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Debtonator
How Debt Favours the Few and Equity can Work for All of Us
By Andrew McNally Elliott and Thompson Limited
Copyright © 2015 Andrew McNally
All rights reserved.
ISBN: 978-1-78396-166-5
CHAPTER 1
Debt and Equity 101
Beware of geeks bearing formulas. Warren Buffett, 2009
Finance can often seem daunting. It is frequently presented as a myriad of complex theories, impenetrable jargon and mind-bending mathematics. Many of its concepts, however, are in essence quite simple. Most people understand clearly the concept of debt, for example; it is something that nearly everyone will have practical experience of at some point in their lives. Equity, on the other hand, is slightly more complex and less run-of-the-mill.
We normally first experience the difference between debt and equity when we buy our first home. To keep it simple: suppose we buy a house for £100,000 and take out a 100 per cent mortgage; at the start, the asset's value is £100,000, the debt is £100,000 and the equity is zero. If the house's price increases by, say, 20 per cent, and so its value rises to £120,000, our debt remains at £100,000 and our equity becomes £20,000. All of the increase in the value of the house, the asset, is reflected in the value of the equity.
It isn't always this simple. We'd rarely, for example, buy a factory or a shopping mall ourselves; a company would do these things and we would help to finance the company. The company would be either debt or equity financed and the company would own the assets – the factory, the land it sits on, the machines that fill it and so on.
To illustrate, suppose we are introduced to Smith Ventures, a company developing genetically enhanced apple trees, which is planning to use its new technology to grow a large orchard. And then suppose we offer to fund Smith Ventures' idea with debt; we give it a loan or buy a bond, which is the same thing except a bond can be more readily sold to someone else. When we do this, the asset we own is the loan we made or the bond we bought and Smith Ventures is described as debt financed. We would, on an agreed date, get our money back with interest. We, the debt financiers, get a fixed return and Smith Ventures pays a fixed price for its funding.
If we want to fund Smith Ventures with equity, we would do so by buying shares; the shares would represent a stake in the future value of the company. After buying the shares the asset we own is equity and Smith Ventures can be described as equity financed. From then on, Smith Ventures has to pay us a share of the profit, after the debt financiers have been paid; an arrangement that carries on for as long as the orchard keeps growing apples. We have bought a share in Smith Ventures' success – forever.
Smith Ventures, of course, is earning the profit from the orchard and so the value of the orchard, what accountants would call the underlying asset, is the factor that's really increasing in value. In fact, the value of the company's equity could be said to be the difference between the value of the orchard minus the value of the company's debt – just as it was with our house. As the orchard makes more money so its value goes up. The value of the debt remains the same, however, so the value of the equity in Smith Ventures rises even more. The increase in the value of the orchard, because the genetic technology works, is completely reflected in the value of the equity.
This is, by necessity, an overly simple portrayal but whatever complex structures and instruments the financial industry invents, whether in a large public corporation or a private business, this is, in essence, how we finance everything.
A house with an orchard
When people talk about assets, especially with respect to inequality, they generally bundle them all together; houses, bonds, cash, equities, pensions, mutual funds, investment trusts, gold, silver, rare stamps, fine art and jewellery are all one and the same. They are simply added up when we compare the wealth of one family relative to its neighbours.
In reality, not all assets are the same. Take the house we bought earlier for £100,000. The house's price, or as we would normally say, value, might increase but unless we spend more money on improving it, it remains the same house for the time we own it.
Now take Smith Ventures. Suppose it grows its orchard and starts to yield and sell even more apples than it thought it would – its new technology turns out to be even better than at first thought. With the additional revenue it can plant more apple trees, or perhaps further develop its technology; the asset, the orchard, starts to grow in value.
Economists call the orchard and Smith's special technology 'productive assets' because they generate more wealth in ways that 'non-productive assets' cannot. 'Apple trees', though, come in all shapes and sizes: robots that build cars, research labs that discover new drugs, social networks that bring people and their ideas together. They are the things that take us forward, that drive progress. By their nature they change and, more often than not, grow as a result of things happening to or being done to them. Non-productive assets, on the other hand, may go up and down in price, they may extract a rent, but they do not create more real wealth in their own right. Bonds, houses, gold and fine art all have value but they do not change their intrinsic value in the way that Smith Ventures' apple trees can.
If you know someone who's extremely wealthy – even if only from the news – ask yourself how he or she did it. They may have made it as a popstar or footballer; they may have built up a portfolio of buy-to-let apartments. I'd hazard a guess, though, that they own a successful business, or at least a big slice of equity in one – they most likely own some 'apple trees'.
If productive assets are the only assets that create new material wealth, then how those assets are financed is crucial. I will later show how, by being debt financed, their ownership is concentrated in the hands of the few. In addition, however, the foundations of financial theory have left many corporations with the belief that debt finance doesn't impact their underlying value; that whether they survive or thrive is not determined by how they are financed. In practice, it seems their choice of finance does matter. It seems that equity finance brings value to their firms that the theory doesn't account for.
CHAPTER 2
The Real Value of Equity Finance
Yet beautiful and bright he stood, As born to rule the storm; A creature of heroic blood, A proud though childlike form. Felicia Hemans, Casabianca, 1826
Samuel Budgett, The Successful Merchant whose posthumous biography ran to forty editions, personified business values throughout the Victorian era. Having started from the small shop his father bought in 1801, his chain of wholesale grocers eventually stretched across much of England. By the time he died in 1851 he was reportedly giving £2,000 each year to good causes, a significant amount in his day. Even by today's standards a number of his business practices would be enlightened, although the thirty-minute prayer service each morning would be difficult to uphold. One such practice, however, defined his success: he would never allow his customers, or his company, to borrow. If they did, he believed, they would never stop. He wanted to show what could be achieved without debt. He left the company so financially secure that it outlasted him by a hundred years.
Some of those that have fallen into the debt trap since Budgett's day would surprise us all. Founded in 1931, Swissair flew its nation's flag like no other airline; for sixty years it was the epitome of Swiss financial prudence and was known as 'the flying bank'. There is, however, an economic theory that says stability breeds instability and Swissair was the corporate proof. In the 1990s it adopted a new approach, what it called 'the Hunter Strategy' – buying stakes in other airlines around the world with debt. By 2001 its balance sheet was loaded with close to $10 billion worth of debt, just as two planes were flown into the World Trade Center. The collapse in air travel occurred just at the wrong time for them; by October 2001, the bankers to the airline refused to refinance its debt – the airline was grounded and 39,000 passengers around the world were stranded. The BBC's business correspondent at the time summed up the gravity of the collapse well: 'Something did die in Switzerland that day: not just an airline but an image the Swiss had of themselves.' Budgett would have found the mere existence of the modern airline industry unimaginable but, since the start of commercial air travel, more than a thousand European airlines have appeared and disappeared one way or another. It has proven to be the ideal laboratory for testing his beliefs on debt and, as I will later exemplify, an ideal showcase for the power of equity finance.
A banker's first instinct these days is to advise a company, particularly if large and successful, to use debt; it's how bankers make most of their money and, on the face of it, is simple to arrange. Taken together, companies around the world have become even more indebted since the crisis: at the turn of the millennium they had $26 trillion worth of debt in aggregate; by 2007 they had $38 trillion; but by the end of 2014 their debts had risen to $56 trillion. Some companies, however, ignore the bankers' advice and have avoided the seductive power of debt finance; they take a different view. For them, using mainly equity isn't 'inefficient' – as bankers often describe it – rather, it captures something different. The stability that equity finance brings allows companies to achieve things they couldn't otherwise; it makes for better decisions, permits adversity and improves the chance of long-term survival. Payback day for an equity financier is not rigid in the way that it is for debt finance; if times are tough, then an equity financier waits longer for their return. That's the deal.
When it comes to equity finance, the sense of shared endeavour can even change the behaviour of external financiers. It's no accident that in company law shareholders are also called members; when they subscribe for shares they acquire a common purpose. Small companies that use equity finance say it's good for business; advice, skills, contacts and contracts all accompany a financial backer whose financial success derives from the company's success. Equity is not just another form of finance – it is a partnership.
The real value of equity finance lies in the things banks don't always account for; things best seen in practice – in the real world. The real world, these days, is a backwater in finance. It's not where collateralised-debt obligations, credit-default swaps, algorithms, dark pools and high-frequency traders reside but where real people, running real businesses with real challenges and opportunities, ply their trade. It is among these that one discerns the full value of equity – the value that Budgett may have recognised 200 years before. Equity finance brings more than money. Management guru Peter Drucker talked of good management as 'doing things right' and leadership in business as 'doing the right thing'. Equity finance, one way or another, gives business leaders the stability to do the right thing; the right thing by their customers, employees and financial backers.
The human touch
Handelsbanken has only ever cared about one thing – its customers. For over 140 years the Swedish bank has won over each of them, one by one, branch by branch, country by country. A personal relationship with its clients, in its mind, helps it serve them better and keep a tighter handle on risk when making loans. When it enters a new town it says it would like all its customers to be able to see the church spire – if they're nearby then the bank will understand them better. Its biggest shareholders, including the bank's employees, have supported its build-it-slow strategy through thick and thin. It didn't need to raise capital or turn to its government for help during the financial crisis. What Handelsbanken's shareholders support is its human approach to doing business; it works without budgets, sales targets or advertising. None of these would help it build the customer trust to which it aspires. Sadly, when it comes to trust, the bank may never achieve its ultimate ambition: they say they would like to give the customer the keys to the bank.
Finance professor Anat Admati takes a common sense approach to banking and debt and states that banks need to use much more equity finance to fund the loans they make. In its simplest form, a bank's assets are these loans and it funds them by using customer deposits, by issuing bonds, by raising equity finance or, more likely, a combination of all three. A mature industrial company, Rolls-Royce say, would typically fund 25–30 per cent of its assets with equity and yet global banking regulators currently ask that banks fund just 3 per cent of their assets with equity. Admati is convinced this approach is way too risky; if a bank's assets fell in value by just 3 per cent as a result of defaults on its loans, the bank would go bust. The bankers, on the other hand, are nearly unanimous in their defence of low equity ratios. Especially since the crisis, banks are in an unusual position relative to other firms; their importance for the economy as a whole has left governments, supported by taxpayers, as backstops to their debt finance. If the banks can't pay off their debts themselves, their governments will. As a consequence, the cost of their debt finance is a lot cheaper than it would be otherwise; their debt financiers will always accept a lower return if they know their debtors are covered by the government. As bankers are paid on profit and their debt funding is cheaper than it should be, why would they issue more equity to finance their business?
A reliance on debt funding and many of the business practices it supported has cost most banks, in spectacular fashion, their most valuable asset – their customers' trust. What Handelsbanken shows is that building trusting relationships with customers takes time and financial stability; the stability that only comes with equity. Once the trust is won, it brings great rewards. Despite having an equity ratio more akin to that of an industrial company, Handelsbanken has consistently been one of the most profitable banks in Europe.
The financial crisis led many to question the role of banks altogether. Adair Turner, the head of the UK's main financial regulator at the time, even described much of what banks do as 'socially useless'. It took a crisis driven by debt, however, for us to question their purpose in this way. We often dwell on a company's profits or on the characters that run it and the mistakes they make. We rarely reflect on the contribution they make to our lives and to our society. Once again, the airline industry offers an illustration. Love it or hate it, the low-cost airline industry has transformed Europe, and actually the world, in unimaginable ways. It's been said that 'you develop a sympathy for all human beings when you travel a lot'. During the twentieth century, tens of millions of people were killed in European wars; today, over 200 million people fly between its cities daily on low-cost carriers. The successful airlines are primarily equity financed, which enables them to survive the challenges that the industry regularly faces. Their financial survival may be worth more to society than we usually give them credit for.
Customers rarely flatter low-cost airlines like they did Swissair, and yet nearly 90 million of them fly between 186 towns and cities on Europe's largest, Ryanair, every year. Historically, airlines have been lousy investments. The 'Sage of Omaha', Warren Buffett, once said, 'investors have poured money into airlines and airline manufacturers for 100 years with terrible results'. As a result, when I bought shares in Ryanair in 1999 on behalf of the investment firm I worked for, some colleagues raised their eyebrows; at the time, it had just 21 aircraft and 4.6 million passengers – but it also had a great idea and no debt. Today, it flies over 300 aircraft on 1,600 routes between almost 60 cities. Had it been highly indebted it's hard to imagine that Ryanair would have survived the collapse in air travel after 9/11, an oil price of $140 in 2008 and the economic meltdown of 2009.
(Continues...)
Excerpted from Debtonator by Andrew McNally. Copyright © 2015 Andrew McNally. Excerpted by permission of Elliott and Thompson Limited.
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