Aug 03, 2020
Posted by Michael Spellacy  FORBES 

Uncertainty has abounded in financial markets over the last few months, but one thing is becoming clear - many companies cannot borrow their way out of this particular economic crisis. That is why the world’s major stewards of capital, whether they are investment banks, private equity players or asset management firms, are busy adjusting to a third phase of the credit cycle: equity financing.

Taking ownership might be the only realistic prospect of ensuring the core solvency of entire industries and their associated ecosystems, but it is unfamiliar territory for some players. Take investment banks, who are used to making loans, and then sitting back to wait for repayment of principal and interest. These players are about to discover that the hard and fast rules that govern the debt markets, such as contracts and the law of covenants, do not apply in the equity financing arena. 

If you missed phases one and two, here’s a quick recap. When Covid-19 hit, we saw heads of state leap into action to throw billions of taxpayer dollars after the pandemic. Hot on the heels of these government stimulus packages was broad financial industry support, with the banking sector serving as the main conduit for debt solutions, which ranged from listed companies issuing high-yield bonds to small firms opting for direct lending.

But these measures will not be enough to get liquidity coursing through the system again. Part of the reason is that we have crossed a threshold in terms of risk and perception. Let’s take the evolution of the direct lending market: In recent years, leverage levels have crept up while contractual terms have weakened – a phenomenon described in the industry as covenant-lite.

A decade ago, around a third of transactions were covenant-lite. Now that is more like three-quarters. As we start to see the core issues and questions of solvency come to light, the law of covenants will no longer make any business sense, and it will become a dead letter. This explains why the industry moved to the third phase and went down the route of equity financing.

We’re already seeing these dynamics play out on both sides of the Atlantic. In Germany, Lufthansa shareholders have overwhelmingly approved a €9 billion ($10.1 billion) government bailout. As part of the deal, the German government will take a 20% stake in the airline with two seats on the supervisory board. In the U.S., the government has taken a near 30 percent stake in troubled trucking company YRC Worldwide in exchange for a $700 million loan.

These examples throw down the gauntlet to capital markets firms of all stripes to service the world’s struggling companies in a similar fashion. But funds, asset managers and PE houses will need to pick their battles. Some equity financing maneuvers can rescue important businesses, and simultaneously safeguard wider national economies. For example, keeping a giant airline solvent could help protect a country’s hospitality, gaming and retail sectors, as well as its airline manufacturing industry and other supply chain partners.

The normal rules of capitalism are to let the fittest survive. While competition is important, is it so important that entire industries have to fail, rather than protecting and saving them? The balance is an important issue that financial services firms will need to consider. 

The Path Forward: Innovating Product Offerings Will Be Key

The capital markets ecosystem can be the key driver of change during this time of transition, pushing itself to innovate its product offerings and provide more equity.

They can be the ones to structure the debt-to-equity conversations, channelling credit via equity stakes through simplified regulation, taxes, or through listed corporates to finance supply chains. While PE and buyouts are one mechanism, new equity solutions can be created that really focus on supporting SMEs, with EFTs and funds who can invest in SMEs at scale. In addition, Emerging markets could be another area where capital markets provide critical equity solutions.

There will some teething problems for capital markets players, such as regulation, taxes and the challenge to find the optimum ratios of private: public and private: private ownership for which the purchase of equity can be handled effectively and still be a profitable venture. But devising the goldilocks equity financing recipe and environment looks like a tiny issue next to the challenge of replicating at scale.

This is also a realm where solutions begin to mend and get flexible, which offers a huge opportunity for next-generation analytics to manage risk and restructure product offerings.

Firms can harness predictive data analytics, machine learning and other AI software to finetune decision-making models and increase digital lending options. The same tools will also allow them to quickly illuminate risk concentrations in their portfolios, identify pockets of resilience, and stress test their businesses.

One of their primary objectives in this regard will be assessing the impact of Covid-19, but similar technology can also beef up their fraud and cybersecurity defenses, expand their stress-testing capacity, and streamline automation capabilities to improve processes.

This means capital markets firms should continue investing in technology that allows them to differentiate themselves during the third phase’s feeding frenzy. Equity financing will also require some cultural adjustment as banks shift their focus from short-term profit maximization to customer lifetime value.

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