Should companies prefer to be financed by debt or private equity?

Debt finance and Private equity investment are two popular options when financing growth. Which option is the best for your business?

Is debt still a good way to finance your company?

In the past few years, UK and global companies have shifted their capital structure from equity financing to debt financing. The reason was the belief that interest rates would remain permanently low and are encouraged by the tax deductibility of interest cost compared to dividends. The assumption was fair. Government debt levels are very high, which should suppress government yields, and thus corporate yields, for the foreseeable future. Even at 8% inflation, the UK 10-year yield is lower than 10%. As a result, debt (short and long term) for the FTSE All-Share has risen by 43% from 2018 to 2020 and by 30% until April 2022. At the same time, the median FTSE All-Share company has extended its outstanding shares (equity financing) by less than 1%. However, we feel that this practice may well be challenged over the coming period. Corporate spreads (the difference between the government and the corporate yield) have been rising since the beginning of 2022, as a result of a more aggressive rate policy by the Bank of England. As the cost of debt rises, companies may need to start to rethink the way they are financing themselves. 

Should companies instead opt for Private Equity?

Momentum for private equity is certainly high. There are record levels of “dry powder” as a result of successful fundraising by existing and new Private Equity Funds over the last 5 years and a more circumspect investment environment in the run-up to Brexit and the onset of the pandemic. This has led to an increasing need for those funds to deploy capital, coupled with the desire by an increasing number of companies to utilise private equity financing to fund growth. The UK’s private equity market saw 1,545 deals for 2021, worth £15bn. This is 400 deals more than 2020 and 300 deals more than 2019. However, the focus of that investment has been on companies that have demonstrated an ability to grow during challenging times and who are likely to benefit from the structural changes resulting from the pandemic – for example, two-thirds of last year’s deals were in the Tech and Telecom Sector. The increasing impetus for and focus on ESG (Environment, Social, Governance) is also driving Private Equity investment with a number of dedicated funds forming focused on this part of the market.

What is interesting is that in 2020, the average valuation was 8.7x earnings, whereas in 2021 that number rose to 9.6x. Global Private Equities sit on an estimated $2tn of unused capital. With global inflation running at 6.7%, its highest level in a generation, holding that capital as cash will become significantly counterproductive, unless it is put to work generating a higher return. This means that all other things being equal, as demand for investment opportunities continues to exceed supply, Private Equity Firms should be willing to pay even higher multiples than previously, in order to put their money to work.

So how should companies finance themselves?

Many companies will need extra financing, as they wrestle with new supply chain and ESG realities. Corporate CFOs will certainly become more apprehensive about debt financing, as the UK central bank is set on increasing the cost of debt significantly this year.  

Yields are set to go higher, and the cost to refinance the debt incurred could remain high in the years to come.

This being said, over the last 10 years, there has been a significant rise in alternative sources of debt funding in the UK market, beyond the typical high street banks. This has included the significant increase in specialist Asset Based Lenders and private debt funds, providing more options for CFOs that sit somewhere between traditional high street debt and equity.  These ‘alternative’ debt funders are often able to lend at higher leverage multiples than traditional high street banks, and the higher interest cost that this attracts is balanced by more flexible structures such as non-amortising loans, less strict covenants and fewer restrictions on the use of this capital which means that debt capital from such sources has been used to fund activities which historically would have required equity finance.

On the other hand, choosing to go public (Public Equity) in a very volatile, post-Quantitative Easing environment, could be dangerous. Stock markets are fairly unpredictable. While they remain high and offer much more attractive valuations than private equity (on average at least 50% higher), investor preference for equities is mostly a result of aversion to debt and fear of commodity volatility. An economic recession could push prices and the earnings multiples investors are willing to pay downward. 

It stands to reason then, that many companies, listed or otherwise, could decide to reduce risk and opt for private equity financing over debt financing, even at lower multiples.

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