Changing attitude towards debt

Borrowing in general helps businesses to survive in crisis periods. However, it also makes economies more fragile and at risk, when done in excess. Resilience is the buzz word and these days; every CFO wants to make operations more robust to face next challenges. Is debt always the best solution? Aren’t we too much in quest of optimized leverages, at the expense of resilience capacity to financial shocks? These are the questions this article raises.

New debt attitude

One of the buzz words in finance over the last months was “resilience”. How could our organizations become more “resilient” to crisis and market fluctuations? How to reinforce our structures to make them more solid, robust, and resistant to economic storms? More than a watchword, resilience becomes a credo, a target, a philosophy… However, how to tend to it? I do believe we should have a new approach towards corporate finance and revisit some key financial principles. Are they really written on stones? These principles should be nuanced sometime. The maximization of WACC and preference for debt over equity, financially speaking is maybe good in theory, but risky in reality. The consequence of (excessive) indebtedness levels has been demonstrated over the last 12 years (e.g. GFC in 2008, State debt crisis in 2011 and more recently the COVID health crisis). Debt can create instability and potentially fragilize groups, banks, States, and even worse economies. Debt in excess is necessary but also a form of atomic weapon. The over-leveraging of banks in 2008 and of the “real economy” in 2020 have shown the dangers they could generate. The GFC has been amplified by the financial innovations and creativity of some smart bankers. The excessive leverage of some banks was also highlighted. New capital requirement rules have been published in the meanwhile.

More debt than before…

Despite low and even negative interest rates, indebtedness level in general, corp’s and States, has increased over time. The current crisis is of course not created by debt. Nevertheless, the side effects of a very long containment period are exacerbated or inflated by the stretched balance-sheets and highly leveraged companies. Some groups have searched for the maximal WACC, at the expense of the minimum-security buffer needed in case of big issue, like a pandemic, a black swan or a strong financial crisis. Applying strictly financial principles and sticking to them whatever the circumstances can be damageable. Some corporations have decided to use cheap borrowing to lever up. Of course, it helps increasing profits (when conditions are favorable). But when the storm is coming, they start struggling to meet interest rate payments during the enforced lockdown and even after as some businesses are slow to start again. In good times, borrowing is indeed a fantastic tool to leverage and maximize returns. However, it can become a sword over our heads when we are facing bad times. When you maximize a situation, you have not anymore headroom for maneuver and remaining flexibility. Deleveraging can be salutary and beneficial. You can promise to repay debts when conditions aren’t extreme. But in terms of risk management, it is also sound to consider extreme circumstances and negative scenarios to assess the headroom and additional debt capacity.

Fresh blood injection

When you are stretched, unless you can inject new equity, debt raising is the sole response available. But if highly indebted, additional debt increase all-in charges of interest and because of ratchet and rating grids, it can even worsen the situation further by increasing spreads applied. Debt has therefore side effects as more debt is synonym of worsening of the financials, of the (implied or effective) credit rating and overtime this will dent the ability of MNC’s to obtain additional funding. MNC’s also need fresh blood and capital to start planning the future without burden of too much leverage. Equity injection is part of the solution. The risk of default is present, and the last resort answer resides in capital injection if shareholders agree. A company needs its shareholders approval. Why not having a law authorizing a company to raise up to 10% or more of new equity without approval from its shareholders or provisions in their bylaws?

In some countries they think about encouraging people in investing in long term equity. It was the case in Belgium years ago and they plan to renew this program. In my opinion, it is an excellent idea. The European Investment Fund (EIF) can also invest in companies but has limited resources and need time to accept investing. It is great to develop the CMU (i.e. Capital Market Union) in the EU. But it is again debt in the balance-sheet, although diversified.

Optimization or maximization of WACC?

The maximization of leverage and WACC push companies to be too close to sub-investment grade area. Falling into that danger zone is like crossing the Rubicon. No way to be back soon. “Alea jacta est”. When banks are under pressure with many demands, when liquidity price increases and when time is an issue, the situation can deteriorate fast(er). The incentive to rely more on debt rather than equity should be removed. It was the famous notional interest principles, to encourage equity injections. More capital prevents debt overhangs. And high debt levels prevent from investing on future profitable businesses to recover. It becomes a vicious circle. Lending is a powerful tool which can be devastator if markets are severely impacted as today. The even more vicious aspect is that it can be fraught and amplified by deep crises. The more flexible mean to finance a company remains equity and it is often forgotten. Now, we saw many groups in tough situations with mountains of debts having recourse to convertible bonds and even pledging lots of key assets. It perfectly highlights the frontier between financial principles and the real economic life. We know that only few MNC’s regularly assess their debt capacity to see the headroom. It is a sound financial recommendation and a best practice; CFO’s will remember post-COVID. It is advised to never go a step too far and always keep room for maneuvering in case of recession.

 Fran?ois Masquelier SimplyTREASURY