Recommended reading:
The Economist's Survey on Corporate Finance.
economist.com
Here's the last article in the survey. If you don't subscribe, you should so you can get the whole survey. Why would anyone not subscribe?
SURVEY: CORPORATE FINANCE
Destructive creation
Jan 25th 2001
From The Economist print edition
What happens when the good times come to an end?
IT IS a banking truism that the
worst loans are made at the best of
times. This survey has argued that,
in America at least, companies’
financing arrangements seem to
assume that the good times will
continue to roll. But all good things
must come to an end. The American
economy cannot continue to grow
forever; indeed, it is starting to
slow. Stockmarkets still appear to
think that Mr Greenspan will perform
yet another miracle, and keep the
economy growing at just the right
pace to keep inflationary pressures
at bay without bringing it to a halt.
Perhaps he will. But there is a risk, a big risk, that the excesses of
boom times will make a bust more likely.
Although American companies are generally considered champions
of shareholder value, there is ample evidence that they have not
been acting in shareholders’ long-term interests. Instead, they
have been looking after their own short-term ones by forcing up
share prices. For big companies, this has been a simple matter of
buying back their own equity with borrowed money. That, of
course, is precisely what corporate-finance theory has been telling
them to do. Moreover, financial economists are forever griping that
companies squander shareholders’ money. So what could be better
than to give it back? The strategy also has the virtue of making
companies look more profitable. The biggest attraction of share
buy-backs, however, is that they are likely to increase the value
of stock options, which make up most of the remuneration of
big-company bosses nowadays.
Stock options are fine for young companies to encourage workers
to help the business grow, but for mature firms they are just a
way of bilking shareholders. Whether they notice or not, they have
to pay for the options, either out of shareholders’ funds or by
having their ownership diluted.
Similar scepticism is in order about mergers, which became ever
more fashionable even though countless academic studies show
that most of them destroy shareholder value. But if they do not
achieve their stated aims, mergers do produce a couple of other
desirable effects. First, the practice of pooling allows returns of
the acquired company to be calculated from a small asset base,
regardless of the actual cost of the purchase. And second, those
precious options can be exercised prematurely.
Bond investors, rather late in the day,
have started to realise that they are
getting an even worse deal. They are
exposed to most of shareholders’ risks
but get hardly any of the benefits. Rapid
advances in technology make their
position more perilous still. Creative
destruction can be a wonderful thing for
a few shareholders, but is bad for debt
holders. Technological change is one
reason why investors treat even some
investment-grade bonds as lowly junk.
Creditworthiness used to be determined by collateral; now,
increasingly, it is determined by human capital, which is far more
volatile.
There are two ways of looking at the reactions to all these
events. On a charitable view, markets have been panicking
needlessly, whereas credit-rating agencies, whose information is
better than the markets’, are being more sensible. On a less
charitable view, though, the credit-rating agencies have been
rather slow to adjust to changes in the real world. That, some
reckon, is why Moody’s (though not Standard & Poor’s) has
become much quicker to downgrade companies’ debt.
Crunch time
The bottom line is that the markets have punished bond issuers far
more than have the rating agencies. At long last, banks have
started to do likewise. Many banks have had to ramp up lending to
ever more risky credits so as to increase profits. Over the past
couple of years, banks have gone where bond investors have
feared to tread. Their lending has been growing at a giddy pace.
Now they are beginning to discover the limits of that strategy.
Their bad debts are increasing and may get worse, perhaps much
worse. Bank of America, Wachovia and Bank One have all had to
admit to big increases in bad loans, even in a strong economy.
Now that the economy is slowing down, bank lending is likely to
decelerate dramatically.
With both bond investors and banks keeping their hands in their
pockets, companies’ cost of borrowing will rise, perhaps steeply.
The reason why bond yields have already risen so far is that there
is more demand for finance than there are willing suppliers of it.
That disproportion is likely to grow. In other words, America’s
present small credit crunch might develop into a big one.
If lenders are starting to worry so much, why not shareholders?
The debt of Amazon.com (a well-worn example but a good one),
with a market capitalisation of $6.3 billion, is rated only a touch
above default. The company could come good; indeed, it is one of
the few Internet firms that might. And there are sound reasons
why shareholders would want to buy a company with bags of
growth potential when bondholders do not: they get the upside,
not the downside.
But the main reason why shareholders have been slow to realise
that there could be trouble ahead is because nobody really knows
how to value shares—except by the obvious means of seeing what
people are willing to pay. Analysts do not have a clue either,
although they pretend they do. And companies are equally
ignorant about their cost of equity. If anybody had any idea of the
“true” worth of equities, stockmarket bubbles would never arise.
Yet another has just burst.
Quite probably, worse is to come. Companies have had to finance
their investments and the servicing of their debts out of cashflow,
which is starting to deteriorate. This is partly because the
economy is slowing, and revenues with it, but also because many
companies resorted to trickery to boost their revenues. Many
high-tech companies have lent money to their buyers to purchase
their products. Now some of those borrowers are finding it difficult
to pay them back.
So far, stock options have helped the cashflow of many companies
because they are treated as expenses by the tax authorities but
not by the accounting ones. However, if share prices drop and
options are not exercised, this boost to cashflow will be lost. That
could be a big blow to companies such as Microsoft.
For many of the companies that pay their employees in options, a
continued fall in their share price is likely to feed through into
higher pay. If employees do not get their rewards from the
stockmarket, they will demand more compensation up front. Higher
expenses and falling revenues will put a big dent in earnings per
share. Stockmarkets tend to get upset about such things. And if
shares drop, companies’ large debt burdens will be that much
heavier.
Higher costs, along with lower spending on technology, would also
presumably hit labour productivity. Much technology spending, and
the availability of finance for it, was based on the assumption that
economic growth would continue at its giddy rate of recent years.
If such spending slows sharply, some, at least, of America’s
productivity miracle may quite possibly turn out to have been an
illusion. The question then is how long will it take the American
economy to unwind the excesses that it has built up. |
