Debt-addicted firms eye equity as interest costs soar
CHEAPER TO SELL SHARES THAN TO BORROW IN THE DEBT MARKETS
For the better part of a decade, Bryan Riggsbee did what countless other finance chiefs, both in the United States and beyond, had done when their companies needed money: he borrowed it.
Late last year, the chief financial officer at Myriad Genetics Inc. took a different tack, one the Dna-testing company hadn’t seriously considered in over 16 years: selling shares.
For CFOS everywhere, what used to be a no-brainer — issuing debt — has turned into a much more calculated decision after central banks cranked up interest rates to levels not seen in decades. And with share prices near all-time highs, it’s starting to make more sense for companies around the world — from smaller ones such as Myriad, to bigger ones like Davide Campari Milano NV and Aston Martin Lagonda Global Holdings PLC, and startups such as Reddit Inc. — to raise capital in the equity markets.
For the first time in more than two decades, it’s cheaper for blue-chip companies in the U.S. to sell shares than to borrow in the debt markets, according to data compiled by Bloomberg.
“The better path was to issue equity,” Riggsbee said after Myriad raised US$110 million in November.
After three years of losses, the Utah-based company wanted to avoid debt and pay off its loan. Riggsbee, currently a strategic adviser after retiring last month, reckoned it would have cost more than 10 per cent in interest to borrow — three times the going rate a few years ago.
Debt, of course, remains the lifeblood of corporations worldwide, and for many, it’s still the cheaper option, especially as interest is normally tax deductible. Moreover, few analysts expect a deluge of equity issuance. But if companies begin to rely less on debt and more on equity in a sustained way — which is still a big if — the ramifications for corporate finance, and broader markets, are significant.
That’s because the global stock market has been shrinking for more than two decades. In the U.S. alone, the number of publicly traded companies has been cut nearly in half, from roughly 7,500 to about 4,000 today, according to the Center for Research in Security Prices. The United Kingdom and Germany have also seen similar declines in their numbers, according to the World Federation of Exchanges.
‘DE-EQUITIZATION’
Robert Buckland, who closely studied and analyzed the long and steady decline of equity over his 25-year career at Citigroup Inc., coined the term “de-equitization” as early as 2003 to describe the phenomenon.
“Companies always gravitate towards the place where capital is cheapest, and for years, public-equity markets were not a good place to source capital,” said Buckland, who served as Citi’s chief global equity strategist before moving to tech start-up Engineai Ltd.
Ultra-low rates during the post-crisis years accelerated the process. Companies borrowed heavily for acquisitions and share buybacks. Leveraged buyouts boomed, putting more public companies in the hands of private equity.
A reversal would reduce companies’ reliance on debt, loosen the grip of private equity and limit creditor claims on assets, all while increasing public ownership and corporate transparency.
Of course, a flood of initial public offerings and secondary sales could lower valuations, depressing returns in the short run. But over the longer haul, the investing public would gain a greater entrance to young, early-stage growth companies, bringing more balance to a market currently dominated by large, established behemoths such as Apple Inc. and Microsoft Corp.
DEBT-VERSUS-EQUITY MATH
For the cost of equity, Buckland looks at something called the “earnings yield,” which measures the cost for companies to issue shares as a percentage of their earnings. It’s calculated by dividing per-share earnings by the stock price. When shares rise, the percentage falls. The lower the percentage, the cheaper it is to sell shares. For S&P 500 companies, it’s fallen to just a bit more than four per cent.
He compares that with the cost to issue debt in the bond market. For investment-grade
U.S. companies, that cost — based on their bond yields — has doubled in the past two years to around 5.5 per cent, data compiled by Bloomberg show.
Based on that comparison, the last time equity was cheaper on a sustained basis was in the late 1990s and early 2000s (though brief periods have occurred, including in 2006 and 2008).
TAKING NOTICE
Companies across the globe are slowly starting to take notice. Recently, the maker of Arc’teryx outdoor apparel, Amer Sports Inc., raised US$1.4 billion on the New York Stock Exchange, adding to a nascent revival of U.S. IPOS after a two-year drought. While demand was modest at best, Amer will use the cash to pay down its loans, some of which had interest rates of nearly eight per cent.
That comes after a slew of publicly listed European companies issued equity in recent months to repay debt, clean up their finances and even fund acquisitions.
In late November, Finnair Oyj funded the purchase of six Airbus jets and paid off a 400-million-euro (Us$430-million) government loan with a share sale to existing holders. Had it not been repaid, the loan would have cost 52 million euros in interest alone this year, the airline said. While Finnair didn’t provide specifics on its interest costs, all else being equal, simple math implies an annual rate of 13 per cent.
“We lowered our cost burden,” Finnair chief financial officer Kristian Pullola said. “The capital loan was expensive capital that was becoming even more expensive as a result of higher interest rates.”
Last month, Campari sold 650 million euros of shares, as well as bonds that are convertible to equity, to fund its purchase of the Courvoisier cognac brand from Beam Suntory Inc. Campari, maker of the namesake Italian liqueur used in Negroni cocktails, went that route after its bond-market borrowing costs nearly quadrupled in the past two years.
Campari, which didn’t comment specifically on its debt costs, in an email said a change to its corporate structure in 2020 enabled it to sell equity to finance growth, rather than rely exclusively on debt, which it did in the past.
Meanwhile, Aston Martin, the U.k.-based automaker of James Bond and Formula One fame, used the 216 million pounds (US$270 million) it raised in July to push into electrification and pay down some of its debt, which carried a 15 per cent rate and incurred a “significant interest cost.”
Aston Martin declined to comment on its equity fundraising beyond its latest quarterly earnings statement.
MORE TO FOLLOW
Globally, IPOS and secondary sales have raised roughly US$50 billion this year, up about eight per cent from last year’s pace, when issuance hit a more-thandecade low.
Morgan Stanley’s Edward Stanley expects more to follow. His quantitative models, based on an analysis of five prior cycles over three decades, show a rebound in equity issuance is long overdue. If the models are accurate, Stanley sees the number of share sales close to doubling this year.
Stanley points to venture-capital-backed startups as a potential source of supply. More than 1,200 startups have become “unicorns” with valuations of least US$1 billion, and they’re likely waiting for an opening to raise capital, pay debt and cash out early investors, he said.
Reddit could be one of the first of many. More than two years after initially filing paperwork to go public, the San Francisco-based social-media startup is finally moving forward with its IPO, which may happen as soon as March.
Start-ups may also turn to IPOS out of necessity. Given how high interest rates are, VCS may think twice about funding startups that won’t show a profit for years, Torsten Slok, chief economist at Apollo Global Management Inc., said
“A venture capitalist will say: ‘Hold on. In year one, I’ll make five per cent at the Fed funds rate, and in four years, I’ll make 20 per cent, before you even start showing me a dollar of revenue,’ ” he said.
NO RUSH
Of course, there are plenty of reasons to think re-equitization won’t take hold.
For starters, private sources of capital remain plentiful, with a war chest of US$4 trillion or more. So even as leveraged buyouts slow, the boom in private credit may continue to persuade companies to finance themselves with debt.
Regulations and disclosure requirements — which benefit the investing public but have become increasingly costly and onerous — remain powerful disincentives for private companies. Plus, there’s little rush for young, high-growth startups to seek an IPO when funding rounds can now reach billions of dollars. Contrast that to Google Inc., which got just US$25 million of private funding in the six years from its founding to its IPO in 2004.
“There’s no way in today’s world where Google would IPO at such an early stage of its development,” Duncan Lamont, an analyst at Schroders PLC, said
Then, there’s the U.S. Federal Reserve, which may start cutting interest rates later this year, making debt more attractive again.
TURNING THE TIDE
Even if that happens, the cost of corporate debt might remain elevated. That’s because the benchmark for capital costs — the 10-year Treasury yield — isn’t expected to fall too much further. Jpmorgan Chase & Co.’s Nikolaos Panigirtzoglou said that sets the stage for equity supply to go “structurally higher.” The strategist predicts net supply will increase by US$360 billion globally this year.
Two big sources of de-equitization, leveraged buyouts and buybacks, have already declined as debt costs rise.
Simply put, “the math doesn’t add up” for companies to go into debt to repurchase stock for a small boost in per-share earnings, Société Générale SA’S Manish Kabra said. Not when deposit rates are high, investors are paying up to own their shares and borrowing is costly.
Buckland said he doesn’t see companies inundating markets with equity at anywhere near the scale of the late ’90s. But he’s hopeful the tide may finally be starting to turn.
“CFOS have two chequebooks, equity and debt, and they can use either,” he said. “They have tended to use the debt chequebook a lot more in recent decades, or cash, which has been a driver of de-equitization. But maybe they will be grabbing their equity chequebooks a bit more from now (on).”