Since roughly the middle of the year, bankers in the debt capital markets have been preaching to corporate CFOs that the time to re-lever has come. Not only is it financially rational to do so – given that interest rates and credit spreads are still historically low – it is inevitable: the markets will force companies to increase borrowing.
Equity investors are rewarding those companies that are pursuing mergers and acquisitions and are increasing capital expenditure. Indeed, the results of the Merrill Lynch survey of fund managers for August, which polled 228 investors managing nearly $1 trillion, indicated a new preference for companies that invest funds in their own businesses to achieve growth rather than returning it to shareholders via dividends and share buybacks.
This is new and startling.
The bankers’ increasingly aggressive message to CFOs is this: you know very well that you are subject to a leveraging cycle that you are powerless to resist; that cycle is now turning; you would be well advised to borrow now while costs are low, rather than waiting until the debt markets are crowded with other issuers and costs go up; you can’t withstand the leveraging cycle, so get in front of it.
This guff might be slightly more compelling were it not so blatantly self-interested. Banks will of course always advise companies to do what’s best for the bankers. And bankers are in the business of lending money. But since they found new derivatives tools to disperse credit risk to capital providers further removed from corporations – and so with less capacity to monitor their fluctuating credit fundamentals – bankers have seemed free to advocate higher leverage with new abandon.
Of course the bankers’ spiel has some element of truth. But there’s something hugely dispiriting about this theory of inevitable subjugation to the leverage cycle. What about the exercise of good business judgment? At the very least CFOs should be wary of repeating the mistakes of the past.
The warnings from history are abundant. The mere availability of low-cost or near-zero-cost funds is no great advantage to corporations if those funds are ploughed into low-return or near-zero-return investments. Corporate Japan suffered the horrible after-effects of this from the end of the 1980s until… well, until now.
Of course it is corporate executives’ job to find and pursue productive investments or return capital to those better able to do so. What’s wrong with funding investment out of surplus cash on the balance sheet and retained earnings?
Of course, this might seem unambitious. But many companies have just endured a hard battle to repair their balance sheets over the past four or five years. They might be wise to consider carefully before submitting to some investment bank’s analysis proclaiming market support for a weak BBB balance sheet. Debt to enterprise value ratios can turn very ugly very fast when stock prices start to fall.
