Opening Credit A Peek Inside the Closed Book

1. Opening Credit A Peek Inside the Closed Book Presentation to London Centre for Corporate Governance and Ethics April 27, 2018

2. Credit: Finance’s Dark Matter • The Federal Reserve measured the U.S credit market at $59.4 trillion at Q1 2015, at a time when the S&P 500’s market cap. was $18.9 trillion. • Yet where, or rather, who, is the Jim Cramer of Credit? • Relative to its size and returns, credit remains the poor relation. • On a risk-weighted basis, returns on BBB-rated credit over the period 1919-2010 were superior to all other major asset classes. • Spreads on investment-grade credit today imply a default rate that is >4x the worst historic cohort since the 1970s… • Something does not add up.

3. Credit is Cheap and Always Has Been! Investment-Grade Credit Spreads Habitually Over-Compensate for Risk…1 1. Sources: Annual Default Study: Corporate Default and Recovery Rates, 1920-2017. Moody’s. March 2018; Bloomberg; Cheyne. Implied 5-Yr Cumulative Default Rate is derived from a 50/50 blend of spreads from Itraxx EUR CDSI IG index and CDX IG index, using average historical recovery rates of 40%.

4. …And Credit Curves Nearly Always Slope Upward 3Yr Credit Spreads as a % of 5-Yr1 Credit Curve for Volkswagen AG2 Upward-Sloping Curves Yield Capital Gain from ‘Roll-Down’ – Free(ish) Money2 If It’s This Simple, Why Aren’t We Rich? 1. Sources: Bloomberg. 2. Bloomberg; authors’ estimates.

5. Negative Migration Erodes Ex-Ante Returns What Happens to a Single-A Credit…1 Crystallised Losses from Negative Migration Deplete Returns from Credit 1. Sources: Annual Default Study: Corporate Default and Recovery Rates, 1920-2017. Moody’s. March 2018;

6. Identifying Credit Migration • Existing approach to analyzing credit is too quantitative in focus. • Numbers are the product of management actions • It assumes most migration is the function of exogenous events. • It succumbs to the fallacy of corporate personhood. “Neither bodies to be punished nor souls to be condemned…”Edward Thurlow (1731–1806), Lord Chancellor of Great Britain. • “I’m Ben, I’m a person. I’m Jerry, I’m a person. Ben & Jerry’s Ice Cream? Not a person.” • Ben Cohen and Jerry Greenfield. • Corporate agency resides with : • The C-Suite. • The board. • Set strategic direction; allocate resources; hire reports; establish criteria for remuneration; determine working environment and ethical tone; hire lobbyists; decide policies on capital allocation and funding; appetite for leverage; risk tolerance; treatment of shareholders vs. other contractees. • Any corporate analysis must begin with an understanding of the C-Suite and the Board. • Defies ‘modelling’.

7. Migration Risk Inheres in Agency Problem • Managements run companies for • 1) Managements • 2) Shareholders • (s172 CA 2006 nods to pluralism but is a paper tiger) • Beyond minimal obligations set forth in the credit agreement, managements can appropriate excess returns for themselves and shareholders. • The erosion of this ‘cushion’ undermines credit quality, prompting negative migration. • Management’s philosophy impacts migration: • Rentiers vs. bureaucrats vs. entrepreneurs? • Management’s appetite for risk impacts migration: • Leverage • M&A • Management’s skill at navigating exogenous shocks impacts migration: • Compare IBM and Kodak • Governance and ownership structures directly impact upon managements. A Qualitative Understanding of Management and Governance is Key to Identifying Credit Migration

8. Regulation and Rules Can Only Do So Much • Embedded in the status quo ante… • Assumption that the market for corporate control works. • Largely crafted by insiders. • …And reactive… • Tweak aspects of market practice that corporate failures have brought to light. • SarbOx responds to Enron. • Cadbury responds to Maxwell. • …Therefore, always behind the curve. • Must look at the substance of governance and not rely on the form. • Culture is key… “The sort of words that we would frequently use were [sic] that there was a sort of culture of gaming … Although I could not find evidence that he [Bob Diamond] personally had his hands on these things, you really could not escape the fact that the culture of this institution was coming from the top … Whatever the form [of the governance] was, it was not working.” Andrew Bailey. Head of Banking Supervision at FSA1 1. House of Commons Treasury Select Committee (2012). Fixing LIBOR: some preliminary findings. Second Report of the Session 2012-2013, Volume II oral and written evidence, p ev 89 ff. {[Online]. Available at www.publications.parliament .uk/pa/cm201213/cmselect/cmtreasy/481/481.pdf [Accessed 24 November 2014]

9. What to look for…

10. What to look for… • Career history and reputation. • CV • Presence on other boards. • Political links, community organisations etc. • Sanctions. • A ‘fit and proper person’? • Evidence of attitude to risk “People used to joke that Olympus was so cautious it wouldn’t cross a stone bridge even if it pounded on it three times…But now, what’s risky is not taking risk. My philosophy is that if there’s at least a 50% chance of success, you should try it.” Tsuyoshi Kikukawa, CEO of Olympus1 1 Dvorak, P. and Osawa, J. (2011). ‘Olympus Ex-Chairman Boasted About Appetite for Risk. [Online]. Available at: online.wsj.com/articles/SB10001424052970204505304577001600497281284 [Accessed 24 November 2014]

11. How to find this…

12. How to find this… • Talk to C-suite • ‘Triangulate’ your findings with other stakeholders • Suppliers • Customers • Regulators • Unions

13. Evaluating the Board • The importance of independence • Academic evidence suggests that firms with high analyst optimism, valuations and “powerful CEOs who exhibit evidence of overconfidence and have strong equity incentives are prone to “outside of GAAP” earnings manipulation.1 • Is the chair/board independent in substance as well as in form? • Dense social networks – old boys’/girls’ clubs. • Diversity? • Does the board have the appropriate experience to counter the executive narrative? • Is there dissonance between board composition and the mission of the company? 1. Chu, Jenny and Dechow, Patricia M. and Hui, Kai Wai and Wang, Annika, Maintaining a Reputation for Consistently Beating Earnings Expectations and the Slippery Slope to Earnings Manipulation (February 28, 2018). Available at SSRN:https://ssrn.com/abstract=2607219 or http://dx.doi.org/10.2139/ssrn.2607219

14. Evaluating the Board Wal-Mart’s Board vs. Its Customer Base1 Ethnicity Age Sex Earnings 1. Sources: Company filings; Statista; AdAge; Business Insider.

15. Evaluating Management & the Board Avon Products, Inc. Industry Expertise By Board Membership1 1. Bloomberg; authors’ estimates

16. Remuneration • Look at the philosophy behind remuneration. • Sallie Mae • How is remuneration benchmarked? Any dissonance? Pay Increases at Carillion 2016 (%, Y-O-Y)1 “In line with best practice… increases in salary for the Executive Directors will not normally exceed the range of increases awarded to other employees in the Group…” Carillion. Report of the Remuneration Committee. 2016. • Is the peer group appropriate? • How does the balance of variable/fixed pay look relative to that of peers? • Carillion: 39% variable/61% fixed • John Laing plc: 69% variable/31% fixed • What about clawback/malus provisions? • Carillion: 2 years • John Laing plc: 3 years 1. Carillion Annual Report 2016; Authors’ calculations

17. Remuneration • Look closely at the structure of variable remuneration. • Targets influence management behaviour. • Carillion had a cash conversion target (underlying cash flow from operations/underlying profit from operations)… • …But they also had an EPS target, which took precedence. • Easiest way to boost EPS is to reduce ‘S’ through stock buybacks or debt-financed acquisitions. • Carillion acquisitions: Planned Maintenance Group, Mowlem, Alfred McAlpine, Eaga, John Laing Facilities Management plus a £2.1bn run at Balfour Beatty that was rejected. • As of year-end 2016, goodwill amounted to £1.57bn or 35% of the balance sheet. • Carillion’s auditors highlighted this as one of the most material risks of misstatement.

18. What Role for Ownership? • Corporate ownership in liberal market economies simply too atomised, institutionalised and internationalised to exert effective control. • Individual ownership of quoted UK shares in UK domiciled companies amounts to under 12%. • In 1963 over half the value was in the hands of individuals. • 89% institutional/non-UK. • Also, oriented towards quarterly financial goals. “Such a wide distribution of the stock dissipates altogether the responsibility of stockholders, particularly of those with five shares, ten shares or 50 shares. They recognise that they have no influence in a corporation of hundreds of millions of dollars’ capital. Consequently they consider it immaterial whatever they do, or omit to do. The net result is that the men who are in control of it become almost impossible to dislodge, unless there should be such a scandal in the corporation as to make it clearly necessary for the people on the outside to combine for self-protection.” US Supreme Court Associate Justice Louis Brandeis Source: Ownership of quoted shares for UK domiciled companies, 2014. ONS. 2 September 2015

19. Governance Impact of Different Ownership Structures • There is no right answer. • Different structures present different challenges. • Europe: common for large corporations with publicly traded debt to be family-owned or controlled. • Initially easy to understand, but ownership atomises over time. • Public listing – institutionalises and internationalises ownership. • Shareholder ownership and management responsibility both attenuated. • Commanditaire – à la Michelin. • Influence of cultural factors. • Dual-voting structures/ super-voting stock. • Economic vs. voting control. • Cumulative votes for long shareholding periods. • The hereditary principle.

20. Drivers of Credit Performance

21. Trading Acumen Drives Returns1 • Chart illustrates cumulative value added by portfolio substitution over period 12/1/15-2/28/18. • Trading returns in the actual fund add value relative to potential returns on retaining a static portfolio from 12/1/15. 1. Novus; Cheyne

22. A more nuanced picture emerges • Clear correlation between higher ESG ratings and investment returns. • Some variability within categories – too much, to be able to claim a linear relationship. • Returns on AAA-AA ESG entities outperform other categories over the four-year period. • Clearest outperformance found in entities with credit ratings ranging between Baa1 and Ba3, - the majority of our portfolio constituents (> 70%). • Lower returns on A-and B1-and below-rated entities influenced by small sample size. • BBB ESG entities weaker at the upper end of the credit scale than the previous group, but markedly stronger in the B1 and lower category. • BB ESG entities have lower returns than all others except for credit ratings Baa1-Baa3 and B1 and below • Low default rates since the GFC have supported returns for weaker credits. Other factors are “Rising Star” effect for Ba1-Ba3 and statistically insignificant Aaa-A3 constituents.

23. Cumulative returns by rating category1 • Bulk of returns clustered in the AAA-BB ESG ratings • N/A rated entities are gradually shrinking in number, but remained substantial over the period concerned. 1. Novus; Cheyne

24. Distribution of returns in a down year - 20151 • Entities with lower ESG ratings materially under – performed in a year of weak credit market performance. 1. Novus; Cheyne

25. Four-year returns by bucketed rating category1 • Generally strong relationship between higher ESG ratings and returns 1. Novus; Cheyne

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