Characteristics of Equity and Debt

I thought that in the wake of the current financial mess, it would be a good time to go over an important difference between equity and debt investing.

Every company faces the choice to finance their business/ expansion plans with equity capital or debt capital. First, let us start with equity investing. There is a clear and pretty well accepted definition for the value of issued shares to investors- it is the discounted future cash flow of your share in the business. It is much more difficult in practice, and most people's guesses are as good as anybodies. For the company however, all that matters is that initial issuance price. Regardless of what the true value of their issued shares are, the amount of money the company raises is equal to the initial share price multiplied by the number of shares issued. These shares can never be "put back" to the company.

Afterwards, investors deal only amongst themselves. If I, as an investor, am able to perfectly calculate the value of a company's share and purchase it for less than that price, I would be value investing. In the short term, their value is reliant on what "Mr. Market" is willing to offer me on that day. But the good thing about stock investing is that I have no deadline on which I am forced to sell my shares. So if I had no time restraints, I could just hold on to those shares and watch as the company generates the cash flow (which I had perfectly predicted). At some point, the market will either recognize this or investors will demand the company dividend this money to them, allowing me to recognize fair value for my shares.

But when dealing with debt investing, the situation is usually very different. The reason is because debt matures and principal must be paid back. Let us say that once again, I can perfectly predict the future cash flow of a certain business. This time though, the business is financed with debt which initially matures in five years. For the first five years, everything goes as planned. The company pays its interest, and even uses its excess cash flow to start repaying its debt. Still, at the end of five years, the company has a large portion of its principal remaining unpaid.

The company now has no choice- it needs to refinance to pay back its existing debtholders, and its ability to do so relies completely on the market's risk perception at the time. With stocks, this wasn't the case: an investor could just hold on to his shares into the future, and the share price would eventually represent its fair value. But as a holder of debt, an investor is now exposed to the danger that the market might not want to refinance the company's debt at a fair cost, if at all. And although I know the company's future cash flow justifies refinancing, I, in all likelihood, can not afford to refinance all the debt myself. The business can now be forced into bankruptcy, and a perfectly viable business can be forced into liquidation. The only way a debt investor can completely avoid this risk exposure is to make sure that the business' income can cover both its interest and its principal payments as they come due, but this type of conservatism is rarely seen.

To make matters worse, the great business rarely even bothers with debt. The Coca Cola's of the world have the most predictable and stable businesses, and the lenders feel the most comfortable lending to them. Yet, these companies also never need to leverage themselves because they have strong competitive advantages and are already earning great returns on their investment. It is usually the bad businesses which resort to debt in order to boost their profitability. And the worst businesses need to leverage themselves to the moon just to earn a decent return. The current financial crisis is fraught with just those types of situations. What happened to Carlye Capital, which collapsed earlier this month? (link)

In a short news release issued early Friday, the fund, which is managed by a unit of Washington, D.C., private-equity firm Carlyle Group, said it received "substantial additional margin calls and additional default notices from its lenders" and that "these additional margin calls and increased collateral requirements could quickly deplete its liquidity and impair its capital."
...
Carlyle Capital managed only $670 million in client money, but used borrowing to boost its portfolio of bonds to $21.7 billion, meaning it was about 32 times leveraged.

What Carlyle did was borrow at X% and invest in securities making (X+.50)%. The only way to make the returns on investment in that semi-attractive was, well... 32 times leverage. And what happened? The market got nervous and they decided not to refinance. The same thing is causing problems for SIV's, hedge funds, and financial institutions in general. Some of these companies may have done all of their work correctly (unlikely), but making the market confident of that is not so easy. After all, if a company like Carlyle was only 3% off, its entire equity would be wiped out and losses would start accruing to its debtholders. These financial firms are starting to realize that when dealing with debt, it is not just what you think that counts. And a 3%, 5%, or even 10% margin of safety is not very reassuring to investors after the housing bubble we have just witnessed.