Tom Kloet bears a passing resemblance to Oliver Hardy and, lately, he too has been on the road as part of a hard-working duo. But the affable TMX Group boss is a much better actor than the stouter half of the world's most famous slapstick team.
In January, when he was in London to celebrate the opening of the TMX's first office outside of North America, Kloet didn't give the slightest hint that he was on the verge of selling TMX, owner of the Toronto, Montreal and Venture exchanges, to the London Stock Exchange Group (LSE).
If anything, he gave the impression that the TMX, the world's most successful bourse for aspiring resource companies, was more or less happy to exploit the exchange's sweet franchise and go it alone. "My job is not to dress this thing up for sale," he said when I interviewed him at the TMX's launch party in central London as a hundred or so guests were offered Moosehead beer and souvenir hockey pucks. "It is to build the business."
Kloet even predicted that exchange consolidation-all the rage until the 2008 financial crisis shut it down-would not make a roaring comeback, even though the bourse industry was alive with rumours that another round of mergers might not be far off (in October, the Singapore Exchange had launched a takeover bid for the Australian Securities Exchange). The big exchanges, he explained, were stuffed with debt, limiting their ability to manoeuvre. If that were not impediment enough, mergers, historically speaking, "have not delivered shareholder value."
Case closed, it seemed. The TMX was not for sale. Bourse mergers would not grip the industry. And Kloet doesn't look like Oliver Hardy.
On Feb. 9, Xavier Rolet, Kloet's LSE counterpart, went to Toronto to announce the two companies' "merger of equals," though in reality he was talking about a $3.2-billion takeover of the TMX by the LSE, financed by LSE shares (all currency in U.S. dollars unless otherwise noted). The very same day, NYSE Euronext and mighty Deutsche Boerse revealed merger discussions of their own. The German exchange later agreed to buy NYSE Euronext for $9.5 billion-but then Nasdaq and IntercontinentalExchange of Atlanta made a sweeter offer for NYSE. Either combination, if approved, would create a global powerhouse.
Was Kloet blowing smoke when he downplayed the consolidation scenario, one that would include the TMX? Obviously, yes; even hinting that he coveted a merger partner would have landed him in the journalistic hot seat. A "no comment" would have done the same, since journalists often take that as code for "yes."
But he wasn't blowing smoke when he said that exchange mergers do not add value. Historically, they have not. And there are plenty of reasons to think that slapping the LSE and the TMX together will not break the pattern.
So why is he doing it? Pick your cliché. Well-worn phrases such as "strongly positioned for growth" and "value creation" and "revenue benefits" were all duly rolled out during the February press conference. In other words, bigger is better, and everyone else is doing it, so why not us?
While apparently half of Bay Street, including Royal Bank of Canada and Ontario Teachers' Pension Plan, is buying into the TMX-LSE hyperbole, the other half, including TD Bank and GMP Securities, is not. Their argument, in short, is: Why fix what ain't broken? "Don't mess with it; it works," says Murray Pollitt of Toronto's Pollitt & Co., one of the grand old men of Canadian mining finance.
**********************************
This is only the latest front in a decade-long contest over exchange consolidation. To date, the promoters of big-is-better have generally come out on top.
Between 2004 and 2006, the London Stock Exchange, then led by Clara Furse (who is Canadian-born, oddly enough), fought off no fewer than three takeover attempts-one from Australia's Macquarie Bank, the other two from Nasdaq and Deutsche Boerse (which had first tried to merge with the LSE in 2000). In 2007, Furse, under pressure to show that she had an international strategy, nabbed Borsa Italiana, the main Italian exchange. But tucking a small bourse in a flat-growth market into the LSE's portfolio earned her few kudos.
Spurned by the LSE, Nasdaq and Deutsche Boerse and others went on to do their own big, international deals. Nasdaq bought OMX, the Scandinavian company that runs seven Baltic and Nordic exchanges, for $3.7 billion. Deutsche Boerse, through its 50%-owned derivatives marketplace Eurex, swallowed New York's International Security Exchange for $2.8 billion. The New York Stock Exchange trumped Deutsche Boerse's bid for Euronext, the pan-European exchange based in Amsterdam. The $10-billion deal created a transatlantic colossus that is now the market leader, measured by revenue, although by one reckoning it's only No. 6 by market capitalization.
In 2007, a derivatives and futures giant was created from the merger of Chicago Mercantile Exchange and the Chicago Board of Trade. A year later, CME Group, as the enlarged company was called, bought the New York Mercantile Exchange.
What drove all this merger frenzy? The exchange bosses were in a tizzy about "globalization" and "global pools of liquidity" that could be available 24/7. The theory (if not the reality) was that consolidation would allow any investor to buy a share or a derivative anywhere on the planet at any time. The timing was right, if only because investors were equally enthralled about globalization and had pushed up the price-to-earnings ratios of the publicly traded exchange companies to outrageous levels. In a couple of cases, shares went as high as 30 or 40 times earnings. The exchange bosses couldn't resist using the rich shares as an acquisition currency.
The industrial logic behind the mergers proved to be less compelling. In spite of all the MBA-speak about globalization, exchanges are inherently local institutions, governed by local regulations and laws, and nurtured and shaped by local capital-raising and particular trading customs and culture. The TMX is unique, ideally suited to Canada's resource-based capital formation, just as Brazil's expansively named BM&FBOVESPA is suited to an ambitious emerging economy.
And even if mergers do allow trades to be done in time zones five or 10 hours apart, so what? Ed Ditmire, Macquarie Securities' capital markets analyst in New York, downplays the utility of anywhere, anytime trading. "Investors already invest globally, so why do they need exchange mergers?" he says. "Look at the TMX and LSE. If they merge, it doesn't mean investors in London will trade Canadian stocks they never heard of."
In reality, he says, global trading doesn't drive exchange mergers; the desperate need for cost-cutting does. At bottom, exchanges are expensive technology platforms. Mergers spread more trades over the same platform, reducing costs and boosting margins. Think of exchanges as airlines. Beyond a break-even passenger load factor, say 75%, every seat is pure profit; but at 74%, the flight is losing money.
As competition among exchanges heats up, thanks in good part to the arrival of low-cost alternative trading systems such as Chi-X Europe (acquired by BATS Global Markets in February) and, in Canada, bank-backed Alpha Group, the urge to merge will heat up, if only to reduce costs. To use the airline analogy, the new breed of low-cost exchanges is the equivalent of Ryanair or WestJet, putting pressure on the old, high-cost "legacy" carriers.
In a survey done in February by TABB Group, a financial services research and advisory outfit in Massachusetts, 65% of respondents cited "increased competition" as the main driver of exchange mergers (the research was done shortly after the LSE went after the TMX and Deutsche Boerse bid for NYSE Euronext). Next came "weak equity volumes," which is a different way of saying the same thing. Trading volumes are generally lower in the post-financial crisis world and competition is robbing the big exchanges of market share. Nasdaq's share declined 13% between early 2008 and late 2010, according to TABB. Alternative trading systems have robbed the TMX of about 25% of its market share and the figure could easily go much higher. Only a few years ago, the exchange had a near monopoly.
While cost-cutting seems to be the real driver of mergers, the exchange bosses would have you think otherwise. Take the London-Toronto deal. The LSE's Rolet, the Frenchman who is to become the CEO of the merged group, and the TMX's Kloet, the American who is to become president, listed "revenue benefits" first as the value creator, with "cost synergies" coming second. The former would add about $160 million (Canadian) in revenues to the combined group in the fifth year. Those dollars would come from cross-listings and new products and services, such as enhanced data feeds.
Sounds good-too good, according to Macquarie's Ditmire. He says the cost synergies are more or less real, while the touted revenue synergies have, historically, been overblown. He compares exchanges to restaurants; just because a restaurant buys the restaurant next door does not mean the individual diner stuffs more food into his face. "The revenue synergies have not come," he says. "Mergers are oversold on the revenue side. The cost rationale is 95% of the equation."
The dubious revenue synergies, combined with heightened exchange competition, lower trading volumes and investor skepticism about the true benefits of mergers, are reflected in the shabby performance of bourse shares (almost all of the major exchanges are publicly traded). Since its peak in late 2007, when the last round of mergers was on the boil, the Bloomberg World Exchanges Index has lost almost 45%. Over the same period, the Standard & Poor's 500 Index is down less than 12%. The TMX itself has lost 26% over five years, greatly underperforming the S&P/TSX Composite Index.
So much for value creation.
**********************************
The lovers and haters of the London-Toronto union were hardening their positions in March as Rolet and Kloet were busy pumping their deal ahead of the provincial, regulatory and Investment Canada reviews.
The pro side argues that a merger presents little to lose and a lot to gain. Together, London and Toronto would be the world's premier listings hub for resource companies, especially miners. Sharing technology would reduce costs and-fear not-local regulations would still govern each exchange. The TMX's head office would not slowly rot away, because the deal would give it co-head office status and, allegedly, equally shared responsibilities, with Toronto emerging as the control centre for primary markets, such as listings.
Big companies such as Royal Bank argue that Toronto's potential to emerge as a global financial services centre would be enhanced by the merger. Absent a merger, the TMX would lack a growth strategy in a world dominated by exchange giants such as NYSE-Deutsche Boerse (or whatever combination comes to pass on that front) and Hong Kong Exchanges and Clearing, the leading exchange on the planet by market capitalization-about $23 billion.
The opponents argue that the increasingly marginalized LSE has a lot more to gain than the TMX, which comes equipped with cutting-edge technology and a derivatives platform, a notable weak spot in the LSE's portfolio. "The LSE is in a precarious position," says Tim Stocks, who heads the financial institutions practice at London law firm Taylor Wessing. "If it does not get it right now [with the TMX purchase] it's doomed."
The antis say the LSE's expensive, bureaucratic culture will infect the TMX, harming Canada's capital formation ability, which is geared toward seeding small companies and moving them up the food chain to national and, in some cases, international stardom.
In an open letter published in March, the opposing banks-TD Bank, CIBC, National Bank-said they feared the deal would harm the ability of small and mid-sized businesses ("the backbone of the Canadian economy") to raise money because the larger exchange "would be less likely to focus" on, for instance, a junior exploration company in Saskatchewan or a software developer in Kitchener-Waterloo. "Our success does not depend on selling out or waiting for others to 'save' us," the letter said.
Indeed, the TMX is undeniably the world's most sought-after resource bourse, with more than 1,500 mining listings compared to 200 or so in London. Mining may be a niche market globally, but it is one that is expanding rapidly thanks to emerging economies' voracious appetite for minerals and energy. The TMX rules this market. Almost 200 foreign resource companies, from Australia to Europe, have made the TMX their home, even though many lack Canadian assets.
Bay Street veterans like Harris Fricker, CEO of GMP Capital, one of the Street's largest independent investment firms, don't think the TMX should be deployed as a life raft for the sinking LSE. They note that the TMX is thriving all by itself, thank you very much. And the pattern of TMX's supremacy in resource listings isn't changing. In 2010, the TMX's main board and Venture small-cap exchange gained 208 new mining listings, compared to a mere 26 by the LSE and its small-cap arm, called AIM.
So why mess with a good thing, asks Fricker. "Ultimately, board control of the merged exchange cedes to London," he says. "The TMX works, and the argument that it would become marginalized in the absence of a merger simply does not add up. The world is beating a path to the TMX's door."
Murray Pollitt fears bureaucratic and regulatory interference on the other side of the Atlantic might crimp the TMX's style. His example: Suppose Hardass Mining and Granitehead Resources, both listed in Toronto, want to merge. No problem. They seek approvals from the Ontario Securities Commission and the TMX (whose own listing, trading and disclosure rules were considerably improved after the notorious Bre-X scandal), and the deal is done.
Now suppose the TMX and the LSE have merged, and Granitehead is 15% owned by a London hedge fund that thinks Granitehead should instead strike a deal with Britain's Spiv-Wideboy Mining, of which they own 35%. To gum up the Hardass-Granitehead deal, the hedgies hint that there is something amiss with Granitehead and demand that the British regulators get involved. "All of a sudden, you have another layer of bureaucracy," Pollitt says. "Once you get into the European Union milieu, you have the potential for all sorts of hassles."
Jackie Sheppard, a Cairn Energy director and a former executive vice-president of Talisman Energy, has worked deals on both sides of the Atlantic. She sees several risks in slapping the Toronto and London markets together. For one, she fears a culture clash. "Canada is a commodity-rich nation where entrepreneurial risk-taking is bred," she says. "An exchange that responds to the environment-the TMX-is different from one that developed primarily as a financial centre and market regulator." For another, she worries that a merger of ownership would lead to an eventual merger of practices, "with the unfortunate outcome of the exchange shaping the Canadian corporation, rather than being itself shaped by the Canadian corporate marketplace." Finally, Sheppard fears that the centre of trading gravity could shift to London, where Rolet will be based, bolstering London's status as a financial services hub at Toronto's expense. "I can envisage the TMX becoming a backwater," she says, unless safeguards are put in to protect Toronto's franchise.
**********************************
By early April, more than a month and a half after the deal was announced, it was still an open question whether Toronto and London would wed.
The CEO of a Canadian bank, who did not want to be identified, put the chances at 50/50, though a survey of the market in the United States attached a higher probability to the deal getting done, unless a rival offer comes in for either exchange. This is a distinct possibility as the number of international dance partners dwindles, adding a rarity value to both the LSE and the TMX. They suspect the LSE will say yes to virtually anything in order to appease the Canadian securities and investment regulators. "The LSE has the aspiration to be a global exchange," says Miranda Mizen, a TABB Group principal. "They can't do it organically. It is either buy, be bought, merge or partner with other exchanges."
The pro-merger side should consider a few things as they make a final push for the deal.
The first is that there is a very real chance that the LSE, as the buyer, will eventually get its way on key decisions, leading to a hollowing-out of both the TMX and Toronto as a financial centre.
The second is that the LSE is unlikely to stop with the TMX; to fulfill its ambition as a global exchange, it will have to do another deal. Toronto could end up as a minor subsidiary of a greater entity than what's now on the table, a subsidiary that might have scant power to exercise a benign influence on Canada's capital-raising efforts.
The third is that the merger may not succeed in creating any value whatsoever. Mergers designed to build international players have not enriched shareholders so far, a point raised by Kloet himself. Why will Toronto and London be any different?
Finally, and crucially, if the Toronto-London deal doesn't deliver its promised benefits, Canada can't simply say, okay, give us our exchange back. Once it's gone, it's gone forever. Why sell something that hast worked so well for Canada?
Eric Reguly