Time for Companies to Load Up on Cheap Debt?

By Jay Wei - September 13, 2012 | Tickers: BRK-A, BBY, KKR | 0 Comments

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Equity investors often have this love-hate affair with their companies about debt uses. Ongoing debt servicing can put financial pressure on a company’s operations and may even threaten to reduce investment returns for equity holders. In addition, shareholders must give the right of way to creditors in claiming rights to company assets in business dissolution. But in good business times, debt leverage can amplify shareholder returns beyond what equity capital alone can deliver. All in all, debt management is not an easy task, and many value investors, most famously Warren Buffett, prefer companies with little or no debt on their balance sheet. So, what's the point to suggest that companies take on some debt?

Well, companies cannot always rely on costly equity issuance or limited retained earnings for additional capital. To grow, sometimes companies have to consider using debt, a cheaper and more readily available way of obtaining investment capital. When using debt, however, a company should keep in check its debt-to-equity ratio, making sure that potential losses from all investments including those debt-financed can be fully absorbed by its equity capital. This way, a company can stay clear of potential financial insolvency, the worst possible business outcome for equity investors.

Some of us may be surprised to see how soon borrowing-related risk-taking behaviors by businesses and consumers seem to be all coming back during the current economic recovery, even though excessive risk taking was partly blamed for having caused the recession in the first place. But at the end, economic growth is all about business expansion and rising consumer demand, which arguably relates to increasing spending and borrowing. The Federal Reserve is keenly aware of such cyclical changes in risk taking within the economy. One of the Fed's stated objectives of its current accommodating monetary policy is to promote a return to productive risk taking during the recovery.

In fact, by providing the historically low interest rates on long-term financing, the Fed has been essentially encouraging businesses and consumers to take on more borrowing for business investments and large-ticket household purchases. The declining borrowing rates have been achieved partly by the Fed’s two prior rounds of large-scale asset purchases, or LSAP. But those rates eventually will rise again upon future rewinds of the so-called quantitative easing when the Fed is ready to tighten credit and pursue a more measured economy. So, is it now the time for companies to load up some cheap debt before it‘s too late?

Some companies apparently think so. For example, Warren Buffett's Berkshire Hathaway (NYSE: BRK-A) increased its long-term debt by over 60 percent from 2009 to 2011, while total equity expanded by only about 25 percent. As a result, Berkshire Hathaway’s debt-to-equity ratio grew from roughly 28 percent to more than 35 percent during the period. Such a change in the debt level may have violated one of Buffett’s own investment and business mantras -- owning and running companies with little or no debt, especially long-term debt. So why the exception here? The answer is simple: there’s a potential gain from using some long-term financing with today’s ultra-low rates. Borrowing now can save on not only interest expense, but even principal repayment if Berkshire Hathaway decides to buy back its own debt on the open market later on. As interest rates rise on similar debt, the value of the company’s original debt decreases, meaning that the same debt can be purchased back, or effectively repaid, for less than the initial proceeds received.

So here we've got a debt memo from Berkshire Hathaway. The changing numbers in the company's debt uses and the debt-to-equity ratio are quite revealing. If a company like Berkshire Hathaway, normally averse to debt uses, is taking advantage of today's low-rate long-term financing, shouldn't other companies give similar considerations? Well, some actually have. For example, the well-publicized Best Buy (NYSE: BBY) takeover deal is said to use up to $7 billion in debt financing and an equity injection of $3 billion at most. This would equal a borrowing leverage of 70 percent, a debt-equity ratio that is much higher than the normal range of 50 percent for a typical leveraged buyout. The amount of potential debt use also dwarfs the $1.7 billion in long-term debt that Best Buy currently has on its balance sheet, which already represents a high debt-to-equity ratio of about 45 percent. I suppose that the intended heavy debt use might not have come out of the Best Buy takeover talks if it wasn't for the availability of the current low rates on long-term debt financing.

Guess who else is inherently interested in debt uses? The buyout industry. The aggressiveness in the Best Buy deal’s planned use of debt likely has been one of the reasons why KKR (NYSE: KKR), a big-name private equity firm, has shown interest in being part of a Best Buy takeover. Besides using debt as leverage in its various equity funds by pairing money raised with money borrowed, KKR also uses a substantial amount of debt in the firm's operations at the corporate level. In 2011, KKR's long-term debt was almost 20 percent more than its total shareholders' equity, representing an eye-popping 120 percent in debt-to-equity ratio. Similar studies of individual companies' debt situations may help investors better evaluate potential results of their investments in the companies.   

So what's the final takeaway for readers here? I'd like to suggest that investors consider loosening their debt filters under the current low-rate financing environment when screening target companies for investments. This is especially relevant for investors who normally adhere to strict standards on debt uses. With lower interest payments and potentially reduced principal amount, borrowing-related financial pressure on operating income can be minimized and earnings retained for equity investors may be increased.

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