Thanks to the coronavirus, executives across the world have been forced to recognise that there is an important trade off between efficiency and resilience in the way they structure their operations. That perception, which relates most obviously to global supply chains, could be usefully extended to the shape of corporate balance sheets.
What finance academics like to refer to as an “efficient” balance sheet is often anything but. Efficiency, in this case, may simply amount to an overleveraged financial structure. Woe betide anyone who is going into this virus-induced global recession with an efficient balance sheet.
There was a time in the postwar period when big corporations routinely aspired to a triple A credit rating. Then came an intellectual revolution. In the 1980s Michael Jensen of Harvard University wrote eloquently about the agency problem, originally identified by Adam Smith, whereby agents (executives) managed companies in their own interest rather than that of their principals (shareholders).
For him large cash balances pointed to waste and inefficiency. Equity on this view is a lazy form of finance that lets managers off the hook since dividends are discretionary. Debt, by contrast, limits managerial discretion and imposes an inescapable debt servicing discipline. It is a mechanism that forces managers to disgorge cash rather than engage in empire building, keeping bloated workforces and tolerating organisational inefficiencies.
Even over-leveraging could be regarded as desirable because it creates pressures and crises that force management to restructure. A heavy debt load has the further advantage of intensifying ownership incentives.
None of this is wholly wrong headed and Mr Jensen’s thinking provided the intellectual foundation of the multibillion private equity industry. Yet it needs handling with care. And care went out of the window in the pre-viral decade in which OECD economists estimate that global corporate bond issuance averaged $1.7tn a year against $864bn in the period between 2000 and the great financial crisis. The rise was most striking in the US, where corporate debt rose from $3.3tn before the crisis to $6.5tn last year.
There has been a marked decline in the quality of that corporate debt because investors’ search for yield in a period of ultra-loose monetary policy has tilted the balance of power in favour of debtors against creditors. So investors have forfeited the protections that are usually available to them when borrowers face financial distress. In fact Moody’s Investors Service’s Loan Covenant Quality Indicator hit its weakest ever level in the US in the fourth quarter of 2019.
A big driver behind this accumulation of corporate debt has been the share buyback phenomenon. Ostensibly this is good for shareholders since it puts money into their pockets. Yet the opportunity cost may be high, especially when executives are buying back shares when the market is overvalued. Interestingly, very little buying took place when the markets were low in 2008-09 while buybacks proliferated in the peak years of 2018 and 2019.
Such expensive buying can be explained by another principal-agent problem. Since so many bonuses and incentive structures are related to earnings and share prices executives have an incentive to shrink the equity to bump up earnings per share. But they do so at the cost of systematically weakening the balance sheet of the corporate sector. Some of the most enthusiastic buyers have been in precisely the sectors such as airlines and hotels that have been worst hit by coronavirus.
Mass corporate defaults are now in prospect. The IMF estimated last October that debt owed by firms unable to cover interest expenses with earnings — “zombie” companies — could rise to $19tn in a scenario half as severe as the financial crisis. Since the economic outcome of the coronavirus will be far worse than the financial crisis, the carnage will be horrendous.
No doubt corporate boards in North America and Europe will become much more risk averse in coming years. Japanese companies that traditionally sit on large piles of cash will be feeling smug. Yet Japan is a case of building too much redundancy into the balance sheet. And given that the conflict of interest inherent in buybacks remains, there is a risk that debt issuance will pick up much sooner than it should.
As the defaults accelerate, asset owners and managers should be asking themselves why they adopted such a permissive stance over buybacks and how their stewardship agenda should address the issue of balance sheet resilience in future.
Letter in response to this article:
Time to end tax relief on interest income / From David Rimington, Solihull, West Midlands, UK