Unpack the capital stack
What distinguishes equities from fixed income opportunities? The clue is in the word “fixed” and what that means for the return profile of the investment. A fixed income investment (like a government bond, or even a bank lending to a corporate) has a known return if held to maturity and if there is no credit default event. If sold along the way, the capital value will vary based on prevailing market returns compared with the fixed income component of the instrument.
That sounds terribly complicated, doesn’t it? Thankfully, there’s an easier way to understand the difference.
In fixed income, the investor must assess whether the company can achieve sufficient profitability to service the payments. Even if the company shoots the lights out beyond that, lenders don’t share in those profits anyway. They focus more on downside risks than upside potential, which is why fixed income instruments come with all kinds of promises to the lender designed to limit risk. These are called covenants. When a company breaches covenants, the lenders suddenly have influence over the company that can give them more power than equity holders. In this situation, things get dangerous for those “further down in the capital stack”— those with less in the way of protection. This is where seniority of debt and other complicated issues come in.
In equity investing, growth is key. In fact, that’s the important distinction to remember vs fixed income investing. You need to establish both the downside risk and the upside opportunity, along with what you are willing to pay for it, as equity investing is about chasing the upside. While it is true that a lender can also lose everything in a default situation, it’s far more common to see equity holders rather than debt holders emerge with nothing in a liquidation or business rescue scenario. This is the risk attached to the upside.
Don’t ignore the balance sheet
Mezzanine finance sits between equity and debt funding (hence the name). Investors in these complicated instruments seek downside protection and upside participation. When you see concepts like exchangeable bonds or convertible preference shares, you’re in mezzanine territory. These instruments are most commonly seen when companies are too risky to raise “cheap” senior debt, yet not valued highly enough to make the raising of equity funding appealing. Mezzanine funders can be a cheaper source of funding than equity, as the cost of funding is typically in the 15%-20% region for companies in South Africa. Risky companies need to return over 20% to equity investors to be interesting.
Equity investors need to be careful though, as the terms of mezzanine funding can become very expensive depending on the specifics. Every deal is unique in terms of the triggers for conversion. Sometimes they are based on a specific level of profitability, or even a listing (like Renergen’s recent mezzanine funding raise that converts to equity upon the Nasdaq listing).
The key for equity investors is to not ignore the balance sheet. You could get away with that during the pandemic in a low interest rate environment, as debt holders were only receiving modest returns and most of the upside was going to equity holders. In a structurally higher rate environment like the one we are in now, companies with more leverage (those with more debt) are dangerous for equity holders. The rise of alternative asset funds investing in private debt provides further evidence of this, as they are now getting a more lucrative part of the economic pie than before. The pie isn’t necessarily larger; it’s just being sliced differently.
Whenever you are analysing a company, be sure to understand the senior debt on the balance sheet and the cost thereof. Look out for when it matures, as the company will need to refinance debt and it might be more costly than before. Consider how operating profit is growing relative to the increase in debt costs and whether that leaves much on the table for shareholders. If there are other instruments on the balance sheet, find the details in the notes to the financials and understand them — especially when they are convertible into equity, as this will dilute you.
In this part of the macroeconomic cycle, you need to do more research than ever before on your single stock positions. You also have to go well beyond the income statement. If you don’t, you might be watching the bank smiling while your dividends go the wrong way. Or worse.