Debt structure: a window into management’s true motivation

By: Dirk Jooste, fund manager at PSG Asset Management

When you invest in equities with a long time horizon, you are valuing a stock based on the cash flows of the underlying business and making an assumption that you will receive a fair slice of future profits.

For this crucial assumption to hold true, a company’s management team need to be good stewards of shareholder capital and make decisions in the best long-term interests of the business.

At a certain level, what you’re really doing is evaluating the character of senior executives and deciding whether you believe them to be competent and – most importantly – trustworthy. Following the events of the past year, South African investors don’t need to be reminded about the dire consequences untrustworthy management can have for minority shareholders.

So how do you accurately evaluate a management team? One solution is to focus on finding the ‘footprints’ of past decisions – what management has done historically, rather than what they say they will do in the future. For example, consistently conservative accounting policies and comprehensive disclosure provide footprints that say something about the character of the senior executives. Other valuable footprints can come from evaluating company balance sheets.

A company’s debt structure reveals crucial management traits

Companies with significant gearing provide a treasure trove of factual insight into senior management. This is especially true in developed countries, where deep and sophisticated debt markets provide a myriad of choices when financing a business. A carefully structured and well-managed balance sheet ensures long-term resilience. Importantly, it also removes or reduces the potential impact of tail risks or rare events (for example, a severe recession).

A well-structured balance sheet comes at a considerable cost, however, which is borne in the currently reported numbers. As rules of thumb:

  • Long-dated debt costs more than shorter-maturity debt.
  • Fixed-rate debt costs more than floating-rate debt.
  • Currency-matched debt often has higher interest rates.

For example, one of the holdings in PSG Asset Management’s funds is Simon Property Group, which has substantial gearing (over $30 billion). However, this consists of 96% fixed-rate funding with an average term of seven years. The group could save $300 million every year if it funded that $30 billion with three-year floating-rate debt instead. In addition, over the past four years, it incurred an average early redemption premium of $130 million per year, as it buys back bonds several years before redemption to keep its maturity window clean. Management voluntarily spends around $430 million each year to make sure the group will have a robust balance sheet for many years to come.

Management who seek out the cheapest debt trigger a warning sign

Management teams who prioritise near-term profits are likely to seek out the cheapest debt rather than incur the costs of maintaining a resilient debt structure. Typically, we see a warning light if a company makes extensive use of the cheapest funding freely available to a corporate (currently, short-dated, floating-rate, euro-denominated debt) – especially if the company has little or no currency-matched revenue.

JSE-listed Aspen Pharmacare provides an example. Aspen Pharmacare recently announced the sale of its Chinese nutritional business, previously regarded as a key component of its investment case. Its overall debt is high, so the proceeds (if the sale is successful) will provide some very necessary de-gearing. What is interesting, however, is that most of the company’s debt (around 74%) is funded in euros, at a floating rate and with an average term of just over three years. As 27% of the company’s revenue is in euros, this means it is taking on a substantial currency mismatch.

A well-structured balance sheet demonstrates a long-term focus

A CEO and CFO who carefully structure and manage a balance sheet display the characteristics of a conservative business owner. They are prepared to incur costs today to reduce uncertainty and minimise exposure to unlikely but severe events in the future. This is excellent evidence that other, less visible business decisions are also likely to be conservative, with due regard for their potential long-term impact relative to their current costs.