Corporate funding in the UK during and after the Financial Crisis

5 July 2011Adrian Marsh,

Director of Tax, Treasury & Corporate FinanceTesco plc

Confidential Presentation

Context: 2007-2009 Financial Crisis

2,000

3,000

4,000

5,000

6,000

7,000

Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09

FTSE 100 Euro Stoxx (rebased) S&P 500 (rebased)

Timeline (January 2007 – December 2009)

• Sub-prime contagion

Apr- Aug 07:

• Northern Rock gets emergency funding from BoE (see slides 18-19)

Sep 07:

• 17 Ma

• Bear Stearns collapse

Mar 08:

• Fannie Mae & Freddie Mac bailed out, AIG $85bn rescue package

• Lehman Brothers bankruptcy. BofA takeover of Merrill Lynch

• Bank casualties reach Europe: HBOS, Fortis, Bradford & Bingley, Iceland, HvB. RBS and Lloyds bail-out

Sep – Nov 08:

• Nov 08:

• Volatility reaches record levels, markets hit bottom

Nov 08 – Mar 09:

• Nov

• BoE, Fed announce quantitative easing

Mar 09:

___________________________Source: Factset, Bloomberg

• During the financial crisis, bank capital and liquidity came under increased scrutiny as banks faced difficulties in accessing traditional sources of funding

– Failures such as Lehman Brothers, Lloyds and RBS threw into focus banks ability to absorb losses and the quality and quantity of capital held for this purpose

– The impact on banks had a profound knock-on impact on the way corporates were able to fund themselves

1

As well as pricing implications, lower-rated companies, particularly non-investment grade, were exposed to liquidity risk in not being able to issue in times of financial distress

Financial Crisis Impact on Corporate Funding

Monthly GBP and EUR industrial issuance volumes and CDS index

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50

100

150

200

250

Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11

Spread (bps)

0

5

10

15

20

25

30

£bn

'A' rated issuance 'BBB' rated issuance 'BB' rated issuance iTraxx main CDS index

___________________________Source: Dealogic and Barclays. 17 month period of closure excludes small £75m issue in June 2008

Periods of sub-investment grade market closure

5 months 17 months

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• Pre-crisis, many corporates over-exposed to bank market

– Driven by historic high liquidity and low pricing

• As liquidity dried-up, unable to refinance and forced into debt or equity capital markets

– Banks withdrew from the markets; bank groups shrank

• Refinanced bank deals typically smaller; 3 year tenor max

• Flight to quality

– Pricing differential between higher and lower rated credits widened

• Emergence of Forward Start Facilities as mechanism to access loan capital

– Weaker borrowers aiming to leverage the residual value of cheap facilities in exchange for renewed

commitments

What Happened to Corporate Funding?

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During the crisis, many corporates were forced to examine their ongoing long-term capital structure and consider diversifying sources of debt away from the bank market

Profile of UK Capital Raising over a Cycle

0

100

200

300

400

2005 2006 2007 2008 2009 2010 2011 YTD

$bn

USPP Equity IPO Convertibles DCM Loans

UK Corporates Capital Raising

$277bn

70%

20%26% 21% 38%

46%

27%

64%

70%

53%

27%59%

33%

59%

$340bn

$431bn

$279bn

$216bn $215bn

$116bn

• Historically UK corporates very reliant on loan market• During the crisis, availability of bank funding contracted significantly, however more than compensated by record

breaking bond market issuance, particularly in 2009• Many UK corporates also forced to access the equity markets (e.g. Wolseley, CRH, Premier Foods, William Hill

etc.)• Total debt capital raising has maintained relatively constant over the past 5 years (ex. 2007 spike driven by high

volumes of bank funded M&A and PE sponsor deals)• Diversification into other funding less evident again from 2010 onwards - evidence of bank market recovery

22%6%8%5%

Further funding diversification to come in EMEA? - move toward US DCM focussed

financing model?

___________________________Source: Dealogic as at June 2011Note: Data includes all capital raising by UK corporates i.e. IG & HY, excl. FIG

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Corporates who continued to rely on the bank market were forced to accept lower liquidity and higher pricing

Evolution of the Loan Market over a Cycle

0

50,000

100,000

150,000

200,000

250,000

300,000

Q1-07 Q2-07 Q3-07 Q4-07 Q1-08 Q2-08 Q3-08 Q4-08 Q1-09 Q2-09 Q3-09 Q4-09 Q1-10 Q2-10 Q3-10 Q4-10 Q1-11

US$m

0

50

100

150

200

bpsVolume A BBB

Pricing and volume dynamics over a cycle

• Characterised by benign regulatory environment, robust bank capital levels and resultant high market liquidity

• Drove highly favourable market conditions for borrowers, and high volumes as corporates took advantage of:

– Availability of tenor: 5-7 years

– Pricing lows: fully drawn margin in mid-20bps range

Average Cycle BBB pricing = 98bpsAverage Cycle A pricing = 72bps

Pre-Crisis Peak Crisis 2010 - Today• Loan pricing begins to increase to mirror

increase in bank funding costs• Volumes fall sharply in response to higher

pricing– Borrowers ceased discretionary

refinancings– Acquisition and drawn funding met

by debt capital markets• Further consolidation in highly fragmented

European bank market• Volumes remain subdued on both supply

and demand side• Bank capital raising and low volumes

(asset run off) repair balance sheets

• Bank capital raisings have repaired balance sheets

• Capital supply/demand imbalance develops: available capacity but supply remains low as pricing remains elevated

• Leads to competitive market behaviour to win business, and drives downward pressure on pricing

• Volumes begin to recover as (i) discretionary refinancing can no longer be postponed and (ii) pricing appears to be stabilising

Average Volume = $180bnAverage Pricing = 29 / 40 bps

Average Volume = $100bnAverage Pricing = 116 / 153 bps

Average Volume = $163bnAverage Pricing = 70 / 101 bps

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The profile of loan market tenors changed significantly during the crisis, although today appears to have returned to pre-crisis norms

Impact on Loan Market Tenors

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

2005 2006 2007 2008 2009 2010

%

< 1 Year 1 - 3 Years 3.1 - 5 Years 5.1 - 7 Years

EMEA investment Grade Loan Tenors

• Historically, a range of tenors up 7 year tenors were available for strong investment grade borrowers

– 5 years more normal, although corporates used a range of tenors, particularly to fund acquisitions

• Given capital sensitive environment , longer maturities were unavailable for even the strongest borrowers during the financial crisis

• Return of tenor despite inflationary capital impact of Basel III

– Testament to relative health of European bank balance sheets

• More limited post credit crisis examples of >3 year tenor for crossover and sub-investment grade borrowers owing to capital consumptive nature of sub-IG exposure under the Basel II regulatory capital regime

• Today’s loan market conditions are generally supportive of corporate refinancings

Loan Market Tenors

___________________________Source: Dealogic and Barclays 6

Current competitive pricing supported by strong technical factors, whilst structural changes in bank market and wider macroeconomic events of increasing concern

• New rules on liquidity buffers via LCR and NSFR

• Additional requirements to maintain ‘liquid’ assets costly to banks

• Higher cost for undrawn lines?

• LMA lobbying ongoing

Where Next for the Loan Market?

Regulation Increasing cost of liquidity

Cost and availability of bank funding

Return of risk aversion? – uncertain macro outlook

Buoyant market sentimentStrong technical factors

• Renewed volatility and deterioration of some credit indicators

• Dampening of sentiment, as evidenced by Central Bank lending surveys?

• Cost of bailouts and contagion?

• Additional exogenous shocks in macro and geo-political environment

• Threat of double dip?

• More expensive capital model for banks

• New regulation directives yet to be ratified at local level

• Impact of super-equivalence?

• Impact of future bank stress tests?

• Further capital raising by European banks to come?

POSI

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• Asset run off as borrowers refinance with smaller facilities

• Limited M&A financing to date

• Bank lending budgets up 20% on average for 2011

• Success of loan transactions in past 12 months

• Relationship lending proving to be resilient with careful management of banks and capital ask

• Withdrawal of Government support schemes

• Eurozone “debt crisis”

• Costly liability extensions, as imposed by regulators

• Elevated bank funding costs for >2 years – a long-term ‘shift’?

• Securitised markets yet to recover

Loan market pricing, liquidity and execution risk

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• Cash/working capital

• Bank Debt

• Public Debt

• Private debt

• Asset Finance

• Hybrid

• Equity

Sources of Liquidity haven’t changed

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• Many corporates got ‘burned’ during the crisis

• Liquidity management is key

• Corporates are refinancing earlier to avoid running up against maturities– 2 -3 years prior to maturity not uncommon

• Corporates have increasingly diversified funding sources– Debt Capital Markets a more important part of the funding mix

• De-levered balance sheets and increasing cash piles are more common as corporates seek to more actively manage their liquidity position

Lessons Learned?

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• No quick fixes

• Understand business “rhythm”

• Align capital structure with business strategies and growth opportunities

• Consider the full spectrum of the capital structure when considering financing decisions

• Make financing decisions from both a strategic and tactical perspective

• Recognise that liquidity is king

• Maintain optionality

• Communicate regularly with past, current and potential capital providers & rating agencies

• Engage (and debate) with banks on structuring, not only execution

What do ‘Best in Class’ Treasurers / CFOs do?

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Disclaimer

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• Cashflow forecast – lift up every “drain cover”

• Engage on multiple fronts – don’t listen to just one advisor

• Learn from past – don’t assume crisis lasts forever

• Embed within business concepts of cash & liquidity – the company does not have a blank cheque book

• Secure liquidity even if it is not yet required – the early bird catches the worm

• Ensure the Board is up to speed and able to respond quickly – markets open and shut extremely quickly

Managing Through Crisis