There’s a war that’s always being fought in financial markets – sometimes beneath the surface, sometimes in plain view – between the interests of debt holders and shareholders.
Through the depths of the recent depression in financial markets and the worst revelations of corporate excess, that conflict has been low intensity. The interests of bondholders and equity holders have become, briefly, aligned. What’s been bad for one group has been bad for another. In extremis, both sides have compromised to salvage the most they can from the wreckage of the latest corporate collapse.
Last month’s e2.3 billion mandatory convertible for Deutsche Telekom marks an outbreak of the old tensions. Creditors were relieved to see an over-leveraged company substantially increase the equity in its balance sheet – albeit with a three year delay. Proceeds of this deal, earlier bond deals and asset sales, provide liquidity enough to cover this year’s maturing debt. Credit investors trust that the deal will head off another ratings downgrade that would inflict more losses on them.
Shareholders were less warm in their welcome. On the day the convertible was launched, furious selling of Deutsche Telekom equity wiped e5.3 billion off the company’s market capitalization.
Such a sharp fall partly reflects specific concerns about the slow pace of non-core asset sales and debt reduction at Deutsche Telekom. But it’s also a salutary warning to companies and advisers about the potential damage to their share prices of new equity raising in today’s fragile markets.
After three years of falling equity markets one might think that shareholders have already suffered enough.
In fact, companies’ recent relegation of equity holders’ interests below those of bond holders marks only a slight redress for the second half of the 1990s.
According to Moody’s, typical leverage – defined as debt-to-internal funds – of non-financial US corporations rose from 65% in 1997 to 90% in the third quarter of 2001.
This was nothing less than a massive transfer of wealth from bond holders to equity holders. Managements that had improved their businesses in the first half of the 1990s, as they emerged from the last recession, resorted to pure financial engineering.
Today, power rests with bond holders. Companies are more worried about maintaining liquidity and solvency than maximizing shareholder returns.
Bond holders have a duty to take advantage of issuers’ desperation.
Before long, assuming markets and economies don’t continue deteriorating indefinitely, shareholders will strive to re-assert their claims over corporate cash-flows.
The psychological and propaganda warfare continues. It was grimly amusing to listen to the boosters of the first few corporate 30-year euro bond deals last month proclaim that buyers could rest easy. The issuers were the most reliable of all – telecom companies. These issuers had seen the dangers of over-leveraging and would not dream of betraying lenders’ trust again. (And all this with a straight face).
That market closed down pretty quickly.
The power of bond holders is curiously limited by its very extent. While equity holders can vote managers out, bond holders retain the nuclear sanction: by calling in or refusing to roll over credit they can bankrupt companies to the cost of everyone including themselves.
There is another way. Creditors might protect themselves against the depredations of managers by insisting on much stronger packages of covenants in standard bond documentation.
Banks often have privileged access to financial information, including sources of alternative liquidity. Bondholders can covenant the right to demand the same information. They can also restrict the freedom of managers to alter the form and identity of an issuer and to do certain kinds of mergers. Such covenants, more than financial ratio maintenance tests, might save bond holders, next time around.
Right now is the time to demand them.
