Complete Blog 3 - The Leverage Dilemma

Leverage – A double edged sword

My upbringing has always taught me to live within my means and that debt is inherently bad because of the drastic consequences its mismanagement can have. This is of little surprise having been brought up during the worst Financial Crisis, and subsequent recession, for almost a century. However, throughout University and my placement year, this notion has subsided somewhat. I now recognise debt’s importance; at an individual’s level, the access to credit plays a huge role in prosperity, whether that’s to fund a mortgage or to become an entrepreneur or for other things. Therefore, I am now of the opinion that debt with responsible individuals in the right quantities can be beneficial for those individuals and society as a whole. 

In looking at debt from a corporate perspective, it can be beneficial because it is often cheaper than equity financing. However, it is also riskier because of the legal obligation to repay interest, irrespective of financial performance. This simplistic view of the world was the extent of Modigliani and Miller's (MM) first paper. It simply outlined that as more debt is added to the capital structure, shareholders will demand a higher return because of the added riskiness of the corporation. This increase in the cost of equity is directly offset by the cost of debt being lower and therefore, according to MM there is no optimal capital structure and firm valuation is independent of its capital structure. While being the seminal paper in capital structure literature, the 1958 work’s assumptions were hugely unrealistic. The view of the world above only gives half of the story, not accounting for the tax advantages of debt (provided the corporation is profitable) nor the financial distress costs of debt. I have a view contrary to that of Milton Friedman in 1953 when he stated that important and significant hypothesis have wildly inaccurate representations of reality. The only thing this paper was important for was providing a grounding for which other academics could tear into it to create more robust models. While it may add value in that regard, it has little, if any, applicable value. I am therefore of the view that despite it creating a foundation for further work, and at risk of sounding blasphemous, the first MM paper's model is so far removed from the real world that I feel it is obsolete for discussion in business school lecture halls.

As we know from our lord and saviour Glen Arnold’s Corporate Finance textbook, debt interest payments can be offset against pre-tax profits, reducing the tax bill. This tax shield plays a role in reducing the cost of debt and therefore the WACC and as a result shifts the optimal capital structure. The second MM paper tried to remedy part of the tremendous failings in the first by incorporating the tax implications for the cost of debt. This paper indicated that as more debt is added to the capital structure, the cost of equity will increase, but not enough to offset the decline in the cost of debt, meaning the WACC declines to become in-line with the cost of debt. This paper has more credence and therefore I will not attack MM further, for fear of an academic disciplinary. However, the paper still lacked an appreciation for financial distress.

Upon going through 36 slides of the capital structure lecture, I finally came across a more realistic capital structure model – Thank God. The trade-off model (see diagram), despite having its foundations in the CAPM (with its limitations - see Fama & French, 2004), outlines a clear risk of exponential bankruptcy costs in the WACC after adding a certain level of debt. As the inputs for CAPM are judgement decisions, the optimal capital structure can only be estimated. Further, while this certain level of debt is not explicit and is dependent upon organisational and industry characteristics, it reaffirms my initial thoughts about the subject; that there is indeed an optimal capital structure and one which contains a mix of debt and equity. My belief from this stemmed from practitioners; aside from private equity firms, it is unlikely for any company for be financed solely by debt. By having the optimal capital structure, a company can minimise its WACC and maximise the company value. This has been evidenced recently by Reliance Communications. The Indian telecoms company had been previously burdened by debt. A restructuring of the company's debt and equity alongside a shrinking of its balance sheet has allowed for shares to increase in price 16%. The markets clearly believe this rebalancing of the capital structure is beneficial, negating MM's first paper's view that firm valuation is separate from capital structure

So, the advice for an optimal capital structure; gear up to a certain level (very helpful!).

Optimal Capital Structure – Does it really matter anyway?

While I believe there is an optimal capital structure, in my view it is highly unlikely a firm will reach it – or continually secure it. 

Why not?

It is not because they cannot, but because there are self-erected barriers in the way. With fear of sounding like Michael Jensen’s mouthpiece during this blog series, I discussed in last week’s blog the importance of the principal-agency problem playing a role in the demise of RBS, and I believe agency is also evident within capital structure decisions.

I feel people are much more motivated to preserve or enhance their own wellbeing, rather than somebody else who they don’t know and won’t meet. This can be evidenced in capital structure decisions because manager’s jobs are at higher risk when taking on more debt and therefore they are cautious to borrow. Therefore, by my logic, it is understandable they would look to be cautious because they are self-preserving as opposed to maximising the wealth of Joe Blogs who is a shareholder. A contrasting point is that managerial bonuses can be awarded based on EPS, therefore by choosing to buy back shares (as I shall discuss in next week’s blog post) the capital structure is altered by reducing the number of share outstanding (and increasing leverage without issuing more debt), the per share earnings increases. Furthermore, managers are likely to not exhaust their debt capacity to ensure availability for future projects e.g distressed companies’ assets in fire sales, which could have significantly higher NPV than typical projects.

Therefore, as I understand it, the principal-agent problem is very pertinent in corporate finance, and the capital structure decision is no different. I empathise with managers in certain circumstances who do not pursue long-term SWM tenaciously in the capital structure decision. However, I do believe that it should be the goal of the firm and manager's have a fiduciary duty to pursue it. I have a kind of cognitive dissonance - I can understand it but don't necessarily agree with it. 

Capital Structure - Lessons from the Past

In the period prior to the financial crisis, the banking and corporate sectors were highly leveraged and were reaping the rewards in these boom years. It seems to make sense; if a company can issue bonds or receive a loan from the bank at a fairly low interest rate and there are a vast number of projects available with significant positive NPVs, they would be foolish not to take those opportunities and shareholders would be questioning why.

Cynical Calum: I feel anger towards the shareholders of the last decade and I believe bank shareholders in particular were complicit in causing the Financial Crisis. All too often they were sitting back and enjoying the returns without questioning how or what happens if something was to go wrong. In my opinion, it is in the good times when these questions should be asked, so forward-looking proactive measures can be put in place to ensure the sustainability of profits. This short-termism among modern shareholders can be evidenced as shares are held for months now as opposed to years only a few decades ago. By holding shares for the short term only, they set the tone for the organisation being run with short-sighted profits as a target.

The magnifying effect leverage had on profits in the good times is replicated in the bad times. As markets & liquidity dried up and projects turned to negative NPV, the value destruction that leverage caused was tremendous. As the debt repayments were not negotiable, those companies which had an inability to pay were liquidated. For other companies, there was serious recapitalisation and balance sheet shrinking occurring. Companies, and in particular banks, who had been borrowing from the wholesale market to fund mortgage derivative operations, needed to issue new share capital to repay debts. An example of this is Barclays in 2008, who scrapped their dividend and instead issued new shares to the value of £11.8bn to cover asset writedowns and debt repayments. The cost of financial distress (or perceived financial distress) became high even at relatively low levels of debt. Often one of the last resorts to re-balance the gearing ratio was debt for equity swaps. Creditors with an interest in the company (e.g national interest or because upon liquidation they may not retrieve sufficient funds to repay the loaned amount) looked to restructure the company’s capital structure to ensure future trading.

This is evidence that the optimal capital structure can vary depending on the environment in which the company operates and the business cycle stage. What is potentially a very rewarding capital structure one day, may jeopardise the future of the company the next.

China's De-Leveraging

China made it out of the Global Financial Crisis relatively unscathed. As a result, they did not feel the effects of excessive leverage - significant bankruptcies and a deep recession - and therefore continued on their merry way. While China has largely been responsible for the growth of the Global Economy over the past decade, it has done so fueled by debt. The Chinese Government has been borrowing vast sums of money to fund this expansive era of growth. With most other economies nursing their self-inflicted wounds and with limited disposable income for households to purchase Chinese imports, the Government initiated policy to increase its sovereign debt and make credit readily available. This has set the tone to normalise debt for the corporate and household sectors, leaving the whole Chinese economy with the issue of leverage. 

The level that the trade-off model advised gearing up to has, at least in my opinion, been surpassed by China. I have only ever known growth for the Chinese economy and while this may seem like a positive thing, it can create ignorant expectations that this will continue into the future - much like mortgage lenders did in pre-2007 with house prices rising - leading to destructive consequences. There are cracks starting to form in the previously impenetrable armour of the Chinese Economy; the first being the downgrading in China's credit rating by S&P. Although not explicitly saying 'ok time to rein it in', it does highlight that creditors will expect a higher return for sovereign bonds because of the excessive debt, which will make it harder, or certainly more expensive, to issue new debt. A further fissure comes from the IMF warning that China could indeed cause a crisis should debt increases carry on.

The stark reality of China's debt dilemma https://www.ft.com/content/1b1c453e-9f80-11e7-8cd4-932067fbf946?mhq5j=e5

With little change as a result of the IMF statement and the downgrading by S&P this year in Chinese policy, China's chief Central Banker has warned of a potential Minsky Moment. This is where excess optimism and overexuberant debt-funded investments lead to instability; what epitomised the Crisis of 2007/8. This warning from inside China is likely to have much more of an impact and it is this kind of warning which I believe was needed from shareholders or Central Bankers in the US or UK. This forward-looking, crisis-averting signal lets the Chinese corporate sector understand that deleveraging is needed to avoid a crisis, which would undoubtedly lead to another Global crisis because of the size of China and the importance to global economic growth they have.

An example of the trade-off model in action is China Evergrande - China's second largest property developer. At the start of this year, they had a gearing ratio of 430% and while property developers typically have high gearing, 430% is extortionately high. Throughout the year, they have embarked upon a capital restructuring programme by redeeming billions of their perpetual bonds. Upon announcement of plans to redeem all of its remaining perpetual bonds, which could see the leverage ratio reduce to 200%, shares lept 9.2%. This clearly evidences the trade-off model because the company valuation increased as a result of deleveraging from excess levels and a reduction in the WACC due to potential financial distress costs. In applying MM's first paper, it would indicate the share price lept because of mysterious forces and not due to the capital restructuring as the paper outlined the separation of company value and capital structure. In applying MM's second paper, it would indicate that China Evergrande should have loaded up with further debt - which in the circumstances outlined above regarding China's debt problem, is not wise. Therefore at least in this example, the only model with applicable value is the trade-off model. 

For the corporate sector, this deleveraging is going to occur gradually over time so as to ensure no shocks. There has been a tightening of the access to credit in recent months and while the chart above doesn't indicate a clear change - it will be felt within corporations in China. For me, this is the way things should be done; a gradual process with clear signals from those in charge. For those corporations who will struggle with this tightening of credit, some rejigging of the capital structure can be exercised through debt for equity swaps by banks and other investors. This will allow companies to reduce their debt obligations by issuing new shares.  While on the face of it, this appears to solve the problem of excessive leverage, it opens up a new issue of corporate control.

When the equity share received by the creditor exceeds the point in which they are a minority shareholder, decisions about the business operations can be made. To avoid this responsibility and potentially damaging consequences, shares will need to be sold on. However, I feel the benefits deriving from a lower risk corporate sector in China and the avoidance of a financial crisis with far reaching consequences, significantly outweigh the issues which may be caused by corporate control. 

Summary

Thus, I will reiterate the point I made initially that credit given to the right companies in the right amounts can be beneficial. I believe the capital structure can be optimised, and see the only real capital structure model as the trade-off model, however because of the dynamism of markets, this optimal varies given the operating environment. The optimal structure can only be estimated and is therefore vulnerable to assumptions in the CAPM. As I have discussed, shareholders played a role in setting the tone for short-term profits as a result of leverage in the boom years. Those who didn’t fall when markets blew up were forced to deleverage by raising new shares or reducing their balance sheets. This picture looks similar to what is happening in China now, however their central bankers have learned from the failings in the West and are trying to manage a period of deleveraging prior to any potential downturn, which I am definitely an advocate of.