Financing innovation during a credit crunch

We spend a lot of time discussing the need to cut Government debt. While this is legitimate, we keep forgetting that in every 6 SMEs in Portugal, one has failed its debt repayment or interest payment obligations.

If you think that companies are adjusting to the crisis by reducing their debt, think again. The debt/GDP ratio for private, non-financial companies was on the increase until 2012 and only recently has there been a change in this trend.

Debt of non-financial private companies in Portugal as a % of GDP, 2009-2013. Source: Bank of Portugal (2014)

The difficulty here is that this lack of credit creates a bottleneck for the financing of innovative projects. The credit market has been affected by the economic crisis. The main problem of the commercial banks is to restrict the concession of credit at all costs, to manage their loan portfolio. This means that innovative companies are unable to get access to bank credit to finance their expansion. It is difficult for the banks’ existing clients to draw credit, let alone for new projects which are inherently risky.

Sources of financing for a sample of start-ups based in Lisbon (2014). Source: Macrometria

In a recent survey, Macrometria found that bank financing accounts for 2.8% of total financing sources for a representative sample of start-ups in Lisbon. As banks seek to cut their credit exposure, and existing funds are used to re-finance over-indebted companies, the true losers are start-ups and ultimately, innovation itself.

On the other hand, bank debt is not being used to finance start-ups and this can be seen as a positive. The current business culture relies excessively on debt. The next stage of recovery will be sustainable if companies learn how to grow using equity. If the excessive levels of debt as a source of financing were one of the reasons for the anemic growth of the last decade.

Way over budget

The Portuguese Government’s 2014 budget is being discussed in the so-called “specialised” committees in parliament. The budget approval process consists of 3 steps: first, a “big picture” version of the budget is approved by Parliament- this was done at the end of October. Second, representatives of parties with a seat in the National Assembly discuss the budget in more detail. The representatives are organised in various committees (the so-called commissions) which are mandated to discuss specific themes. This is underway. This coming week, the National Assembly will again cast its vote on the budget, following its review by the parliamentary commissions. This last step is largely pro forma.

Embed from Getty Images

In practice, this means that the true political decisions are made at this stage, within the various parliamentary commissions. The process is relatively opaque, which gives politicians some leeway to do their job. Negotiations are often disguised as technical arguments, with each party using an army of lawyers to bring some credibility to what is largely a political debate.

PS, the main opposition party, has put forward several proposals which are small and have no real economic impact on investors or economic growth. Sentiment seems to be that PS does not really have any alternatives to the austerity measures which are being put forward by Government.

Yet there are alternatives. While the 2013 budget was largely about raising taxes and getting more income to service debt, this one is about cuts in expenditure. The cuts are being carried out essentially via reductions in wages and pension obligations. Very little is being done to improve the efficiency of Government’s consumption. Specifically, Government could use electronic procurement platforms to optimise public spending. The gains in efficiency could be real. Various proposals have been put forward in this direction, none of which seem to have been taken into account.

This budget represents another lost opportunity to improve the State’s efficiency. The Portuguese State is like a huge tanker which follows its course. Trying to steer it takes extremely long and the only way to reduce costs seems to be via cuts in wages and pensions. Any attempt to improve its efficiency seems to be futile.

Leonardo da Vinci, innovation and execution speed [story]

It is not easy to write about Leonardo da Vinci, a man of genius. Various serious authors (i.e. more qualified than me) have written about him. Here are some notes following a visit to an exhibition at the Accademia in Venice.

Leonardo was perhaps the original Renaissance Man, highly competent in a variety of disciplines, from painting to engineering. His technical notes, much like his paintings, are both detailed and beautiful. He was incredibly advanced for his time – we are talking about the 16th century.

Leonardo used analysis and research to solve a variety of problems, both artistic and scientific. As a trained artist, the observation of reality was one of his priorities. He was also fascinated by mathematics, which formed the basis of his investigations.

It was interesting to find out that he was rather slow in execution. This infuriated some of his patrons. One of the most famous episodes is Leonardo’s horse, a sculpture commissioned by Ludovico Sforza, Duke of Milan. It took Leonardo 7 years to produce a clay model. By that time, the French had invaded Milan and ousted Sforza. French soldiers ended up destroying the model.

The conventional wisdom is that Leonardo was not particularly concerned with producing results but rather with tackling difficult problems. However, it could have been the other way round: the world around him was not sufficiently organised to channel his creativity, or his sponsors were too impatient to invest in what you would today label as R&D. There are other, more elaborate explanations for Leonardo’s behaviour, namely a psychological analysis by Merleau Ponty which suggests that Leonardo had a deep-rooted problem with authority.

While da Vinci was clearly a genius, today’s innovators are likely to share a number of traits with him, including the drive to solve problems in a new way. But innovation and speed of execution do not always go hand in hand. Specifically, product development often takes longer than expected and shareholders are impatient by nature. There is evidence that in the case of quoted companies under intense analyst scrutiny, managers feel pressure to meet short-term goals and invest less in long-term innovation projects. These managers are not slackers, they just tend to get more cautious when the amount of scrutiny increases. The other side of the equation is that equity research analysts are often knowledgeable about an industry but do not always understand the mechanics of innovation (to put it mildly).

From this perspective, the world has not changed much in the past 400 years.

Related articles

• Leonardo da Vinci: a different mind (criticalthinking8.wordpress.com)

 

Innovation, nonconsumption and the Portuguese education system [barrier]

The recently published IMF report on Portuguese public sector reform (“Portugal: Rethinking the State—Selected Expenditure Reform Options”) lists several reform options and advice based on country data and comparisons to international standards. The comparison is drawn mainly with EU15 countries, which is a sub-group of countries in the EU comparable to Portugal.

While innovation is not directly mentioned in the report, some of the measures suggested are really about process innovation. In the private sector, process innovation is constantly used to gain a competitive advantage in the marketplace and to create wealth. In the public sector, process innovation should be used as a tool for creating efficiencies in government organisations, which lead to better services for the public.

In his article “Why Innovation Matters In Politics And The Public Sector”, Faisal Hoque approaches innovation in the public sector with business and financial concerns that are basic and widespread in the private sector. Return on investment, risk management, technological innovations and efficiency are essential for the success of any company and should also be a concern of Government officials and managers when investing public funds in critical sectors such as health and education.

In the education sector, the IMF identifies a serious inefficiency in the management of schools. The IMF’s analysis reveals that there is over staffing and that career progress for teachers is based solely on seniority. Schools have very limited management leeway and in fact cannot choose whom to hire. Can you imagine a company being managed without the ability to choose its own staff? This is what happens in this case: every year, a number of teacher positions become vacant nationwide. Teachers apply and the choice is made based on seniority.

Taking a step back, a useful concept to describe the failures of the Portuguese education system is nonconsumption, which describes an area which appears unattractive to the companies or institutions that offer a service and where at the same time, some people would like to do something but are unable to get access to the available offering. At first sight, there are no obvious areas of nonconsumption in education: everyone is required to attend school up to a certain age. However, if you look deeper, you will probably find that a large proportion of Portuguese students simply do not manage to reach higher education, although they would like to, because they failed to grasp the more basic concepts between ages 12-18. This is the crucial problem that needs to be addressed. The first step towards solving this problem is to place motivated and capable teachers in front of those students that aspire to attend university but do not have the means or the background to do so. This is simply not achievable if the schools cannot differentiate between teachers based on their competences.

These problems have plagued the education system and seem to have flown under the radar screen of previous (and numerous) reforms of the education system in the past. The IMF suggests a better appointment system for teachers (not only based on seniority but on competence) and a framework whereby money would “follow the student”, which would allow better teacher hiring practices and a more efficient provision of education services.

While some other measures proposed by the IMF in the report are painful, involving loss of jobs or the reduction of income for civil servants, this type of reform is really about the implementation of important and sometimes long overdue structural reforms.

Failure to launch

See on Scoop.it – Innovation and business models

Innovation is a key component of any enterprise, but failure is an intrinsic, inevitable part of the process. Most products fail, most mergers and acquisitions fail, most projects fail and most startup ventures fail.

See on www.fastcompany.com

 

Innovation and Portuguese film production [barrier]

The Portuguese film industry is an example of the difference between creativity and innovation. Portuguese films fail to attract audiences even in their home market, let alone internationally. With dwindling public funds to finance productions and fierce competition, prospects are not bright to say the least.

A total of 23 films were produced in Portugal in 2011. Ten of those had fewer than 500 viewers. The others typically achieved less than 10,000 and only a couple managed to attract audiences around 20,000. This is a dismal track record by any standard. Why were these pictures unsuccessful?

There are four stages in the innovation process: ideas, insights, invention and innovation. Everyone has ideas. If you share your idea, it may become an insight. If your insight is turned into a product (or service) it becomes an invention. Finally, if that invention is successful in the market, this makes up innovation.

"Innovation means selling tickets"

Films (or documentaries) are often based on new ideas and insights and original scripts – a product of creativity. In my opinion, the right measure for judging whether a film is innovative (not just creative) is public acceptance. If a film is creative and manages to attract large audiences, this is an innovation. Having good reviews is not enough.

Note that the reverse is not necessarily true: public acceptance does not always stem from innovation. Most Hollywood blockbusters are not innovative at all. Instead, they are based on small, incremental variations on a well-known genre. Looking at 2011 global box office results, the top 7 films are sequels.

Back to Portuguese film production, I am willing to accept that at least part of the 23 films produced in 2011 involved some creativity, new insights or original scripts. What prevented these films from reaching larger audiences? I confess that have not seen any of them, but I am willing to take a guess.

The first potential barrier is that Portuguese cinema production is State-financed, to a large extent. Both State and local authorities spend a considerable amount of cash to finance films and promote them. Financing films using public funds has various drawbacks. Among others, a committee has to decide which films are worthy of support. Decision by committee is a known innovation killer.

Another barrier is viewer education. The Portuguese population has a relatively low-level of education compared to most European countries and to draw audiences, films have to be simple – perhaps too simple. Lack of education acts as a constraint on innovation.

Foreign markets could give additional audiences but in fact, Portuguese-spoken films do not seem to be easily exportable. Brazilian audiences have to make an effort to understand the language as it is spoken in Portugal.

Hollywood studios are the dominant force in the industry, shaping audience preferences. Hollywood has developed an ability around simple films, based on familiar genres.

The difficult economic conditions and large State deficit will create more difficulties. The Government’s budget for 2012 specifically identifies cinema as one of the areas where the State will review its policy. This will almost certainly involve spending cuts.

Is there any way to overcome these barriers?

The obvious choice would be to produce films for mass consumption. However, cinema production and direction is a complex eco-system. It is questionable whether directors working in Portugal are interested in reaching large audiences. In fact, the most successful film of 2011 (in terms of audiences) was João Canijo‘s “Sangue do meu sangue“, describing the harsh realities of a family living in a slum in the outskirts of Lisbon. Tough subjects seem to be the norm.

With limited audience acceptance, reduced State budgets and strong competition, the future does not look too good for Portuguese cinema production. Yet it is essential that the industry continues to exist as it encourages pluralism, creativity and diversity.

[Updated April 2012 by Hugo Mendes Domingos]

Why are acquisition multiples a taboo subject in Portugal? (2)

In a previous post on the subject of transaction multiples, it was argued that lack of information and analysis in the Portuguese press acts as a barrier to innovation. If the media does not report adequately on the value of businesses and no one really understands what a company is worth, is there any incentive to develop a new product, break into a new market or even start your own business?

The latest instalment in this series is the EDP privatisation. We are now used to silly headlines however “Christmas sale: the German, Brazilian and Chinese all want EDP as a present” is hard to beat (source: Jornal I).

Here is a basic question on the privatisation: Are taxpayers getting a fair deal?

There are various ways to determine the value of a company. The media are obsessed about market values however, other methods such as discounted cash flow valuation are more reliable.

A simple way to answer the question without going into the detail of cash flow estimation is to use relative valuation. If you calculate EDP’s value in relative terms and compare it to similar quoted companies, you will gain a better understanding about the offers on the table.

The Enterprise Value (EV) is the sum of a company’s market value and its net debt. EV is a measure of value which can be compared to EBITDA (an approximation of the annual cash flow) and this provides a valuation multiple. So the question is: what is EDP’s EV/EBITDA multiple?

Bloomberg estimates that EDP’s Enterprise Value at current market prices is EUR 28.8 billion and its EV/EBITDA is equal to 7.9x. That should be a good enough approximation.

In the case of the privatisation, acquirers are not offering market prices for the stake being sold. Instead, a premium is being offered, relative to current market prices. The resulting EV/EBITDA taking into account reported offer values is around 8.3x.

How does that compare to EDP’s competitors? These trade at around 6.5x – 7.0x EV/EBITDA so from this perspective, it looks like Portuguese taxpayers are in fact getting a reasonable deal. As a taxpayer, I feel that I am entitled to know whether the company is being sold at a fair price, which appears to be the case.

All the other aspects of the transaction, such as the corporate governance and in particular whether the current CEO will keep his job are analysed with a great amount of detail in the press, but would it not make sense to answer basic questions first?

Why are acquisition multiples a taboo subject in Portugal? [barrier]

Whenever a UK or US newspaper reports on an acquisition, one of the most usual subjects is a short analysis of the acquisition multiples. Why is this important? One of the main questions that arises when a company is acquired is whether the acquirer paid the right price.

One of the most bewildering facts about the way journalists report acquisitions in Portugal is that price and value multiples are almost never mentioned. I really cannot say for sure why this is the case – there could be several explanations.

One explanation could be that transactions in Portugal are comparatively small and there would be limited interest in the price. But then, why bother reporting at all? Perhaps journalists simply know that, if they were to ask questions about the value of the acquisition, they would not get a straight answer.

Another possibility is that journalists cannot be bothered to calculate an EV/EBITDA multiple. The maths are not challenging… The media sector is going through a difficult phase now with cost cutting and editorial staff limitations, which may explain why there are rarely in-depth articles about acquisitions.

While multiple analysis has a number of limitations, it allows analysts to draw certain conclusions. The lack of transparency in M&A in Portugal is yet another barrier to entrepreneurship. No-one really understands what a company is or could be worth, so why bother starting a business?

Yet there are positive developments. TTR is a financial information company which focuses on providing proprietary information about global M&A transactions which involve Portuguese and Spanish companies.

Should TTR data make its way into mainstream media in Portugal, this could indirectly act as an incentive to entrepreneurship. However, newspapers and TV stations have given up on actually hiring editors and are happy to use and reuse existing news so this could prove unrealistic.

Do you think that mainstream media and particularly newspapers should focus on acquisition multiples? Or would you find it too technical?

When the yield curve indicates that a bailout is imminent [barrier]

The yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower.

The following chart shows yield curves for the sovereign debt of three countries: Portugal, Spain and the UK (all in %):



What the chart immediately shows is that Portugal is paying outrageous yields on its debt – something we all we knew already. Now let’s look at the shape of the curve. The yield curve is supposed to be upward sloping. In other words, from the borrowers’ perspective, if you borrow money for a longer period you will offer your lender a higher return (or higher interest). In fact, this is the case for Spain and the UK.

Portugal’s yield curve is now hump-shaped. A yield curve showing this shape is also called “inverted”. This means that yields on 5-year debt are now higher than, for instance, yields on 6-year debt or yields on 30-year debt. This in turn means that investors find it riskier to lend to the Portuguese Government for 5 years than for 30 years.

This is counter-intuitive and only happens in situations when investors expect a period of recession. Or in this case, a bailout (or both). As stated in the FT today (James Mackintosh explains it all in a nice video) one of the factors preventing a bailout in Portugal is pride. The yield curve for Portuguese sovereign debt is indicating that a bailout is imminent (and if that is the case, it is likely that the current Government will be replaced).

Note that Spain’s yield curve does not indicate that a bailout is imminent in Spain.

I have to confess that I am amazed at this Government’s resilience but there is of course no causality link between an inverted yield curve and a change of Government. In my mind the current Government is in the way of change at the moment – from that perspective it should be removed.

A tough measure for tough times [barrier]

First of all, I have decided to write this post in English as a number of my readers, surprinsingly, are located outside Portugal. I will start writing in English and we will see how it goes…

The issue here is the intention stated by Pedro Passos Coelho to reduce the number of Ministries (a Minister in Portugal is the equivalent of a Secretary of State in the UK).

Pedro Lains wrote a post on the subject in which he claims (to sum up) that reducing the number of Ministries is not the answer to the problem.

Reducing the number of Ministries is not a new idea. In fact, Jornal de Negócios asked its readers back in 2010 to list a number of initiatives to improve the public sector and Government and this reduction was one of the most popular measures suggested by the poll.

As you can imagine, I was never involved in merging Ministries and therefore cannot base my analysis on experience, however the decision to reduce the number of Ministers and their staff can be looked at in a rational way. The main motivation is obviously to reduce expenses. Less Ministers and Ministers could translate into a reduction in the number of Secretaries of State (which in Portugal are the equivalent of Ministers in the UK), their advisors and support staff. This is a potential cost synergy i.e. will lead to cost reductions.

There are risks associated with this reduction as well as strategic implications. There will be barriers to the implementation of this measure. Two major risks in my view are to concentrate power into fewer hands and work overflow.

Ministers are constantly monitored by Parliament. Reducing the number of Ministers would potentially lead to a greater role for Parliament. This would be a welcome change at a time when Parliament’s role and relevance is also being questioned. It would also mitigate the first risk.

Work overflow may not be an issue at all. Being a Minister, as far as I know, is not similar to being a factory worker. Whereas someone working in a production line will only produce as much in an hour, a Minister, provided that he or she is properly briefed, can take decisions relatively quickly if needed. Reducing the number of Ministers could in fact increase the Minister’s productivity and can be seen as a positive.

There are of course strategic implications. Some issues which deserve the attention of a Minister at present will get less attention. There are 14 Ministries at the moment (source Ministry of Justice and loosely translated!)

1. Defense
2. Justice 
3. Internal Affairs
4. Foreign Affairs
5. Finance and Public Administration
6. Economy and Innovation
7. Agriculture, Rural Development and Fisheries
8. Education
9. Culture
10. Science, Technology and “Upper Education”
11. Public Works, Transportation and Communications
12. Environment and Regional Development
13. Work and Social Solidarity
14. Health

In addition, Government includes the Prime Minister, the Minister of the Presidency (in charge of liaising with the President) and the Minister of Parliamentary Affairs (in charge of liaising with Parliament).

A rational and dispassionate way to look at this question would be to use similar criteria to those used when looking at the benefits of a merger between two companies. Companies merge for a number of reasons which cannot be properly detailed in a post. In this particular case, if it is felt that the end users of public services (i.e. all of us) are not getting any value from some of these 14 Ministries, then their existence can be questioned. To draw a parallel, if a company is not adding anything relative to its competitors, if it does not have any competitive advantages, it is likely that shareholders will question whether it should merge with a competitor in order to produce synergies.

The same could happen with Ministries. What is the added value of the Ministry of Agriculture and Fisheries? Did it contribute in any way to create competitive industries? As far as I know the answer is no. How about the Ministry for the Economy and Innovation? The proof is in the pudding and again the answer seems to be negative. A merger is a way not only to reduce costs but also to send a signal: if a Ministry is unable to produce any tangible results over a decade, it should be axed. I know – it is a tough measure, designed for tough times.