Tuesday, 18 January 2011

Cevian Capital II Ranks High on 2010 Returns

Europe's largest activist fund, the €3.5bn Cevian Capital II, has had a(nother) banner year – up over 34% in 2010, after a return of 35.7 percent in 2009. This puts the Fund very close to the top of the ranking for hedge funds of any style, ahead of almost any other equity hedge fund, and given that most of the other top-ranking funds are a fraction of the size of Cevian II it again confirms the quality of the management. Without doubt founders Christer Gardell and Lars Förberg are amongst the most impressive managers of capital I have met. So I thought I would share some thoughts from Lars Förberg that were elucidated during a session in October last year under the auspices of The Greenwich Roundtable.

First here's a bit of background on the firm and what it does, and the talk should illustrate the principles outlined.

Cevian Capital was founded in 2002 by with the launch of Cevian Capital I, a fund dedicated to activist investments in the Nordic region, and in which Carl Icahn was a significant investor. In 2006 Cevian raised its second fund, Cevian Capital II which had a remit to invest in companies in Northern Europe. To put the wider remit into practice Lars Förberg moved to Zurich, whilst Gardell remained in Stockholm.

Cevian Capital's version of active ownership creates value by (i) acquiring substantial ownership positions in undervalued public companies and (ii) realizing their long term value potential through change. Cevian generally invests in companies overlooked or misunderstood by the market and in many instances out of favor with investors. Cevian targets investments where there is a meaningful opportunity to enhance the long term value by improving corporate governance, operational performance, corporate strategy and structure.

Cevian manages a concentrated portfolio of 8-12 companies at a time, with significant ownership positions in a limited number of publicly listed companies and is typically one of the largest shareholders in its portfolio companies. Consequently, Cevian maintains a strong commitment to oversight of each of its investments.

The investment process of Cevian is in two stages. Prior to investing, Cevian commits considerable time and resources to evaluating and analyzing prospective investments. All investment decisions rely on a well established and rigorous proprietary due diligence process, including comprehensive financial, commercial, operational and legal analysis. In the second stage Cevian looks to work constructively together with the management and board of directors of its portfolio companies, aiming to increase the company's long term competitiveness and create value for all shareholders. Cevian frequently participates on boards and nomination committees of its portfolio companies.

Lars Förberg
Three Questions for Lars Förberg

Question One: Is Europe Falling Apart?

To the first question, is Europe falling apart, the answer is clearly no. Sure, there are immense macroeconomic issues in many parts of Europe, notably in the south, what many people call Club Med or the pigs. That is Portugal, Italy, Greece, and Spain. These countries are over-levered. They have big deficits. They're not easy to run politically.

Having said that, the most difficult countries -- Greece, Portugal and Ireland -- only account for 6 percent of GDP of Europe. If you add Spain to that, you go 10 percentage points higher. This is still a small part of Europe, and it's not big enough to bring the more healthy northern and central Europe down. And what is interesting is that fiscal and labour market reform of almost unprecedented scope in the problem countries is going roughly according to plan.

Question Two: Can Europe Compete?

On the second question, can Europe compete -- a common view is that Europe is ridden by Euro-sclerosis, an inability to grow and compete based on regional labour markets, militant unions, punitive taxes, and generous social security. In some countries this is true. But when I look at our home market, Scandinavia, and German speaking Europe, i.e., Norway, Sweden, Finland, Denmark, Germany, Switzerland, Austria, you see a different picture. Look, for instance, at the statistics over which countries are the most competitive in the world, and I'm now using the World Economic Forum's global competitiveness statistics. You'll find Switzerland number one, Sweden number two, Germany number five, Finland number seven. As in parenthesis, U.S. is in the middle of these being ranked at number four.

Also interestingly, these numbers go hand in hand, leaving the U.S. aside, with where you will find the most fiscal sound countries. These northern European countries, I imagine, have limited budget deficits, if at all. And a country like Sweden, as an example, has been running budget surpluses for almost every year since the mid-nineties. Another characteristic of these countries is that they all have a strong industrial base geared towards exporting and being the home of a number of successful global companies with strong market positions, excellent product and services, and wide ranging distribution capabilities. These companies benefit from the global economic growth driven by emerging markets, and they have shown an ability to adapt to the changing market environment. I will come back to these companies a bit later.

So, the somewhat short answer to the second question, is Europe competitive, is two-fold -- a strong competitive northern Europe and a somewhat weaker south. One thing I'd like to add here, though, is that when you look at most of the countries that are now successful and most competitive, they went through major reform to get there. Germany did that in the early 2000s after the reunification of the problems that that led to in Germany. Scandinavia did that in the mid-nineties following the financial crisis in a number of Scandinavian countries. These reforms, many times orchestrated by the social democratic governments, led to labour productivity growth way above peers, many times at the level of 5 percent year after year.

Many of these same measures are now being undertaken in the currently weak countries - the fiscally problematic countries in southern Europe. This is being forced by the financial crisis. Examples of these efforts are major deregulations of labour markets, fiscal savings of up to 10 percent of budgets, restructurings of the pension systems, and VAT hikes of 5 percentage points. It's difficult to tell, but in a rosy scenario, these changes can lead to pretty benign environments in southern Europe and have attractive effects in the medium term. But that's something I wouldn't bank on, though, because the political situation is difficult and will continue to be difficult and uncertain over a couple of years, in my estimation. But what should be noted is that the financial crisis is used as a tool to move through structure reforms that are well needed in many parts of Europe, especially in the labour market.

Question Three: Attractive Opportunities?

So, on to the third question -- where do we see the most attractive investment opportunities in Europe right now? Well, we are an activist fund operating primarily in northern Europe, buying into equities, so I will back up the earlier comments by what we're doing. What we think are the most attractive investment opportunities right now are the companies I mentioned before -- the equities of the globally oriented companies out of Scandinavia and Germany.

You can still buy these companies as they are for double digit cash on cash yields, and get companies with excellent products, strong market positions, and full exposure to the emerging markets. Prices vary, though, and I don't believe there's going to be an over the line bull market, but I believe that with selective stock picking there are immense opportunities. I'll give you a couple of examples that we have put on into our concentrated portfolio of ten companies.

One example is the German crane manufacturer, Demag Cranes AG, in which we bought more than 10 percent of the share capital over the spring. Demag is the global leader in its field and has the largest installed base of industrial cranes globally. This is important because that means a great opportunity for stable earnings servicing this installed base. The company was undervalued because of its late cyclical nature, but also because there were some question marks over its strategic -- future strategic direction. Therefore, we could buy the company only paying for the service business which is 35 percent of the business, and getting 65 percent of the business - the equipment business - for free.

Another way to see it is that we bought the company paying an enterprise value equivalent to 50 percent of sales. This is for a company that we think will make 10 percent EBIT margin on a sustainable basis.

Another example is Panalpina World Transport, one of the global leaders in freight forwarding, which is based in Switzerland. This company we could buy early this year for a price reflecting the difficult conditions of the logistics industry during the slump. If the company comes back to its normalized earnings level, it will mean a doubling on our initial investment. If we manage to close the company's underperformance to its peers, which is our job as an activist, it will be a 3x investment.

On top of having these sound companies with attractive valuations, I think Europe has offered and continues to offer great opportunities for restructurings. Many companies have been unexposed to active ownership due to a legacy of passive shareholdings, unengaged board members, and value destroying cross share holdings. I believe there is a tremendous value potential in the existing unwieldy corporate structures, operational inefficiencies, underutilized balance sheets, and entrenched boards and management teams that are not pressured to perform. And in most parts of Europe, the corporate governance framework is there to unlock these inefficiencies. The restructuring opportunities, the low valuations, are coupled with one of the greatest opportunities that is not in the share prices today, and that will soon come to fruition, which is restructuring in terms of M&A.

If you are on the right side of M&A, there is tremendous opportunity to make great returns. And I point to a few factors that is driving this. One, corporate restructuring has been absent over the last two years. We all know why. So, there is a pent up demand and appetite. Two, the debt financing is there, both for industrial companies and private equity firms, and corporate cash is at all time highs. Three, the ability to make these M&A decisions is back in the boardroom: markets have stabilized; there's better visibility, and you don't have to focus on your short term crisis anymore. If you as a CEO had brought a big acquisition to your board a year ago, you would have gotten no traction. Now it's a totally different story.

When this M&A boom will happen is difficult to know. It's going to happen. Will it be three years ... three months from now, six months from now, or within a year, I can't say, but it's going to happen.

So, I think these three factors in terms of low valuations, restructurings, and the M&A opportunity, have created some very attractive opportunities in Europe from our vantage point in what we think, at least in northern Europe, is going to be a relatively benign macroeconomic environment.


Q1. To marry what you're seeing in terms of micro opportunities with the macro, I was wondering, have you come across situations in your portfolio where macroeconomic or regulatory risk that one of these companies, say the crane company, in the tough economic environment, dwarfed what you saw as the micro economic opportunity. So what you thought was a great value turned out not to be because of macroeconomic risks?

A. (Lars Förberg): You're saying with a macroeconomic environment is it too tough for these companies? Well, when we buy companies that are cyclical, like at Demag, the crane manufacturer, yes, it was a cyclical company. But we would not buy it if we had to rely on a macroeconomic upturn. I think this is the attractive thing. We could buy it paying only for the servicing business. That servicing business is really something, and this was in a slump. So, this servicing business is typically something when you're a core manufacturer or, which Demag sells to, you need these things to function.

It's almost like an elevator business. So, we could buy into this company only paying for this business which is very stable. An elevator business has to go there. You know, it has to run. But we've got the equipment business - 65 percent of the business for free - so we're covered on the downside because we're not paying for the macroeconomic upside, but we're getting that if it comes. I think it's going to come, but it doesn't need to come for it to be an okay investment. If the macroeconomic environment swings up, which it's doing, it's going to be an excellent investment. So, that's the way we think about it.

Q2. Have you thought about playing on the fixed income side at all - corporate fixed income?

A. You know, there isn't much corporate depth in that. I think if you have a credit fund in Europe you have a lot to do two years, and then you have nothing to do for five years. It was a great opportunity two years ago. Then there were many of the convertibles trading maybe at 35 percent of par - very attractive opportunities, companies that you know would survive maybe with equity infusion but they were not going to go dead. But I think that opportunity is gone from my perspective. I think the opportunity in (European) corporate bonds is not there now.

I think when you look at the macro there are a number of issues in terms of how Europe is going to grow, and I think a common view is that Europe is not going to grow that much. When I painted a pretty positive picture of Europe, I was not talking about the GDP growth numbers. I pointed to the Export-oriented companies that have global market positions. If we do something in the domestic oriented sector, which we do limited of but if we do, we only do situations where we can increase the profits of the company by, say, 50 or 100 percent by cost-cutting, typically, or by restructuring in terms of selling off non-core assets because I don't think you should expect in Europe domestic demand to drive growth.

The joker could be Germany, actually, which has been a laggard for many years in terms of domestic demand - consumption demand being very low for many years. But you have a situation in Germany where the unemployment is at its lowest for probably 20 years, and so there could be consumption growth coming in Germany, which would surprise the markets, I think. But it's not going to make a huge lot of difference if you go from 1 percent growth to 3 percent growth. You're not going to make much money from that, so in the domestic economy you have to find special situations.

Q3. There's been a concentration on bank debt in Europe, as opposed to corporate fixed income. So there's not enough in play in the distressed and high yield and corporate bond markets. Does that make it difficult for an activist to get purchase to force through labour reforms in target companies? Europe needs labour reform to make the economies more flexible. That's what the activists need isn't it, flexibility?

A. I think restructuring in Europe is much easier than generally perceived from a legal/cultural perspective. There are countries in Europe where the companies have already restructured. In Germany it used to be impossible to restructure a company ten years ago. It's completely different now. After the agenda 2010 laws that were passed by the social democratic government in the early 2000s, you can restructure in Germany.

And you have to remember that these companies, and many of the countries of Europe, are very dependent on exports. And the governments and the unions know that the companies have to be successful, otherwise it's going to be a problem in terms of employment. They're subject to global competition from China, from the U.S., from everywhere. And therefore many times you have a consensus among the stakeholders (the boards, shareholders, unions, and governments) in cutting costs.

In the countries where I operate (Germany, Sweden, Finland, Denmark, Norway) you have, by law, unions on the boards of companies. And you would think that's going to be problematic in terms of restructuring a company. It's actually the other way around because the unions understand that if we don't do anything to improve the company we're going to be out of business. They hate underperformance more than shareholders do or as much, I should say.

Now, southern Europe is a different thing ... if you look at Spain and Italy and so on. But I think we're seeing labour reform there, and in Portugal as well. And I think that that's the good thing, that the crisis is used to reform labour laws. I think in terms of Greece, we should recognize that it's not that relevant. We talk a lot about Greece, but it's like in a discussion about the U.S. talking 50 percent of the time about North Dakota. It's not that significant.

Q4. So can Europe split – into a fast-track Euro with a slower Euro for certain countries? There are countries that were thinking of leaving the EU, though there are a lot of logistical issues with that?

A. I think politically it's a no-starter. When Europe looked this spring at the budget problems in Greece it took some time for Germany to come around and help bail Greece out. That was a purely political calculation, and I think rightly so. What they did was to wait to endorse a bailout package until Greece had committed to more far reaching reforms. So, it was more a political process than anything else. I don't think a two-speed Euro is going to happen.

I should say, though, I personally voted as a Swedish citizen against the adoption of the Euro a few years ago. I'm a Euro skeptic - there are a lot of problems with it that we're seeing in a country like Greece where they should have a lower currency. But look at Estonia, for example, a country which was not with the Euro, but they were locked in terms of parity with the euro, and they made an internal devaluation by lowering the salaries of government employees by 25 percent an incredible process to adjust their economy to staying with the locked in currency rate with the Euro. They managed through that, and hopefully they will manage through that in Greece as well.

Appendix- Key terms of Cevian Capital II 
A full profile of Cevian Capital can be found at The Hedge Fund Journal

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