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Finance for the P&P industry can be obtained in a number of ways, even in the emerging markets of Asia. But you have to know where to look
By David Allwood
Taking a look at Asia’s financing options
The pulp and paper industry has often been criticized for not providing adequate returns on investment. For that reason, many companies are now starting to focus sharply on boosting shareholder value. Despite the industry’s risky reputation, there are still some investors out there willing to put their money into pulp and paper companies. In fact, there may be more options open to the industry than most companies are aware, particularly in the financially stricken parts of Asia. The following roundup of financial options reveals that the door to finance is far from closed to pulp and paper companies.
Traditionally, the financial instruments used by most companies have been equity and debt. Equity was provided by the owners of the company and debt came from the bank. Nowadays, the situation is much more complicated and the options are far more wide-ranging. The three main types of capital available to pulp and paper companies are senior loans, portfolio equity and venture capital (see box).
The main types of capital in the paper industry
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| Senior loans are normally secured on the assets of the company or, in some cases, on a reliable cash income stream. Interest and principal repayments are made on a regular basis from the company cash flow and the term of the loan is usually between 5-10 years. Defaulting on an interest or principal repayment can result in the lender taking over the company’s assets. This level of security means that the lender is exposed to a low risk level, but equally, the lender can only obtain relatively low returns.
Portfolio equity is an investment in the ordinary shares of a company that is listed on one or more stock markets with a high degree of liquidity. Returns to the investor come in the form of dividend payments and the increase in value of the shares between the purchase and the sale. As the shares are freely traded the investor can buy and sell at any time, but there are no guarantees of either dividend payments or share price increases. As a result, the investor is exposed to the full business risk and expects high returns as a means of compensation. The investor can exit the business at any time though. Senior loans, followed by portfolio equity, are the cheapest ways of raising capital for companies with good security and/or a track record of profitable operations.
The third option open to companies is venture capital. This idea was developed in the USA and Europe to meet the needs of business situations that are inherently risky, but offer high potential rewards. Typically, the investments are long term (over five years) and are difficult to sell, since the shares are not quoted on a liquid stock market. Although the expected returns are high, they are also very variable. A venture capital investment may be in the form of ordinary shares, but due to the problems of exiting from these, it is frequently in the form of preferred ordinary shares, preference shares, convertibles or unsecured subordinated debt. These latter instruments are usually referred to as mezzanine or quasi-equity. Although they usually provide some return to the investor from the company cash flow, they all carry the full equity risk for the initial period of investment.
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Asian availability
In Asia, pulp and paper companies can access these three types of capital from a number of sources. Firstly, there are the local banks. These institutions provide loans, usually in local currency, which are either secured on the company’s fixed assets (for senior loans) or the moveable assets (for working capital finance). The term of the loans is usually fairly short and interest rates are comparatively high.
Development finance institutions and international banks also provide senior loans which are often denominated in dollars. Repayment periods are quite long (7-10 years) and interest rates comparatively low. In this case, a currency devaluation could cause difficulties as the loans are dollar-denominated. Some development finance institutions and international banks also provide small quantities of venture capital, but this is not their main business.
Another source of finance is the powerful American, European and Japanese leaders in the pulp and paper industry. These companies are increasingly keen to invest outside their home markets. Their preference is for portfolio equity so that they can exit at the first sign of trouble, but in some circumstances companies are prepared to invest through venture capital. The objective for making the investment may not be for simple financial return, but usually forms part of a long term strategy. In contrast, the sole objective of a private equity fund is financial return. Due to the nature of the companies or local stock markets, investors offer venture capital largely in the form of quasi-equity and they are usually looking for an exit in five to seven years, if not sooner.
Cautious moves
Investors do not leap into such ventures without looking first though. They take some common factors into account when assessing a company for potential investment. First of all, the enterprise must be commercially viable. No-one wants to back a company that fails only a few years after an investment. Secondly, many investors look for companies that run environmentally acceptable operations. For many investors in the pulp industry, this means that a company needs to use ECF (elemental chlorine-free) technology in the bleaching process, or even TCF (totally chlorine-free) bleaching. This requirement is not due to pressure from environmental organizations or any moralistic view, but it is a commercial necessity for any business aiming to be sustainable in the long term.
As the world market continues to open up and customers are provided with more choice and information, paper made from chlorine bleached pulp has been rejected in favor of ECF or TCF products. Pulp and paper suppliers using chlorine have been forced by the market to offer heavy discounts and then eventually to invest in newer technology simply to continue operations. Today, there is no point in investing in companies which have not already planned to upgrade to more environmentally friendly technology. Many investors use the World Bank Pollution Prevention and Abatement Handbook as a reference guide for the standards that they expect companies to achieve.
A more recent phenomenon is the consideration of social issues, but the importance attached to this factor varies widely among the investing institutions. Investors are looking for companies that actively involve the local community as well as the employees. Many investors also require some degree of consultation so that all stakeholders are given the opportunity to contribute to the long term viability of the company and to benefit from its success.
There are also additional conditions that need to be met, depending on the type of investment. For banks and traditional development finance institutions (DFIs) providing senior loans, the main concern is the availability of assets on which to secure the loan. This is in the belief that, even if the enterprise fails, recovery of the funds invested will be possible through the sale of the assets.
Traditional DFIs might also be prepared to use their low cost finance to compensate for weak management or a second rate business proposition with the aim of being developmental. At one time, the Commonwealth Development Corporation’s (CDC) mandate from the UK government was only to invest in projects that were unable to attract private capital. This is no longer the case, though, and the government now expects the CDC to achieve development through investment of venture capital. Added to that, some DFIs and all export credit agencies are required to support their local industry and capital availability may be tied to the use of particular suppliers.
Industry leaders often look for different conditions as well. In such cases, investment is often a first step toward establishing a major presence in the new region. For example, pulp and paper companies may be looking for new markets in Asia for their existing production capacity by buying into a company with a good distribution system. Or they may be looking for a similar product range with lower production costs for their home market. Either way, companies usually offer to provide some assistance in the management of the company they are investing in and may eventually expect to take control.
The prime objective of private equity funds is the return on their investment. Although they are prepared to share the business risk, they try to minimize this by only investing in companies that have excellent management. They also encourage alignment of interests of all the shareholders and motivation of the management through participation in the ownership of the company. Since a large part of the financial return to the private equity fund comes from the increase in value of the shares it owns, the fund needs to exit from the investment in order to realize this capital gain.
Advance Agro is one of the companies that CDC has supported financially
Venturing out
Venture capitalists also have a long list of conditions that need to met before they commit any capital. Whatever the industry sector, there are several key principles for the venture capital industry:
- back excellent management with a good track record
- ensure management is focused and committed
- align financial interests
- base entry price on actual performance rather than future prospects
- agree plans for the eventual exit in advance.
Many venture capitalists maintain that the most important factor to consider when accessing any potential investment is the management. It is essential that the management team is highly competent, know their business well, and have many years of experience. Beyond this, venture capitalists also look to increase the motivation of the management team by linking their remuneration to the long term performance of the business. This is most easily done by providing the management with stock options. In addition to providing motivation, the system encourages managers to stay with the company in order to reap their rewards and also puts the interests of the managers in line with those of the shareholders.
The valuation of a company is always a difficult discussion and a compromise must inevitably be found in this type of investment. The existing owners will wish to include the wonderful future cash flow that they are confident of generating, while the investor will start by looking at the performance of the existing company. The future income stream is only made available for everyone through the investment and the investors should receive at least the same benefit as everyone else.
Since the relationship between the existing owner and the investor will never be one of identical partners with identical rewards (one is the managing partner, the other is the financial partner), part of the valuation is usually based on the future business. Existing owners must be prepared to accept heavy discounting of this income stream since, in reality, it is based on hope and faith in their ability to predict the future rather than concrete facts.
It is essential that both partners in this relationship understand the long term objective of the other. The managing partner must understand that the financial partner will eventually need to exit. Experience to date has shown that by discussing and agreeing on the process early in the relationship, the eventual exit has been accomplished smoothly.
In the pulp and paper industry, there are several features that investors look out for that are key to a company’s success:
- access to long term, low cost raw materials
- efficient process technology
- product appropriate for market
- efficient distribution system
- financial structure suited to cyclicality of industry.
Many of these factors are common to all production industries - such as access to a sustainable supply of low cost raw materials and efficient operations. The pulp and paper industry is different in one important way though. To date, producers have been unable to control the industry cycle and, while in some bizarre way the rollercoaster ride of peaks and troughs may be enjoyable, companies need to ensure that they can withstand the exposure to this particular stress.
Many industry analysts point to the recent period of price stability, which appears to have been a prolonged trough, and the increasing level of consolidation between many of the major players as a positive sign. But there is little evidence yet that the industry will not return to the four year cycle that it knows so well. This is where the use of venture capital can be extremely important.
Whereas senior loans are very rigid in their service requirements and pure equity is considered too risky for many investors, venture capital instruments can be tailored to meet the specific needs of an individual business. The venture capital provider may be prepared to forego dividends during the troughs in the cycle provided that there is compensation by means of a good dividend stream during the peaks.
One example of this would be a subordinated loan to a pulp producer for which the dividend coupon was tied to the market price of pulp. At low pulp prices, the coupon would be zero, while at high pulp prices the coupon would be high. As a result, the company would only be required to pay the coupon when it could afford to do so and the overall dividend yield would be acceptable to the investor.
It is time that the investor community played a more significant role in determining the future of the pulp and paper industry. For this to happen, the current owners and managers must accept the role of financial partners in the pulp and paper industry’s future. At the same time, venture capital investors must ensure all risks are balanced by appropriate rewards. The financial partners should make full use of the flexibility of the venture capital instruments to ensure that all partners obtain rewards that are commensurate with the risks that they are taking. In this way, the pulp and paper companies will have access to much needed capital, but at the same time they will manage to keep their investors happy.
David Allwood is the director of Paper and Forest Products at the Commonwealth Development Corporation (CDC) in the UK. Prior to this appointment, he held various positions in the paper industry within R&D, corporate engineering and mill management
Case by Case
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| Looking at three cases in the pulp and paper sector that CDC has analyzed, it can be seen that different types of capital are appropriate, depending on the type of company and product. The first example is a typical southeast Asian, fully integrated fine paper producer. The business is focused on the export market and has a product of world class quality. The vast majority of the fiber comes from local plantations that are sustainable in the long term and very close to the mill site. The operations are on a world scale to ensure all the economies of scale are available and the latest technology is used to ensure that the product is acceptable in every market.
This company is in a very strong position with an operating cost level that puts it among the lowest cost producers in the world. It also has a dollar income from exports, while most of its costs are in the local currency. The dollar income stream means that the company is able to benefit from low interest rate dollar denominated loans and has ample assets with which to provide security. Devaluation poses no threat as it has local currency costs and dollar income. The cheapest source of capital is therefore senior loans.
But the last two years have demonstrated the danger of taking on too much debt, which carries with it the obligation to make interest and principal repayments on a regular basis, whatever the state of the world market. Following senior debt, the next most appropriate form of capital is portfolio equity. The company has issued shares on a major international stock exchange, giving it access to some portfolio equity.
Despite its world class operations, worldwide overcapacity means that the company is finding some problems in maintaining its share price. This means that additional funds cannot currently be easily raised through this instrument. As a result, it must turn to private equity funds if it is in need of additional capital at this moment.
In a box
The second example is typical of an east Asian company producing high quality containerboard. Until two years ago, the company’s market was growing rapidly due to the manufacturing strength of the region, but sales were mainly in the domestic market. The vast majority of the company’s fiber comes from imports of wastepaper, including old corrugated containers (OCC), and unbleached kraft pulp. The operations are on a medium to world class scale and the latest technology is used.
Since the imported fiber needs to be paid for in dollars and the group’s income is in local currency, it is important for this company to minimize its other dollar commitments. It should therefore look to local banks to provide the senior loan portion of the funding. Sometimes this can be facilitated by the provision of a guarantee for this loan by an international financier.
Although the company may be quoted on the local stock market, in many cases trading in shares is very thin and the funds that can be raised through portfolio equity are restricted. This is where the private equity funds can have a big part to play. The venture capital invested in this type of enterprise may be in one or more of the following instruments - ordinary shares, preferred ordinary shares, preference shares or subordinated loans.
These are all considered to be equity style instruments, because at the moment of disbursement the level of risk is the same. There is no guarantee that any of them will generate a dividend stream or that the original capital will be recovered. They are all dependent on the good performance of the business in order to generate their expected returns.
In Europe, private equity funds usually make investments using a combination of these instruments. The current favorite blend is a combination of preferred ordinary shares and subordinated loans.
Question of size
The third Asian example is a small, family run business producing printing and writing paper for the domestic market. The product quality is suited to the domestic market and the fiber comes from local production (bamboo, bagasse) and a small amount of imports. The operations are relatively small scale and the technology is by no means the very latest.
For this type of operation the potential devaluation of the local currency means that the company cannot risk the commitment to dollar denominated debt. Similarly, it is very unlikely that the company would have quoted shares on a liquid stock market.
This type of company must therefore look to local banks and venture capitalists for funding. But any private equity fund is going to be very wary of investment by means of ordinary shares or even preferred ordinary shares as the opportunity to exit through an eventual stock market flotation or through a trade sale is likely to be very limited. As a result, high yielding preference shares will probably be the only option, and even then the investor will be looking for a very high level of commitment from the existing owner/managers.
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