To avoid being taken over - borrow more!
Bill Robinson
Long-term interest rates fell steeply in the second half of the 1990s (see Figure 1), bringing them down to levels not seen in the UK since the 1950s. The fall has coincided with a sharp switch from equity to bond finance (see Figure 2), which presents something of a puzzle. Why should lower interest rates cause a switch from equity to debt? According to standard finance theory the cost of equity is equal to the risk-free rate of interest (typically the interest on a government-backed security) plus the equity risk premium. So when official interest rates fall, the cost of equity falls as well as the cost of debt. If both debt and equity have got cheaper, why the massive switch into debt finance?
Figure 1Long-term interest rates in the UK
Figure 2Capital issues by UK industrial and commercial companies
One possible explanation begins from the observation that corporate treasurers all know that debt is the cheapest form of finance on offer,especially when the tax savings are taken into account. What limits their borrowing is the reluctance of lenders, who worry about the borrower's ability to service, and ultimately repay, that debt. Lenders always take a very conservative view. Whether they are bankers, or ratings agencies (who assess credit risk on behalf of bond holders), they look closely at interest cover (the ratio of profits to interest payments). Traditionally they prefer interest cover above 3 and worry if it falls below 2. Interest cover below 1 (which means that profits do not cover interest payments) signals a crisis, even if income is growing and the loan is backed by assets that are appreciating in value.
Given that the quantity of borrowing is rationed by lenders who focus on interest cover, lower interest rates have an important, and underestimated,effect: they enable companies to borrow more for the same level of interest cover. This is a matter of simple arithmetic. If the rate of interest falls by one-fifth (e.g. from 7.5 to 6 per cent), then the borrower can increase debt by a corresponding amount and still have the same interest bill and interest cover. Lower interest rates thus boost borrowing because lenders are comfortable that a higher level of debt can be serviced from the same earnings.
There is a great deal of mystique surrounding corporate lending and it is helpful to draw parallels with a market we all understand very well: the house mortgage market. Mortgage lenders assess loans against:
the value of the underlying property; and
the income of the buyer.
Corporate lenders do the same, though they use different language. They look at debt in relation to:
the capital assets of the company; and
its earnings before interest and tax.
The key parameters are the debt to equity (or debt to value) ratio and interest cover. A given level of interest cover can be translated (at a given interest rate) into a loan-to-earnings ratio.
PwC research into a large sample of FTSE 350 companies shows that on average earnings cover interest four-and-a-half times. When this figure is converted into a home-buyer's language, it implies a willingness to lend a capital sum of between two-and-a-half and three times earnings. On the face of it this seems rather similar to the rules of thumb applied by mortgage lenders, but there is an important difference between the two cases: people who borrow to buy houses put up the houses as collateral. If they fail to meet their mortgage payments,the lenders can repossess and sell the asset. Some companies can offer this kind of collateral, but many cannot.
The existence of a saleable asset is always immensely reassuring to lenders. Companies with saleable assets will typically be able to borrow a larger multiple of their earnings – i.e. the lenders will accept a lower interest cover. There is thus a wide variation in average levels of interest cover in different industries.
These observations are borne out by the data shown in Figure 3, which is drawn from our FTSE 350 sample. Each point in Figure 3 represents an industry,and shows its average debt-to-value ratio and average profitability (measured by earnings as a percentage of capital employed, where capital is the market value of equity plus debt). The lines radiating from the origin show the level of interest cover – high for firms with high earnings and low debt levels, low when earnings are low and debt high.
Figure 3The link between profitability and gearing by industry
The basic point that companies' borrowing capacity is a multiple of their earnings is illustrated by the general tendency for companies with strong current earnings (as a percentage of enterprise value) to have more debt than lower-yielding companies. Fast growing sectors on low yields (IT,pharmaceuticals, advertising) have relatively little debt. Slow growing sectors on high earnings yields (water, property, tobacco) have relatively high levels of debt. On average the debt-to-value ratio is 2.75 times profitability(earnings-to-value), which implies that on average lenders are comfortable with debt levels 2.75 times earnings.
However, Figure 3 also shows a wide variation in average levels of interest cover. Contrast, for example, the property and hotel industries, with interest cover below 3, with the paper and packaging industry which has an average interest cover of nearly 7. The explanation for these large differences is quite simply that property companies and hotel companies can offer collateral –they have valuable assets that can, if the business cannot generate enough cash to meet the interest charges, be sold. The paper and packaging industry has no such readily saleable assets.
The main practical lesson to be drawn from Figure 3 is quite simple. There are a lot of industries with a high level of interest cover which have the capacity to service more debt. Since every £ of extra debt creates 30 pence of shareholder value in the form of reduced tax payments, this represents an important opportunity to create value. The surge in bond issues suggests that many companies are exploiting this opportunity already. But our analysis of the FTSE 350 companies shows that there is still a great deal of unexploited borrowing capacity out there.
Companies that are slow to seize the opportunity to borrow more run the risk of becoming take-over targets for those who are quicker off the mark.
Bill Robinson is head UK business economist in Financial Advisory Services at PricewaterhouseCoopers. He is a former special adviser to the Chancellor of the Exchequer.
