Debt or equity: that is the question
With the synchronised rate from western central banks cut some weeks ago, and trillions of dollars pledged in rescue packages for the world’s biggest banks, one would hope that the worst of the credit crisis is over. In reality, this remains to be seen.
The equities market – and banking shares in particular – have never been more volatile than now. And it’s not just the equity market in turmoil, but the funding market also has its problems. Banks, corporates and even some governments are finding it difficult to raise funds.
In the US, the Federal Reserve has had to go in and buy up commercial papers directly from corporates to ensure that they would have enough cash to operate. The World Bank had to come to Hungary’s rescue after several failed bond auctions. And worse may be to come.
Standard & Poor’s has released a report which predicts that US companies need to refinance maturing debt to the tune of almost $ 800bnuntil the end of 2009. Where will they get this money in the current climate? It makes the rate cut irrelevant for many of them but if there is no access to funds, it doesn’t matter what the rate is.
This provides a clear lesson for corporates: secure access to liquidity is essential. Trust cannot be laid upon the ability to tap the market at will. We all have lots of friends in good times, but it is in testing times that you learn who your true friends are.
It is a matter of trust. If you constantly change bank to get a cheaper loan, or only go to the capital markets for funding, you cannot blame the banks for failing to support you in tougher times. Rather than chasing the lowest price when times are good, corporates should work on their loyalty and seek to build lasting, long-term relationships with partner banks.
This liquidity squeeze is worse than any we have seen for almost 80 years, so you might forgive the corporate treasurers for their lack of preparation in the face of an event that lies outside living memory.
The Miller and Modigliani theorem, which says that the capital structure (i.e. a combination of debt to equity) is irrelevant, completely breaks down in such an environment. The previously efficient debt market is broken, and so relying on equity and own cash flow for funding is worth gold now. Having invested in a long term facility when times were good is second best (unless it was with Lehman Brothers).
I am sure we will see many companies without a pristine credit rating fold or being bought up for small change over the next 12 months. In a normal functioning debt market they would have survived, but due to their inability to raise funds when debt matures they will find themselves in dire trouble.
October 22nd, 2008 at 3:45 am
Your blog is absolutely right to emphasis the importance of access to liquidity and that with the abnormal market conditions the lack of funding to companies could be the final straw for some. However on behalf of professional treasurers working in companies we would take issue with your comment – “This liquidity squeeze is worse than any we have seen for almost 80 years, so you might forgive the corporate treasurers for their lack of preparation in the face of an event that lies outside living memory.”
Prior to the start of the credit crisis in 2007 treasurers were being offered access to bank funding at very attractive rates and on borrower friendly terms. Many took advantage of this by signing up credit facilities for 3 to 7 years. Bond rates and credit margins were low so that significant volumes of new issues took place with some companies even pre-funding their cash expenditure needs to the extent of having cash to deposit. It is for just these reasons that we are 15 months into the crisis and generally speaking non financial companies have not run out of cash.
However with the crisis continuing and deepening there will come a time when the arrangements made by prudent treasurers begin to expire and need replacing. Conditions in the banking market will not be easy. Professional treasurers will be anticipating this and already taking steps to conserve cash, perhaps through better working capital management, perhaps through rescheduling capital expenditure or in extremis looking at disposal possibilities. On the funding side the banking market will be much reduced in size in the years ahead and for that reason alternative sources are being explored from capital markets around the globe or by private placement type transactions with insurance companies, fund managers, pension managers and other investors.
Treasurers do need to plan for an uncertian future and in May 2008 the ACT issued a briefing “Contingency planning for a downturn in the economy: a treasurer’s checklist”
Martin O’Donovan, Assistant Director - Policy and Technical, The Association of Corporate Treasurers