Black box - the net asset value discount

Written by: Arne Karlsson, January 1999

The investment company’s “raison d´être”

Here Ratos describes the reasons for the net asset value discount and the background to Ratos’s business concept.

The number of investment companies in Sweden has fallen dramatically since the beginning of the 1980s. In 1982, 30 investment companies and industrial holding companies were listed on the Stockholm Stock Exchange. Today (January 1999) only seven remain; Atle, Bure, Investor, Industrivärlden, Ratos, Svolder and Öresund.

In addition, the market has virtually throughout valued these companies’ assets – net asset value – at a discount. Buyouts or dissolution of companies have generally been the best way to free values. Does this mean that it is not at all possible to run a listed investment company in Sweden successfully? The answer to this question requires an understanding of the fundamental reasons for the phenomenon, the investment company discount – or the net asset value discount as it should really be called – since, over the years, this has also hit sectors outside the investment companies. At the time of writing, examples can be found in the forest products, real estate and building sectors, shipping companies, asset management companies and conglomerates.

Factors behind the net asset value discount

Over the years, many different explanations have been presented for the net asset value discount. However, no model or variable – taxes, trading rate in the portfolio, ownership structure, power factors, number of holdings etc – has proved sufficient to explain this phenomenon consistently over a period of time. At the same time, the net asset value discount is now, as far as Swedish investment companies are concerned, in its late middle age. This means that there must be a rational explanation to the problem. The market cannot be wrong for so many years.

In order to find a solution, the issue must be viewed from a very general perspective. A toolbox must be created which explains the phenomenon at a general level. This box contains many tools – taxes, ownership structure, number of holdings, etc. – which with a varying degree of success and different combinations can explain each individual case.

An investor who owns shares in “Black Box AB” (BBAB) is willing to value SEK 100 in net asset value in the company at exactly SEK 100 if BBAB’s net asset value consistently provides the investor’s required rate of return. This applies regardless of what BBAB contains – gold, a company, a portfolio of wholly owned companies, listed shares, bingo tickets, real estate or cargo vessels. However, the key word is consistently. BBAB must be able to produce this return year after year which means that a concentration exclusively on, for example, bingo tickets would hardly be a successful strategy.

If the investor instead owns shares in “Extra Box AB” (EBAB), which in turn is the owner of BBAB, this will have a number of consequences. The two most important are:

  • Operations in BBAB must now yield more than the investor’s required rate of return. If that is not the case, the investor – after the expenses which are linked with running EBAB (payroll, premises, taxes, etc.) – will not have obtained his required return.
  • Even if the operations in EBAB produce sufficient return to avoid the discount problem per se, EBAB must nevertheless create its own added value. If that is not the case, the investor could just as well own the contents of BBAB himself, and as a result obtain a higher return.

This simple model, which is a strong concentrate of the explanation model that Ratos worked with in connection with the strategy analysis during 1998, will have a number of consequences for the criteria for running a company like EBAB – which can be an investment company, a holding company or the parent company of an industrial conglomerate. The most important conclusions drawn were:

I) Ratos’s portfolio must consist mainly of unlisted companies

To create an investment in a listed company that is unique for the shareholders is difficult. To do this in a portfolio of listed companies is even more difficult. Market players are always able to “copy” an investment company’s portfolio and as a result obtain the same return as the company without the costs involved in running a company. In addition to this it can be noted that most listed portfolios of a reasonable size develop approximately like the Index over a period of time. This means that the return after management costs does not meet the investor’s return requirement from a definition viewpoint. However, this does not prevent unique, albeit often more short-lived opportunities, arising in listed companies, nor the creation of an unlisted company through the buyout of a listed company.

II) Ratos must have an active acquisition as well as exit strategy

Obviously it is impossible for EBAB to create excess returns in a static BBAB consistently over the years. For this reason, the “line” between EBAB and BBAB is decisive for EBAB’s opportunities for success. Active work on both acquisitions and sales of companies, combined with the exercise of active and operating ownership on a daily basis, creates three value-added stages in the business. It should then be noted that an active acquisition and exit strategy involves considerably more than trying to achieve the lowest and highest possible price in the transaction, respectively. It also involves trying to find and create own acquisition and exit opportunities in order to achieve even more advantageous negotiation situations and a higher added value for its owners.

III) Ratos must be an active owner in the true sense of the word

Exercising ownership authority in a portfolio company requires active work in order to implement the objectives which were adopted in connection with the acquisition and subsequently as events unfold. In that way, the value can be optimised at exit while the active ownership will at the same time lead to an increased added value for the benefit of the company’s owners.

Effect of too low return

The effect of not achieving the requirements of uniqueness and sufficiently high returns is dramatic. For example, a relative return of 80% (i.e. a return of 8% when the market’s return requirement is 10%) combined with a dividend of 25% of net profit for the year will thus, as people might intuitively believe, not lead to a 20% but a 50% discount!

The explanation for this is something that we call the “discount-on-discount effect”. If an investment company returns 8% when the market’s return requirement is 10%, this – all other things being equal – will lead to a 20% discount if the company pays an annual dividend of 100% of the profit. If that is not the case and the dividend portion is, for example 25%, then 75% of the profit of the investment company is annually reinvested and immediately down-valued with a discount (a form of implicit new issue). In the example which is used here, a balance does thus not arise in the system until the discount is 50% , since out of a profit of SEK 8, SEK 2 is then paid in dividend and is worth just SEK 2, whereas SEK 6 is reinvested and immediately down valued to SEK 3. SEK 3+2=5 becomes the actual return and, since the investor has paid SEK 50, he has thus received a return of 10%. Some examples of the discount-on-discount effect are found in the table below.

It can be worth noting that these simplified tables illustrate clearly the dynamics which exist in the valuation of investment companies and the dramatic effects which arise if the company does not meet the market’s return requirements.

It is against this background that Ratos’s strategy is to concentrate on finding unique, sufficiently profitable investments while at the same time pursuing a continued aggressive dividend policy.

Inversely, it can be noted that the tables also show the potential that exists for a company in Ratos’s situation. Only comparatively modest improvements are needed for the valuation situation to improve radically.

The tables show the potential that exists for a company in Ratos’s situation. Comparatively modest improvements combined with an aggressive dividend policy are required in order to achieve a fundamental improvement in the valuation situation.



From this, Ratos has drawn the following conclusions:

  • Ratos must work with a flexible target by gradually making exits for its owners and produce in full the values which exist in the company’s investments. The result will then be higher for its owners than in cases where an external party buys the company and carries out exits and itself takes a large proportion of the profit, something that has occurred in many investment companies since the beginning of the 1980s.
  • Ratos must make unique investments which means that Ratos will mainly work in the market for unlisted companies.
  • Ratos must work with three value-added stages – acquisition, development and divestment of companies – which provide opportunities for creating added values in more ways than one.
  • Ratos must achieve excess returns on its investments which will at least cover its own management costs.

One question that immediately arises is whether it is at all possible to achieve an excess return in relation to the market’s return requirement. Should this not be impossible? As has already been noted, Ratos makes the assessment that it is difficult, maybe impossible, to achieve excess returns over time on a large portfolio which contains exclusively listed shares. However, for several reasons the opportunities for achieving excess returns are considerably higher among unlisted companies and with the direction that Ratos has now chosen. The market for unlisted companies contains imperfections and distortions from which Ratos can benefit.

Changed business concept

Ratos is a listed private equity conglomerate. Ratos’s business concept is to generate, over time, the highest possible return through the professional, active and responsible exercise of its ownership role in a number of selected companies and investment situations, where Ratos provides stock market players with a unique investment opportunity. Added value is created in connection with acquisition, development and divestment of companies.