Big shocks can undermine any balance sheet

This is one of a series of columns that were produced for Moneyweb Investor in which Stuart Theobald explores the intersection of philosophy of science and finance. This followed an earlier series for Business Day Investors Monthly on the same theme. This column was first published in May 2014.

Corporate finance can be a beautiful thing. Equity and debt are two soloists before an audience eagerly watching for signs of risk, backed by the orchestra that is the economy at large. When done it right, the performance provides a powerful foundation for companies, countries and even the world’s economic system. When it goes wrong, the result can be a cacophony, but amazingly the orchestra plays on.

A balance sheet is a risk management device. It should be built to handle the vicissitudes of the economy, a system that will deliver disappointments and successes that are impossible to predict. It is not, however, all powerful. Too big a shock can undermine any balance sheet.

The basic structure of a balance sheet is simple enough. Think of it as a casacade of insurance. Ordinary shareholders, such as those who buy shares listed on the JSE, are the primary underwriters of the performance of the company. They take the most risk on their shoulders, put their money on the table first. They will never get it back if the company performs much worse than expected. On the other hand, if it exceeds expectations, then shareholders are the ones who benefit, getting a bonus for having taken on the risk.

Debt holders are effectively insured by the shareholders. They lend the company money in return for a fixed return, an interest payment which usually varies according to prevailing rates in the economy. The debt holders risk losing their money, but only after the shareholders have lost all of theirs. So the risk they face is considerably less. Then there are hybrid instruments between the two, such as mezzanine debt which pays a higher interest rate but is the next tranche to fall if a company gets into trouble.

This basic structure underpins the complex adaptive system that is the economy as a whole. Shareholders spread their exposures widely. They study companies carefully. They signal their perceptions by moving prices on publicly visible stock exchanges. They oversee boards of directors and empower them to manage the company in such a way that expectations are met or exceeded. They calibrate their exposures to tune their own balance sheets, with more vulnerable shareholders shifting to lower risk prospects while large long term investors take on extra risk with an expectation of earning higher returns. Bond holders watch the performance carefully, drawing out lessons for their own exposures, ensuring that they understand the risks in their own balance sheets. Governments watch the drama too, using it for clues as to what potential tax revenue will look like and whether policy is having desirable effects on the economy. So an outcome of effective corporate finance is that a whole country can carefully manage its risks. But it goes even further – countries use the global financial system to manage their risk too. Foreign exchange reserves and sovereign wealth funds allow states to diversify their risks from their home economies while allowing their companies and citizens to do the same with their personal balance sheets. That has spill over effects into the liability side of a country’s balance sheet, with global diversification, as well as a sophisticated domestic financial system, lowering a country’s risk profile. That means it can raise capital from the rest of the world more cheaply, as those investors in turn calibrate their own risk exposures. Among it all, individuals can manage their risks, primarily to ensure they have the resources to live comfortably in retirement, while benefitting from the companies and other institutions that couldn’t exist without the risk management the system provides. The whole system forms a remarkable organic whole that must rank among the finest achievements of human creative endeavour.

Of course, it can go wrong. Witness the recapitalisation of Edcon, the massive damage a sovereign downgrade can have, and the global financial crisis. All of these are examples of the system being shocked by unexpectedly poor outcomes, lines being crossed in which the structure of balance sheets collapse. Edcon has seen its equity entirely whipped out, with Bain Capital giving up and handing over the company to its creditors, who have been forced to swap R20bn of their R26bn debt exposure into equity. Sovereign downgrades, like that of Turkey recently and Brazil before it, fundamentally alter a whole country’s balance sheet, forcing it to effectively reduce debt and increase equity in the form of tax revenue. The financial crisis is the closest in modern times we’ve come to a system-wide collapse, in which the entire basis for risk management across the economy was tested.

Yet, while all of these put severe stress on balance sheets, if anything we’ve becoming better than ever at managing the consequences. The fact that Edcon was able to restructure its balance sheet rather than tip into bankruptcy is remarkable. That countries can be downgraded and forced into conservative fiscal positions provides an important pressure valve that makes the system work. The fact that governments could intervene forcefully during the financial crisis showed that the system is capable of intensive resuscitation efforts, that we are not condemned to death when the economy becomes ill, that the system has remarkable powers of resilience and self-healing. And the more we recognise the remarkable benefits this system delivers, the more resilient it will be.