High-quality issuers revive corporate hybrid market
| The clocks are turning back all across the credit markets this autumn. When big LBOs, corporate M&A deals and debt-financed shareholder payouts took off at the start of this year, the bears warned about an imminent credit crunch. It hasn’t happened. Those headline leveraged deals glossed over just how strong corporate credit fundamentals had become, as earnings and margins stayed high, cash built up and corporate spending stayed modest until very recently. Yes, many companies will overextend themselves; some low-rated credits already have. And the crunch will eventually come. But as lenders remain flush with liquidity, the credit cycle clocks now say the day of reckoning might be years, not months, away. Peter Lee reports. |
VOLVO HAS TRADITIONALLY been regarded as a conservative but well run company that prudently maintained high cash balances to shelter it though downturns in the cyclical heavy truck business. That might not be good enough any more.
Over the summer, Christer Gardell, a venture capitalist, having amassed a 5% stake in Volvo’s equity, began pressing the company to return part of its Skr19 billion ($2.58 billion) cash pile to shareholders. In September, the Volvo board responded, accepting that the company had achieved structurally higher profitability, stronger cashflow and lower risk and setting new and ambitious financial targets – a 7% margin or better through the cycle compared with the previous target of 5% to 7%, annual sales growth of 10% and a leverage ratio of debt to shareholders equity up to 40% from the previous 30%.
The board said, rather ambiguously, that it would look favourably on opportunities to return cash to shareholders at its next AGM, but would continue to monitor acquisition opportunities in the meantime.
Whether this turns out to be a good example of shareholder activism prompting a sharper performance from management only time will tell. Not everyone is convinced. “We’ve seen this company burn through cash before due to a sharp slowdown in the US heavy truck sector in 2000 and 2001,” says Vivek Tawadey, head of credit strategy at BNP Paribas. Volvo faces challenges including possible consolidation of competitors Scania and MAN and investment to meet new emission standards. “And if we are about to go into a period of slower growth, levering up hugely may not pay off, as demand for heavy trucks is closely tied to the economic cycle,” Tawadey says.
The debate over what constitutes the optimal corporate capital structure, the best mix of debt and equity to produce the lowest sustainable weighted average cost of capital, used to be a largely academic one: the province of corporate finance theorists arguing over how best to measure the cost of equity.
Now it is an increasingly urgent, rancorous and pressing debate drawing in more and more participants – shareholders, lenders, regulators, rating agencies and corporate managers – across various industry sectors. It is not quite so intense for companies in growth sectors or industries subject to technological change and unpredictable earnings cycles. But in stable, mature industries with limited technology risks and predictable supply and demand patterns – building materials, capital goods, utilities, fixed-line telecoms – the pressures to gear up and return cash to shareholders are growing ever more powerful.
The private equity industry, emboldened by huge amounts of capital raised on the promise of high returns, presents a doleful reproach to public corporations: we can take you over and run your businesses with much higher leverage; you’re not doing a good enough job for your owners.
Dissident public shareholders – from the activist hedge funds militating to turn minority stakes into board representation and to influence strategy at leading companies such as Heinz and Volvo right up to the most traditional long-only managers – are pushing for higher returns either through richer dividends and share buybacks or investment of cash and profits in future growth.
Set against these clamouring proponents of higher debt levels, the regulators of the corporate world, the ratings agencies, are reminding companies of the need to maintain adequate credit lines and liquidity to see them through a downturn in the business cycle. They are also warning that unfunded pension liabilities are as close to debt-like obligations as makes no difference.
Other regulators are chipping in. The utility sector has long been seen as one with the kind of stable cashflows that can and should be levered up. Average ratings have fallen from AA to single A and lower in recent years as managers of utilities, accepting that they operated in a mature sector with low risk of technological change, made life exciting for themselves by leveraging up for M&A. But in the UK, regulator Ofwat recently warned potential private equity bidders for Thames Water – for which owner RWE is running a dual-track disposal strategy that might end in flotation or outright sale – not to leverage their bids too far because the company faces substantial capital expenditure requirements to mend its leaky pipes.
It’s not so long ago that entirely debt-financed water utilities were in vogue. Now, it seems, the regulator is mandating investment-grade ratings and suggesting it might require a change in dividend policy or other form of cash lock-up if investment-grade status is at risk in a way that threatens a company’s ability to fulfil its regulated function.
Corporate managers themselves tend to be cautious about running their balance sheets too efficiently. They want a cushion. The tax shield on debt service is attractive but the downside of debt – bankruptcy – might be far more damaging to a CEO’s or CFO’s career prospects than to those of fund managers investing in the company’s equity or debt.
“Some of the leveraged loans put on in 2005 and 2006 will need more than just marginal adjustment and covenant resetting”
Fenton Burgin, Close Brothers |
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If corporate managers push their debt levels right to the point where just one more step up in gearing will make their companies appear so risky that the cost of debt spikes up, equity becomes volatile and shareholders demand a higher return on it, then managements might well have lighted on the optimal weighted average cost of capital. But they have also surrendered all flexibility. There’s no cushion left to protect against a downturn in earnings, an unexpected investment cost, and no debt capacity left to fund that suddenly available must-have acquisition.