Debt Valuation

Debt valuation can be defined as the appraisal of the amount of debt that has been incurred by a company. Companies incur debt or secure credit for a number of reasons that may include the financing of organizational growth, financing a merger or acquisition or to keep an organization solvent during a financial downturn. Some organizations wish to avoid debt at any cost and use the pay-as-you-go strategy to finance growth and operations. Other organizations see debt (or securing credit) as a way to finance growth and opportunities that might otherwise be beyond reach. This essay discusses the implications of business debt from the opportunity standpoint and explores the ways in which debt has been used to fund an era of recent and unprecedented corporate growth and mergers and acquisitions. The rise in the levels of corporate debt will be discussed in terms of its historical significance and the current challenges that organizations face in securing and managing their debt. No current review of this topic would be complete without discussing the role of private equity firms (PE) and the phenomenon of leveraged buyouts (LBO) and their role in the explosion of corporate debt.

The rise of the issuance of corporate debt from 2003-2007 has been astounding by almost any measure. Low interest rates, rising corporate profits and lots of global credit are cited as helping to fuel an era of rising corporate debt. The early years of the new millennium are somewhat reminiscent of the credit markets that were the norm in the 1990s. In the 1990s, corporate bond issuance or selling of corporate debt was very high. Rapid economic growth was occurring, but the corporate debt load was also bigger than it had ever been. Many felt that even a slight slowing of the economy combined with a rise in interest rates could change manageable debt into debt that would put corporations and individuals under strain. In the 1990s, big debt payments caused companies to cut back on capital expenditures and the potential downturn in the economy was seen as a sure sign that defaults would rise, liquidity would dry up and an overall credit crunch would arise. In the late 1990s, companies were borrowing at rates that had never previously been experienced. Corporate debt was being used for:

• Corporate stock buy-backs (re-purchases)
• Financing for acquisitions and mergers
• Funding of high tech prospects for exponential growth
• Telecom industry growth.

Rising Corporate Debt

The following examples show the trend toward rising corporate debt in the late 1990s. Computer Associates (a high tech darling) had just $50 million in long term debt in 1995, but by 1999, its debt service was $5 billion. Telecom growth was spurred by de-regulation, new technology and competition and debt was incurred by many companies to make a move in the market. During the first half of 1999 alone, $20 billion in corporate defaults had occurred worldwide with 85% being in the USA.

The following warning was being sounded in late 1999. "The most alarming sign of trouble ahead may be what's happening to corporate balance sheets. Despite the huge gains in the stock market, there is a pronounced tilt in corporate financing toward debt and away from equity. Even at today's prices, companies are buying back far more stock than they are issuing. Over the past 12 months, an eye-popping 3.6% of gross domestic product went into stock buybacks, and even with the IPO boom, nearly $500 billion in equities have been taken off the market since 1997" (Mandel, 1999).

Negative Impacts of Debt

The dotcom bust of early 2000 was a wakeup call to many investors and financial institutions. Stock prices fell 40%. The Federal Reserve lowered interest rates to help stimulate the economy as threats of recession loomed. Stock prices remained stagnant, but corporate profits kept rising. Many saw the rise of private equity (PE) firms as an natural outcome to economic conditions shortly after the tech/telecom bust. Those conditions were: Depressed stock prices, low interest rates and rising corporate profits. With a "dollop" of cash and loads of debt, PE firms began to snap up companies on the cheap. The average buyout in 2002 was 4 times the price of the company's cash flow (aka EBITA). It was not uncommon for PE firms to borrow 70% of the purchase price for these acquisitions. The loans were then put on the acquired company's balance sheet which doubled or even tripled the company's debt load (Tully & Hajim, 2007).

By 2003, the Federal Reserve had slashed interest rates in an effort to get the economy growing after the tech/telecom bust. Corporate profits continued to remain strong, and with the opening of global markets and associated global credit, the era of corporate mergers was ushered in. Lots of cheap and readily available credit and a higher tolerance for risk helped bolster many private equity firms and their LBO deals.

A brief discussion of differing attitudes about the value of debt will follow as well as an overview of corporate credit ratings as they pertain to today's trends in corporate debt. Finally, this essay will outline some of the current trends and outlooks related to tightening credit markets, investor risk tolerance and the potential for market corrections in relation to potential corporate failure.

Applications

Risk Assessment of Debt

Corporate credit ratings help investors determine the amount of risk associated with acquiring debt. Credit ratings are independent objective assessments of credit worthiness. Ratings "measure the ability or willingness of an entity (person or company) to keep its financial commitment to repay debt obligations (Heakal, 2003). Three of the most widely respected raters of corporate credit are: Moody's, Standard & Poor's, and Fitch IBCA. Each of these rating agencies provides a rating system that helps to determine the credit risk when acquiring a corporation's debt. Ratings can be assigned to long term or short term debt. For example, Standard and Poor's AAA rating is given to companies with the highest investment grade and very low credit risk. This credit-worthiness indicated a company's high ability and willingness to repay its debt. "Investment grade" is the level of quality that is generally thought to be required for an investor considering overseas investments. It is interesting to note that in the 1990s, investment grade was more of a requisite for incurring debt than it has been in recent years. PE firms have not paid as much attention to the ratings (since 2003) and have basically been much more tolerant of risk as many PE firms have bought and sold lower grade or "junk" investments.

Bond Ratings Moody's Standard & Poor's Grade Risk Aaa AAA Investment Lowest Risk Aa AA Investment Low Risk A A Investment Low Risk Baa BBB Investment Medium Risk Ba, B BB, B Junk High Risk Caa/Ca/C CCC/CC/C Junk Highest Risk C D Junk In Default

The Value of Debt

Many companies are opposed to borrowing funds or leveraging debt to fund operations and growth. Many privately-held companies are debt-free by choice, while many other companies (ex: service companies) don't have the means to support long-term borrowing and are debt-free by necessity. Many business owners and corporate management teams feel a great deal of security in knowing that their organizations are not mired in debt, and may even have a sense that a lack of debt makes their business more attractive in the marketplace. However, in the age of global markets and virtual customers in a "flat world" economy, many see debt as a strategic tool to be leveraged to support growth.

Gross Value

Having some debt on the books may be a selling point when it comes to the overall "gross value" of an organization. Gross value, to many, includes what a company earns, but also may reflect its value or brand in the marketplace. Intangible assets can be leveraged by companies who expand their market reach and presence in global markets. Sophisticated buyers or investors will look at overall capital structure. Debt is necessary for many organizations to invest in growth and gain increased market share. Lack of debt may indicate a non-aggressive stance in the marketplace; global brands can't afford to shy away from opportunity that might hinder growth. From a growth and expansion view, corporate debt can be seen a very positive thing. However, investors would be well advised to avoid debt that is not necessary, overly costly or of high risk (Fraser, 2000).

Growth of Debt

The amount of debt that is on many company's balance sheets went from reasonable to outrageous between 2003 and 2007. Debt, once thought of as a necessary evil to help companies finance growth and expansion, became the hottest investment opportunity of the early 21st century.

"Like every mania, this one carried the seeds of its own destruction. The lure of easy riches drew new players, and the pace of deal making picked up. In 2005 there was a string of splendid deals at reasonable prices. As the good times rolled, the buyout binge took on a life of its own. The real craziness started in 2006. Dazzled by rich returns, investors threw more and more money at private equity firms. Flush with cash, the PE shops started pushing prices to unsustainable heights" (Tully & Hajim, 2007, ¶10).

Debt Management

In 2007, the economy slid into recession and bad debt began to have serious repercussions worldwide. Shudders in financial markets surrounding sub-prime mortgage troubles shouldn't have affected most holders of corporate debt, but many saw the tightening of global credit as inevitable. The cycle headed down from its heady high, and there was renewed pressure on management teams at public companies to manage debt; private equity was not be able to "bail out" troubled companies, notably General Motors, and the federal government stepped in with taxpayer money to prevent the collapse of institutions considered "too big to fail." Credit became scarce, even after the federal reserve lowered interest rates to near zero to stimulate lending. Lenders are not likely to return to the liberal lending policies of the early 2000s (Shearer, 2007).

The media is full of sound bites that warn investors that much of what happens in the stock market is cyclical ("Spreading caution," 2007).

Issues

Propping up Companies

"Low interest rates and a flood of cash have helped many troubled companies skirt certain demise in recent years, which has led to an era of record low defaults and put a strain on the entire sector" (Kirby, 2007, ¶4). According to Alex Jurshevski, CEO of Recovery Partners in Toronto, "'The whole industry has been depressed because of the default rate,' says Jurshevski. who, despite having $500 million at his disposal, has yet to put any of it to work. Now, as the sub-prime mortgage collapse sends ripples beyond the housing sector, some foresee a credit crunch spreading to other sectors. 'I hope so,' he says. 'All the bad loans have already been made. They're just waiting to turn bad, like fruit left out on the counter'" (Kirby, 2007, ¶4).

During the global financial crisis of 2008, central banks around the world pumped hundreds of billions of dollars in cash into financial markets to stave off a crisis. Yet failure is an integral part of the business cycle. "If you don't have a cleansing process where certain firms go under, the pain is delayed. Generally that means the pain will be that much greater later on" (Kirby, 2007).

"Defaults, which are triggered when companies fail to make debt repayments or break the terms of their loan contracts, have hovered around zero for the last three years. In a typical year, default rates on corporate loans and bonds can be anywhere from 3% to 10% or even higher. Even the riskiest of loans have handily dodged insolvency until now. That's because companies struggling with their debt have found a steady stream of investment funds willing to give them ever more money. 'On the one hand nobody is going bankrupt and nobody's getting thrown out of work,' says Jurshevski. 'But it also means there may be a lot of people lending money on non-economic terms and that means firms that shouldn't be surviving are being kept afloat by cheap credit.' Investors are worried buyers won't be able to handle their debt loads if interest rates rise further" (Kirby, 2007, ¶7).

Private Equity

Between 2006 and 2008, there was huge activity in the high yield and leverage loan market. Sub investment grade ratings loans raised $146 trillion in 257 deals and $950 billion in 2219 leveraged loan deals. The increase in transactions is attributed to an increase in debt-raising by private equity firms which are used to fund buyouts. Blackstone Group, a private equity firm, financed 75-80% of its deal through debt. Blackstone has acted as a buyer, a broker w/other firms that it owns and as a lender. Blackstone has had huge success in its deals -- many attribute Blackstone's success to a core of talented partners with industry and financial expertise. Because Blackstone partners have vertical and sector depth of knowledge, "they have the wherewithal to dig deep when doing transactions and figure out the most flexible and cost-efficient capital structures to match the investment needs of the businesses they are buying. This has paid off regarding their ability to handle complex transactions" ("Blackstone group," 2007; Segal, 2013).

Some think the level of debt of private equity firms is too high and that the same firms may not be informing investors of the true level of risk when they buy debt. Some high profile LBO deals have happened in industries that investors would normally shy away from. However, firms like Blackstone have gained a huge amount of trust in the debt business. There's an underlying fear that liquidity will dry up and private equity firms will get left holding debt that they won't easily be able to dispose of. Many LBOs are actually completed with unfavorable credit terms and then are renegotiated with financial institutions at a better rate. A firm like Blackstone has capitalized on the debt business and has gained the confidence of investment bankers who trust firms like Blackstone that are experts in debt ("Blackstone group," 2007).

Pricing Risk

Firm failure is a natural part of the business cycle. However, it has been a rare part of the cycle since 2003 and is likely due to a couple of factors. After the collapse of the tech bubble around 2000, the Federal Reserve slashed interest rates. Low interest rates and increased global liquidity that was raised by hedge funds and private equity firms produced tons of cash in global markets. Businesses took advantage of the cheap cash by borrowing heavily to fund acquisitions and expansions. The rate of defaults on loans and business failures has been very low to almost non-existent during this period. Defaults result from a failure of a company to repay its debt, or when a company fails to honor the terms of a loan contract.

Many contend that money was so cheap and easy to come by that even firms that should have gone under found a steady flow of cash to keep them solvent. Banks ceased operating on a "slash and burn" or "close-the-door liquidations" policy as they once did. Lenders are looking for alternatives to foreclosures and defaults and usually reserve those scenarios for firms that are responsible for fraudulent business practices or gross mismanagement. In mid 2007, there were a few high profile examples where private equity firms had trouble selling corporate debt. While these examples are still relatively rare, concern lingered that some small and medium firms could have also fall into debt trouble.

Risk for some firms means opportunity for others -- there are companies that will benefit from a rise in the corporate default on loans. Miscalculations on the risk/reward equation will cost some companies their very existence and many investors acknowledge that this is a necessary part of the business cycle. Central banks have been accused of pumping billions into financial markets to stave off corporate collapse (some of which should be allowed to happen). Recovery Partners, a Toronto based company, is in just that market. Recovery Partners has cash in hand for the sole purpose of buying portfolios of underperforming corporations. According to Alex Jurshevski, "By snatching up the debt of struggling companies, he aims to take over the businesses, turn their fortunes around, and resell them. It's a precarious strategy, akin, he says, to safely catching a falling knife, but it's one that promises huge returns" (Kirby, 2007).

Conclusion

Private equity firms were blamed for creating a "market that is completely out of touch with economic reality." Private equity has been called the perfect Wall Street bubble for its part in making fortunes from increasingly risky investments and strategies. Predictions of tightening of credit markets came true, while optimism that robust global markets would provide investors with corporate debt as well as investment capital fell far short, at least for a time. The financial crisis of 2008 was accompanied by a credit drought and worldwide contraction and was followed by a glacial recovery.

Putting corporate debt on a company's balance sheet can provide necessary capital from investors to fund expansion or acquisition. Reasonable amounts of investment grade debt are the safest bet for companies to incur. In 2002 the average buy-out of a company was four times its cash flow; in 2007 buyout prices were closing at 15 times cash flow-or 4 times the rate of 2002 (Tully & Hajim, 2007). By 2012, as the economy began to show signs of recovery from the worst downturn since the Great Depression, private equity firms were once again able to borrow the lion's share of funds toward a leveraged buyout -- at a very low interest rate -- if the target companies were stable, had tangible assets, and maintained a healthy cash flow (Sheahan, 2012).

Terms & Concepts

Corporate Debt: Short or long term debt issued as securities by corporations. Short term debt is issued as commercial paper. Long term debt is issued as bonds/notes.

Corporate Credit Rating: Corporate credit ratings are assigned by credit rating agencies (for example Standard & Poor's) and are designated by letter groupings (for example AAA, B, or CC). These ratings serve as finance indicators to potential debt securities investors.

Credit Crunch: A shortage of available loans. This could raise interest rates, but it usually means that certain borrowers are unable to get loans due to credit rationing.

Debt Security: A security that represents a loan given to an issuer by an investor. In exchange for the loan the issuer makes a commitment to pay interest and completely repay the debt on a predetermined date.

EBITA: Earnings before interest, taxes, depreciation, and amortization.

High Yield Debt: A bond rated lower than investment grade when it is purchased. These bonds are riskier in situations of default or adverse credit but usually yield higher returns than higher quality bonds to entice investors.

Leveraged Recapitalization: A technique employed to avoid involuntary acquisition. Using this strategy, a company takes on a significant amount of debt in order to repurchase stocks through a buyback offer or dispenses a significant dividend between current shareholders. The company share price then increases significantly, which makes the company less appealing as a takeover target.

Mezzanine Loan: Mezzanine loans can be compared to second mortgages, apart from the fact that a mezzanine loan is secured by company stock of the company owning the property rather than by the real estate property itself.

Private Equity Firms: Any type of non-public Ownership Equity security not listed on the public exchange. An investor who wants to sell private equity securities must find a buyer without the help of a public marketplace. There are three ways in which private equity firms usually obtain returns on their investments: An IPO, a sale or merger of the company they own, or a recapitalization.

Risk Assessment: A technique used to measure two different quantities of risk: The size of the possible loss and the likelihood of the loss occurring.

Sub-investment Grade Loans: Also referred to as junk bonds, or high yield bonds, they are issued by companies carrying an uncertain credit rating. Any credit rating lower than "BBB" is considered to be an uncertain, or speculative, grade.

Bibliography

Beware of the debt bomb. (1999, November 1). Business Week, (3653), 220. Retrieved September 17, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=241 0703&site=ehost-live

Blackstone group. (2007). Euromoney, 38(458), 100. Retrieved September 14, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=25585141&site=ehost-live

Corporate finance. (2007). QuickMBA.com. Retrieved September 14, 2007, from http://www.quickmba.com/finance/cf/

Frasier, J. (2000) Giving credit to debt. Inc.com: The Daily Resource for Entrepreneurs.. Retrieved September 15, 2007, from http://www.inc.com/magazine/20001101/20913.html

Kirby, J. (2007). Let the feasting begin. Maclean's, 120(33), 30-31. Retrieved September 14, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=26295581&site=ehost-live

Heakal, R. (2003). What is a corporate credit rating? Investopedia. Retrieved September 14, 2007, from http://www.investopedia.com/articles/03/102203.asp

Mandel, M. (1999, November 1). Is the U.S. building a debt bomb? Business Week, (3653), 40-42. Retrieved September 17, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=2409107&site=ehost-live

Rosenbush, S. (2007, July 30). Corporate debt: Dressed up, nowhere to go. Business Week Online, 11. Retrieved September 14, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=26003795&site=ehost-live

Segal, J. (2013). Blackstone Group's GSO Capital: lenders of last resort. Institutional Investor, 47(6), 12. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90371235&site=ehost-live

Sheahan, M. (2012). Private equity firms writing smaller checks. High Yield Report, 23(21), 23. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=75649108&site=ehost-live

Shearer, B. (2007). Deal market braces for credit crunch. Mergers & Acquisitions: The Dealermaker's Journal, 42(9), 74-91. Retrieved September 14, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=26484343&site=ehost-live

Spreading caution. (2007). Economist, 384(8539), 76. Retrieved September 14, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=25952117&site=ehost-live

Tilly, S., & Hajim, C. (2007). Why the private equity bubble is bursting. Fortune, 156(4), 30-34. Retrieved September 14, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=26199030&site=ehost-live

Suggested Reading

Clouse, C. (2007). Mounting debt may spell opportunity for some investment banks. Private Placement Letter, 25(31), 1-6. Retrieved September 14, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=26096492&site=ehost-live

Karp, A. (2006). Cash crunch. Air Cargo World, 96(2), 10-11. Retrieved September 14, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=19819894&site=ehost-live

S., M. (2007). Distressed debt outlook: Make room for a little doom and gloom. Bank Loan Report, 22(2), 5. Retrieved September 14, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=23768870&site=ehost-live

Woyke, E., & Henry, D. (2007, August 13). The buyout boom's dark side. Business Week, (4046), 40-42. Retrieved September 14, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=26057452&site=ehost-live