An investor who is already a shareholder would take into account not only the return on new investment but also the impact on the overall profitability of the company in which capital is injected.
Update on Temporary Framework:
Number of approved and published covid-19 measures, as of 14 August 2020: 252*
Legal basis: Article 107(2)(b): 27; Article 107(3)(b): 211; Article 107(3)(c): 20
Four Member States have implemented 15 or more covid-19 measures each: Belgium, Denmark, Italy & Poland.
– Average number of measures per Member State: 9
– Median number of measures per Member State: 11
– Mode number of measures per Member State: 6
* Excludes amendments to previously notified measures
Under the rules of the Directive on Bank Recovery and Resolution [2014/59], a public intervention that is classified as “extraordinary public financial support” automatically leads to the classification of the beneficiary bank as “failing or likely to fail” which then triggers either its resolution or liquidation. There are only two exceptions to this outcome. The intervention is not classified as extraordinary public financial support because it conforms with the market economy investor principle [MEIP] or the intervention aims to improve the liquidity or strengthen the capital base of a bank which is solvent.
In early 2019 Romania notified the Commission of its intention to recapitalise state-owned CEC bank. The total assets of the bank amounted to RON 29 billion [EUR 6.2 billion]. Although it was only the 7th biggest bank in Romania in terms of assets, it had the largest branch network in the country. The recapitalisation would inject RON 940 million [EUR 200 million] with the state remaining the sole shareholder.
Romania also submitted a detailed business plan based on the cost of equity [CoE] estimated at 10-12%. [The precise number is a business secret] The CoE was calculated according to the Capital Asset Pricing Model [CAPM] that included a risk-free rate, a country-risk premium, a beta coefficient estimate for the bank and an equity market risk premium. The business plan examined two base scenarios [base scenario without capital increase and base scenario with capital increase] and two adjusted scenarios reflecting different assumptions about the business environment with and without the capital increase.
Since the projections of the business plan showed that profitability would increase with the capital injection and that the return for the shareholder would exceed its costs of capital, Romania considered that the investment would conform with the MEIP and notified it only for purposes of legal certainty. The Commission, in decision SA.53869, found that indeed the recapitalisation was MEIP compliant.
Application of MEIP to an investor who is the sole owner
In examining whether the capital injection would constitute State aid, the Commission focused its analysis on whether an undue advantage would be granted to CEC Bank.
The Commission began its assessment of whether CEC would receive a non-market advantage by recalling that “(59) the EU legal order is neutral with regard to the system of property ownership, that is, it does not prejudice the right of Member States to act as economic operators. However, under EU State aid rules, it is necessary to assess whether economic transactions carried out by public bodies (including public undertakings) are in line with market conditions, so as not to confer an advantage on its counterpart. This principle has been developed with regard to different economic transactions. When public authorities make injections in the capital of a given undertaking, the Commission examines whether the State’s behaviour in making the investments under consideration was in line with the Market Economy Investor Principle („MEIP“).”
“(61) In the present case, the Commission has used a methodology that primarily relies on a set of relevant quantitative indicators to assess the profitability of the Bank and the return on investment made by a potential market economy investor through the capital injection.”
“(62) To assess its profitability, the Commission would generally consider the RoE [return on equity] that the Bank can generate over the Business Plan period. As the RoE reflects the maximum cash that an average investor holding the Bank’s shares would obtain, a bank is generally considered profitable if it can generate enough profits to adequately remunerate its shareholders by the end of the Business Plan. Concretely, this means that the Bank’s RoE needs to be higher than its specific CoE by the end of the Business Plan, i.e. in 2023. However, that approach alone does not take into account the specificities of the investment and does not provide the return which is specific to the Romanian State as the sole and existing shareholder of the Bank.”
“(63) Regarding the return on investment to be made by Romania, as mentioned in the Notice on the notion of aid, [paragraph 102] the Commission has assessed the recapitalisation on the basis of common financial metrics such as the IRR [internal rate of return]. As the Romanian State is already the sole shareholder of CEC and will remain so after the capital injection, the IRR calculation needs to take into account this prior exposure of the Romanian State and consider the counterfactual without the capital increase. [paragraph 106 and 107 of the Notice on the Notion of Aid] To assess whether the equity investment is made on market terms, the marginal IRR, stemming from the difference between the capital increase scenario and its counterfactual without the injection, must be higher than the normal expected market return, i.e. the Bank’s CoE.”
There is a lot of information that is compressed in this paragraph. It needs to be unpacked so that its significance can be properly understood. The fundamental condition for profitable investment is that the internal rate of return [IRR] exceeds the cost of equity or, more generally, the cost of capital. The IRR is the discount rate at which the net present value [NPV] of the future stream of revenue becomes zero. The NPV is the total revenue minus the total operating cost of the investment. If the IRR exceeds the financial cost of capital, it follows that a lower discount rate will lead to a positive NPV, implying that the investment covers all its costs, operating and financial. For example, if the cost of capital is 5%, EUR 100 invested in an activity which, in a year’s time, generates revenue of EUR 205 and costs of EUR 100, will lead to a net revenue of EUR 105 which will be sufficient to return the EUR 100 to the investor plus a profit of EUR 5 [which represents a cost to the company invested in].
In this paragraph, however, the Commission makes another important point. Since the Romanian state is already invested in the CEC bank, it is also necessary to consider what is likely to happen to its existing investment if the new investment is not made. The following simple example shows that it may be rational for Romania to make the investment even if by itself it does not appear to cover its cost of capital.
Assume that the revenue generated by the project is only EUR 203, instead of EUR 205. If the costs linked to the investment remain the same and if the new investment has no impact on the remaining operations of the bank then the net revenue is EUR 103 [= 203 – 100]. The investor will not undertake the project because net revenue of EUR 103 discounted at 5% leads to EUR 98.1 [another way to express this is that EUR 98.1 invested at 5% results in EUR 103]. Although the project shows an operating profit of EUR 3, the IRR is 3% [103/(1 + IRR) – 100 = 0] while the cost of capital is 5%. If the financial costs are also taken into account the projects makes a net loss of EUR 2.
But now assume that without investing EUR 100, the remaining operations of the bank are affected and the investor incurs a net loss of EUR 10 on its existing investment [e.g. in the case of the CEC bank, it may be necessary to improve its branch network to make its services more attractive to customers]. This means that by taking into account what happens without the new investment [i.e. the counterfactual of – EUR 10], the derived IRR [103/(1 + IRR) – 90 = 0] is 14% which far exceeds the assumed cost of capital of 5%. So the investor should undertake the project even if, seen on its own, it appears to be unprofitable.
Then the Commission added that “(64) on top of quantitative considerations, the MEIP assessment by the Commission also takes into account all relevant circumstances of the case at hand. This notably means that qualitative aspects can underpin the conclusion stemming from the quantitative indicators.”
The Commission’s quantitative analysis was based on the following points.
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Cost of equity
The Commission considered “(65) the [10-12]% CoE to be in line with CEC’s risk profile. The figure reflects (i) the current level of interest rates in Romania; (ii) the country-specific risks of investing in Romania’s equity market as well as the low risk-profile of the Bank (simple business model and adequate capitalisation). In particular, the Commission views that the country-risk premium added in the CAPM appropriately reflects i.a. the judicial, legislative, fiscal and regulatory risks which a market economy investor would be exposed to in Romania. The Commission also positively notes that the specific risks rely on parameters empirically determined by an independent expert contracted by the Bank.”
“(66) The Commission acknowledges that the [10-12]% CoE is an appropriate benchmark that reflects the opportunity cost of investing in the Bank’s equity. In general, the Bank would be considered profitable enough if the RoE is above the CoE by the end of the Plan. However, to better take into account the specificities of the present equity investment (notably the fact that Romania has been the sole shareholder), the Commission would consider instead that the MEO test would be met if the IRR is above this bank-specific benchmark.”
Assessment of the contingencies in the business plan
The objectives of the business plan were as follows:
- Keeping the bank’s prudential metrics at the levels recommended under European and national regulations.
- Maintaining a position in the top 7 banks in Romania.
- Improving the bank’s profitability and its efficiency.
- Digitalising the technological platforms to become a modern bank.
A business plan must be credible by making realistic assumptions about future policy, market and technological developments.
“(69) The Commission notes that the Business Plan is based on prudent macroeconomic assumptions which stem from the October 2018 forecasts made by the IMF for Romania.”
“(80) Overall, the Commission considers that the base-case scenario [base scenario with investment] is realistic. The assumptions are in line with projected developments concerning the Romanian market and do not foresee a significant growth of CEC’s market share (in terms of total assets in the domestic banking sector). … The RoE [in this scenario] is projected to be 9% in 2023.”
A credible business plan also takes into account the impact of deviations from expected trends.
“(81) The Commission positively notes that the further adjustments made to the Business Plan as embodied by [the adjusted scenario with investment] reflect additional execution risks that a prudent market economy investor could expect:
a) A downward adjustment to the interest rates of corporate loan. […]
b) A further increase of deposit rates for individuals to stick to the average rate of CEC’s peers. […]
c) The issuance of […] to fulfil the final MREL requirement of RWA already in 2023, the final year of the Business Plan. […]
d) A higher interest rate for […] envisaged for building up the MREL buffer. […]
e) A lower fee income generated by unit of loan and deposit. […]
f) A higher annual growth rate of the average staff costs per FTE.”
“(82) The Commission notes that [the adjusted scenario with investment] provides a situation where all execution risks would be materialising simultaneously in all years of the execution of the Business Plan. The Commission considers this scenario to be very conservative. Under this scenario, the Bank would expect a net profit of RON [150-200] million and a RoE of 4.9% in 2023.”
“(84) While the RoE in [the various scenarios] is below the CoE, that approach based on RoE does not sufficiently take into account the specificities of the investment and does not provide the return which is specific to the Romanian State as the sole and existing shareholder of the Bank. A market economy investor that already has prior exposure to a company will consider the incremental return that it will obtain from its investment and not merely look at the RoE of the bank.”
The overall return on the investment
“(85) The Commission considers that assessing the investment made by the Romanian State based on a marginal IRR is appropriate considering the nature of the transaction.”
“(87) The Commission is of the view that a market economy investor would mainly consider the base-case Business Plan (Scenarios 0 WITH & WITHOUT) while also looking at Scenarios 1 & 2 WITH and Scenario 1 WITHOUT, which better incorporate the execution risk.”
“(89) In such a context, the IRRs stemming from Scenarios 1 & 2 WITH and Scenario 1 WITHOUT with the Romanian assumptions on growth rate and CoE constitute a prudent estimate of the return a market economy investor could obtain. As the Commission is of the view that a market economy investor would also consider in its assessment a more conservative scenario (as reflected in both Scenarios 1 & 2 WITH and Scenario 1 WITHOUT), applying the DDM methodology would yield an IRR in the range [20.2% – 30.7%], i.e. well above the Bank’s CoE of [10-12]%.”
“(92) Overall, the Commission notes that the IRR is above the CoE of the Bank in all scenarios of the Business Plan, even in the most conservative scenarios that a market economy investor could consider in its due diligence. In addition, the Commission also positively notes that the IRR remains above CoE in all standard methodologies used to compute it.
Conclusion and a quibble
On the basis of the above considerations, the Commission concluded that “(93) CEC could obtain the same capital injection from the market and therefore, the recapitalization by the Romanian Government is in line with the MEIP. As a consequence, the capital injection does not grant an advantage to the Bank.”
I think that the Commission proved in fact that even if the market would not provide funds to CEC, it could still be rational for an existing shareholder to invest in CEC. Therefore, in this case it would have been more instructive if the Commission had stressed that even if a market investor would not inject capital, a private investor in its capacity as the sole shareholder would be willing to provide fresh capital.
 The full text of the Commission decision can be accessed at: