Credit Risk for Equity Investors

Credit risk is often underestimated for equity investors — This results in optimal leverage being miscalculated — Managing this risk is essential for businesses and investors.

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CREDIT RISK FOR EQUITY INVESTORS

Credit risk is a well researched topic. Debt investors price bonds based on three primary risks: default, market (interest rate or spread changes), and liquidity.¹ Notably, these risks are specific to the credit instruments they price.

Both academically and in practice, debt markets are viewed as adjacent to equity markets as opposed to undeniably intertwined. Management teams seek out fairly priced debt as part of an optimized capital structure and use this financing alongside equity capital to fund their businesses.

The credit market’s ability to accurately and efficiently price debt creates an illusion of stability and simplicity, and ultimately a siren song that can wreak havoc on equity investors.

The issue is that the risks associated with credit are different for equity investors. This topic is rarely discussed and management teams often fail to understand why their debt may trade at or above par, a sign of credit strength, while shares sell off as equity investors flee. 

Default Risk vs. Dilution Risk

For both equity and debt investors, default risk is viewed as a low probability “tail risk.” This risk is recognized and priced by the market. The probability of defaulting is the same for a business from both a credit and equity perspective. The returns in a default scenario are different but fairly clear: zero return for equity investors and some level of recovery for credit investors (for which substantial recovery data is available).

What is missed in this analysis is an in-between scenario where the credit investor is paid in full but the equity investor still loses. Because the credit investor is paid in full, this risk is absent from the cost of the debt. Without this risk, the creditor is willing to offer excessive debt at a (seemingly) low rate. If equity investors price this risk, though, the additional debt impairs the value of the equity.

Numerous examples of this in-between scenario came to fruition during the Covid-19 pandemic. Due to the Fed’s intervention, few defaults occurred, but many businesses were forced to issue equity or costly short-term debt instruments. Creditors were unimpaired while equity holders were diluted.

This dynamic can cause businesses to appear distressed to an equity investor at far lower levels of leverage than to a credit investor. To protect equity value, management teams must operate at lower levels of leverage than are offered by the credit market.

Market Risk vs. Earnings Growth

Credit investors generally fix either a rate or a spread when issuing debt. By fixing either of these variables for the maturity of the loan, credit investors accept market risk. A credit investor will see the value of their asset fall if interest rates rise or credit spreads increase.

Equity investors experience this market (or interest rate) risk differently because rising interest rates have a direct impact on a business’s P&L. Rising rates, for companies with floating rate financing, directly translate into lower net income and earnings per share.² 

Equities are generally priced as a multiple of earnings per share, so every dollar lost due to rising interest rates reduces the share price by a large multiple. This dynamic results in equity investors being more exposed to interest rate risk than debt investors (at reasonable maturities).

Even worse, the multiple a business trades at is influenced by its earnings growth. When interest rates rise and earnings fall, the growth rate of the business appears to slow. Slower growth can translate into a lower multiple.

Interest rate changes create a cascading effect for equity investors. The combination of lower earnings, lower growth (and valuation multiple), and the leveraging effect of trading on a multiple basis can result in rapid share price declines even in scenarios where the business is not distressed from a credit perspective.

Liquidity Risk vs. Optionality

The final risk faced by credit investors is liquidity risk. This risk arises if the investor is unable to sell at a reasonable price. Equity investors face similar liquidity risk when looking to sell their shares.

For equity investors, though, there is a further dimension to liquidity. The business itself, when taking on debt, reduces its own financial flexibility (also known as reducing liquidity). As businesses reduce their available liquidity, they constrain their ability to invest in future opportunities.

A company with net cash holds the real option to pursue attractive M&A in any environment. As a business levers up, this real option value dissipates. Notably, since debt holders do not participate in upside, none of this real option value accrues to creditors. This loss of value is borne entirely by shareholders.

The Fix

Management teams are tasked with maximizing value for equity shareholders, but most management teams evaluate their debt levels through the lens of credit investors. With a new understanding of credit risk for equity investors, management teams must update their approach to leverage.

Businesses should hold less debt. Growth should more often be financed with equity, even if debt is theoretically cheaper, as the cost of debt to equity investors can be far higher than the stated coupon. Cash should be held to preserve the real option of future deployment at high returns.

This strategy will ultimately maximize shareholder value over the long term. Continuing to operate with an outdated point of view, optimizing balance sheets without consideration for equity risk, will continue to destroy value for businesses, employees, and shareholders.

NOTES

1. Additional, but generally less impactful, risks include transaction costs, reinvestment risk, prepayment risk, and currency risk for international bonds.

2. For companies with fixed rates, the impact arrives at refinancing.