Half a century ago, two starlets of economics argued that whether companies funded themselves with debt or equity was irrelevant. One legacy of that insight is becoming clearer in the wreckage of corporate failures mounting in the wake of the pandemic.
Franco Modigliani and Merton Miller both later won the Nobel Prize in economics, partly thanks to their groundbreaking work on what became known as the “M & M theorem”. Until then most companies had assumed that too much debt would affect the value of the firm, so their paper was a counterintuitive bombshell.
Their initial findings only held in a world without “frictions” — such as taxes, imperfect information and inefficient markets. But a later revisitation that incorporated the tax-deductibility enjoyed by interest payments showed that the value of an indebted company is actually higher than that of an unleveraged one. It eventually helped lay the intellectual groundwork for a dramatic erosion of corporate creditworthiness.
If the mix of funding is in practice irrelevant to the overall cost, why not leverage up and increase returns to shareholders that own the business, and, indirectly but no less importantly, corporate executives? Indeed, given that debt enjoys tax breaks in most countries, isn’t it almost irresponsible not to take advantage?
When interest rates began to fall globally in the 1980s, many companies did just that. That executive compensation is largely tied to earnings per share was an additional incentive for companies to leverage up.
Later on, other economists would give the corporate borrowing binge more academic legitimacy by arguing that debt was a potent tool to ensure corporate discipline and therefore increase economic dynamism. This gave rise to the idea of “efficient” balance sheets layered with debt, and immortalised by a memorable phrase written by two corporate finance specialists in 1988: “Equity is soft, debt hard. Equity is forgiving, debt insistent. Equity is a pillow, debt a sword.”
The result can be seen in the evolving distribution of corporate credit ratings. Four decades ago, Standard & Poor’s had given 65 companies around the world a spotless triple A rating, equal to almost 6 per cent of its total ratings. Another 679 companies enjoyed ratings in the A range.
Today there are only five — five! — companies with triple A ratings, out of nearly 5,000 companies. And under 14 per cent of all rated companies are in the A range.
Once again, we can see the cost all around us with many corporate executives now rueing choosing the sword over the pillow. For sure, the Covid-19 pandemic was an extraordinary shock that could have threatened the solvency of even the sturdiest company. But the fact that so many companies around the world are far from sturdy is a major reason why governments and central banks had to go to eye-popping lengths to moderate a tidal wave of corporate bankruptcies.
Those efforts have largely been successful. Yet the cost has been gargantuan and the pain will still be frightful. Standard & Poor’s tallied 88 corporate bond defaults just in the second quarter of 2020, the highest since the peak of the financial crisis. Millions of smaller businesses have gone under.
While the overall toll is likely to be more moderate than that caused by the global financial crisis, we will be living with the legacy for years to come.
After 2008, there was a reckoning with banks and how they fund themselves. After 2020, there should be a similar overhaul for companies. The aim can obviously not be to immunise every company completely from every crisis — let alone one as abrupt, broad and deep as Covid-19. But a shift from efficient to resilient balance sheets would be a long-term boon to the health of the financial system and the global economy.
Ideally, this should happen in response to the signals already being sent by markets: The shares of companies with stronger balance sheets have this year massively outperformed those with weaker ones, according to Goldman Sachs data.
But if this proves a fleeting phenomenon — as is likely — then more countries should start taking a hard look at the tax advantages enjoyed by debt. Such a draconian move can only be done carefully, over a long period of time. But everyone would benefit from a world where companies once again aspire to be more creditworthy.
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