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Funding in the aftermath of the credit crisis gave nightmares to many business executives at companies large and small.
Bank debt, long the staple for corporate funding, dried up as the 2007-08 financial crisis roiled even the largest institutions. Even capital markets, touted by many as the most likely replacement, shut down as companies found bond deals tricky in the months after the collapse of Lehman Brothers, the US investment bank.
Now, several years on from this, experts say a subtle shift is taking place in how companies fund themselves, which could have huge implications for how they operate in the future. The trend can best be summed up by the phrase: bank to bond.
With banks trying to shrink their balance sheets – a process known as deleveraging – and impending regulation such as Basel III set to make their loans more expensive, more and more companies have been flocking to the capital markets. Despite the difficulties of late 2008 and early 2009, recent months have seen some of the cheapest corporate debt ever issued.
“Compared to the early 2000s, the main difference for corporate liquidity is that banks might be more cautious when it comes to the use of their balance sheets,” says Jean-Michel Carayon, senior vice-president at Moody’s, the credit rating agency. “The availability of bank debt appears less secure, more expensive and generally less certain for corporates now than in the past. As a result we have seen an increasing recourse to the capital markets.”
That shift has been intensified by a number of factors. One is that companies are scarred by the experience of the crisis, when several saw banks pulled credit lines with little or no explanation. “Companies are a bit suspicious about banks. It is hard to be confident that the capital will be there,” says John Grout, policy director at the UK’s Association for Corporate Treasurers (ACT).
A second is that the bond markets are opening up for a greater number of companies. The so-called high-yield market, previously known as junk bonds, refers to smaller and riskier corporate debt. It is well established in the US, but has only recently taken off in Europe and Asia.
Bankers say the covenant deals on such bonds can give companies more freedom to operate than those in bank debt, where lenders tend to have stricter oversight on their borrowers.
But not everybody believes the shift will happen as quickly as many bankers would like. US companies finance themselves about three-quarters through capital markets and a quarter through banks. In Europe, it is the other way round.
Mark Thomas, a business strategy specialist at PA Consulting, the UK management consultancy, underlines that at the height of the crisis companies either had to fund themselves with their own cash or tap capital markets. But, he argues the move to bonds has been less pronounced than many would like: “My own view is there has not been as much of a change as expected. There has been a bit of a move away from banks.”
One brake on a big jump is the dominance of small and medium-sized companies, classified as having 250 workers of fewer. “The SMEs are well below the horizon of bonds,” says Mr Grout.
Another is that banks are still pricing loans aggressively, even if all observers agree that the Basel III rules on capital will eventually force them to increase prices. Mr Carayon says that if official interest rates stay low, presumably because economic recoveries remain weak, the impact on business will be limited: “The cost of funding might be increasing. But higher spreads should probably be balanced to some extent by the lower level of interest rates. So the implication for corporate business models might not be so dramatic at the moment, but investment decisions might have to meet higher hurdles in terms of cost of capital.”
An undoubted consequence of the credit crunch is that companies have become hoarders of cash. Gibson Smith, co-chief investment officer of Janus Capital, the US fund manager, in Denver, Colorado, says that companies have the strongest balance sheets and liquidity profiles in decades. “This new-found corporate conservatism is real and it is here to stay for some time,” he adds.
That means companies need to develop new skills in areas such as managing cash, dealing with money-market funds and monitoring bank counterparties. Companies are also monitoring their entire supply chain to see how financially secure their suppliers are. Many large groups now offer so-called supplier financing to help smaller companies they depend on to survive.
But corporate conservatism is expected to manifest itself in other areas. Leading up to the recent crisis, companies enhanced their growth with cheap credit. Now several experts expect them to have to fall back on more equity and less debt.
“I would not be surprised that, in the same way that the last decade was one of debt, we now move into an era of equity,” says PA Consulting’s Mr Thomas. Mr Grout of ACT adds: “We would expect smaller companies to have a future that is more equity and less debt.”
For Mr Thomas that means corporate performance could become a little more stable with fewer of the wild swings associated with debt-funded growth. “Debt acts as a magnifier of performance and that works both up and down. When things are going well, it is a fantastic magnification of performance. If things start to unravel, they unravel far more quickly if you have lots of debt,” he says.
One thing is clear: with official interest rates at record lows and bank lending due to get more expensive, the cost of capital for borrowers worldwide is likely to increase in the coming years, making funding more important than ever to corporate strategy.
Janus Capital’s Mr Smith says increased dealing with the capital markets is a healthy thing: “It has forced chief financial officers and chief executives to be more disciplined in how they deal with their balance sheets.”