Our view of the
financial markets

The investment strategy of Proventus Capital Partners is based on our analysis of macrodevelopments in general, and more specifically on what we are seeing in the capital markets.

In 2009, both the demand and supply of capital were on hold. On the demand side, very little happened in terms of deals and other activities – the exception of course being refinancing of old debts as well as restructuring in cases where it could not be avoided. As regards refinancing, the use of the proceeds of bond issues changed from 90 per cent going towards acquisitions in 2008 to 75 per cent being used for refinancing in 2009. On the restructuring side, it seems that the many European restructurings that took place were focused on waiving bank covenants, extending maturities and postponing interest payments. Few restructurings involved injections of new cash and even fewer resulted in write-downs of senior debts. In essence, time has been bought, but there is bound to be a second wave of restructurings within the next 12-24 months where real changes in balance sheets need to happen and new capital will be key.

On the supply side, the banks withdrew from the market entirely and did not start to return – albeit slowly – until the end of the year. The primary equity markets were also closed for most of the year. The bond market however took care of most of the funding needed for refinancing – issuance of corporate bonds in Europe was more than double the average for the past ten years. In 2010, we already see the demand for capital returning. First of all, refinancing needs are enormous. In the market for high-yield bonds and loans, maturities are increasing from less than EUR 10 billion in 2008 to over EUR 50 billion in 2013. In addition, we see signs of mergers and acquisitions starting to take place. Many companies are looking to resolve challenges to their competitiveness by increasing scale and efficiency through mergers. Some are healthy enough to be proactive in their merger activities, while others are reacting to pressure from banks or financial markets. Also, the demand for working capital in many industries is radically changing. Weakened customers and suppliers mean that a larger working capital needs to be funded externally. During the phase of lower economic activity, many companies have survived the decreases in demand by letting stock levels drop and cutting their working capital drastically. When demand starts to return, they will find themselves in a new situation with much higher needs for working capital. Overall, we foresee that the needs of financing and restructuring in European industry will be considerable in the years to come.

Things are also changing when it comes to the supply of capital. The banks are slowly returning to lending. Primarily, the banks are taking care of their existing customers, especially the bigger accounts which were in many cases treated as frugally as the smaller ones in 2009. However, we find it very unlikely that banks in general will return to the type of risk attitude and activity that prevailed before 2007. First of all, there are still a large amount of nonperforming credits that need to be taken care of. IMF predicts that we are only halfway through the necessary write-downs and loss provisions in US and European banks, with over USD 1,300 billion still to come. Also, we will still see the effects of deleveraging over time – the banks need to shrink their balance sheets. Many banks and financial institutions have also gone out of business or have refocused on their home markets, reducing the supply of international credit. As always with this type of crisis, there is also a new attitude to risk that will be present for a number of years – the span of possible outcomes in any given situation has expanded, making banks increasingly cautious. Also, the competition for capital is increasing with the sovereign crisis in Europe which risks leading to severe crowding-out effects. And finally, we will see increasing regulation both as a result of among other things the Basel process that was already in progress before the crisis in the financial markets, and new regulations that are being drafted to prevent a similar collapse to that which we saw in 2008. The proposals that the Basel Committee on Banking Supervision has recently published – Basel III – include major changes, not least with regard to capital requirements and liquidity. This has the potential of increasing the cost of lending and restricting the supply of credit.

As for equity markets, liquidity is improving. We have seen some IPO activity in the spring of 2010 and private equity firms are well financed and are moving from dealing with old problems to making new investments. However, the public equity market remains very sensitive to shocks. The expectation in the S&P 500 is that profit levels in 2010 should be 90 per cent of what they were in 2006 – a year when corporate profits hit a record 14.6 per cent of GDP in the US and when a large proportion of the profits came from banks and financial institutions. The risk of disappointments looms large.

On a different level, we are also demographically challenged in that we are living with ageing populations in the West. This also means that a large part of the population will need to make use of savings – or de-save – in coming years, which means that the volatility of the stock market could be a problem. In many ways, the bond markets offer a better match for the large pension liabilities on the balance sheets of companies as well as nations. In fact, over the last 20 years in Sweden, the total yield of the bond market has been higher than the stock market.

This is the reason for our strategy focusing entirely on investing in subordinated lending and corporate bonds for mid-sized companies in Europe.