Page 28 - DIY Investor Magazine Issue 24

LET’S FINALLY CONSIGN ‘BOOM AND BUST’ TO THE HISTORY BOOKS
Richard Buxton, head of UK equities at Merian Global Investors, issues an impassioned rallying cry for investors, companies, governments and broader society to treat the corona virus crisis as an opportunity for a fundamental rethink about the role of equity, leverage, dividend policies, executive compensation and the relationship between business and the public. Only by doing so, he argues, can we achieve greater economic stability, and reduce the risk of future equity market crises.
Whilst we all focus on the immediate challenges posed by Covid-19, companies, investors and Government must also begin to think about the longer-term consequences of what we are living through.
For one, we need to re-think the relative attractions of debt and equity capital to finance businesses.
Over my career the mantra that equity is expensive capital and debt cheap has grown ever louder, with the academic blessing of the ‘efficient balance sheet’ demanding that Boards and management teams juice up the returns to equity by maximising the use of debt.
I have lost count of the number of conversations I’ve had with management teams about the fact that their
‘WE NEED TO RE-THINK THE RELATIVE ATTRACTIONS OF DEBT AND EQUITY CAPITAL TO FINANCE BUSINESSES’
US shareholders regard UK shareholders’ reluctance to endorse leverage much above 3x the standard metrics, as feeble in the extreme. What’s wrong with 5x, 6x, 7x, they cry. If their balance sheet is ‘flabby or inefficient’ as opposed to ‘strong or prudent’, they are sitting ducks, ready to be taken out by rivals or private equity.
I hoped the global financial crisis (GFC) twelve years ago might have reminded companies, equity is permanent capital. Debt isn’t.
Management should ask: will your lenders be there for you when you need to re-finance the debt?
And at what cost? Equity may be deemed to be expensive, but never more so than when issued during a crisis to repair balance sheets. It’s debt that gets you every time.
We need to re-think what is the right amount of debt for a company to use relative to equity, in a world where economic activity can come to a grinding halt overnight.
I remember a conversation after the GFC with a senior Treasury figure, challenging the wisdom of the tax benefits which bias companies towards debt finance not equity, such as the tax-deductibility of interest payments.
‘WE NEED TO RE-THINK WHAT IS THE RIGHT AMOUNT OF DEBT FOR A COMPANY TO USE RELATIVE TO EQUITY’
He laughed, suggesting it was so entrenched that to attempt to overhaul this would be impossible, particularly in a way which was revenue neutral to the Exchequer.
Given that in due course the Government will be exploring ways in which to raise taxation to pay for some of their necessary but extraordinary support schemes, rather than simply raise corporate tax rates, might
some thought be given to gradually phasing out the tax benefits of debt finance?
A tax-driven nudge in favour of more prudent balance sheets could prove very powerful over time in changing corporate behaviour. Stronger balance sheets would mean an economy more capable of withstanding shocks and downturns.
DIY Investor Magazine | Apr 2020 28