trends that will prevail well after this downturn has ended. For instance:

• A
 s the scepticism around the applicability of portfolio theory to the real world suggests,
investors may be less willing to pay a premium for securities that offer conventional sorts of
diversification benefits. “Whatever else you might want to say about the virtues of international
diversification,” wrote Floyd Norris in The New York Times, “in this cycle it has done little to
balance the risks of investing in any one market.”2
• On the other hand, the experience of ABP holds out the prospect of investors leapfrogging
traditional fixed-income and equity in favour of more volatile and less highly-correlated asset
classes (hedge funds, private equity). As pension funds and other institutional investors adopt
more creative asset allocation strategies, new opportunities will arise for some borrowers, while
others will suffer.
• One-third of survey respondents predict growing experimentation with open-source credit
modelling – an example of how a crisis of confidence can shake loose long-standing
arrangements and drive new market-oriented approaches. As Aaron Brown of AQR Capital
Management observes, if you give credit analysts a way to prove themselves, they will figure
2 “Off the charts: Around out how to monetize their reputation on their own.
the world, stock markets • As Francis Beddington of Insparo Asset Management suggests, financial markets follow the
fell and rose, together” money, and the U.S. and U.K. may no longer be the world’s largest pools of liquidity. Moreover,
Floyd Norris, survey respondents are far more pessimistic about the future growth and stability of the U.S.
The New York Times, and U.K. financial markets than those of China, India or even Brazil. Enbridge’s decision to
September 12, 2009, reach out to sovereign wealth funds throughout the world is only the beginning. The great shift
page B1 is under way.

The details may be murky, but the broad outlines are clear. Capital-raising has become a contact
sport. Companies will have to look farther, dig deeper and work harder to lock in the long-term
capital that fuels growth. The lessons of previous downturns are still valid. Investors require
balance-sheet strength and access to liquidity; borrowers need to lower expectations and accept
higher costs. At the same time, a world in flux can be a world of opportunity. Creative approaches
to capital raising are abound. It’s up to you to go find them.

18 Raising Capital in a New Era

RBC Capital Markets is the business name used by certain subsidiaries of Royal Bank of Canada, including RBC Dominion Securities Inc., RBC Capital Markets Corporation, Royal Bank of Canada Europe Limited and Royal
Bank of Canada – Sydney Branch. The information contained in this report has been compiled by RBC Capital Markets from sources believed to be reliable, but no representation or warranty, express or implied, is made by
Royal Bank of Canada, RBC Capital Markets, its affiliates or any other person as to its accuracy, completeness or correctness. All opinions and estimates contained in this report constitute RBC Capital Markets’ judgement
as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. Nothing in this report constitutes legal, accounting or tax advice or individually tailored
investment advice. This material is prepared for general circulation to clients and has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The investments or
services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. This report
is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. RBC Capital Markets
research analyst compensation is based in part on the overall profitability of RBC Capital Markets, which includes profits attributable to investment banking revenues. Every province in Canada, state in the U.S., and most
countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, the securities
discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as securities broker or dealer in any jurisdiction by
any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. To the full extent permitted by law neither RBC Capital Markets nor any of its affiliates, nor
any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or
copied by any means without the prior consent of RBC Capital Markets.

Additional information is available on request.

To U.S. Residents:
This publication has been approved by RBC Capital Markets Corporation (member FINRA, NYSE), which is a U.S. registered broker-dealer and which accepts responsibility for this report and its dissemination in the United
States. Any U.S. recipient of this report that is not a registered broker-dealer or a bank acting in a broker or dealer capacity and that wishes further information regarding, or to effect any transaction in, any of the securities
discussed in this report, should contact and place orders with RBC Capital Markets Corporation.

To Canadian Residents:
This publication has been approved by RBC Dominion Securities Inc. (member IIROC). Any Canadian recipient of this report that is not a Designated Institution in Ontario, an Accredited Investor in British Columbia or
Alberta or a Sophisticated Purchaser in Quebec (or similar permitted purchaser in any other province) and that wishes further information regarding, or to effect any transaction in, any of the securities discussed in this
report should contact and place orders with RBC Dominion Securities Inc., which, without in any way limiting the foregoing, accepts responsibility for this report and its dissemination in Canada.

To U.K. Residents:
This publication has been approved by Royal Bank of Canada Europe Limited (‘RBCEL’) which is authorized and regulated by Financial Services Authority (‘FSA’), in connection with its distribution in the United Kingdom.
This material is not for general distribution in the United Kingdom to retail clients, as defined under the rules of the FSA. However, targeted distribution may be made to selected retail clients of RBC and its affiliates. RBCEL
accepts responsibility for this report and its dissemination in the United Kingdom.

To Persons Receiving This Advice in Australia:

This material has been distributed in Australia by Royal Bank of Canada - Sydney Branch (ABN 86 076 940 880, AFSL No. 246521). This material has been prepared for general circulation and does not take into account
the objectives, financial situation or needs of any recipient. Accordingly, any recipient should, before acting on this material, consider the appropriateness of this material having regard to their objectives, financial
situation and needs. If this material relates to the acquisition or possible acquisition of a particular financial product, a recipient in Australia should obtain any relevant disclosure document prepared in respect of that
product and consider that document before making any decision about whether to acquire the product.

To Hong Kong Residents:

This publication is distributed in Hong Kong by RBC Investment Services (Asia) Limited, a licensed corporation under the Securities and Futures Ordinance or, by Royal Bank of Canada, Hong Kong Branch, a registered
institution under the Securities and Futures Ordinance. This material has been prepared for general circulation and does not take into account the objectives, financial situation, or needs of any recipient. Hong Kong
persons wishing to obtain further information on any of the securities mentioned in this publication should contact RBC Investment Services (Asia) Limited or Royal Bank of Canada, Hong Kong Branch at 17/Floor, Cheung
Kong Center, 2 Queen’s Road Central, Hong Kong (telephone number is 2848-1388).

To Singapore Residents:
This publication is distributed in Singapore by RBC (Singapore Branch), a registered entity granted offshore bank status by the Monetary Authority of Singapore. This material has been prepared for general circulation
and does not take into account the objectives, financial situation, or needs of any recipient. You are advised to seek independent advice from a financial adviser before purchasing any product. If you do not obtain
independent advice, you should consider whether the product is suitable for you. Past performance is not indicative of future performance.

® Registered trademark of Royal Bank of Canada. RBC Capital Markets is a trademark of Royal Bank of Canada. Used under license.
Copyright © RBC Capital Markets Corporation 2009 - Member SIPC
Copyright © RBC Dominion Securities Inc. 2009 - Member CIPF
Copyright © Royal Bank of Canada Europe Limited 2009
Copyright © Royal Bank of Canada 2009
All rights reserved.