Banks have high benchmarks

The cost of capital for small businesses is theoretically at reasonably benign levels. National Australia Bank, for example, is advertising prime business loans of 7.76 per cent and prime business overdraft levels of 9.76 per cent. But can small businesses get the loans?

It is certainly getting harder. A March quarter report by the Reserve Bank of Australia describes an environment in which business lending has tightened.

The report says banks have increased their margins to business because they have had to use more equity capital and are becoming more risk-averse.

“This is particularly the case for lending to businesses, as both the share of their equity capital used to fund business loans and banks’ perceptions of the risks associated with this form of lending have increased noticeably,” it says.

Peter White, national president of the Finance Brokers Association of Australia (FBAA) says small businesses are being squeezed from two ends. On the one hand, banks are using more bearish loan-to-valuation ratios (LVRs) when assessing loans.

“The banks are saying they have plenty to lend out, and they have,” he says. “The trouble is meeting the benchmarks. Before the global financial crisis, banks were using LVRs of
75-80 per cent. Now, they’re insisting on
50-65 per cent.”

White says that reduces the capacity to gear against assets and many small businesses are finding that their assets are falling in value as well.

“The other hurdle is lending and cash flow,” says White. He says before the global financial crisis, it was common for banks to lend out on a ratio of interest payments covered 1.5 times by net profit. Now, that ratio is likely to be closer to two times.

“We are seeing businesses that have never had a problem in 10 years that are being squeezed at both ends,” he says.

“That is the biggest single issue for most small and medium enterprises in the market place. It is only when money is accessible that the interest rate becomes an issue.”

Conditions may be difficult for small businesses that need to borrow. But according to Dhruba Gupta, the managing director for research firm DBM Consulting, only about one-tenth of small businesses say access to finance is “an issue at all”. He says the other nine-tenths tend to fund business growth through retained earnings.

Most surveys of business lending are either skewed towards bigger businesses or those businesses that need their credit assessed, Gupta maintains. About nine-tenths of small businesses do not want to borrow at all.

“They are not affected very much by high interest rates, unless it is out of cycle, like what happened last November,” he says. “The access to finance is a relatively minor issue compared to other things that keep them up at night.”

Gupta says there has been a growing level of pessimism over the past few months due to the economic crises in Europe and the United States.

“Things have taken a turn for the worse when you look at their expectations for the next 12 months,” he says. “You are seeing quite a strong decline in their expectations for growth. They would not be looking to borrow, they are just hanging on to what they have at the moment.”

Gupta says surplus funds are being used to pay down debt, even though the banks have loosened lending since the global financial crisis.

“[The banks] would be very happy to lend to businesses that believe they can grow,” he says.

One area that does not change, in terms of the cost of funding, is angel capital. Jordan Green, co-founder and deputy chairman of the Australian Association of Angel Investors says angel terms tend to stay the same, irrespective of what is happening with interest rates or the stock market. Because angel capital is typically provided before the company has achieved revenue, costing the capital that is provided to these firms is determined by how much equity is handed to the investor.

“What does change is what entrepreneurs think they can ask for.” Green says. As a rule of thumb, angel investors look to get a tenfold return over three to five years. But at least half of the companies are expected to fail. The equity stakes are typically 20-40 per cent.

The Finance Brokers Association’s White says the tough line taken by the banks is preventing many businesses from growing and it is likely to have a contractionary effect.

“If an SME can’t grow, it will have an impact on the employees,” he says. “That in turn will have an impact on consumer attitudes and borrowing for home loans. Then you look at the impact on farmers and how much they can export overseas. I was talking to one Tasmanian developer who took two years to get an approval and when he did get it, it wasn’t enough.”

The picture that emerges is that many types of small businesses do not rely heavily on bank lending to grow. Which is just as well, because if they need access to debt funding, it can often prove difficult to get. Those that do want to use a highly geared strategy to catalyse growth are finding access to bank funding tough. Money may have become a little cheaper since the GFC but getting access to it is the problem.

Capital costs more in the middle

Mid-sized companies need to get creative if they are to reduce their cost of capital.

Defined by BRW as those outfits turning over between $10 million and $100 million a year, the mid-market is too small to access the corporate bond market, yet companies in this sector tend to have funding needs that are difficult for a single bank to swallow, particularly when the Big Four are playing as hard to get as they have been since the financial crisis.

Businesses that want to fund growth, or handle a succession, will need to think outside the bank and consider costlier options such as convertible notes or mezzanine debt, or otherwise recognise when they can’t do it all alone and transfer some ownership to “angel” or private equity backers.

If your company is in the right industry with the right consistency of financial performance, the banks will still provide senior debt at an interest rate between 2 and 4 per cent over the cash rate. Those in the “wrong” industries include retailers and manufacturers, reports the head of mergers and acquisitions at Deloitte, Tony Garrett, although he adds that caution prevails in most industries apart from “frothy” pockets such as coal seam gas.

If, as a business owner, you’re also willing to provide repayment guarantees, such as putting your house on the line, the banks will nudge you towards the lower end of that 2-4 per cent margin, says a senior partner in Ernst & Young’s transactions team, Bryan Zekulich.

Yet even then you’ll be struggling to be lent much more than two or three times your last year’s earnings before interest tax depreciation and amortisation (EBITDA).

That’s if you want any more to do with your bank. Stories are legion of lenders mistreating business customers during the global financial crisis, only to sheepishly re-emerge over the past year or so with a more reasonable cost of capital.

Remember the guy in New Zealand who was accidentally credited a $10 million overdraft and promptly went overseas? Well, pretty much the opposite happened to the managing director of healthcare and engineering business The Byron Group, Alan Moses.

“In late 2008, our bank was becoming concerned about our property portfolio, even though only a couple were investment properties – most we were leasing back to ourselves,” he says. “But it was adamant the loan-to-value ratios should be pulled right back, from 75 to
65 per cent. We were trading well, so I said let’s talk about it in the new year.”

“So I’m away on a business trip around that Christmas and they pull $2 million out of our account without warning. It was more than frustrating, no one likes asking their creditors to hold them up for a while.”

Needless to say, when Byron needed a capital injection in early 2010 – to fund the handover of the business from its two founders to Moses – its bank didn’t get a look-in.

“They’ve come back saying they can put the LVRs back up and I said ‘that’s great now!’”

Moses wanted to “remove himself from having to maintain those relationships”, so he saw private equity as the obvious answer to Byron’s succession conundrum.

Wolseley Private Equity took a 76 per cent stake in the company and installed as chairman the executive who brokered the deal with Moses.

The managing director of Wolseley, Andrew Petering, says having an entity between the entrepreneur and the provider of debt can be a good thing for all concerned.

“The banks like the level of governance and oversight we bring,” he says. “It gives them the confidence to let go of the ‘belt and braces’ approach, so they’re not looking for personal guarantees from the owner.”

However, the “cost” of private equity capital seems to have become less favourable to mid-sized business owners, according to the head of business banking at Commonwealth Bank, Symon Brewis-Weston.

“Private equity is not paying the seven to eight times EBITDA that it was five or six years ago; it’s more like two and a half to three times,” he says. He says there’s a natural reason that private equity investors tend to buy companies cheaper than equity investors: “The listed market is not usually wrong when it’s pricing future opportunities, whereas in private equity of course there is no market”.

Offered 2½ times EBITDA, Deloitte’s Garrett says he’d be telling his clients to raise bank debt instead. Although he admits in his recent experience a private equity price tag of “five times EBITDA or less” still prevails in the mid-market.

“The fact that there’s not a lot of private equity deals being done tells you that valuations are low,” he says.

Private equity manager Archer Capital recently paid eight times EBITDA for Quadrant Capital’s Quickservice restaurants business, although Garrett points out the $400 million value of that transaction puts it at the big end of the mid-market and that “fast food” is a highly defensive sector that often will attract top-of-the-range prices.

Of course, private equity managers claim to bring more to the table than money.

“We bring committed capital, an average five-year investment period, an appetite for building and funding growth, and an understanding of business and the business cycle,” says Wolseley’s Petering.

Byron Group’s Moses seconds that Wolseley has been “forgiving and understanding” after an early setback during its involvement with Byron, where a couple of unfortunate executive hires lead the company to its first unprofitable year in its 30-year existence.

And while Byron’s bank today would be unlikely to yank back its financing as it did during another period of adversity following the GFC, there is new pressure building on the big lenders’ relationships with mid-market business. It goes by the name of BASEL III.

Commonwealth Bank’s Brewis-Weston says the new capital requirements will add between 0.75 per cent and 1.5 per cent to the Big Four’s cost of funds, although that’s unlikely to all be passed on when mortgage finance is slowing and the banks recognise they need assets on their books.

So with private equity funding expensive, bank debt becoming dearer and less available and the initial public offering market a no-go zone amid global volatility, Deloitte’s Garret says mid-market companies can lower their overall cost of capital through diversifying their sources of lending.

“We see clients sourcing small pockets of senior bank debt but then also pushing their working capital, overdrafts and asset financing,” he says.

Where angels dare

There is virtually no venture capital investment carried out by institutions in Australia. So entrepreneurs wanting to go from zero to the $10 million annual turnover at which the banks or private equity become interested must rely on “angels”, be they family and friends, wealthy individuals or the occasional family office. The devil is in the detail: angels typically take between 20 and 40 per cent of your equity and because they’re early, if your company is successful they always appear to have gotten it cheaply.

Why costly capital’s not all bad

The finances of much of the world are behaving very strangely, as oddly as at any time since the 1930s. The Great Recession, which started in 2008, is being replaced by what might be called the Great Stagnation. It is creating an extremely unusual financial condition in most of the Western business world – the disappearance of the cost of money.

A quick glance at the interest rates on one-year government bonds in the major nations of the developed world reveals the unusual story. In the United States and Britain, the rate is zero, in Germany it is a low 0.75 per cent and in Japan 0.2 per cent.

In Australia, the interest rate on one-year government bonds stands at 5.75 per cent, an indication that the local economy is not suffering from the same financial pressures as most of the rest of the developed world. It is pushing up the currency, helping offshore competitors and forcing Australian companies to pay close attention to international economic conditions.

This unusual international situation means the basic unit of momentum of capitalist economies, the official cost of capital, has largely been lost in the developed world.

The fear is that Europe and America will start to become like Japan, which for more than two decades has had interest rates at low or zero levels, yet that has not been enough to pull the economy out of deflation and low or negative growth.

Adrian Kucukalic, senior strategist at Credit Suisse, notes that both equity and debt are simultaneously cheap (that is, there is an unusually low cost of capital).

“Investors do not want to buy equities because of fears of risks to growth and they are also reluctant to buy bonds because of sovereign debt concerns,” he says. He believes the situation is symptomatic of a liquidity trap: an environment in which there is an abundance of money supply but no one is willing to put cash to good use.

Why are low or zero interest rates potentially a problem? In theory they should make business conditions easier but they can also suck out all of the momentum in an economy by sending the wrong signal. That danger was identified recently by Richard Fisher, president of the Reserve Bank of Dallas, in dissenting from the US Federal Reserve’s decision to keep interest rates at record lows until at least 2013.

“Put yourself in the shoes of a business operator,” he wrote. “On the revenue side, you have yet to see a robust recovery in demand; growing your top-line revenue is vexing. You have been driving profits or just maintaining your margins through cost reduction and achieving maximum operating efficiency. I understand from the Federal Reserve that I don’t have to worry about the cost of borrowing for another two years. What incentive do I have to invest and expand now? Why shouldn’t I wait until the sky is clear?”

There is some academic support for the argument that keeping interest rates low is counterproductive. A paper about the Great Depression by Gauti Eggertsson and Benjamin Pugsley, The Mistake of 1937, suggests that zero interest rates have the effect of distorting expectations.

“The reason is that in this environment the economy is susceptible to contractionary spirals,” the authors write. If the public expects a more contractionary regime in the future, this itself discourages activity. Eggertsson and Pugsley comment that this creates a “vicious feedback effect”, adding that when an economy has zero interest rates both inflation and output are “extremely sensitive to signals about future policy”.

What does this evaporation of the cost of capital in the developed world mean for Australia, an economy whose interest rates remain comparatively normal?

International competition will become more intense, especially for domestically-focused Australian businesses. Australia is likely to be seen as an attractive destination for Western competitors finding it hard to locate demand elsewhere in the developed world. And those foreign competitors are able to raise money more cheaply than Australian firms.

Simon Feiglin, a partner in the private equity firm Riverside, estimates that private equity capital is about 2 per cent more expensive in Australia than in its OECD counterparts and similar ratios apply to other types of funding.

The tactic can be reversed, however. Globalising Australian firms provides the option of raising funds in offshore markets. Given the unemployment occurring in many developed economies – another symptom of the Great Stagnation – it also provides the option of looking for cheap labour overseas.

A persistently high currency is another likely outcome, both because base interest rates are significantly higher in Australia and because that higher interest rate indicates a greater level of economic health and therefore safety.

Not that the developed world is providing much competition on those fronts. The bleak prospect facing the US and Europe is a slowdown similar to that which has occurred for over two decades in Japan. When monetary policy becomes ineffective, even at the lowest possible levels, there is a threat to the whole financial system. That leaves only fiscal policy as a way out and with most developed country governments intent on austerity, it is an avenue not likely to be pursued. The danger is that, in the rich economies, the basic engine of capitalism is shuddering to a halt.

A note on convertibles

Convertible notes are becoming popular because they suit the uncertain times in which we live, says Ernst & Young transactions executive Bryan Zekulich. Small-to-medium enterprises unable to decide between taking on debt or giving away equity can issue convertible notes, initially a loan to their business that converts to equity at some negotiated point in the future. The coupon (interest rate) paid to the note holder can be up to 12 per cent, Zekulich says, and he warns that in times when investors aren’t confident in valuations and capital is scarce, the “ratchet” to equity usually works against the business owner.

The top end is awash in it

Wealth adviser Tom Murphy is upset that the $500 million Woolworths note issue now in the book-building phase is not larger. That’s because it’s been poorly priced in the investor’s favour and he’s worried his clients will be scaled back in their allocations.

Woolworths is taking advantage of its brand name and the sophisticated debt markets to rejig its debt portfolio by issuing notes that pay investors interest quarterly on a calculation of the average 90-day bill rate plus a margin to be set between 3.25 per cent and 3.5 per cent.

It’s that margin that has Murphy – the managing principal of Family Office Research and Management and former Deutsche Bank equity strategist – excited. Woolworths had originally expected to pay a margin of 3.1 per cent but its advisers, which include JPMorgan, National Australia Bank and UBS, said it had to increase the margin to make the offer successful.

The offer has now been swamped with applications well over $1 billion and Woolworths will likely issue $750 million of notes that will be listed on the Australian Securities Exchange in November.

Murphy says the issue easily could have been done at a margin of 3.1 per cent or even 3 per cent as Woolworths has such strong brand recognition and there is a large appetite for investment-grade instruments, particularly in the current risk-averse environment and amid a general lack of securities issued by non-financial institutions.

Despite paying too much, the Woolworths issue is well designed in its duration and flexibility and is an example of how good corporate balance sheets continue to strengthen and gain robustness. Despite the poor outlook and sentiment for growth and uncertainty over the direction of interest rates and inflation, large companies are considered a safe bet and in the case of top companies a safer bet than most government bonds.

In the same way that investors flock to haven companies when equity markets get disrupted, the same occurs in debt markets. In 2008-09, very few companies issued debt instruments, as there was no appetite or capability during the global financial crisis.

And with uncertainty and volatility still ruling global markets, it’s the investment-grade companies that have the easiest task of lowering their cost of capital by taking on capital management programs.

Perpetual’s group executive, income and multi-sector, Richard Brandweiner, says low demand for corporate debt during the global financial crisis was exacerbated by the exit from debt markets of arbitrage players, which buy long-term investment grade paper and then borrow against it to fund more speculative investments.

“They have not returned, so the people buying debt now are using cash they earned,” he says.

Although Australia has one of the most sophisticated debt markets in the world and leads in areas such as equity-linked, “hybrid” issues, it is not tax-efficient.

“Australian superannuation funds have the lowest exposure to fixed income of any developed market,” says Brandweiner. “Part of that is the lack of tax-effectiveness for debt as investors get taxed on their return, with inflation effectively being a double tax, and it was raised in the Henry tax review as a major issue. There has been no response from government yet but if it does act, it could change demand for fixed income.”

From a company point of view, that’s important as higher demand for non-bank debt markets will lower the cost of entry and broaden the market for different grades of debt, as well as increase the number of issuers. Coming out of the GFC, capital raising was not a problem as there was an expectation that reasonable growth rates would return and, as equity markets had already been pummelled, investors poured money into companies through scrip as they sought to repair balance sheets.

Although the low share prices of companies made equity less attractive, its sheer availability was irresistible as about $130 billion was tapped from investors over 18 months.

However, this exacerbated what Perpetual’s head of credit, Michael Korber, sees as another problem – that superannuation funds have the lowest allocation to fixed income of those in any developed nation.

The subsequent poor performance of the equity markets, combined with any tax review that makes fixed interest more attractive, will therefore see large flows from super into fixed instruments, including corporate debt. That will again deepen the corporate bond market, although syndicated bank finance is still the primary source of corporate debt.

But just like an investment portfolio needs diversification to lower its risk profile, so does a debt portfolio. Debt portfolios need to contain a mixture of instruments, from bank debt to corporate bonds to quasi debt-like convertible notes, and with varying maturities so the debt burden is spaced over a longer time.

Such a structure makes refinancing relatively easy even in difficult times, as the amount of refinancing at any given moment will not involve the entire portfolio but just the portion coming close to expiry.

The average debt profile of corporate Australia has changed significantly since the GFC, with average debt terms lengthening from three years to five. While that is sound balance-sheet management, there is also a bit of desperation involved as companies are eager to get their debt profiles set in case another credit crisis hits global financial markets.

In 1991, News Corp learnt this lesson, as it had a large portion of its debt instruments maturing at the same time. The Kuwait war broke out and banks didn’t want to refinance in the suddenly volatile global outlook. News Corp almost went bust.

The same thing happened on a much larger scale during the GFC. The crisis didn’t just pummel equity markets, it made debt suddenly very expensive as lenders didn’t trust giving their money to anyone, given the extreme volatility across the economies and financial sectors of the Western world.

Some canny investors got in quick when companies started issuing debt instruments in late 2009 and were able to get returns 400 to 500 points above the cash rate but those opportunities are gone. Yet corporate debt still offers better returns than government bonds.

With all the cheap money that was available before the GFC, even companies that had maintained good debt-to-equity ratios had likely lowered the duration of their debt portfolios, as in a stable environment refinancing is easy and competition among lenders strong to provide lower rates.

The return of risk has changed that equation and longer-term instruments now offer the security companies want in their balance sheets.

The average chief financial officer might assume that equity provided by shareholders is the cheapest form of capital available. That’s not the case. For starters, shareholders expect a return by way of dividends. They also nominate the cost of equity by how much they are willing to pay for forward earnings forecasts of a company, known as the price-to-earnings ratio. 

That ratio is substantially lower now than before the GFC – single digits for the first time since the 1970s, in fact – and the lower it goes the less attractive new equity is to corporate treasurers. New equity also dilutes other stakeholders’ interests, so in today’s environment borrowing has a number of advantages over equity. It is actually a good time for companies to be accessing debt markets, as relatively expensive as they’ve become. After all, companies usually want more debt only so they can take advantage of buying opportunities while markets are trading at lows.

Institutional options

Setting up a balanced corporate balance sheet is a complex procedure, but Australian Unity’s chief financial officer, Tony Connon, breaks it down into some simple components.

1. The most expensive form of capital is equity. It’s the big gun of listed companies but less attractive at the moment as a result of low price-earnings multiples and weak investor appetite following the big equity recapitalisations of late 2008 through to 2009.

2. Next is hybrid securities, which offer a fixed or floating rate of return until redemption time, at which point investors can choose between converting their notes into equity or redeeming for cash. It’s an increasingly attractive form of funding as it counts as equity for gearing purposes and can attract franking credits if desired. The convertible bond is the most common form of hybrid security but it comes in many formats.

3. Below that is the corporate bond, the mainstay of long-term corporate funding. In April, Australian Unity put to bed a $120 million five-year bond with a fixed margin 3.55 percentage points above a 90-day bill rate. Connon originally had looked to raise $80 million but had not anticipated how strong both institutional and retail interest in fixed interest has become and took advantage of the situation to boost the debt raising to retire some existing debt on the balance sheet. Ratings agencies gave it an “investment grade” rating, which is vital in today’s risk-averse market..

4. Bank funding. This is usually done through a syndication of banks to minimise a bank’s exposure to a single company or project.

5. For working capital or top-up funding, an overdraft facility is still the popular financial tool.

6. Mezzanine finance is an option which sits below bonds but above equity in the creditor queue. It can currently cost as much as 10 per cent over cash.