Friday, December 21, 2012

Back to the Future Again: The Beginning of a New Debt Bubble?

You cannot blame investors reaching for yield given the current near zero interest rate environment. This has depressed credit spreads and increased the market appetite for higher risk transactions. Plentiful cheap credit has proved to be too much of a temptation for many firms to ignore.  An unintended consequence of this development has been an increase in corporate leverage for both investment grade and noninvestment grade corporate issuers. Much of this increase for investment grade firms is related to shareholder distributions such as debt financed dividends and share repurchases.  Issuers like Costco and others have been issuing new debt to fund these distributions. True, some of this is related to the expected increase 2013 tax changes. Nonetheless,  the net result is investment grade corporate leverage multiples are creeping up to 2X EBITDA.  Just like in the pre-crisis era, firms are scolded for lazy balance sheets with low debt levels and high cash balances. The rise in leverage levels for the noninvestment grade LBO is even more dramatic. Leverage as a multiple of EBITDA has increased to over 5.5X while equity levels have fallen below 35%. These levels are approaching their pre-crisis highpoints.

This is reminiscent of the 'optimizing balance sheets by leveraging up' themes prior to the crisis. The problem with leverage is the benefits are visible while the costs are hidden. This is because risk is difficult to measure. The key benefits are control, usually reflect in share accretion, taxes (because interest expense is tax deductible) and higher equity returns. The tax benefit associated with leverage comes from a value transfer from the IRS by reducing their take in the firm’s cash flows. This benefit was reexamined and revised  downward from the statutory tax rate times the level of debt by Merton Miller in 1977 once the impact of personal taxes are considered.

Leverage costs are reflected by the product of the probability of distress times the cost of distress. The probability of distress is a combination of business risk from factors including cyclicality, regulation, competitors , and others as outline in my previous  November 14, 2012 post "How Much Debt is Right for Your Deal?".  The second component-cost in the event of distress -is much more amorphous and frequently understated if not ignored all together. These included heighten risk of competitor attacks, negative relationship impact on suppliers, customers and employees, and ultimately risk of default and failure. Leveraged firms have simply less room for error. Many firms discovered this fact during the 2008/2009 period.

These firms lost financial market access, were unable to rollover maturing debt, had to curtail investments and dividends, and some ultimately failed. As James Grant has noted all lessons in finance are cyclical and not cumulative. They are continually being rediscovered. What is surprising is how quickly many of the crisis lessons have been forgotten again. They may be painfully rediscovered again.

Financial markets still face considerable macro headwinds which could result in their closure to some firms. This could severely impact their strategic investment programs - their main source of shareholder wealth creation - and especially the flexibility to capitalize on market disorder by profiting from competitor weakness. That is why capital structure decisions must be tied to overall strategy. Also, they must be consistent with an appropriate debt rating and liquidity levels.

Less leverage and more liquidity are not mere redundancies or insurance. Rather, they represent opportunistic investments. Firms sometimes under estimate their liquidity and capital needs during bullish markets. Apart from tax shields (which may be overstated) leverage does not create value-it only magnifies short term results.  In addition, offsetting costs of financial distress are difficult to estimate. See Nassim Taleb’s recent book “Antifragile -Things That Gain from Disorder” (Random House, 2012) for a more philosophical approach to this topic.

Cautious Joe

p.s. Best Buy (original post November 19, 2012 “Not Sold on Best Buy LBO") update: The firm has granted its largest shareholder and founder an extension to next February to make a bid. This another sign of the difficulties associated with the planned buyout. As the saying goes, good deals get done right away, while bad deals don’t.

We won't post next week, but will return Jan 4.  We wish all of you a wonderful holiday season and a fantastic 2013!

Joe and Ralph

No comments:

Post a Comment