TheChek News Flow

Study into global FDI finds 40% of flows used as vehicle for financial engineering

A large proportion of the world’s stock of foreign direct investment is “phantom” capital, designed to minimise companies’ tax liabilities rather than financing productive activity, according to research.

Nearly 40 per cent of worldwide FDI — worth a total of $15tn — “passes through empty corporate shells” with “no real business activities”, the study by the IMF and the University of Copenhagen found.

Instead they are a vehicle for financial engineering, “often to minimise multinationals’ global tax bill”, said researchers Jannick Damgaard, Thomas Elkjaer, and Niels Johannesen, who carried out the study.

The findings come at a time when governments are trying to clamp down on multinational corporate tax avoidance.

Tax reform features high among the priorities of the G7 group of countries. Recent unilateral moves by France to tax global tech groups operating in the country have increased the pressure on other G7 members to reach an agreement.

The OECD has been charged with identifying globally acceptable solutions by next year.

Nearly half of the phantom FDI the researchers identified was in Luxembourg and the Netherlands. Other countries in which less than half of FDI is “genuine” included Malta, Ireland, Switzerland and a number of British overseas territories and crown dependencies, according to the study’s authors.

Brad Setser, an international economist at the Council on Foreign Relations in New York, said the study showed that “these structures — phantom companies or phantom investments — are optimised for minimising firms’ global tax”.

“Apple does not produce its iPhones in Ireland, nor does Apple design them or develop the majority of its operating system in Ireland [but] one of the most valuable US foreign direct investments now is Apple’s ownership stake in Apple Ireland,” Mr Setser said.

Nearly two-thirds of Ireland’s inward investment is “phantom”, the IMF study found.

Despite recent international efforts to prevent companies from shifting profits internationally for tax purposes, the study showed that phantom capital was growing as a share of overall FDI. As late as 2010, phantom FDI made up 31 per cent of the total FDI stock; by 2017 it had reached 38 per cent.

Behind the global number, countries differ widely. The UK’s share of phantom inward FDI jumped from just 3 per cent in 2009 to 18 per cent in 2017, the estimates show. In Belgium and Sweden, the share fell from about 30 per cent to single digits in the same period.

Alex Cobham, head of the Tax Justice Network, a campaigning organisation, said efforts to reduce “profit-shifting” to low-tax jurisdictions earlier in the decade because of “fiscal and political pressures after the crisis” had, perversely, led to even “more aggressive avoidance behaviour”.

“Profit shifting has gone from a marginal feature of the global economy to a systemic feature,” he said. “This is just the way of doing business now.”

But the current reform effort is promising, he added. It will “allocate some share of profit according to where real activity takes place, and that has to be the answer, the systemic response this systemic problem requires”.

Corporate America is over-caffeinated

Let us hope our dependence on the fragile US consumer holds up

Starbucks isn’t just the world’s largest coffee chain; it’s a bellwether stock, one that tells us a disproportionate amount about the American economy and where it may be headed.

When Barack Obama was president of the US, he used to call Starbucks founder and former chief executive, Howard Schultz, for a read on the American consumer. The store sales figures coming out of thousands of communities around the country, four times a day, were much more sensitive than any Bureau of Labor Statistics data.

Last week, Starbucks told us something important and disturbing. The company’s stock took a dive after it signalled, during a presentation at a Goldman Sachs retail conference, that its recent 10 per cent rate of profit expansion wouldn’t carry into next year. In large part, this was because the benefits from President Donald Trump’s tax cuts were tapped out.

As Patrick Grismer, the chief financial officer of Starbucks, put it, “far and away the driver of our outperformance in fiscal 2019 relative to our original expectations was our effective tax rate”. Now that the tax boondoggle is over, so is Starbucks’ outperformance. The company also announced it was pulling forward $2bn worth of share buybacks it had planned for 2020 into the current year, as its sales and earnings are falling short of expectations.

Using equity repurchasing to bolster share prices is nothing new for Starbucks, which has seen its share price grow by some 80 per cent in the past year thanks not only to those Trump tax cuts, but to share buybacks (much of the company’s earnings per share growth comes from them).

The money raised from new bond issuances is often used to pay for those buybacks. Starbucks’ own debt load has roughly tripled over the past few years as it has pivoted to what it calls a “more highly leveraged model”.

Starbucks is of course by no means alone in its employment of such financial engineering. One of the biggest market stories of the past several years has been corporations capitalising on cheap money, using record low rates to issue bonds and then using the money raised to buy back their own equity in order to bolster share prices.

It’s a shell game that has always made my head spin, particularly when done at a market peak, rather than a trough, which tells you that the strategy isn’t a bet on a real, underlying growth story but an attempt to make headlines.

I thought we’d reached a peak in such Faustian financial wizardry a while ago, but no. In recent days, Apple, which has $200bn dollars of cash or cash equivalents on hand, announced a $7bn bond offering, part of a slate of $54bn worth of corporate debt issuances in the past week or so. Just when you think the bond bubble can’t get any bigger, it does.

Given the looming risk of recession, a spate of recent corporate trouble (involving heavyweights such as GE, Kraft Heinz, Boeing, PG&E, and now Johnson & Johnson, which is under fire for its role in the opioid crisis), you would think investors might steer clear of even “high grade” corporate debt. But the asset class seems to fill an existential need for something between equities, which many worry could crash, and the glut of negative-yielding government bonds.

In today’s bizarre and bifurcated market, any middle ground, it seems, is better than none. To me, all this says that corporate America is over-caffeinated and due for a crash. Starbucks would say the American consumer is not.

As Mr Grismer says, “we see in the US a very healthy consumer”. And it’s true that, while tax cuts and buybacks have been a big part of the Starbucks story over the past couple of years, they aren’t the only part. Consumer confidence in the US has, at least so far, been surprisingly resilient in the face of the US-China trade conflict, monetary policy uncertainty, and the sound and fury coming out of the White House. Starbucks same-store sales growth, a good measure of underlying demand, has been robust.

But policymakers worry that this resilience may not last. As New York Federal Reserve president John Williams put it recently, “the consumer is now carrying all of the weight, or much of the weight, for growth going forward.” Or, as Dallas Fed chief Rob Kaplan, who worries that bad macroeconomic data could shift consumer sentiment, says, “if you wait to see weakness in the consumer, you’ve likely waited too long”.

This reminds me of something Mr Schultz told me in February of 2015. Starbucks had just released impressive quarterly numbers. But Mr Schultz worried that economic bifurcation and political dysfunction following the 2008 global financial crisis had created a new and more “fragile” consumer, one that was quick to button up their wallet at the first real sign of economic trouble.

“There is no company you can point to that is as dependent as we are on human behaviour, the human condition,” he told me back then. In a nation divided between latte makers and latte drinkers, any small piece of bad news could trigger a downturn.

Economic bifurcation, political dysfunction, and our dependence on the fragile American consumer has only increased since then. For the sake of the markets, and the global economy, let’s hope they’ve had their double shot.

The stock (ticker: BBY.UK or BAFYY), which has a market cap of £1.5 billion ($1.8 billion), is exceptionally cheap, and management has done an impressive job of improving profitability over the past few years.

“Shares appear to be discounting a very negative scenario,” according to a report by Swiss bank UBS. How bad? Investors may be assigning zero value to its U.S. military housing business and its United Kingdom construction division, UBS says. And worries over whether Britain will leave the European Union without a trade deal haven’t helped investor sentiment either.

Using conservative assumptions, UBS figures the stock is worth £3.60, more than 60% above the recent price of £2.22. European brokers Peel Hunt and Berenberg both have target prices of £3.50. The stock has lagged over the past three months. It lost 7.1% over that period, while the FTSE 100 index, which tracks Britain’s largest listed companies, was up 0.7%, according to Yahoo.

Some of the negativity over the stock involves the company’s U.S. military housing businesses, which was accused of falsifying maintenance records at an Oklahoma U.S. Air Force base. The company hired legal counsel to investigate.

While the UBS report said that “the downside is limited,” analysts took a 15% haircut, or £80 million, to the value of that business. The report added that the hit could be smaller.

Investors have generally soured on the sector. “General construction is looking under pressure,” says Nicholas Hyett, an equity analyst at U.K. financial firm Hargreaves Lansdown. The company gets more than half of its revenue from outside the U.K., with a large portion coming from the U.S.

Dwindling investor sentiment has made the stock even cheaper than the already-inexpensive U.K. market. Balfour stock now trades at 9.4 times next year’s earnings, according to Morningstar. The MSCI United Kingdom index has a forward price/earnings ratio of 11.7, well below the 16.8 figure for the MSCI USA index, according to data from Yardeni Research.

That low valuation contrasts with the turnaround the company has made in the past few years. In 2014, operating margins were negative 5.9%, but that turned positive—if only just—in 2017. And it recently reported operating profits of 3.4% over the latest 12 months, according to Morningstar. “Two to three percent is a good margin in this industry,” says Hyett.

The company has also firmed up its balance sheet with a recent debt-to-equity ratio of 50%, versus 101% in 2015. “The strength of our balance sheet...leads us ideally to the point that in the future we can see strong cash distributions from the company,” Balfour Chief Executive Officer Leo Quinn said in a recent investor conference call. He took the helm in 2015.

Quinn recently said that this year’s 31% increase in the dividend is the third straight annual increase of 30% or more. The stock yields about 2.4%.

Still, investing in Balfour Beatty is not without risk. The construction industry is cyclical. The allegations against the U.S. military business could do long-term damage, especially in the coming election cycle. Sen. Elizabeth Warren (D., Mass.), a presidential candidate, has been at the forefront of the investigation into the housing problems. And yet, given the massive discount at which the company is trading and its steadily increasing dividends, it makes sense to give Beatty shares a look.

When it comes to the Boeing 737 MAX, investors have largely focused on when the troubled jet will return to service. But, like with most issues related to the MAX, that process might not be as simple as investors would hope.

Europe’s chief aviation regulator—the sister agency to the U.S. Federal Aviation Administration—gave a presentation to the European Parliament Transport and Tourism committee on Tuesday. In it, the European Union Aviation Safety Agency, or EASA, sheds new light on several Boeing (ticker: BA) 737 MAX issues. More important, it raises the possibility of a new risk for Boeing investors: That different aviation authorities around the globe lift the flying ban at different times.

The MAX, Boeing’s latest narrow-aisle aircraft model, has been grounded world-wide since mid-March. Boeing stock has dived about 15% since March 8, the last trading day before the second fatal crash involving the 737 MAX occurred, compared with the 5% rise of the Dow Jones Industrial Average over the same span.

“The FAA is the running point on the Boeing situation,” Cowen analyst Cai von Rumohr tells Barron’s. “But EASA has always said it would make up its own mind.”

Read more: Boeing 737 MAX’s Return Could Bring an Airline Fare War. American Airlines Stock Could Rise.

That makes sense—no local aviation authority will outsource safety to another country. Still, it is better for Boeing if regulators can agree.

In a letter sent to the FAA on April 1, detailed in Tuesday’s presentation, EASA outlined its conditions for MAX re-entry to service and said it is committed to doing its own review of proposed design changes and wants crews “adequately trained.”

EASA could require more pilot training, regardless of what the FAA decides. “It’s probably not a major delay, but MAX [simulation] training could require payment from Boeing to airline customers,” Teal Group aerospace consultant Richard Aboulafia told Barron’s last week.

Potential training isn’t a new issue. In fact, all of the concerns outlined by EASA are known issues. That’s a silver lining for investors who have been bombarded by MAX headlines.

Along with pilot instruction, the EASA report discusses MCAS, short for maneuvering characteristics augmentation system; angle of attack, or AOA, sensors; and the trim stabilizer wheel. (The trim stabilizer wheel is the emergency crank system that can be physically difficult to turn.)

Of those three, EASA seems to be most concerned about the AOA sensors. “Still no appropriate response to Angle of Attack integrity issues,” reads one of the presentation slides. That doesn’t mean Boeing isn’t working to address the issue. Investors, however, would obviously feel better if the solution was already in place.

EASA declined to comment about the 737 MAX grounding and referred Barron’s to Boeing about any hardware, software, or training changes being contemplated. Boeing, for its part, said in an emailed statement, “We continue to work with the FAA and global regulators on addressing their concerns to safely return the MAX to service.”

The presentation does indicate progress is being made. For instance, flight tests on a modified 737 MAX at the Boeing flight test center are coming and represent a “major milestone,” according to EASA.

Ultimately, it is difficult to say what the EASA report specifically means for Boeing’s timeline. Safety regulators, and Boeing, have been tight-lipped. Boeing’s best guess, given when the company reported second-quarter earnings in July, is the MAX will fly again commercially by the end of 2019.

Von Rumohr believes it is best if global aviation authorities can agree with one another, “but the FAA is the most important regulator for Boeing.” The majority of Boeing 737 MAX backlog is destined for U.S. routes. He believes the FAA will be the first aviation authority to act on the MAX grounding, even if EASA doesn’t follow suit immediately.

Fee structures encourage excessive debt and transfer too much value to insiders

One of the consequences of shrinking public stock markets is that investors now route ever more of their money through private market vehicles.

It is a switch that has permitted an extraordinary increase in the size of private equity funds. Their net asset value has grown more than seven fold since 2002; twice as fast as global public equities, according to recent data from the consultants McKinsey.

And there is little sign of this trend flagging. Investors have placed 14 per cent of their assets in private markets, according to Willis Towers Watson, a risk management firm. It predicts this will rise to 20 per cent over the next 10 years.

There was a recent reminder of how lucrative all this is for private equity insiders when Oxford university revealed its biggest single donation “since the Renaissance”. Stephen Schwarzman, the billionaire founder of US buyout firm Blackstone, coughed up £150m to fund research into the humanities.

But a more important question is whether it is a good deal for the pension funds that put up most of the cash. The frictional costs of private equity are both higher and less transparent than those on public markets. That is because of the high management fee and 20 per cent profit-share structure, as well as the need for periodic liquidations.

Ludovic Phalippou, a professor at Saïd Business School, has estimated that over the long term, buyout fees have equated to 7 per cent a year — way higher than the charges of less than 1 per cent typically levied by active fund managers. The issue is whether those additional costs can be justified by what private equity firms actually do.

One way to answer this question is to break down the returns on buyouts into different parts. First there is the bit that comes from stock market performance — the “beta” you can get simply by sticking your cash into quoted equities. Then there is financial engineering; mainly the additional debt that private equity firms pile on portfolio companies.

And lastly there is the “residual”, which is a mixture of bits and bobs. True, these might include superior operational performance. But they can also lump in any benefit from buying low and selling high. Pension funds make this easier by committing cash for ten years. This free option allows buyout bosses to buy when other investors are selling, and vice versa.

Research from both the British Private Equity and Venture Capital Association (BVCA) and academics suggests that the returns from private equity break down roughly equally between these three components.

So take a hypothetical situation where a buyout deal generated a £1bn cash gain over four years. Some £200m of that would go to buyout firm insiders as their profit share or “carry” — the reward that is supposed to align them with external investors.

Now if we use our crude split, we can see that £333m of that £1bn gain comes from beta, and the same again from extra leverage with the remaining £333m from the “residual”.

This leads to the key question: what are those slices worth to external investors? Logically, it would be odd to pay more for beta than a passive management fee of, say, 0.5 per cent annually, and maybe 1 per cent for leverage. After all, beta is a mechanical outcome, and while extra debt requires some skill, financial engineering does not grow the overall economic pie.

Plug in those percentages over four years and the rewards for beta and leverage come to about £11m. That leaves some £189m of the performance fee to reward the “residual” of £333m. Which in turn implies the buyout firms are carrying away at least 60 per cent of the true “performance”.

Aside from being grossly disproportionate, there are other reasons to worry about this outcome. The majority of buyout firms’ incentives have nothing to do with running businesses better.

There is no consensus view about the extent to which private equity returns exceed those on public markets, given the complexity of measuring returns. But fees are stubbornly high, whatever the performance.

Take, for instance, a case study by independent researcher Peter Morris looking at Gondola, a British restaurant chain taken private by Cinven in 2006. Despite Gondola underperforming a similar, quoted rival, TRG, over the eight-year period of the buyout, investors in Gondola via private equity paid all-in costs that were three times as much as if they had simply bought TRG stock.

With such rewards on offer, it is hardly surprising that so many quoted company bosses want to go private. Or why, given the high rewards for leverage, so many buyout bosses load up companies with risky debt.

Private equity does sometimes run companies better. But current fee structures encourage excessive debt and transfer too much of any real benefit that is achieved from millions of pension fund members to a few buyout firm insiders, thus helping to drive social inequality. Private equity contracts need redrawing to ensure these excesses are curbed.

Carmakers will face huge fines if they miss new emissions target

More than 1m electric or plug-in hybrid vehicles are expected to be sold across Europe next year as carmakers ramp up output to avoid crippling fines under new emissions rules.

The figure, predicted by environmental campaign group Transport & Environment, is four times higher than sales last year, and comes on the eve of the Frankfurt Motor Show, the last major industry gathering before the new rules come into force in January.

Volkswagen, Daimler and Honda are among carmakers that will use the trade fair to showcase their latest electric vehicles, which are needed to help them avoid punitive fines that could exceed a billion euros for missing the targets.

Under the rules, carmakers must lower the average CO2 output of their fleet to 95g of CO2 per km, or risk fines.

Any carmaker that misses the target faces a fine of €95 per gramme over the target, multiplied by the number of cars sold in the EU.

A flurry of electric and hybrid cars are coming to market this year and next, as carmakers seek to avoid penalties and the environmental stigma that would come from missing them. 

Just 250,000 electric of plug-in hybrid cars with a significant electric range were sold last year, and about 200,000 sold in the first half of 2019, according to T&E.

“Thanks to the EU rules, carmakers are finally preparing to start selling the more fuel efficient and electric cars the climate emergency demands,” said Julia Poliscanova, director.

“This means we are going to see good-quality, affordable electric vehicles in the next year or two.”

The industry’s efforts to lower emissions has faced setbacks as consumers have opted for high-polluting sport utility vehicles and sales of lower-polluting diesel vehicles have continued to slide.

Sales of SUVs have risen from about 7 per cent of the car market in 2006 to 36 per cent last year, according to T&E.

Companies from Volkswagen to Daimler will unveil new battery models in Frankfurt that they hope will appeal to consumers and push their emissions lower.

IHS Markit, the data provider, also expects the number of electric models available will triple by 2021, as carmakers bring new vehicles to market.

At the motor show, which starts on Tuesday, Volkswagen will show its ID3, the first battery car from the world’s largest carmaker, which uses architecture designed for electric vehicles under its new €30bn programme.

Honda will show the production version of its “Honda e” battery city car and Vauxhall will show the electric Corsa model.

Among the high-end brands, Porsche will show the Taycan, its first electric sports car, while Mercedes-Benz is expected to reveal an electric passenger van.

This week, everyone will be talking about Rihanna's Savage X Fenty spectacle in New York and a hyper-politicised London Fashion Week. Read our BoF Professional Cheat Sheet.

THE CHEAT SHEET

Rihanna Goes For Maximum Impact With Savage X Fenty Show

Savage X Fenty is staging a show on Sept. 10 in Brooklyn, which will air on Amazon Video on Sept. 20

Rihanna’s brand is one of several challengers taking on Victoria’s Secret, where sales have slipped in recent years

Savage X Fenty recently raised $50 million from investors including Jay Z's fund and Avenir Growth Capital

A massive spectacle featuring celebrities galore and models in lingerie, recorded for global broadcast. Sound familiar? Rihanna is going straight for the jugular with her latest Savage X Fenty show, promising to lift the best elements of the Victoria’s Secret fashion show and layering on the inclusivity, body positivity and digital savvy that event has been lacking. This is no scrappy disruptor taking on Big Underwear. Savage X Fenty raised $50 million last month, and is part-owned by TechStyle Fashion Group, which built Kate Hudson’s Fabletics into a leggings empire, with $300 million in sales last year and plans for dozens of stores. Rihanna's brand is on a similar path, though it faces plenty of competition from body-positive start-ups like ThirdLove as well as American Eagle's Aerie (not to mention Victoria's Secret itself, which still sells billions of dollars of lingerie annually).

The Bottom Line: Savage X Fenty’s main advantage over its competitors - big and small - is Rihanna’s cultural clout, as demonstrated by the immense amount of media coverage her show earned last year, even as ratings for Victoria's Secret's show hit new lows. Adding Amazon to the mix will only amp up the hype.