April 20, 2018
With passage of federal tax reform still fresh, companies are assessing the impact – positive and negative – on their operations and growth plans. One important consideration is how the changes will affect companies’ plans to manage debt and raise capital.
Stephanie Hogue, Managing Director and head of US Debt Private Placements for PricewaterhouseCoopers Corporate Finance LLC, and Howard Friedman, PwC Deals Partner, recently discussed the implications of tax overhaul on the debt markets and how companies could respond in the months and years ahead.
Before we look into the future, where are the debt markets today?
Stephanie: We have an interesting convergence of excess
liquidity paired with limited deal flow. Just like the equity markets, the credit markets have peaks and troughs. Today, we are in the peak of a credit cycle with a significant amount of liquidity and deal flow that can’t necessarily fulfill the demand that is looking to be put to work. Ample liquidity plus constrained deal flow lends itself to sustained elevated valuations.
Yet on some level, we should be seeing the inverse. With the new tax reform and tax rates dropping, there should be some impact on valuations. A lower tax rate reduces the interest deductibility benefit, which will increase a company’s weighted average cost of capital, lending itself to a decrease in valuation. However, we have not consistently seen that yet. What we are seeing is some level of volatility but not a consistently applied downward pressure on valuations.
The other thing to consider before we launch into this is that we are talking about an $8-10 trillion corporate bond market in the US. Those are bonds only, excluding the equally broad and complex corporate loan market. Today’s debt markets are incredibly diverse, with many different types of corporates and underlying assets. And at the end of the day, debt is less expensive than equity. All of this should be kept in mind as we look at the potential impact of tax reform.
You mentioned interest deductibility. The new limits on that seem to be a concern.
Howard: Quite frankly, some people focus on certain parts of tax reform because of the headlines. Tax reform is going to affect companies differently. For instance, what a company might lose in interest deductibility they could more than compensate for with the lower tax rates. It’s just depends where they are in the extent of their leverage and rating.
Stephanie: Right, it’s not just about the reduction in interest deductibility. Companies have a reduction in tax rate but also can take advantage of capital expenditure deductions. Companies need to look at the full scope of tax reform to understand what it could mean for cash flows and investment opportunities. For example, companies may decide to increase capex in the next few years, or PEs may go long on businesses that require intensive capex, like infrastructure or manufacturing, in the coming years. They can then take those deductions immediately in the early years to offset the interest deductibility loss. Or PEs can buy businesses that have tax losses and operating losses that they can then carry forward. The entire story is important, not just headlines, as Howard referenced.
Given those factors, which companies could face problems when it comes to issuing debt and raising money for deals or other big moves?
Stephanie: You really have to bifurcate the credit spectrum. Broadly speaking, investment-grade issuers are low on leverage anyway. If you take the idea that reduced interest deductibility means investment-grade issuers will be less active, you could see a spread compression to reduce the overall cost of debt, which could offset a rising Treasury yield. Right now, there is some room – not a lot, but some room – for spreads to compress a little bit.
That said, over the longer run, this story may change. If we go back as far as 2007, before the financial crisis, Libor was hovering around 5%. Today, it is around 2%. If base yields rise to comparable levels, it will not be possible for spreads to compress enough to offset that rise in rates. In the short run, I think tax reform is largely net positive for investment-grade companies. They get the benefit of the lower tax rate but aren’t hurt by the interest deductibility. Not to mention many of them have cash on hand and can invest in capex and write off the expense.
When you look at high-yield issuers, the closer they are to the investment grade cross-over, the less the impact of tax reform will be. Where I see the greatest risk for material impact is the CCC range and below. Those issuers really do rely on the ability to deduct their interest to reduce their cash taxes and do not have the cash buffers necessary to retire debt or invest in capex. As we look to the lower part of the credit spectrum, interest rates become higher given the higher leverage, but they also are more exposed to rising rates, as they do not have the advantage of ultra-long tenors of debt. So in the instance where interest rates continue to rise, these issuers will be hit with both higher rates than today, lower interest coverage ratios and a more restrictive measure of interest deductibility as tax reform moves from an EBITDA metric to EBIT.
Today, defaults are at a fairly low level, but as we look to 2020, the question is whether we will see greater defaults from these companies as they try to navigate through all of the changing factors. I see a similar risk for privately held companies with floating rate bank debt and leverage higher than can be supported in a rising rate environment.
Is there anything those issuers can do to avoid that hit?
Howard: A lot of the work we’re doing now with companies is trying to help them forecast 2018 – helping them figure out going forward what really is the net impact and how to consider that impact on their capitalization strategy.
Stephanie: We’re just starting a maturity wall, in which, according to Moody’s, about $400 billion of high-yield issuance will need to be either repaid or rolled over in the next few years. At the same time, the Fed is expected to raise rates three or four times this year. So those high-yield companies that don’t get the benefit of the interest deductibility are refinancing in a rising interest rate environment. Their debt is more expensive.
If base rates go up as much as 1% in the near future, it’s not such a big deal. But what happens later in that maturity wall, between 2020 and 2022, when the US Treasury or Libor rates have meaningfully increased? Not only is the base rate higher, but things like interest coverage start to decline. A company could appear closer to distressed, and the spreads become much higher, creating a downward cycle. Companies should be thinking about prepaying or repaying debt, or locking in longer-term fixed rate debt to protect against that cycle. The key is proactively starting to plan for those changes that are 12 to 24 months away.
Howard: And there are alternatives between debt and equity. Some of these companies can access the direct lending market to mitigate some of that downside – like convertible preferred or instruments that are a little bit more costly than bank debt but cheaper than equity. There are options like that, depending on where they’re coming out.
Stephanie: This is an important point. If you compare today versus the financial crisis, there is a convergence with private equity and private debt funds, as well as different instruments. Broadly speaking, pre-crisis, banks held loans and institutions held bonds. Today, we see institutions underwriting loans in the middle market. The same investor will look at both a loan and a bond. Similarly, we have this with funds. PEs have direct lending arms to lend to private companies. They may have equity-like returns but they are non-dilutive and sit as debt in a balance sheet. They’re structurally more creative, offering optionality like the ability to have payment-in-kind (PIK) interest or sculpt an amortization profile. This may allow a company short-term cash flow relief, while offering the fund their hurdle rates.
The alternative lending universe is so different than 10 years ago. Now companies have a number of different options, and they can be more creative in how they structure the debt to access the capital markets. Most importantly, these investors offer liquidity and optionality to lending that can provide cash stability to companies through cycles.
Have we started to see any of this yet, or is tax reform still too new?
Stephanie: Companies are just starting to talk about it in detail. As Howard mentioned, tax reform is impactful at different points in the credit spectrum, and it is the most impactful the farther down you are in the credit spectrum. On the high-yield corporate side, companies will either refinance or repay, or they’ll have to come up with structural alternatives like convertible notes or issuing more equity and diluting shareholders. For investment-grade issuers, the short term is likely business as usual. And then there are areas of structured finance, like collateralized loan obligations (CLOs), that we have not touched on but could be impacted under the new guidelines.
Howard: This just hit at the end of December, when most companies went into year-end. Most are just in the process now of starting to forecast what the real impact will be. While new financings will and should be considering the impact of tax reform, we don’t expect to see big changes in the near term. This will play out significantly as companies are in refinancing scenarios and facing the debt wall Stephanie referred to earlier.
Stephanie: Absolutely right. That’s really the key when we think about tax reform and the debt markets. A company should assess what it’s trying to achieve and look at its capital structure and balance sheet. Then it can refine the lenders and the types of capital based on strategy – whether that’s acquisition strategy, long-term planning or accretion with shareholder returns. It’s a chance for companies to reset and match the two together.
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