Time for risk to return

Debt and what’s next

risk capital

Peter Morris looks at the trend for equity investors to expect a bail-out when they become badly exposed instead of having to put up more of their own money

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The turn of the year is a time for nostalgia, so why not in corporate finance, too? Many readers will remember a distant era when equity was ‘risk capital’. Shareholders invested in companies knowing that their role was to absorb downside risk. In return, they could receive a share of the company’s profits in the form of dividends. Since profits are variable, dividends also would be: no profits, no dividends. If things went well, both profits and dividends would grow over time and see the equity’s value rise. But if things went less well, equity investors accepted they might have to put up more cash to support their investment. Potentially, they could lose it all.

Debt, meanwhile, was once a secondary source of financing. Used in moderation, it would spice up returns a little. But neither lenders nor equity investors wanted debt to put the flow of dividends or the equity value at risk. Unlike equity, debt has to be repaid. The prudent way to get repaid is out of a company’s surplus cash flow. That’s why home mortgage lenders, for example, have traditionally insisted that borrowers repay their loans out of their earnings. Interest-only mortgages do exist, but they are risky because repayment depends on a combination of refinancing and house prices.

Even before the pandemic, this picture of prudence was acquiring a nostalgic glow. Over the last generation, some equity investors have learned how to shift from acting as society’s shock absorbers to shock amplifiers. Instead of absorbing risk, increasingly they have become able to shift the risk to others – without forgoing risk premiums. Covid-19 has only reinforced this long-term trend, and one easy place to observe that is the airport sector.

Come fly with me

Once upon a time – 20 or 30 years ago – most of the world’s airports belonged to the public sector. Then came privatisation, closely followed by the invention of ‘infrastructure’ investment. Although no one ever defines it clearly, the term infrastructure generally carries the implicit promise of great stability – ie very reliable cash flow. That has enabled high levels of debt. This, in turn, has fuelled higher returns than one might otherwise expect from the sort of stodgy assets that the word infrastructure suggests – including airports.

Instead of absorbing risk, they have been able to shift the risk to others – without forgoing risk premiums

But airports are one of the sectors that the pandemic has left badly exposed. It turned out that risk for airports was not as low as everyone assumed. In theory, or in the fairy tale, equity investors who used the most debt are most exposed. In practice, they seem to see things differently.

Ferrovial, the Spanish construction company, bought BAA, the British airports operator, near the top of the pre-financial crisis market in 2006 for £19bn. That included a sizeable mortgage: £13bn of debt, producing a loan-to-value ratio of two-thirds. (Figures are based on the author’s analysis of Companies House filings by FGP Topco, the holding company that owns Heathrow.) The rationale was that BAA was “a high quality asset expected to deliver attractive cash returns over the very long term”. What could go wrong? Over the past 14 years, Ferrovial has brought in other global infrastructure investors, including, in 2013, the UK’s Universities Superannuation Scheme.

Competition concerns have forced BAA, which changed its name to Heathrow in 2012, to slim down its airport operations since 2006 to just Heathrow. Operations that have been sold have contributed a collective £7bn to Heathrow’s coffers over the years. So it would be easy to assume that Heathrow’s debt load has fallen since 2006.

Not a bit of it. At December 2006, BAA’s many airports were shouldering net debt of £13.5bn. Thirteen years later, despite collecting £7bn from airports that have been sold, Heathrow went into Covid with net debt at December 2019 of £15.8bn. The company itself publishes a debt ratio that measures the relationship of net debt to the Regulatory Asset Base. This ratio rose steadily – meaning risk was increasing – from 81.6% at December 2012 to 86.5% at December 2019, just before the pandemic.

It did not have to be this way. Heathrow’s owners can point to £12bn of capital spending over the years, but they have had to spend £8bn just servicing debt. That is because they chose to start out with such high debt levels. And, since 2012, they have also chosen to take out £4bn in dividends.

Heathrow’s owners could have chosen to use that £4bn in a different way. For example, they could have reduced Heathrow’s debt load by nearly one-third. But apparently the temptation to reward themselves was too great. Although the investors had to wait six years to receive their first dividend, they have been catching up with a vengeance. Since 2012, Heathrow has paid out more in dividends than its cumulative net income over that period. Investors have now recouped two-thirds of their original investment.

Heads I win, tails you lose…

In the long-ago world of risk capital, Heathrow’s investors would have recognised that when they chose to reward themselves with dividends instead of de-risking their balance sheet, they were upping their ante. Covid-19 has now exposed that risk for what it was. In that other age, shareholders would have accepted the consequences of the risk they took by putting up more cash to protect their investment.

But that was then. A recent article in The Sunday Times shows how things have changed. Heathrow’s owners are reportedly demanding a £2.7bn ‘bailout’. In return, they are generously offering to forgo any dividends in 2021 and 2022, before resuming thereafter at a reduced annual rate of £400m compared with the £600m rate they had previously expected. In effect, Heathrow’s owners are prepared to forgo £1bn of near-term payouts in return for a £2.7bn bail-out.

The most striking part of the article is the language Heathrow is quoted as using: it reportedly describes the £1bn dividend give-up as “aggressive forbearance” by shareholders. This is a clue to the topsy-turvy world of modern corporate finance. Dividends used to be a contingent reward that shareholders earned in return for bearing risk. But Heathrow’s language suggests a sense of entitlement to dividends.

No one wants Heathrow to go under, but its shareholders do not have special rights. It makes at least as much sense for the taxpayer to support many smaller businesses that have taken a hit from the pandemic.

In effect, Heathrow’s owners are prepared to forgo £1bn of near-term payouts in return for a £2.7bn bail-out

Heathrow itself is not the point here: it is only one example of a broader issue that predates the pandemic. High financial risk has been rewarded in many areas over the last generation, including infrastructure investment and private equity more broadly.

Banks received explicit bail-outs 10 years ago, even though they had simply made too many bad bets. Then a decade of quantitative easing rewarded big borrowers long before Covid-19 arrived. And now we have the pandemic. A bill will come due eventually, when risk and return in capital markets get recalibrated. Only time will tell how and when this story ends.

Peter Morris

Peter Morris worked for 25 years in financial markets, most recently at Goldman Sachs and Morgan Stanley. He now works in social investment and is an associate scholar at the Said Business School, University of Oxford