Following a trend that has been happening in other markets globally, several JSE-listed companies have initiated equity raises. The raising of additional funding has been done through rights offers and accelerated bookbuilds. The equity raises have mostly been either to reduce debt or to pursue growth opportunities.
There is likely to be many more to come, as not only are many companies facing rising debt, but the economic lockdown has also left many companies vulnerable and natural targets for acquisitions.
Over the last few months, the spotlight has been on our big four banks, as they provide most of the lending to households and businesses. As a result, they have had to extend more debt to corporates as they draw down on facilities due to Covid-19 related financial strain. There are two common reasons why corporates will seek out additional debt funding before approaching equity investors — not only is debt seen as the cheaper financing option, but it is also much easier to access.
Raising additional equity must follow the regulatory process; as such, it can be lengthy, especially if shareholder approval is a requirement. The process of setting up a general meeting of shareholders is costly and can take months - this is unlike securing additional funding from your bank, which is achievable within a few weeks.
The companies that had elevated levels of gearing ahead of the lockdown would have had a tough negotiation with their funders, as they were likely going to breach debt covenants. However, due to the extraordinary circumstances that we find ourselves in, it would have been in the best interests of all stakeholders to provide some measure of relief and assistance to these companies. In some instances, the banks would have charged higher interest rates to reflect the higher risk associated with the client. The same cannot be said for equity investors. Shareholders can neither "charge" the companies a rate of return, nor is there a contractual relationship that guarantees this return.
When a company seeks to raise additional capital through the equity markets, there are generally two reasons - either to make an investment or to pay down debt. From an investor’s perspective, the former is more likely to generate a return; however, there is no guarantee. The latter is akin to preventing losses, much like a once-off insurance payment.
This is the reality of providing additional funding during Covid-19 – it has become about limiting your losses. The risk of companies succumbing to business rescue proceedings is so high in the current economic climate that no equity investor wants to deal with potential losses from not bailing out a company before the creditors start making their claims.
Equity as asset class getting riskier
So, when investors are contemplating exercising their rights during a rights issue, the reality is that the decision is not whether they will get a return on investment, but instead, whether they can limit losses on it. That is the precarious position currently being faced by investors.
There is no law that governs how much debt or equity a company may have, as it is a decision made by the board of directors and the management team. The amount of debt a company has on its balance sheet directly impacts equity investors because if there are no profits left after servicing debt, then equity investors will likely not get any returns. Contrarily, the amount of equity a company has on its balance sheet has no bearing on whether or not debt holders receive interest payments. Many will justify this by saying equity is riskier, and this is reflected in the higher returns. Realistically though, the equity market has struggled to generate good returns in the last few years. So investors find themselves in a situation where equity as an asset class is getting riskier yet the returns are not proportionally increasing.
The reason behind this is that equity markets’ high returns are mostly dependent on economic growth and investor sentiment. It is difficult for companies to generate profits when an economy is in recession. Nonetheless, debt providers will still earn their interest. Therefore, economic cycles play an understated role in expected equity returns. What usually happens is that companies build up debt when the economy is growing and then are hit with an economic slowdown that leaves them with an unsustainable debt burden. Nobody forecasts a recession until it's imminent.
Risks higher, returns lower
Tongaat, Sasol and Sun International are great examples of companies that went on an investment spending spree that saw them accumulate vast amounts of debt. They are now in need of equity raises to keep debtors happy. It is essential to point out that the relationship between a company and its debtors is contractual, and there are legal remedies available for creditors if obligations are not met. Equity investors, on the other hand, are lucky if they get a dividend.
A possible solution to this problem is that the Memorandum of Incorporation of each company can include a clause on the maximum debt level that a company should have before requiring shareholder approval for additional funding. This could be measured by the standard debt covenant ratios, such as Net Debt-to-Ebitda and the interest cover ratio. The maximum level chosen should be in line with the industry standard. This can be assessed on a three-year forecast provided by management.
If the company is expected to breach this within the forecast period, then shareholder approval should be sought before embarking on any new debt facilities. Usually, the movement in a company’s debt levels is gradual and predictable, unless the company management is making sizable acquisitions that are funded through debt. This solution may be a burdensome task that requires a lot of admin; however, it goes a long way to offset the imbalance between funders of debt and equity holders. There will always be unexpected encounters like Sasol in its Lake Charles project, where costs swelled, primarily due to poor management execution. If the stakes were higher, and they had to get both equity and debt funders, there might have been better management of project costs.
So, as more companies approach the equity market for additional funding, shareholders should bear in mind that risk is higher and returns lower until the economy recovers. The funding itself may not be an investment, but rather a once-off insurance payment for protection from creditors.