Can debt be more expensive then equity?
I am working through some SBA financing and the terms sheets for debt that I am seeing are not very favorable right now. Rates are higher then some of the pref. equity I am seeing on the market, which is making me think I should potentially be running full equity situations. Also the covenants are much lighter on the pref. equity right now. I think this is primarily due to banks having to restructure their balance sheets right now and significantly risk adverse in new lending. However, this would go against what most of us would have been taught.
Is there ever an instance where equity is actually cheaper then debt from a real life stand point?
at1 a la suisse non?
Well if you consider the wacc formula, no. If debt is more expensive your risk free rate goes up.
As you add debt to the capital structure, the beta goes up when you lever it. I don’t see how the risk-free rate changes as it’s a market rate.
Further, I don’t know how the cost of equity can be cheaper than the cost of debt. Equity holders will always demand a higher return as they have a residual claim vs bondholders with a contractual one.
Of course, when your D/E ratio gets too high, adding more debt hinders your cost of capital as the interest rate on the debt is simply too high.
Here is an example that illustrates quite well the relationship between, CoE, CoD, and CoC.
I’ve seen preferred equity price well above cost of equity
Sounds like your imposter syndrome is warranted
Ouch 😂
Lol! I misspoke. What I was attempting to say was look at the CAPM formula. When interest rates rise, the risk free rate increases. Since theoretically treasuries are risk free the market premium will always have some sort of spread even if small. No rational investor would invest in the equity of a business if they can do better with treasuries.
Yes. If you already have an extremely large portion of debt in your capital structure adding more debt will be more expensive than adding equity. Reason being chances of defaulting will go up with that much debt. If you made a graph with your wacc on the y axis and amount of debt on the x axis. Then the line would be in the shape of a U
To answer this question, yes and as you can expect, what usually happens then is that equity just buys out debt entirely (or just doesn't take on debt). I mostly see this in the context of emerging markets infrastructure PE. A situation actually just came up recently when we realised that our LPs were ok with 10% returns on a brownfield renewable project in Vietnam, but the financing attached to it also had an interest rate of just above 10%. Sure it was floating rate so there was potential upside if rates went down, but if we had gone ahead with the acquisition we would have probably just fully paid off all debt on that asset. (For clarity, in Vietnam there are some bizarre regulations about refinancing loans so we couldn't just rework the capital structure post-acquisition if/when rates actually went down.)
This would be unusual and I’ve never seen it in real life, but I’m thinking that if the capital structure had onerous levels of debt, that perhaps the next dollar of debt could be higher than the next dollar of equity.
I’ve seen it happen with junior debt over the last year
Look at equity markets during 2021
My understanding is that the SBA sets guidelines for the interest rates. If you're using SBA financing, then that means it's a small company/deal. At that part of the market, debt is just much more expensive than you would typically be used to unless you find some dumb money.
Is the preferred equity participating? If not, and the rate is lower then the debt, then I would say the investors are mispricing the equity and hope that they don't realize it before you close.
This is exactly what is happening. We have some pref. from a bigger investor that seems to be miss pricing which is slightly cheaper then the debt we are seeing in the market. Everything within me says that this shouldn't happen, but we have term sheets that are telling us otherwise. Which, makes me wonder if cheaper debt should exist, but I am thinking it does not, at the size and level we are at.
Gotcha. The space I play in is just north of this market, but we occasionally see some smaller stuff. Sometimes a regional/community bank will offer debt at a price that makes no sense (cheap), but you have to get lucky.
Just curious, is this deal a personal deal for you or something you are doing professionally? I've been exploring getting exposure to these types of deals personally.
No, debt can never be more expensive than equity because it entails inherently less risk by being higher in the capital structure. There are circumstances where, for cash flow or liquidity purposes, a business might greatly prefer to raise equity instead of debt. In the case of a very-high-growth startup, for instance, a dollar today is compounding at an incredible rate, so even though equity is more expensive, your internal ROI might actually be higher by entirely avoiding any near-term outflows required to service debt. But higher ROI doesn’t mean it’s cheaper, just that it’s the correct instrument to exercise.
In theory yes, but in reality over the last year we’ve seen junior debt price higher than the cost of equity.
I think one explanation is that management views cost of equity as a longer term number.
Also consider examples like CS, where their preferred (a debt-like instrument) was wiped but there was recovery in common equity.
There’s always going to be a point where debt with very very very friendly terms to the company will make it more expensive than the cost of equity (and thus they’d finance with equity) sure, but there’s also other factors / reasons a company might want to use a more expensive product
Especially for companies where bankruptcy is a very very remote possibility (and a default scenario becomes less of a consideration in the analysis)
Frankly, I have no idea what you're saying.
Cost of debt will never be higher. Equity holders will always demand a higher return than debt holders.
It has nothing to do with management. It is not a long term number. It's computed using today's rates. Also, I suggest you start levering a beta to see how high the cost of equity actually goes once you start hitting 80%+ debt in the capital structure. If you do so, you will realize that the cost of debt will never be higher that the cost of equity.
Best answer. This is how a small business owner (OP's scenario) will think about it. They will use debt unless it is not practical and then they will use equity as it is more expensive (unless they were able to raise very cheap equity somehow which I would consider a mispricing).
They will not be thinking about CAPM lol.
Look at GameStop Hertz and AMC. Free equity issuance to irrational participants. But the academic answer is never.
Junior CLO debt yields more than equity in some new deals. Unless you are looking for some general asset class exposure to CLO equity (a captive or something that does all your CLO equity), or are counting on a refi in a couple years (risky), not sure why anyone would want to buy equity in a new CLO right now (and they aren't really).
You can tell who is an academic and who is a pragmatist by the way they answer this question
Or just who has seen some shit - much like the Analyst 2 above I used to firmly believe debt would never be priced higher than equity until I saw it happen IRL due to various macro/regulatory complications...
I mean if you have the stupidest investors ever, I guess your equity C-o-C could be less than debt but in practice the answer is never.
The theory that equity is more expensive than debt is not a purely economic argument, it is also (1) a "what if" discussion that assumes that the biggest sum of the future profits will go to equity holders and (2) it builds an economic argument around the power/control that those equity holders have over the company, the economic rationale being that temporary covenants are "cheaper" than permanent control because removing the control of debtholders (covenants) is cheaper - paying the required interest - than the price equity holders will demand to give away their shares (an avg. 20-30% above their MV as per historic M&A transactions). Now, you can already observe 2 assumptions about this theory: (1) cheap interest vs. demanded compensation to equity holders and (2) positive future growth.
In a financial distress situation (when the credit rating of the company is lower or the risk of default perceived by the lender is high) those 2 assumptions become flawed. Interest on debt can be so high that eats all profits (or more), and if the company continues to be in financial distress, then debtholders have more power over the company and they could exchange their debt for equity at more favorable terms than what they could otherwise obtain in an open market. So from the company's perspective, in such a situation, debt becomes more expensive than equity because they could be in a position of giving away free (or cheaper) equity - assuming an exchange offer- (and from an equity investor's POV: why would you buy equity before debt when you risk some debtholder receiving x700 more shares than yours as part of an exchange offer and dilute your entire ownership to such a degree that your expected dividends/stock appreciation reach a negative ROI; so to erase the debt, the company must spend more on it because distressed debt investors understand the upside, in other words, in good financial health = equity holders are in the high risk and high reward scenario, in bad financial health = distressed debt investors are in the high risk and high reward scenario, so they demand a higher premium than the other side). Thus, debt is more expensive than equity at the moment that the company is in financial distress, if it can remediate its problems, then equity again becomes more expensive than debt (the rule).
I like this example of restructuring because it shows that finance theories hold only if everything acts "rational" and favorable i.e., players, market conditions, etc. But in bad moments, those theories are easily disregarded (as the EMH: all fun and play until the first bubble after the theory happened). So it's good to understand scenarios where the assumptions behind theories don't perform as expected to test their "always" validity.
I think this is backwards. I think you are conflating the cost of debt before an LM transaction with the cost of equity after a hypothetical transaction. Not sure if that is at all a fair comparison. If the company is speculated to or is planning to do an exchange, why would the cost of debt go up or debt prices go down? The business is being restructured to become more financially solvent and therefore the expected return on debt should lower. Debt holders don't see the equity conversion in an exchange as inherently attractive; it's a tradeoff they have to make to decrease leverage and maybe let the business cash flow again.
Additionally, "Why would an equity investor enter the business before debt if they risk the debt holder receives a bunch of equity" is contrary to your point that debt would be more expensive. You are making the point that an equity investor is an extremely unattractive position-thus they would demand far higher returns.
If I was offered an equity position in the secondary market, the equity would practically be worthless again, for the reasons you pointed out, and also the extremely high likelihood that the position would be entirely wiped out. With debt investors, you at least have some recoverability on assets, and you have those various recourses. Again, I think people have criticized arguments like this for being too academic, but we need to compare things on a level-set playing field and I would want to see an actual mathematical argument here.
We can put up a real example: a companies debt is trading very poorly (maybe because they were a clearlake lbo in 2021) and yielding 30% - so for sake of argument let's say after-tax cost of debt is ~25%. How on earth could you argue to me that the equity required IRR should be below the 25% if someone was to invest in a secondary trade for the equity? Somebody would have to underwrite to a significantly higher return, an option-value like return with significant conviction. I don't find that convincing.
If a business is in distress, the equity value is at option value levels, it is basically worthless.
to take your example, if the cost of debt is 25 and it is widely known that those debtholders are opportunistic in the sense that they have a successful history of buying distressed companies to take the equity side and escalate it, the IRR of stockholders/equityholders (I'll come back to that at the end) can be lower than 25. The assumption of this premise is that those debtholders will 100%/guaranteed take the equity position if their requests are met (precisely: asking the company to not issue equity =/= cost of equity). If the company decided to do it regardless, then those debtholders may pursue another strategy that will distance those potential investors that were mainly interested and ready to take a lower IRR because of the expected strategy pursued by the majority debtholder/s (or alternatively require a higher IRR), so the market will also avoid investing because they're aware of this risk (i.e. distancing debtholders from their initial strategy) thus the company can't raise liquidity.
Theoretically, it is argued that the cost of equity before this exchange is higher for the reasons you pointed out (huge risk even if equity is worthless), but in reality, the cost of equity is lower because it incorporates the expected exchange and investors are fine with that (non-expecting this event to happen = higher cost of equity = but it also means it won't happen -- something like the Soros' theory of reflexivity/egg or chicken idea). In other words, those equity investors wouldn't invest and expect a higher return relative to debt at the present moment, but instead, their expected return is lower than the expected return of the debtholders because it is assumed that those debtholders will take the equity position and the company will be back on track with the cost of debt at lower levels than equity.
To come to the equityholders point, if we take into consideration this reasoning i.e., if it's well-known that the debtholders will take the equity position, then the cost of debt could be higher than what the market would request for the company's equity because they're aware that the cost of equity is appropiate and it will again become bigger than the cost of debt after the exchange of debtholders -> equityholders takes place.
p.s. i'm aware it may sounds confusing/unclear/some typos, I will reformat it later on when i'll have more time because it's quite a difficult abstract idea/scenario to be put into words
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