A margin of safety is a wonderful thing for a company. It could be an unassailable market position, an industry-leading level of competitiveness or similar. As investors, we love margins of safety. It gives us confidence that companies can overcome challenges and therefore confidence to buy or hold onto investments when times are tough. Sometimes, bondholders will blithely say that a large ‘equity cushion’ is a margin of safety. An easy way to think of the equity cushion is how much the equity market loves the company in question. Of the total valuation of the company, how much is equity versus debt? The theory goes that if a company has a significant amount of equity value relative to its debt then bondholders are protected – the equity market will support the company. This is dangerous.
An obvious and topical example of this going wrong is WeWork. The company is notoriously lossmaking and much has already been written about its financial position and business model. But the bull case for bondholders has, in our view, an undue reliance on the massive equity valuation of the company, courtesy of SoftBank’s Vision Fund. While the bonds haven’t traded particularly well over their life, they recently looked like a slam dunk as an IPO loomed. When a company is private and the equity cushion can be quite uncertain, an IPO is the Holy Grail; it provides confirmation of the market valuation and typically comes with a debt reduction kicker. But WeWork’s valuation wasn’t what was hoped – investors balked at the price relative to the real fundamentals of the business. The IPO gave them an initial valuation of almost $50bn, but was soon drastically cut to $10bn. This was still not enough to entice investors, and the IPO was withdrawn – and CEO Adam Neumann was forced out. The equity cushion was vaporised, and so has the supposed bondholder margin of safety.
It isn’t just ‘new economy’ companies like WeWork that can suffer from the vicissitudes of equity markets. Petrobras is the state-owned Brazilian energy company. They supposedly had two ‘equity cushions’, one from a chunky market capitalisation (in 2013 this was $124bn of equity vs $95bn of debt) and one from the protection of state ownership. But in the energy crisis Petrobras’ market capitalisation was destroyed, so much so that in 2015 it was only $22bn versus $124bn of debt. Equity cushions work for as long as the equity market keeps believing in the story, and as long as the market and sector isn’t in meltdown.
The key message here is that we don’t rely on the benevolence of equity owners as a fundamental part of our investment thesis. We lend to companies that we like, based on our bottom-up analysis, and can clearly persist past their next debt maturity whether equity markets are in meltdown or not. A company that thinks it can rely on the equity market to fund it in extremis may find itself in danger if the equity market loses faith in the story.
Equity cushions exist… until they don’t.
Kames Capital does not hold WeWork