Coping With the Swiss Finish

Credit Suisse spooked the market last week by cutting its group target for return on equity by three percentage points, to about 15%. The move raises the question of how its investment-banking business will earn returns above its cost of equity. The bank may just have to increase its risk appetite.

Credit Suisse's fourth-quarter numbers show why it is struggling to make its cost of equity. In the first half of 2008, its average daily value at risk stood at just over $250 million. Last year, the quarterly average was just over $100 million. Over the past year, there has been virtually no growth in the investment bank's risk-weighted assets. In its client-focused model, 91% of revenue is said to come from direct client business, and that means the volatility has, to a large extent, gone out of the investment-banking business.

Although in 2010 it had losses on six business days, compared with 22 loss days in 2009, the days on which it made revenue of more than 100 million Swiss francs ($103 million) dropped to 19 in 2010, compared with 74 the previous year.

To some extent, the bank has been restricted by the tough Basel III regulations and the so-called Swiss finish, Switzerland's own capital requirements. By 2019, Credit Suisse will have to show a core Tier 1 capital ratio of 19%, of which at least 10% must be common equity and up to 9% can be contingent convertible bonds.

Credit Suisse doesn't break out its return on equity to the level of individual businesses, but some analysts believe it is earning between 25% and 30% from its private-banking and asset-management businesses. That implies that, for an overall ROE of 15%, it must be making just about 10% from investment banking, either below or barely equal to its cost of equity. Chief Executive Officer Brady Dougan says the bank's investment-banking business is profitable. But more clarity in the future would help.

The reality is that the bank needs to put capital into some higher-growth areas. An obvious space is emerging markets, where the bank said its 2010 market share fell to 8% from 12% in 2009. Another area is in the bond market, where it is ranked No. 8 with only a 4% market share.

With 17.2% Tier 1 capital, and core Tier 1 of 12.7%, it can afford to get more aggressive. It just has to go out and win market share.

—Joe Ortiz

ISS IPO won't be a party

With a secondary buyout deal for Danish outsourcing firm ISS AS falling through, the most likely route for the company is now an initial public offering. The alternative, a breakup of the 525,000-employee company, the world's fourth-largest private employer, wouldn't be easy.

Current owners EQT Partners AB and Goldman Sachs Capital Partners bought ISS in 2005 for $5.1 billion and are looking to cash in. But having failed to make a sale to private-equity group Apax Partners, an offering looks inevitable.

Apart from pricing, where and when to list present conundrums for ISS's underwriters. The IPO market in Europe is still struggling for momentum, although secondary equity markets have been gaining strength. Bankers will recall last year's underwhelming IPOs of Betfair and asset manager Gartmore Group. U.K. retailer New Look contemplated a float last year but gave up and is still privately owned.

That said, in many ways ISS makes a good IPO candidate. It runs a global business. It is showing signs of looking past the credit crisis—revenue grew 7% year-to-year in the third quarter of 2010—and its margins are growing faster than revenue. One negative is its relatively high debt, a legacy of ISS's private-equity ownership. Net debt is 6.5 times current earnings before interest, tax, depreciation and amortization, which compares with an average ratio of 2.2 for the sector.

The company likely has an enterprise value of between $10 billion and $11 billion, which implies an equity value of between $4.3 billion and $5.3 billion, assuming net debt of $5.7 billion. This is based on 2009 financials, the latest available, and growth assumptions of around 15% over the subsequent two years.

The company is keen to first list at home in Denmark, and then in London. But the Danish stock market may not offer the liquidity that ISS would want. London, however, is already home to companies with which it can easily be compared. Serco Group PLC and Compass Group PLC trade at nine times and 10 times Ebitda, respectively.

Assuming EQT and Goldman stumped up 20% of the takeout back in 2005, they are in line for an internal rate of return of around 30%. They have already rejected an outright sale, claiming Apax's $8.5 billion play was too low. The 2010 financials will shed some light on whether that was a good offer.