Why Capital Structure Matters
Lessons from China Evergrande
Capital Structure is one of the core topics we study in the field of Corporate Finance, and it is a subject with great practical importance. How should a business corporation finance its operations? With what mix of debt and equity, structured how? Does capital structure impact the corporation’s cost of capital? If debt is cheaper than equity, why not load up on debt, particularly low cost short-term debt? How do the answers to these questions vary with the nature of the particular business being financed, or the state of the capital markets?
Capital Structure involves more than simply the choice between issuing debt and equity. Think for a moment about just some of the many debt funding alternatives available to a corporate treasurer: bank loans and bonds, short and longer-term maturities, variable and fixed interest rates, callable and non-callable securities, priced in USD or other currencies. And then there is leasing, which looks a lot like debt in many respects but with different legal, tax and accounting treatments. Debt is a more complex topic than it might appear at first glance, with varying terms, costs and risks.
Equity is simpler than debt in many respects, but it is not always plain vanilla. When we refer to “equity”, we generally have in mind common equity but there is also preferred equity as well as convertible securities and other forms of equity options. And the biggest source of equity funding for most established companies is not the capital raised from the sale of shares but rather retained earnings, ie the cumulative net income previously accrued but not yet returned to shareholders in the form of dividends or share buybacks. Most corporate equity funding is raised internally, not externally, which is how the subject of dividend policy links to that of capital structure.
The capital structure of an airline or an industrial corporation will likely look very different from that of a software or biotech company or that of a bank or insurance company. This is in part due to the distinct types of operating assets employed in these very different businesses: airplanes and fixed PP&E (Property, Plant & Equipment) vs intangible IP (Intellectual Property) vs financial assets (loans and securities). And so we see that airlines employ a lot of debt, but software companies do not. Financial institutions are somewhat of a special case, and here we see that banks finance themselves primarily with deposits, debt and counterparty credit, with equity generally comprising 10% or less of total assets, compared to over 50% for many industrials and closer to 100% for many tech companies.
In addition to operating assets, many companies also own various types of non-operating assets and they don’t always have 100% ownership or control of all the business entities in which they have economic interests, which may result in rather complex capital structures not easily understood from a quick look at a consolidated balance sheet. To understand a company’s capital structure, and to value the company properly, we will need to take into account other balance sheet items such as “investments”, “equity in affiliates”, and “minority interest”. And we will definitely need to read the financial statement footnotes, paying special attention to taxes, lease obligations, pension plans and contingent liabilities.
Another important type of capital is Working Capital, consisting of Current Assets (cash, receivables and inventory) less Current Liabilities (trade and other payables). We generally think of working capital as “operational” capital rather than “financial” capital, because it is provided not by banks and investors in financing transactions but rather by commercial counterparties (customers and suppliers) as part of a company’s normal course of operations. In class we often focus our capital structure discussions on financial capital (debt and equity), but working capital needs to be part of the discussion as well. For many companies, working capital represents a major component of their overall funding and this is often where we see the first signs of financial trouble, when sales growth slows, inventories build up, customers have trouble paying on time, or suppliers decide they want cash on delivery.
It is sometimes hard to distinguish between working capital and financial capital. Think for example about cash, the ultimate form of liquid asset. Cash can be either a core part of working capital (cash used in the operations, eg to meet this week’s payroll) or it can be part of financial capital (excess cash not used in operations, and available to pay down debt or distribute to shareholders). There was a time when Apple had over $500bn of cash on its balance sheet, representing one-third of the total value of the company. Some of this cash was needed for operating purposes (working capital and capital investment) but most of it was not (financial capital). At the time Apple did not pay a dividend, but it does now and it has also returned a large amount of excess cash to shareholders in the form of share buybacks. To understand the financial strategy of Apple and other companies, we need to think about all these various aspects of capital management: working capital, financial capital, capital investment and dividend policy.
Those of you who were finance majors may well recall the capital structure work of Modigliani & Miller. These two financial economists won Nobel Prizes for their academic work done in the 1950s and 60’s, which showed that differences in corporate capital structure (simplistically, different mixes of debt and equity) should not theoretically impact a corporation’s cost of capital or the value of its business. This work was very insightful and has been hugely impactful on the practice of corporate finance, in large part because it demonstrated how and why the increased use of low-cost debt raises the cost of equity, leaving the weighted average cost of capital (WACC) largely unchanged. But in my mind, the work of M&M was equally important because it clearly articulated the specific reasons why capital structure might matter, not just theoretically but in practice: (1) governments often subsidize the cost of debt by making interest expense (but not dividends) tax-deductible; (2) capital markets are not always open to issuers, and certainly not in unlimited size and at stable and fair prices; (3) bankruptcy or financial distress often entail significant operating and financial costs; and (4) unbalanced capital structures may force companies to make sub-optimal changes in operating strategy, which will impact operating cash flows and therefore the value of a business.
Which brings us back to China Evergrande. I have written several posts on this topic, but I have not been able to keep up with all of the fast-breaking news. (See the links below and check out my prior blog posts on the subject.) China Evergrande is in serious financial difficulty for various reasons, most notably because of a big change in Chinese housing policy which is decimating Evergrande’s business model and financial results along with those of the entire property development sector. But Evergrande’s operating difficulties have been compounded by its unbalanced capital structure and undisciplined capital investment, the consequences of which are playing out in real time.
Evergrande has about $300bn (USD equivalent) of liabilities, two-thirds of which consists of short-term trade liabilities, essentially amounts owed to suppliers and to customers who prepaid for their unbuilt homes. Most of the balance is in the form of financial debt, primarily domestic bank debt denominated in Yuan but also including $20bn or so in USD-denominated debt borrowed from the offshore bond market. It seems that Evergrande may also have large amounts of contingent (off-balance sheet) liabilities associated with guarantees on various forms wealth management products sold to its customers as well as cross-defaults on some of its debt obligations. And did I mention that Evergrande has already deferred paying large amounts of bond interest and appears unable to refinance billions of dollars of upcoming bond debt principle payments?
In a frantic effort to raise cash, Evergrande has begun selling assets of all sorts, in some cases at firesafe prices. Essentially anything which can be sold is for sale: uncompleted property development projects, equity interests in affiliates, a big office building, its football team, and even the corporate jets. When high-flying companies like Evergrande sell the corporate jets, you know things are really bad. At this time it is unclear how much money Evergrande will raise from the asset sales, and how quickly, but the outlook does not seem promising.
Insolvency comes in two forms: (1) balance sheet insolvency, in which the value of assets is less than the amount of liabilities, leaving a company with negative equity value; and (2) liquidity insolvency, in which a company is short of cash and so cannot pay its maturing debts in full when due. Many companies which fail are insolvent in both senses, and some of these may need to be liquidated, but otherwise sound companies facing a liquidity crisis can often salvage their business by means of a more comprehensive financial restructuring, which may entail some loss of control by the current owners. But this only works if the business is viable, the capital markets are open and investors are accommodating. I don’t know enough about Evergrande’s assets or operations to know if the company is insolvent from a balance sheet perspective, but it certainly seems insolvent from a liquidity persecutive, or close to it. Unfortunately the capital markets are not currently open to Evergrande, and its investors and commercial counterparties seem far from accommodating. Which makes restructuring the company even more complicated than would otherwise be the case.
In any event, Evergrande could soon be effectively bankrupt if it is not already. (I don’t know legally how this works in China.) The company may not have to be liquidated, like Lehman was, but it may not be able to continue life in its current form, at least not without a huge injection of new capital into the business, most likely with government support of some kind. Like Evergrande, Lehman Brothers failed during a major domestic housing market correction, which destroyed the value and viability of its business. But the demise of Lehman was much faster than that of Evergrande. Lehman went bust as quickly as it did because its creditors and trading counterparties lost confidence and refused to continue doing business with the firm. Almost overnight, Lehman lost access to essentially all of its short-term funding, without which it could not continue in business for even another day. But Lehman also failed because it operated with unconscionably low levels of capital (equity) and because the capital markets were in a death spiral, decimating the market value (and liquidity) of Lehman’s assets and eliminating any refinancing or restructuring alternatives which might otherwise have been available. Ultimately Lehman failed because the US government refused to rescue it, rightly or wrongly, a decision which remains controversial even to this day.
We don’t yet know how things will play out at Evergrande, and it is still possible that the company could pull the proverbial rabbit out of its hat and save the day, or at least prolong the pain. If this doesn’t happen, however, the fate of Evergrande--and its customers, suppliers and creditors—may well be in the hands of the Chinese government. And while we don’t know what the government might ultimately do, bailing out foreign bondholders and Evergrande shareholders will likely be at the bottom of its priority list.
Evergrande is a truly fascinating case, which we will be studying for years to come. And when we do, we will point to Evergrande— as we still do to Lehman—and conclude that this is why capital structure matters.
Links:
China Evergrande Scrapes Together More Cash from Tech Company Sale, WSJ, 11.8.2021
Chinese Junk Bond Yields top 25% as Property Market Strains Intensify, WSJ 11.8.2021
China Evergrande, Strapped for Cash, Unloads its Jets, WSJ, 11.5.2021
Evergrande Crisis all but Shuts Bond Market for China’s Junk Borrowers, WSJ, 10.28.2021
Evergrande Calls Off Plans to Sell Key Unit, WSJ, 10.21.2021