Companies need to refinance over £70bn of debt over the next twelve months. Not every firm will get the cash it needs.
There was a good article in The Sunday Times over the weekend which drew attention to the fact that £50bn of corporate debt would need refinancing before the end of 2009. Plus there could be another £20bn or so of debt secured on commercial property that’s coming up for renewal.
Companies will be competing with homeowners for the banks’ scarce capital and something will have to give. That said, when compared to mortgages, a greater proportion of corporate debt is due to international banks rather than domestic ones.
The debt of corporate Britain
So just how indebted is corporate Britain? The Bank of England provides some figures for non-financial companies and it shows an alarming trend over the last few years.
| End of... | Cash
£bn | Debt
£bn | Net debt
£bn |
|---|
| 1998 | 118 | 188 | 70 |
| 1999 | 127 | 200 | 73 |
| 2000 | 138 | 224 | 86 |
| 2001 | 146 | 240 | 94 |
| 2002 | 155 | 255 | 100 |
| 2003 | 169 | 268 | 99 |
| 2004 | 181 | 282 | 101 |
| 2005 | 203 | 350 | 147 |
| 2006 | 227 | 414 | 187 |
| 2007 | 250 | 479 | 229 |
| 2008 | 231 | 500 | 269 |
From 1998 to 2004, the build up in corporate borrowing was quite mild. Net debt went from £70bn to £100bn, which is an increase of 6% a year.
The last four years have seen our companies take on a much heavier debt burden though. Net debt has increased by an average of 28% a year! The debt figure actually peaked about half way through 2008 at £507bn, suggesting companies are already having to use cash reserves to reduce their debts.
It’s hard to know how accurate these figures are, but if £70bn of corporate debt is indeed up for renewal this year then £500bn sounds about the right sort of number. It suggests the average length of debt is around seven years. Even if the figures aren’t wholly accurate, it’s the trend that is the real concern.
I suspect two of the major reasons for the recent increase are private equity deals, where companies are traditionally loaded with much more debt to enhance returns, and institutional investors encouraging quoted companies to make their balance sheets more ‘efficient’ by taking on debt to fund special dividends and share buybacks. To make matters worse, many of the shares companies bought back are now worth a fraction of the price.
It goes without saying that we’d like to see this debt reduce over the next few years. However, the wind-down needs to be done as orderly as possible to minimise the impact on the economy.
Just like those coming off short-term mortgage fixes, any company looking to roll over any of its financing is a hostage to fortune at the moment. Banks are more or less able to name their price when it comes interest charges. Some companies won’t get all or any of the money they require. They’ll have to sell assets, cut expenditure or slash dividends. Those that can’t raise the money elsewhere could go bust.
The mysteries of covenants
Perhaps the most galling thing for investors is that companies that seem to have no short-term financing problems can soon find themselves in trouble if they breach any covenants (i.e. conditions) relating to a loan. Unlike a mortgage, merely keeping up with repayments isn’t always enough.
If profits fall below a certain level for example, debt that isn’t due for several years suddenly could become repayable. Companies often remark that they are in compliance with their covenants but very rarely give any details that allow investors to gauge how serious the situation is. Whenever any reference is made to covenants though, it’s normally a bad sign.
Reports and accounts aren’t much better either. They’ll provide an overview of when debts are due but usually lack a detailed repayment profile and there is no discussion of covenants. Let’s not forget that the purpose of a set of accounts is to clearly indicate the health of a business to its investors, customers and employees. Currently they lack too much information on cash, cash flow and covenants to do this. For example they could show how cash levels vary over the course of a trading year.
Of course, you can avoid these troubles by eliminating companies with debt from your portfolio. It’s not always easy to do but in the Fool’s Champion Shares newsletter Maynard Paton has taken just such an approach. Of the shares in the current portfolio, 18 out of 23 shares have a net cash position. You can take out a 30-day free trial to see which shares Maynard thinks offer the best value at the moment.
Whatever investing strategy you decide to take, here’s hoping that your portfolio doesn’t suffer from the refinancing blues in 2009!
