How do you think about equity risks?
I come from a debt background (project finance) and I always get a variation of the question: “how do you think about debt va equity risks?”. I end up talking about driving value and growth in equity vs driving repayment and covenants in debt. Curious if anyone has a good response for this / a good framework for how to think about it across industries. Thanks!
I try to think about risk/reward up and down the capital structure. To be in the first loss position, I need to be compensated with a greater yield than the credit senior to me. That means find the high yield bonds’ YTW and see if I can get a similar return story on the equity. Then: what growth drivers will be necessary to back out that level of return? Recall that while debt just needs capital preservation (no further cash burn / maintaining status quo is often sufficient to lead to recovery to par), for equity, you need explicit upside on either operational top-line or financial/cost structure engineering. And then also because you have no covenants in place: how much debt can be further stacked on top of your equity? What happens in a set of bad outcomes (how deep is my loss)?
I think analyzing equity in terms of a credit investor’s perspective first before doing any growth modeling is the most logical way to do this.
Would that work in an interview though? Feel like they’d chuck you aside as someone that’s all credit with no “equity mindset”, even though it’s a very logical approach.
Thanks! This is helpful and I like starting on the debt side and working down the cap structure... feels intuitive given my background.
For more background, I work in infrastructure and energy and always get stuck on the low growth nature of the industry. I find myself finding the equity and debt risks very similar (I.e. long term contracts, “easy” to operate assets, little room for growth etc.) and maybe it’s because I am a debt investor, but it feels like with stable cash flow businesses with low growth there’s little upside to equity unless management can deliver (i) growth or accretive acquisitions, (ii) renegotiate more favorable revenue/om contracts or recontract better terms at expiry, or (iii) financially engineer higher returns through more leverage or structured trades.
That’s how I have been thinking about this answer and curious about others thoughts on my framework / if I am missing something.
Thanks again for your help.
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