The Changing Role of Debt
Early in the post-war era it was not uncommon for financial managers
to eschew debt altogether. Despite, low financing costs in the
1950s and early 1960s, many corporate executives sought to maintain
"clean", debt-free balance sheets which maximized flexibility.
The chart above shows that firms have significantly increased the amount
of debt on their balance sheets over the last forty years as managers
learned about high costs to shareholders of avoiding debt. By
exploiting the tax advantages of leverage, financial managers
have created hundreds of billions of dollars in shareholder value
(relative to a no-debt world). Today, firms
remain which avoid debt altogether. But such examples are becoming
increasingly rare because managers have learned to manage debt much better
(even in growth firms). The problem with debt, of course, is that
it can worsen business problems in economic downturns. These are
the so-called indirect costs of financial distress which hurt
Chrysler so badly in the 1980-82 recession. While these problems
will never go away, firms have learned to manage financial distress
costs much better. Today, we have instruments like PIK (payment-in-kind)
debt, better abilities to work out financial distress and strip
financing where debt and equity are held by the same parties.
These instruments allow firms to side step many of the problems
which arise when you can't pay your bills.
An important development in the next decade will be a more scientific
approach to capital structure management. Today, it is typical
for financial managers to set target leverage ratios. This approach
is basically correct but can be improved in two ways. First, managers
can make leverage ratio targets dynamic. Recessions and
other times of poor performance not only increase the risk of
financial difficulty but also decrease the need to obtain the
tax benefits of debt. Thus, value-maximizing managers should attempt
to systematically lower their leverage targets in recessionary
periods (many firms passively do the opposite). And, in good times,
it will often make sense to increase leverage to take advantage
of tax shields and debt discipline. Second, managers should attempt
to quantitatively balance the expected costs of financial distress
due to debt which can come with very high leverage versus the
tax and discipline benefits debt. Today, these elements are well
enough understood that managers can determine an optimal leverage
ratio target with modest simulations and create far more value
for their organizations that might be possible from improving
payment systems.
An important change in recent decades has been the emergence of
a global financial marketplace. Today firms can finance their
activities in multiple markets. The Euro-Markets were started
in the late-Fifties after the Suez Crisis. A company like Pepsico
today takes full advantage of the global financial market with
a complex capital structure which has a Swiss franc bearer issue,
a Swiss Franc FIPs, a British Pound issue, borrowing on the EuroCP
market, an overseas medium-term note issue, a currency swap and
borrowing overseas in dollars and ECUs. In the words of Peter
Houchin, a Pepsico Treasurer:
"Looking at the marketplace, the question is who's buying
what? Our general approach is that there are lots of investors
looking for pieces of paper. What are they looking for today?
What is driving them? If Swiss investors want dollar paper, let's
find a way to give them dollar paper. We believe that the broader
the spread of our investor base, the better it is as a whole."
One important effect of global opportunities to source capital
is that when the capital market in one country is closed down
or troubled (e.g. Japan in 1994), a large company can shift into
the global market. When the engine fails on a single engine plane
you're done for. But, when an engine fails on a four engine jet,
the pilot can land the plane the safely. The same thing holds
for the capital market. If one country's market goes down, firms
can resort to other markets.
The market for junk bonds (below BBB debt) has also blossomed
and remains strong in the 1990s. While many have criticized hostile
deals done with junk, the truth is that junk bonds provided some
of the most important corporate financing in history in the Eighties.
Whole industries were made with junk. For example, Turner Broadcasting,
MCI, TCI and McCaw Cellular are firms who would only be ghosts
of what they have become without junk. For all the criticism leveled
at Drexel, the firm made an enormous contribution to the national
economy by developing and promoting what has become an important
financing technique.
New Sources of Short-term Capital
Most businesses have traditionally resorted to banks for short-term
capital and have maintained large amounts of long-term financing
to avoid roll-over risk (the likelihood of not being able to refinance
short-term debt). In recent times, the required rate of return
on short-term financing has been sufficiently low to lead managers
to increasingly favor this type of financing. Moreover, rollover-risk
has fallen as credit access has improved and regulatory pressure
on banks has eased up.
This chart shows that the fraction of total
business debt which is due within a year has fallen dramatically
since the 1950s for large U.S. firms. Two crucial developments
which have accelerated this change are growth of the commercial
paper market and emergence of the medium-term note market. In
1977, commercial paper accounted for roughly three percent of
all short-term business liabilities in the United States. By 1993,
that fraction had more than doubled to eight percent. The commercial
paper market has grown because the spread between commercial paper
rates and the prime bank lending rate has widened steadily over
time (the CP-prime spread was virtually nil in 1972 but was more
than 150 basis points by 1993). The commercial paper market has
become more efficient over time as the investor base in this market
has grown, creating economies of scale in the distribution process.
This figure shows growth in the volume of the medium-term note market.
This market has came out of nowhere in 1983 to over $80 billion
today. Medium-term notes (MTNs) are senior debt securities with
fixed coupon rates and investment grade ratings. They tend to
be noncallable and unsecured and differ from traditional straight
bonds insofar as they are issued with no guarantee of raising
funds, in small pieces and in a continuous process. This market
works through the process of reverse inquiry in which issuers
announce a schedule of yields and maturities and investors purchase
securities in the amount desired along the one to ten year portion
of the maturity spectrum. The MTN market will continue to evolve
in the Nineties and is likely to open up to smaller and younger
firms.
The Changing Role of Bank Credit
Banks have long served as an important credit source for business.
Their role as credit providers has diminished in recent years,
however. It is widely recognized that medium to large businesses
have been increasingly satisfying their credit needs through nonbank
sources, including markets for commercial paper and the medium-term
note market. Because small businesses contribute significantly
to economic growth in the United States, and because banks one
of their primary sources of credit, it is important to understand
the factors that influence the relative amount of bank debt held
by small businesses.
Economic theory suggests that banks have a comparative advantage
as providers of capital because of their special knowledge of
customers and ability to closely monitor users of funds on an
ongoing basis. It may be that banks are losing market share because
they have not pursued their comparative advantage in monitoring
and building relationships or because these services are not sufficiently
valuable in the marketplace. This perspective is called the information
asymmetry view and emphasizes the idea that bank loan officers
are able to obtain information needed to grant a loan (e.g. character
of a manager of quality of inventory) that is not readily available
to the marketplace. Banks traditionally establish relationships
with borrowers which gives them access to information on a firm's
performance and insights into its future business prospects. The
information asymmetry view of banks' role in the credit process
implies that a firm with investments that are more difficult to
observe will be the most likely user of bank debt. A bank may
be able to monitor the investment efficiently, while other lenders
would find equivalent monitoring too costly. Similarly, a firm
with performance that is difficult to observe will likely use
bank debt because banks are probably better at monitoring use
of funds.
A more complex version of the information asymmetry story explains
how a firm's choice between bank debt and other debt is affected
by its reputation. The reputation view illustrates how
bank loans can help a firm build and establish a reputation that
would enable the firm to obtain a higher credit rating in the
future. The reputation view holds that a firm that has not yet
established a reputation and therefore has a low credit rating,
may be rejected for a bank loan. By contrast, a firm with a better
reputation will usually be accepted for a loan. Firms with very
long track records and well-established reputations will probably
not use bank loans at all. These firms have arrived in a sense
and can directly access the public debt markets in commercial
paper, medium-term notes and commercial paper. The reputation
view implies that it is important for young, growing firms to
work closely with one or a few lenders for an extended period
of time to maintain access to capital even in bad times. Then,
eventually this firm will be able to access other, cheaper sources
of capital.
A Study of Bank Debt
Linda Hooks, Assistant Professor of Economics at Washington and Lee
University, and I measured bank borrowing behavior and financial
characteristics using industry-level summary information from 1982-1987
distributed by Dun and Bradstreet in their InSight Database. We
used 4-digit SIC level medians of balance sheet and income statement
items provided by Dun and Bradstreet. These data summarize the financial
condition of more than 1,000,000 proprietorships, partnerships and
corporations in the United States.
To our surprise, we did not find strong support for the predominant
view that banks provide loans to firms where problems of monitoring
and verification of project quality between insiders and outsiders
are greatest. Proxies for the need for bank monitoring (levels
of intangible assets and research & development spending/sales)
were not consistently related to bank debt concentration as suggested
by the theory. We find the strongest support for the special monitoring
role of banks among larger firms with more than $1 million in
assets. Bank debt as a percentage of all liabilities is somewhat
greater for these larger firms with a high proportion on non-collateralizable
intangible assets.
Our results are more consistent with the view that banks can overcome
informational problems by building relationships with firms, but
that these same relationships may become onerous and prevent managers
from pursuing growth opportunities. Consistent with the idea that
firms with strong growth opportunities use bank debt less and
opt for arms-length debt, we find that larger firms which can
most readily access arms-length debt do so when they are in industries
which are viewed positively by the stock market. Also consistent
with the idea that banks build relationships with firms only when
they can be assured that such relationships are largely exclusive,
we find that bank borrowing is greatest among firms with relatively
little debt in their capital structures. Banks lend far less to
firms which are heavily indebted, especially when they are small.
One of the important implications of our study is that credit managers
and bank relationship managers need to be cognizant of the impact of
decisions to drop bank relationships. Given that bank loans are most
likely to be made when a firm has built a good track record with a
relationship, it is important to maintain the relationship even in cases
when cheaper sources of capital may be available. This holds even for
firms with some access to debt in the public market. The public bond
market and the market for private placements seems to tighten more
frequently than bank debt markets. In 1989, adverse news in the junk
debt market, for example, led to conditions where a number of mid-sized
firms were not able to obtain credit at any cost.
This figure shows that the mean ratio of cash and investment securities
to assets for the largest firms in the U.S. economy dropped dramatically
between 1952 and 1993. The most significant efficiencies in cash
management among large firms came in the 1960s and 1970s with
the advent of computerization. Computers which facilitated forecasting
and control necessary to maintain zero-balance accounts, lock
box systems and concentration accounts. The advent of the Automated
Clearing House in 1972 helped spread these efficiencies to smaller
businesses as well which today continue to obtain significant
value improvements in the area of working capital management.
A recent McKinsey study found that the great majority of companies
have not fully automated their payments and cash management systems.
As this changes in the future, greater efficiencies will come
from working capital management. Another area in which the efficiencies
appear possible is in payment process redesign. Complex organizations
such as EDS, the data-processing arm of General Motors, have recently
completely reengineered their payments systems and have been able
to create millions of dollars in value in the process. Major consulting
firms (including EDS) and banks are able to assist businesses
in reaping the gains of working capital management process redesign.