There are some striking similarities between the balance sheets of companies immediately prior to the Great Recession of 2008-2009, and balance sheets of companies today.
We have experienced one of the strongest and most persistent positive economic environments in history, over the past 10 years, which has emboldened many CEOs to take on massive amounts of corporate debt.
Even Saudi Aramco, Saudi Arabia’s national oil company, which generated $224 billion in earnings before taxes and interest, is planning to issue $10 billion in debt securities soon.
Debt-based strategies that work during positive economic environments often place companies in vulnerable financial shape that can have disastrous consequences when the economy goes into recession.
I believe everyone should contribute to their chosen field of expertise. One way I have tried to give back over the years is to teach classes. One of the classes I teach is called Multinational Corporate Finance. This class is basically an international finance class that focused on financial management strategies for multinational corporations, including currency hedging strategies, and managing the balance sheet of the business, among other key financial metrics.
In this class we focus on a number of case studies, including the CEMEX acquisition of Rinker Industries, and the bankruptcy of Wuxi Suntech, which was a Chinese solar panel manufacturer. In both of these cases, egotistical CEOs with virtually complete autonomy pursued aggressive growth strategies that worked well during the economic expansion that preceded the Great Recession, but that ultimately destroyed both companies when the recession hit.
A key aspect of both company’s strategies was the extensive use of debt.
One would think that smart people would learn from the mistakes of others instead of blindly stumbling down the very same path of those who came before them.
Unfortunately, we see many companies today that have accumulated significant amounts of debt, many of which are highly dependent on refinancing that debt to avoid serious financial consequences.
Entrepreneurs running early stage businesses face similar challenges. With interest rates at historic low levels, it has been tempting to use debt instead of equity to finance growth.
It is, of course, much more attractive to maintain ownership of a business rather than issuing shares to outside investors. Entrepreneurs, with good reason, worry that selling too much equity could result in a loss of control, or at minimum, a loss of management autonomy and a drift away from the core vision they have for their business.
Using debt can be a viable alternative to selling equity ownership in the company, but debt comes with its own challenges.
First, regardless of the structure of the debt, it is a loan. At some point, it matures, meaning the company must repay the loan. There are ways to structure debt issuances that lessen the impact of the repayment, such as using a balloon payment structure rather than having to make monthly payments.
Another option is to use an interest-only structure, with a lump sum to be paid at maturity, in which the company only pays interest every month, or only at the end of each year, with principal paid at the maturity of the loan/bonds, in say three years or five years.
Still another structure that delays the timing of repayment is making once-a-year payments of principal and interest, at the end of each year until maturity. This at least allows the company to put off making any payments until year-end each year.
With all of those options (and one could certainly think of many other ways to structure debt), at some point the money comes due, and cash must be available to make the payments.
Many companies, and this is especially true for early stage, fast-growing companies, experience significant cash-flow constraints. These businesses are typically reinvesting their cash into the business to foster that fast growth, and rarely have excess cash sitting around to use to repay debt.
Often companies, large and small, will try to refinance their debt when it comes due. While this is certainly much easier for publicly traded firms that can access the public markets, larger banks, private equity funds, venture funds and the like, it can be difficult if not impossible when the economy goes into a recession.
For privately held businesses, refinancing can be substantially more difficult, regardless of economic conditions. Add a weak economy to the mix, and privately held small companies with limited cash flow will find refinancing debt virtually impossible.
The key problem with debt is that, as mentioned above, unless it is refinanced, it must be repaid when it matures. That repayment must come either from new funds raised through a new debt issuance, or it must come from internally generated cash flow.
As stated above, most early stage companies that are growing rapidly, and that are using cash flow to support that growth, rarely have the cash lying around to repay debt. In the best circumstances, these companies will be forced to siphon off cash that could and should be used to drive growth, to repay debt. All too often, especially if the economy weakens, cash flow is not sufficient to accumulate the necessary balance to repay the debt.
In the latter case, in which cash is not available to repay maturing debt, companies face limited options. In these circumstances, debt holders are in a position to dictate terms. They can force the company into bankruptcy, meaning that they can force the liquidation of the business — selling-off any assets and taking any proceeds.
In that case, only if the sale of the assets generates more cash after all expenses and the repayment of all outstanding debt would the shareholders receive anything. If the debt holders agree to a restructuring, the typical outcome is that the debt holders receive all of the equity in the company, and the original shareholders are wiped out.
While there are many permutations of a bankruptcy or restructuring, none of these are attractive to shareholders, including the entrepreneur(s) who started the business, took great risk, and invested their blood, sweat and tears — and probably a lot of their own money — into the business.
Given the current state of the economy, and the recent inversion of the yield curve (long-term interest rates fall to levels below short-term interest rates), which in my experience is the most accurate, forward-looking indicator of a recession to come, entrepreneurs and investors should be very wary of heavy debt loads for companies.
While the typical timing of a recession following the inversion of the yield curve is about 18 months, recessions have come much more quickly. As with the CEMEX and Suntech cases cited previously, the takeaway should be that the balance sheet of any business should not be managed in a vacuum. Rather, decisions about the capitalization of a business should be made in the context of the operating environment within which the company operates.
For early stage, U.S.-based businesses, that operating environment is the U.S. economy. If entrepreneurs and executive management believe the economy is, in fact, heading for a recession, they should be actively pursuing deleveraging strategies to reduce or eliminate debt, or, if that is not possible, to refinance debt with longer maturities than stretch beyond the anticipated end of the possible recession to come.
Through effective capital structure management, entrepreneurs can support ongoing growth and positive cash flow, and, more important, avoid driving their businesses into dire financial situations, including forced bankruptcies or restructurings resulting from excess debt.
— Craig Allen, CFA, CFP, CIMA, is president of Allen Wealth Management, and has been managing assets for foundations, corporations and high-net worth individuals for more than 25 years. He can be contacted at craig@craigdallen.com or 805.898.1400. Click here to read previous columns or follow him on Twitter: @MPAMCraig. The opinions expressed are his own.
