Yet the data reveal a striking oddity: the largest listed firms have disproportionately little debt compared with both smaller listed peers (see bottom chart) and private firms. Of America’s ten biggest non-financial firms, no fewer than six, including Microsoft and ExxonMobil, reported net cash positions at the end of 2008. Different accounting conventions make comparisons inexact, but non-financial firms in the S&P 500 index of listed American companies appear to account for only about a third of national corporate net debt, despite contributing a majority of profits. In Europe, with its tradition of bank financing, firms have always been keener on debt, but although overall corporate gearing has risen to “unprecedented” levels, according to the European Central Bank, listed firms have actually steadily cut theirs since 2000.
To grasp why big listed firms are different requires a bit of theory and some history. In theory, chief financial officers spend idle moments admiring charts of the idealised firm’s optimal capital structure. From this they are meant to conclude that debt is only moderately attractive. Since interest payments are tax deductible, but dividends are not, some borrowing makes a balance-sheet more efficient. Too much, though, makes a firm too risky, raising its overall cost of capital. It is a fine trade-off, which at most should add 10-20% to a firm’s overall value.
In the real world, however, many managers burnt their textbooks long ago and steadily increased their firms’ leverage, taking only the occasional breather in tricky economic patches such as the 1970s and early 1990s. This partly reflects their pay, which is often based on measures (such as earnings per share) that are flattered by higher gearing, giving them an incentive to take on more debt than is justified by mere tax planning. More demanding owners and abnormally low interest rates also led firms to take on more risk.
Also interesting but yet still important is how the article talks about how financial deregulation, and the large number of new innovative products that came along with it allowed many of these companies to stay afloat:
Financial deregulation, too, has played a big role, notes Jeffrey Palma, a strategist at UBS. A series of new debt products enabled even the leakiest corporate balance-sheet structures to stay afloat—for a while. In the 1980s junk bonds opened up credit markets for lower profile firms. In the most recent boom, companies bought by private-equity outfits, the corporate equivalent of subprime borrowers, packaged their debt into collateralised loan obligations, a form of structured credit that is now as toxic as it is hard to explain. The rash of leveraged buy-outs may account for as much as half of the rise in American corporate net debt since 2002.
Lo and behold their prediction of the future was: companies will be more risk-adverse and avoid carrying as much debt:
All this is likely to change the debate on corporate leverage in two ways. First, the gung-ho and largely erroneous assumption that higher debt means higher risk-adjusted returns will be replaced with a more measured assessment of the limited boost to tax efficiency that leverage can provide. One banker in London suggests that for the next few years, managers will be prepared to take on more debt only to the point where they are sure that they can refinance it if another crisis should strike. That suggests that quoted firms could further reduce their net debt from today’s level of about 50% of their book equity.
Second, the psychological scars will run deep for the private firms that bear a disproportionate burden of overall corporate debt. Many face bankruptcy, with the destruction of value that entails. Financial regulators, too, are far less likely to tolerate the sort of capital-market fads that allowed private companies to overload on debt at the top of the economic cycle and infect the banking system as they did so. It used to be that equity, as well as lunch, was for wimps. Not any more.
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