Dumb question but how do you articulate how debt financing contributes to capital efficiency, given it’s not focused on upside?
I don’t believe in strongly efficient markets, but I do think in the long-run that finance is good at distributing capital to companies that perform well. However, whenever you hear people articulate that view, it’s usually in the context of equity investing. For example, someone invested in Microsoft early on, which allowed them to grow and build all these computers blah blah blah. If Microsoft were to start to do a bad job, investors would pull back and send capital elsewhere, bc they would not be getting a return.
For context, I’m currently interviewing with a BB corporate banking team that covers a very capital intensive industry. The group has been around for 75 years and has directly loaned and helped the industry raise huge amounts of debt over that time, and has been an important provider of liquidity during downturns. The returns probably aren’t great for the company on the loans directly but they do make a lot in cross selling fees.
While I certainly understand how the financing and liquidity is beneficial for that industry and the employees, how does the bank determine that this much capital should be going to the industry? Cynically, I could see someone arguing they are just creating zombie companies that have to keep operating to service their debt? Just don’t fully understand the pricing/feedback mechanism like I do for equities.
If the companies in question - you mention capital intensive type businesses - are high quality, stable, good cash flow businesses that are simply using short-ish lines of credit, loans, etc. it's almost a 'why not' if you have the relationship. To your point - you are cross selling services and it's probably a pretty good spread to your own borrowing costs (NIM!). The bank, being in point position for the company, will have a very good idea of how much debt they can take on as they've done the work on cash flow, coverage ratios, outlook, etc. I may be missing your question - but it's more the strategic plan and outlook for the bank. What industries do they cater to, do they have an advantage in coverage/specialization/positioning to service those. They might not have the view that they should be in the higher risk, higher return business. The reality is that highly capital intensive businesses yields deal flow which drives fees, etc.
Beyond the firm using it's own balance sheet/directly lending - then it's simply the appetite of the market and debt markets do a commendable job of penalizing companies they don't like, and helping out those they do. Same with equity folks, low quality/bad companies will be hit with higher borrow costs, lower credit ratings, more concessions at issuance, maybe even different tenors of debt (i.e. can't go out too long as markets don't trust them). High quality is the opposite of all of those. It then flows down to the bank, should the risk outweigh the return on the relationship - they'll pull back balance sheet allocation, have them cut down their leverage, etc. etc.
I'd also keep in mind that there are companies and industries where, well, debt is the preferable form of capital. Airlines are an example where unless you enjoy being diluted, wiped out or otherwise smacked in the head every few years - debt is the place to be. Revolving lines of credit are necessary for them, longer term stuff they pledge assets against (i.e. AAdvantage program) and when they run out... well. Markets either cut them off or severely constrain them. Maybe a bad example as now there's that whole implicit bailout - but anyway.
Last thought - and I'm not honestly sure if I'm rambling or even being remotely helpful at this juncture - allocating capital in fixed income has a lot of considerations that stretch beyond just 'max return'. Insurance and pension funds are good examples of this. If I'm running an insurance portfolio at cost - I care about two things: what's your yield, and will you blow up in that time frame. I'm matching cash flows, largely, and defraying liabilities. In some ways you might pray they are a zombie company just servicing their debts.
Thanks for taking the time to reply, this is all super helpful. Going to read thru your other posts this weekend since this was so interesting.
Makes sense that banks are looking for attractive spreads and these types of corporate loans are just easy and safe for them to take on. Also makes sense that they make those top down allocation decisions in terms of what industries they like in the long run. I do think it's interesting how their investment decisions have to consider returns that are separate from the security itself (ie., maybe you only make 2% on a loan but can make X mil in fees with that client). I guess that kind of "external" investment consideration is pretty common in business more generally, but its not how I'm used to thinking in finance.
For some reason I was having a hard time connecting all the fixed income concepts (borrow costs, covenants, credit ratings, tenors, etc.) to the reward/punish feedback mechanism, but this helps a lot. The group I'm looking at actually covers airlines (I actually had a small role on the AAdvantage deal at a prior firm), so that was a perfect example. I wasn't making the connection that it's just a preference thing of the company- i.e. the market can make a decision to allocate capital to an airline, but more of the capital will just flow into the firm thru debt since that matches the firm's financing needs better.
I think my disconnect was coming from the fact that most of my investing knowledge is coming from Buffett/other value-style public equity investors, but that's only due to how accessible that perspective is. Do you recommend any good people I should read/listen to get more familiar with the philosophy behind fixed income investing?
This is sort of separate thought so feel free to ignore, but I guess my real confusion is ultimately around the relative efficiency of that feedback mechanism in debt markets. The equity market just seems so much simpler (buy if you like, sell if you don't, stock goes up/down). It is easier to understand how companies get punished/rewarded since the instrument is more simple and uniform. There is so much more variety across debt instruments, but I guess that makes it interesting as well. From an academic finance or economics perspective, is there any interesting research on how different markets vary in their pricing efficiency? I remember some stuff from my CFA coursework on variance in equity markets by geography, but it must vary by asset classes as well right?
Seems like Swenson has some stuff on relative pricing efficiencies across asset classes by using distributions of actively managed returns. Greater spreads holding over a long-term period implying less pricing efficiency. He notes debt is the most efficient bc its just so much simpler mathematically. The cash flows are contractual and the main external judgement is around default/recovery. So that makes sense thinking about it more. Still think the overall complexity of certain debt instruments means some of the specific instruments must be less efficient (as evidenced by MBS in 2008 or whatever). He also notes PE/LBO/VC etc are on the low end of efficiency, and is why Yale dedicated so much resources there (seems like a lot of this must have to do with the nature of these markets or instruments themselves - i.e. PE investments being less volatile due to no public market, inability to index VC investors like you could the SP500).
But going back to the why question (debt's impact on capital allocation) - I guess a corporate bank's loans in particular might be beneficial specifically bc of the "fee-based" external cross-sell return. Bc they have a specific risk profile due to the nature of their capital deposits, they would focus on debt. But maybe bc of their "point position" knowledge and ability to capture "idiosyncratic" returns in cross-sell, they can get more comfortable lending at low rates than other market participants. This would be beneficial for companies as they then get cheaper capital that better fits their needs.
"If Microsoft were to start to do a bad job, investors would pull back and send capital elsewhere, bc they would not be getting a return."
This may sound obvious, and perhaps I misunderstood your point re equity investing, but there is no pulling back of capital once a company's stock is publicly traded (secondary market). Buys and sells don't add or remove capital as they are traded between third parties like you and me. Now if a company performs poorly and it's stock holders want out, they'll sell and someone who feels it's a good deal will buy. Maybe the CEO loses his/her job. I guess the company loses value in as much as they own their own stock but there's no pulling capital like that which exists in the debt market if say a lender refuses to renew a note or extend a line of credit. Of course additional equity offerings would be a different story. If a company is a poor performer, might be difficult to do another round of equity.
The value changes daily based on the stock price (price X outstanding shares), but the capital doesn't (because they already received it in exchange for those shares),
Yeah thanks for highlighting this. It’s pretty easy to elide stock price changes and capital allocation, but as you mention most equity trading is on secondary markets and therefore doesn’t change company’s capital (at least directly). Think this actually answers the question really well, just from the other side. The exact mechanism whereby equity investing influences “capital allocation” is less direct than I was characterizing it.
Everyone above has excellent points but even simpler put, as an investor, it provides a class of investing which is lower risk than any "upside-focused" equity type of strategy. Since debt-holders are higher up in preference of payment in any capital structure in the event of default, the lower return is justified by less risky capital.
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Lots of long responses that get into more nuance but in simple terms from the capital provider standpoint, have a mix of upside (equities) with current pay annuities (debt) is a good way to smooth and de-risk through cycle returns. From a company perspective, debt does not dilute equity and provides tax advantages - so its efficient on two fronts.
Thanks, this is actually helpful. Debt is efficient in the sense it just has different characteristics than equity which make it beneficial to both investors/companies.
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